CAPITAL STRUCTURE DETERMINANTS OF GERMAN [629334]

CAPITAL STRUCTURE DETERMINANTS OF GERMAN
SMEs: THE POST -UNIFICATION ERA

ABSTRACT

This study investigates the determinants of capital structure behaviour in small and
medium sized firms (SMEs) of former East Germany and West Germany in the outset of the post-
unification era.
Financial data including asset structure, firm size, net debtors, non -debt tax shield, and
liquidity among other factors were tested using descriptive and multi -variable regression
analysis to examine effects on dis -aggregated levera ge models. Observation from 3,458 firms
were analysed using the latest statistical program to test the hypotheses developed from
validated literature.
The results were consistent with previous literature with regards to the overall effect of
the predictor variables. Asset structure, firm size, stock level, net debtors and liquidity were
significant determinants of short and long -term debt financing. Profitability and non -dent tax
shield were only significant determinants for long -term financing decisions f or West German
firms. Not only were firm specific factor important, but also financial restrictions and the
prevailing lending -gap present at the time.
The paper contributes to the existing literature by examining capital structure of German
SMEs in the l ight of convergence of East with West Germany after unification and how capital
structure behaviour changed within this transition.

Keywords: Capital Structure; Small and Medium Firms; Germany, Financial Leverage.

INTRODUCTION1

The Modigliani -Miller (1958) theorem, forms the basis for modern thinking on capital
structure, examining real world reasons of why capital structure is relevant, that is, that a
company's value is affected by the capital structure it employs. Since then, a rich theoretical
literature has emerged that sculpts a firm’s capital structure choice under different theories,
assumptions and incorporate more realistic and fundamental factors, such as corporate and
perso nal taxes (Miller, 1977), bankruptcy costs (Myers and Pogue, 1974), and agency costs
(Jensen and Meckling, 1976), formulating the ‘Trade -off Theory’; information asymmetry, or the
‘Signalling Theory’ (Ross, 1977); and Myers and Maljuf (1984) who elaborated and brought out
the ‘Pecking Order Theory’ originally developed by Donaldson (1961).
An extensive amount of the empirical research so far has been largely confined to large
publicly listed companies in the United States and other international capital ma rkets (Zingales,
2000; Myers, 2001; Karmel and Bryon, 2002). Much of the earlier literature on the financing of
SMEs emphasised the difference between SMEs and large sized enterprises (e.g. Walker and
Petty, 1978), considering the question if it was approp riate to apply the theory of large publicly
quoted companies to firms in the SME sector (Cosh and Hughes, 1994, Chittenden et al., 1996,
Hughes, 1997, and Berger and Udell, 1998). Thus, it is important to shed some light on the
capital structure of these f irms.
The substantial contribution of SMEs to national economies, particularly in terms of
employment, was first highlighted by Birch (1979). It is widely known that SMEs represent a
vast portion of the population of firms of almost every developed countr y and are the ‘real giants
of the European economy’ (The European Commission and Eurtostat, 2001; Observatory of
European SMEs (2002); Voller, 2008). Since then, financial theories have been developed to

explain capital structure of small and medium sized firms in the realization that these firms play
an essential and increasingly vital role in a country’s economy (Berger and Udell 1998,
Michaelas et al. 1999, Romano et al. 2000, Gregory et al. 2005).
An important question in the Small and Medium Sized Ent erprise (SME) literature is the
definition of what is really considered as an SME as these companies are often very
heterogeneous. As Stanworth and Curran (1976) indicated, “defining the small firm is in itself no
easy task”. Over the many years of its exa mination, many scholars have used varying criteria to
define small to medium sized firms to the extent that the central distinction between large and
small firms had to do with the external uncertainty of the environment and its impact on the
internal cons istency of its motivation and actions (Pavitt et al. , 1987; Scott and Bruce, 1987).
This study examines small and medium sized firms in both former East and West
Germany and how their transition post -unification has altered the determinants and behaviour of
capital structure financing. The key feature of this study centres on the effects the unique
circumstances present in Germany have on these SMEs in order to determine the degree of
convergence between East Germany, as a transition economy, and West Germ any in the post –
unification era at the outset of the 1990s. In Germany, the term ‘Mittelstand’ is used as a
terminology to represent SMEs and to a certain degree is identical to the above mentioned
criteria definition, only in that it also comprises of cha racteristics which cannot readily be
identifiable from mere official statistics. Therefore, using only statistics to represent the

Mittelstand’s economic and social functions neglects the fact that the Mittelstand plays a very
important role in the dynam ic, competitive and market oriented economy of Germany
(Günterberg and Kayser, 2004).
The border line that defines SMEs and its larger counterparts is inherent above all in two
criteria, namely the number of employees and annual turnover. Given the intern al contradiction
in its philosophy, the German economy is both conservative in the sense that it draws on the part
of the German tradition that envisages some state role in the economy and a cautious attitude
toward investment and risk -taking; while dynami c in the sense that it is directed toward growth,
even if that growth may be slow and steady rather than spectacular. It tries to combine the virtues
of a market system with the virtues of a social welfare system. With German reunification in
1990, the Eas t German economy has been challenged to be transformed from a centrally planned
economy to a competitive market economy with the same standard of living as in West
Germany. Consequently, the banks have been asked to finance the transformation of formerly
state owned East German firms and the foundation and growth of new firms.

Background and Hypotheses

Taking into consideration the rules established by agency theory, the pecking order
theory and the signalling approach, and bearing in mind the unique char acteristic that the SME
presents, it seems reasonable to examine the qualitative and quantitative factors of the capital
structure of German SMEs. The variables chosen to represent the explanatory side to capital
structure follows a mix of work from past a nd present literature and includes Asset Structure,
Stock level, Net debtor, Profitability, and Liquidity upon which the hypotheses are developed.
Moreover, just as important as the influence of these predictors have on total leverage, the
examination of s hort and long -term debt may reveal important results.
In its many years of use, asset structure has been the predominant factor in explaining the
financial behaviour of firms in both corporate and SME literature. Firms whose assets are
suitable as securit y for loans tend to use debt rather heavily and various studies have confirmed
positive associations with asset structure. The ‘close’ nature of most SMEs makes the problems

of information asymmetry more severe for them, causing lenders to rely particularl y heavily on
collateral to mitigate those problems. Evidence for small firms suggests a positive relationship
between asset structure and long -term debt, and a possible negative relationship with short -term
debt (Van der Wijst and Thurik, 1993; Chittenden et al, 1996; Jordan et al, 1998; Mira (2002)
and Hall et al, 2004). Furthermore, Daskalakis and Psillaki (2005) do not discriminate between
long and short -term debt in their study but predict that in the event of a negative relationship
outcome between ass et structure and leverage may signal that firms use more short -term debt in
their capital structures than long -term debt. This may well be the case for German SMEs, and
more profoundly for those firms in East Germany where the lack of long -term financing i s
substituted for short -term financing. With the lending gap existent between East and West
Germany, East German SMEs have more difficulty in attaining the leverage they need to operate
than do West German SMEs (Lehman et al 2002). These financial restrict ion in the lending
relationships with banks, would force East German firms to have to come up with greater amount
of tangibles as collateral, especially in the earlier years of unification. Therefore, the hypotheses
for the relationship between asset struc ture and the leverage measures stipulates:

H1a Asset Structure is negatively related to Short -term debt
H1b Asset Structure is positively related to Long -term debt

Generally, smaller firms are expected to have less debt because of the higher costs in
resolving information asymmetry problems. Several studies indicate to a positive relationship
between size and leverage, suggesting that as firms grow, they tend to take on more leverage, but
also become more diversified in their projects, ultimately reducin g the probability of failure
(Warner 1977; Smith and Warner, 1979; Ang et al. 1982; Bradley et al. 1984; Long and Malitz,
1985; Pettit and Singer, 1985; Harris and Raviv, 1991; and Rajan and Zingales, 1995). A positive
relationship between size and leverag e is also viewed in support of the “asymmetric information"
argument (Myers and Majluf, 1984) because small firms are unlikely to have adequate and
reliable financial statements.
The association the size also has a tendency to be negative when short -term liabilities are
used to represent leverage because of the Quasi -equity and debt confusion of and characteristics
inherent in small firms (Ang, 1992; Cassar and Holmes, 2003). In addition, long -term debt is
likely to be proportionately more expensive for sm all enterprises because of the significant
transaction costs involved which can be mitigated by the use of short -term debt. For the SMEs in
Germany, it is expected that smaller firms will have more leverage in their capital structure,
especially of short -term debt and less of long -term debt. In light of this, it can be hypothesized
that for German SMEs:

H2a Firm Size is negatively related to Short -term Debt
H2b Firm Size is positively related to Long -term Debt

In explaining the relationship between ‘Stock ’ level (i.e. inventory including plant and
equipment) and leverage, this study views the role of stock as security pledged against debt.
Myers (1977) suggested that representing assets in stock may increase agency cost problems
because of the positive rel ationship between stock and growth opportunities; and that firms can
mitigate these agency problems by issuing short -term debt. Michaelas et al (1999) also believe
that Myers’ (1977) proposition is more applicable in the small business context where the tr ade-
off between independence and availability of finance is likely to be highlighted and where much
debt is of a short term nature. However, Van der Wijst and Thurik (1993) and Hall et al (2004)
suggest that firms with higher stock levels within their asse ts generally will have less leverage

regardless of its maturity. Whether the stock levels of the German SME samples examined in this
study do contain opportunities for growth will be left for future research, but may however aid in
the explanation of the o utcomes from this study. For the purpose of this study, Stock remains an
asset that can be pledged as collateral which would suggest that a positive relationship exists
between stock and leverage, especially of short -term maturity. Therefore the hypothesis for this
variable is that:

H3a Stock is positively related to Short -term Debt.
H3b Stock is positively related to Long -term Debt

Net debtor like some of the other variables examined in this study has not received much
attention in the finance literature but was only recently included in the corporate and more
recently SME capital structure literature. This variable measures the effect of the excess of
debtors over creditors and is the ratio of debtors less creditors to total assets (Hall et al, 2004).

Chittenden and Bragg (1997) argued that because shareholder interests and long -term
loans represent a smaller percentage of a small firm’s liabilities, there appears to be less scope
for accommodating late payments of receivables by increasing equity or lo ng-term debt. As a
result, the two main avenues open to small firms suffering from late payments, are to increase
short -term bank borrowing, or delay payments to creditors (Michaelas et al, 1999). However, it
has also been shown by Chittenden and Bragg (19 97) that delaying payments to creditors cannot
be taken beyond a certain point, thereby it can be expected that small firms increase short -term
bank borrowing when suffering from late payments. Although, the effect of trade debtors and
creditors on capital structure are not mentioned in the finance literature, this study proposes that
the higher the net debtors, the greater the need to borrow and the higher the debt levels,
especially short -term.
Following Hall et al (1996), for the German SMEs in this stu dy, it is predicted that:

H4a Net-Debtors is positively related to Short -term Debt.
H4b Net-Debtors is positively related to Long -term Debt.

According to tax based theories, taxpaying firms would be expected to substitute debt for
equity, at least up to the point where the probability of financial distress starts to be important.
However, in practice firms do not follow this policy. The lack of maximum use of debt is
particularly apparent in small firms, with survey results (for instance, Ray and Hutchins on, 1993)
showing that many small firms do not use any debt. Furthermore smaller organizations derive
less benefit from the tax shelter of deductible corporate interest (McConnell and Pettit, 1984;
Ang, 1991, 1992); and the greater the potential bankruptcy for small business implies that
smaller firms should use less debt than their larger counterparts (McConnell and Pettit, 1984 and
Pettit and Singer, 1985). Among the literature on non -debt tax shields, Chiarella et al (1991),
Michaelas et al (1999), Hall et al (2000), Mira (2002) and Gajdke (2002) find support for a
positive relationship of non -debt tax shields to short -term debt, a negative relationship with long –
term debt and total debt. Accordingly, and following previous studies, it is hypothesized her e
that the greater the non -debt tax shields and therefore the increased need for investment, the
greater the amount borrowed.

H5a Non-Debt Tax Shield is positively related to Short -term Debt
H5b Non-Debt Tax Shield is negatively related to Long -term Debt

Myers (1984) and Myers and Majluf (1984) argued that there exists a hierarchy in the
financing of companies. Given the information asymmetries between firm profitability and the
higher costs associated with external capital, firms that are profitable wou ld have a preference
for internal financing rather than using debt. Therefore, the relationship between profitability and
leverage should be negative. Empirical evidences from previous studies show that a negative
relationship between debt and profitabilit y to exist which are consistent with Myer’s (1984)
Pecking Order Theory (Wijst and Thurik, 1993; Chittenden et al , 1996; Jordan et al , 1998;
Colema and Cohn, 1999; Michaelas et al, 1999). Simply put, a firm which can generate more
earnings will borrow less , all things equal (Adedeji, 1998). However, Jensen (1986) argues that
the relationship between leverage and profitability depends on the effectiveness of the market for
corporate control. If the market for corporate control is effective, managers of profi table firms
are forced to pay out cash by leveraging up; on the supply side, lenders are also more willing to
lend to profitable firms. Therefore, the relationship between leverage and profitability can be
positive. There are a few studies which have suppo rted the positive relationship between
leverage and profitability and include Chang (1987), Friend and Hasbrouck (1988), Titman and
Wessel (1988), Rajan and Zingales (1995), Wald (1999), Booth et al . (2001), and Fama and
French (2002) and Chen and Strange (2005).
It is worth stressing that this way of firm financing could also be applied to SMEs in the
sense that SME requiring external finance would choose the debt that does not reduce managers´
operability, like that of short -term debt which is not likely to include any restrictive covenants
(Holmes and Kent, 1991; and Hamilton and Fox, 1998). Therefore, the hypotheses predicted for
profitability for the German SMEs examined are as follows:

H6a Profitability is negatively related to Short -Term Debt
H6b Profitability is negatively related to Long -term debt

While variables such as size, profitability, growth opportunities, and even measures of
information asymmetry have been used to explain leverage, liquidity has largely been ignored.
Weston et al (2005) s howed that the liquidity of a firm’s equity affects the ease with which a
company can raise external capital through stock offerings. Researchers like Baker and Stein
(2004), Lipson and Mortal (2009) and Graham and Harvey (2001) suggest that a stock’s or
asset’s liquidity will alter a firm’s capital structure because managers have an incentive to raise
money by issuing equity rather than debt when a stock’s liquidity is high, with Graham and
Harvey (2001) adding that market timing may also play an important role.
According to the pecking order theory, firms have a preference for internal finance over
external finance and that the availability of internal funds is captured by liquidity. If the pecking
order theory holds, liquidity should be negatively correl ated with capital structure. The majority
of empirical evidence favours the view that profitability and liquidity are negatively related to
debt ratios (Titman and Wesssels 1988; Rajan and Zingales 1995; Kim et al (1998); Opler et at
(1999); Campbell and J erzemowska 2001; Bevan and Danbolt 2002; Skowroński, 2002; Lipson
and Mortal, 2009; Akdal, 2011). Drever and Hutchinson (2007) and Sarlija and Harc (2012)
show indirectly that a negative relationship exists between liquidity and short and long -term
debt. A nderson (2002) also finds a negative but non -significant relationship to short -term debt,
but a positive relation existing between liquidity and long -term debt.
Concerning the hypothesis developed for liquidity, it predicts that the higher the liquidity
is, the less a firm has to rely on external debt, so:

H7a Liquidity is negatively related to Short -term debt
H7b Liquidity is positively related to Long -term debt

Finally, this study aimed at determining the existence of a difference between former East
and West Germany by examining the factors that influence the financial behaviour of small and
medium sized firms in East and West Germany within the context of German unification. At the
start of the unifications optimistic views held that East Germany woul d rapidly transform and
quickly converge to West German in terms of economic performance. Scepticism however
viewed East Germany as a region permanently lagging in economic development and dependent
on transfers from the West (Von Hagen and Strauch, 2000). The question remains of how
successful transition has been and to what extent convergence has occurred. Therefore, the study
develops a two final hypotheses in this regard which states that in light of the results found:

H8: There is a difference between former East and West Germany in 1995.
H9: There is no difference between former East and West Germany in 2000.

METHODOLOGY

Data

The empirical investigation utilizes data obtained from the “Creditrefom -Bilanz –
Datenbank" database which contains the fina ncial reports of just over 19,700 German and
Austrian companies. The software incorporated in this database was able to extract companies
according to region, separating companies into East and West German states and further into
small and medium classes a ccording to the classification scheme developed for SMEs by IFM
Bonn (i.e., less than 50 million Euros turnover and more than 1 employee and less than 499.).
Further, the periods chosen for the purpose of this study were 1995 and 2000 keeping in mind
that the study did not want to stray too far forward from or be even too close to the time of
unification. The resulting population of German SMEs was segmented to produce a total sample
of 3,458 non -financial companies, of which 2,848 companies were from West Germany and 610
from East Germany.

Measurement of Variables

In each of the empirical hypotheses that we formulated in the previous section an
economic or financial aspect of the firm was taken into account and the question that arises now
is how to measu re these attributes. Capital structure theory does not specify clearly this issue,
which has taken some researchers like Titman and Wessels (1988), or Harris and Raviv (1991) to
conclude that the choice of appropriate dependent and explanatory variables is potentially
controversial. Nonetheless, previous empirical work can help us to define objectively the proxy
variables needed to undertake this study.

Table 1. Measurement of Dependent and Independent Variables

Dependent Variables Measurement
Short -term Debt (STD i,t) Short -term Liabilities divided by Total Assets
Long -term Debt (LTD i,t) Long -term Liabilities divided by Total Assets
Independent Variablesa
Asset Structure (ASS i,t) Tangible Fixed Assets divided by Total Assets
Size (SIZE i,t) Log val ue of Total Assets
Stock Level (STO i,t) Stock divided by Total Assets
Net Debtors (NETDEB i,t) Receivables minus Payables; divided by Total Assets
Non-Debt Tax shields (NDTS i,t) Depreciation divided by Total Assets

Profitability (PROFIT i,t) Earnings bef ore Interest and Tax divided by Total Assets
Liquidity (LIQ i,t) Current Assets – Current Liabilities; divided by Total Assets a Drever and Hutchinson (2007); Van der Wijst and Thurik (1993), Voulgaris et al (2004); Hall et al (1996);
Bradley et al (1984); Titman and Wessels (1988), Barton et al (1989); Sogorb (2002), Hall et al , (2004),
Chittenden et al (1996).

The variables used in this study as an indicator of a firm’s capital structure is the Short –
Term Debt (STD i,t) and Long -Term Debt (LTD i,t). Following previous capital structure literature,
the dependent and independent variables were measured as follows (Table 1 above):

The Model

In order to determine the set of factors influencing capital structure choice in German
companies multiple regres sions were run, in which the short -term, and long -term ratios served as
the dependent variables. On the other hand, asset structure, firm size, stock, net debtors, non -debt
tax shields, profitability and liquidity served as the explanatory variables.
Mode lling for the German firms, according to the variables described in the previous
section, the multiple regression models take the following form:

Y0 = β 0 + β 1Xi,1 + β 2 Xi,2 + β 3 Xi,3 +…… + β kXi,t (1)

Where i is the number of observations, t is the number of explanatory variables, β 0 is constant,
and β 1 to β t are regression coefficients.
When replacing the variables chosen in this study to represent leverage and the
explanatory factors for the capital structure of the German SMEs, 12 regression models are
obtained, three for each of the four samples as follows:

STD i,t = β0 + β1ASS i,t + β2SIZE i,t + β3STO i,t + β4NETDEB 4,t + β 5NDTS i,t + β 6PROFIT i,t + β7LIQ i,t + ε i,t (2)
LTD i,t = β0 + β1ASS i,t + β2SIZE i,t + β3STO i,t + β4NETDEB 4,t + β 5NDTS i,t + β 6PROFIT i,t + β 7LIQ i,t + ε i,t (3)

Where STD i,t, and LTD i,t, are the variables to be explained (short -term debt and long –
term debt respectively), ASS i,t is ass et structure (given by tangible fixed assets over total assets
ratio), SIZE i,t denotes size variable; STO i,t refers to firm stock level, NETDEB i,t is the ratio of net
debtors (or the difference between debtors and creditors over total assets), NDTS i,t is used to
represent non -debt tax shields in the regression; PROFIT i,t denotes is the profitability variable,
and LIQ i,t is the variable of Liquidity (represented by net working capital).
The most recent version of the SPSS statistical program was used to run the multiple –
regression models developed for equations 2 and 3. Due to the fact that the data could not
guarantee consistency of trading data over time, a panel data analysis was not possible.
Therefore, the study examined SMEs data at two time periods to guarantee the highest possible
observations possible. Nevertheless, the expected problem of multi -collinearity (Gujarati, 2003)
was considered amongst the variables studied, and if present, cannot be avoided due to the lack
of control over the data that w as available for empirical analysis within the selected time periods.

RESULTS

Examining the determining factors that influence the financial behaviour of Small and
Medium Sized Firms in Germany, this study analyses not only the effects of the chosen

determinants on total leverage, but on varying debt maturities, i.e. short and long -term debt as
well.

1.1. Descriptive Statistics

The descriptive statistics highlights some important indicators which can assist in
shedding light on the results of the study . Table 2 examines the average leverage ratios across
Germany, reveals that the proportion of total debt to total assets for SMEs in East Germany
was significantly higher in 2000 than in 1995 while short -term debt as a proportion of total
assets was highes t for East Germany in 2000 (40.44%) and lowest for East Germany in 1995
(19.3%). Even though SMEs in both regions used higher amounts of short -term debt, those in
East Germany were noticed to use significantly more Short -term debt in 2000 compared to
1995 than West German firms did in the two periods. On the other hand, Long -term debt as a
proportion of total assets was found to be less for both samples in the year 2000 compared to
1995.
When examining the average leverage ratio then reveals that East Germ an SMEs used
more leverage as a total than West German firms, which actually used less; but examining
Short and Long -term separately reveals that SMEs in both regions borrowed more of the
former and less of the latter. This would seem the more likely finan cial behaviour expected
from firms of small and medium size.
Table 2. Average Leverage Ratios across Germany
German Block Short -term Debt (%) Long -term Debt (%) Total Debt (%)

East 1995 19.3% 29% 46.3%
East 2000 40.4% 21.3% 64.2%
West 1995 28.8% 21.8% 49.5%
West 2000 33.8% 11.7% 46.8%

Table 3 indicates that the values for the potential determinants of capital structure for
the SMEs vary between East and West Germany and between the two sample years. The
figures show that even thoug h East German SMEs had higher asset structures and higher tax –
shields, in comparison to West German firms, they were less liquid, less profitable, had less
stock, were smaller in size (in terms of their total assets) and had lower net debtors. Also
looking at current assets in conjunction with the above findings shows those East Germans
firms had lower current assets compared to West German firms. These results clearly indicate
the financial constraints that East German SMEs faced during the periods post -unification and
indicates their struggle to converge.

Table 3. Determinants of Capital Structure across German Samples
Sector Asset Profitability Size Stock (%) Net Non-debt Liquidity
Structure (%) (%) Debtor Tax Shields (%)
(%) (%)
East 1995 68 .915 167704 5.6 12.4 3 6.23
East 2000 36 1.53 101828 6.8 15 4 (9.25)
West 1995 32 10.65 154032 6.2 19 3 8.7
West 2000 21 3.5 171287 5 24.6 2 7

Regression Results

The findings in the previous section did reveal significant differences in the financial
behaviour of SMEs in East and West Germany. Examining the results presented in tables 4 and
5 may further support the results in the previous section.

Table 4. Short -term and Long -term Debt Models for East and West Germany in 1995.
Variab le East 1995 West 1995
STD Model LTD Model STD Model LTD Model

Constant 0.9063 -0.2289 0.7774 -0.1919
(10.18) (-1.06) (18.81) (-2.31)
Asset Structure -0.6963 0.3729 -0.4355 0.5739
(-11.68)*** (2.17)** (-21.84)*** (14.75)***
Size -0.0376 0.0403 -0.0564 0.0482
(-2.06)** (0.92) (-7.23)*** (3.15)***
Stock 0.3466 0.3021 0.5120 0.0696
(3.93)*** (1.11) (18.51)*** (1.16)
Net Debtors 0.1317 0.1966 0.3295 -0.7822
(2.41)*** (1.10) (12.65)*** (-1.28)
Non-debt Tax Shields -0.0828 0.2938 -0.0406 -1.4738
(-0.87) (1.14) (-0.46) (-8.51)***
Profitability 9.55 × 10-4 3.26 × 10-4 0.3325 -0.4659
(0.91) (0.16) (4.14)*** (-2.14)**
Liquidity -0.9493 -6.33 × 10-4 -0.8254 0.1939
(-21.49)*** (-0.00) (-44.27)*** (5.04)***

R2 0.8878 0.2545 0.7989 0.5177
F-Statistic 95 1.80 426.79 80.20
***, ** indicated significance level at the 1 and 5 per cent levels. Values for each of the variables represent β
coefficients and t-values (in parentheses).

First, in the case of Short -term debt, the models develop for East Germany was
reasonably strong with an F-statistic of (95) with high significance ( p= .000); and an R2 of
0.887. The model for the 2000 period for East German firms was even stronger and had an F-
statistic = 269.83, was also significant at p=.000 and exhibited an R2 value of 0.875. The
models developed for West Germany also showed signs of significance, with the model
developed for 1995 having an F-statistic of 426.79 at p= .000 with R2 value at 0.798; while the
model for the year 2000 revealing an F=535.6 at p=.000 with the R2 value equal to 0.7728.
Tables 5.8 and 5.9 show the coefficients and t-values for the significant variables which reveal
that across all 4 models, asset structure, firm size, stock level, net debtors and liquidity were
significant at the 0.01 levels and therefore confirm the respective hypotheses (H 1a; H2a; H3a; H4a;
and H 7a). Profitability was only significant West Germany in 1995 but contradicts the
hypothesis developed. Non -debt tax shield was an insignificant factor under all models tested.
Regarding the long -term debt models, the model East Germany was quite weak and
had an F-statistic of only 1.8 with low significance at p= 0.1125; and with the R2 value at
0.2545. For East Germany in 2000, the long -term model in 1 995 was a weaker predictor of the
variables than the short -term model, with an F-statistic reported at 8.02, significant at p=.000,
and with an R2 of 0.2791. Furthermore, the models for West Germany for 1995 was significant
(F-statistic = 80.20, p=.000) wi th a value for R2 at 0.5177. Finally, compared to the model for
1995 model, the year 2000 model was weaker with F=38.02 at p=.000 and the R2 was reported
as 0.3420. According to the results found, asset structure was a mutually significant factor for

East German 1995 ( P=0.05) and 2000 ( P=0.01) long -term models. Stock level and liquidity
were significant determinants of long -term debt for East Germany in the year 2000 both with a
significance level of 0.05. Stock level on the other hand was significant but w eak in its effect
on long -term debt in the 2000 model.

Table 5. Short -term and Long -term Debt Models for East and West Germany in 2000.
Variables East 2000 West 2000
STD Model LTD Model STD Model LTD Model
Constant 0.9310 -0.1932 0.7688 -0.2937
(21.63) (-1.86) (22.54) (-3.91)
Asset Structure -0.6497 0.4264 -0.4954 0.4959
(-20.82)*** (5.56)*** (-26.42)*** (12.90)**
Size -0.4829 0.0377 -0.441 0.0618
(-5.32)*** (1.74)* (-6.77)*** (4.48)***
Stock 0.3029 0.2937 0.4951 0.1956
(6.84)*** (2.46)** (20.08)*** (3.32)***
Net Debtors 0.1331 0.1579 0.2532 -9.96 × 10-3
(4.27)*** (1.70) (12.91)*** (-0.21)
Non-debt Tax Shields -0.0149 -0.2569 0.0181 -0.9146
(-0.32) (-1.34) (0.19) (-4.61)***
Profitability -1.69 × 10-3 0.0574 8.96 × 10-3 -1.42 × 10-3
(-0.59) (1.11) (0.87) (-0.07)
Liquidity -0.8926 0.1345 -0.8234 0.1426
(-37.14)*** (2.15)** (-55.99)*** (3.66)***
R2 0.8753 0.2791 0.7728 0.3420
F-Statistic 269.83 8.02 535.60 38.02
***, ** indicated significance level at the 1 and 5 per cent levels . Values for each of the variables represent β coefficients and
t-values (in parentheses).

As for the short -term models, asset structure for German SMEs was the dominant
predictor for short -term debt, confirming the H 1b hypothesis across all models deve loped. Firm
size was significant also at the 0.01 level only for West German samples and therefore
confirms hypothesis H 2b. Furthermore, firm stock level also significantly determined short –
term financing for both East and West German SMEs in the year 2000 , thereby accepting
hypothesis H 3b for those cases. The hypotheses developed for non -debt tax shields (H 5b) and
liquidity (H 7b) were confirmed for West German firms as a significant factor at the 0.01 levels,
with liquidity results

also confirming the hy pothesis for East German firms for the year 2000. Finally, profitability
was significant at the 0.05 level and influenced only the capital structure decisions with regards
to short -term debt for West German SMEs in the year 2000, and therefore accepts Hypo thesis
H6b.
In conclusion, examining the behaviour of SME by using short -term and long -term
measures for leverage proved beneficial to the overall cause set forth to be achieved by this
study. Even though the regression models employed just by themselves could grant a reasonably
good insight into the situation faced by SMEs in Germany in general and the difference between
both regions, taking into account also the results from the descriptive statistics may add support
the final conclusions.

DISCUSSION

This study examined firms from both East and West Germany in order to empirically test
the determinants of SME capital structure. The seven hypotheses proposed tested the influence of
variables of Asset Structure, Firm Size, Stock Level, Non -debt tax shield , Net debtor, Profitability
and Liquidity on financial leverage on short and long -term debt.

In particular, and as predicted, the significant results for asset structure confirm both the
hypotheses and validated research for both short -term leverage acros s all samples. This suggests
that German SMEs tend to the match the durations of assets and liabilities as was confirmed by
Cassar and Holmes (2003), Drobetz and Fix (2003), Jõeveer (2005) and Fattouh et al., (2008) as
well as the majority of previous stud ies. Both East and especially West German SMEs generally
relied more on short -term debt than on long -term debt; and with the unique circumstances these
SMEs face from moral hazards and adverse selection, creditors required guarantees in the form
of collate ral assets. Similarly, the results revealed that firm size was the second most
predominant variable in explaining capital structure, validating the hypotheses and previous
literature. Van Der Wijst and Thurik (1993), Chittenden et al (1996), Hutchinson et al (1998),
and Bevan and Danbolt, (2002) among others support these results and suggest that survival and
growth for German SMEs present a wide range of challenges to the small firm owner -manager,
so smaller firms are expected to have less debt because the higher costs involved in resolving
information asymmetry problems. Furthermore, stock level was an important determinant for
SMEs in Germany especially for leverage of short -term maturities for both East and West
Germany. Credit restrictions have being on e of the highest impediments to firm foundations
especially in East Germany, and had left many SMEs in East Germany complaining of severe
financing restrictions because of lacking equity capital and a low willingness of banks to grant
loans (Hummel and Lud wig, 1994). Consequently, these firms would turn to short -term debt
which accompanies lower intrusion and more importantly lower risk in loss of control.
The finding also indicate the vital role that net debtors pays in determining the financing
behaviour s of German SMEs. The results were consistent with those of Hall et al (2000) and
Voulgaris et al. (2004) who showed similar results for short -term debt. This is indicative of small
firms’ tending to finance debtors by delaying payments to creditors and ma king extensive use of
relaxed credit terms as a way to promote the firms’ sales. According to financial theory and
empirical evidence from the EU, SMEs tend to turn to short -term debt to finance their increased
working capital requirements due to restricte d access to long -term financing (Chittenden and
Bragg, 1997). Germany’s capital market revealed some imperfection which created a gap
between internal and external sources of funds and in spite of the large equity aid programs
offered, the equity gap betwe en East and West Germany could not be closed (Lehmann et al,
2004). On the other hand, non -debt tax shields seemed not to be relevant when it came to capital
structure financing decisions for German SMEs with regards to short -term debt.
When it came to pr ofitability, the results were all contrary to common belief that firms
tend to borrow less when they are more profitable. Although the results were insignificant, they
do reveal that German SMEs tend to behave in this matter when it came to short -term debt .
Plausibly, reliance on short -term debt can affect profitability positively through enhanced
monitoring and control, or by allowing greater flexibility to exploit investment opportunities
(Baum et al, 2006). Statistics revealed that SMEs were more profita ble in 1995 compared to the
year 2000, especially in West Germany which revealed a significant positive relationship to
short -term debt. Previous studies among which include those of Wald (1999), Booth et al .
(2001), and Fama and French (2002) and Chen and Strange (2005) have confirmed such results.
Gale (1972) reminds that the conventional (non -Miller -Modigliani) financial theory would
suggest that if the level of business risk is held constant, the rate of return on equity would be
larger, the larger the ratio of debt to capital. Furthermore, German SMEs borrow less short -term
debt in light of increased liquidity. As explained by Chittenden et al (1996) liquidity is positively
related to profitability and that liquidity was a function of profitability, the refore the use of short –
term debt by German SMEs was negatively related to liquidity of these firms. Anderson, (2002),
Voulgaris et al (2004) and Frieder and Martell (2006) lend support to these findings and the
figures for asset composition reveal that fi xed assets were higher in proportion to current assets

for both East and West Germany in both years. German SMEs in general were less profitable and
therefore less liquid and with the information constraint had to rely on short -term debt financing.
Asset structure was as expected positively related and significant to German SMEs when
they turn to long -term financing. The majority of literature confirm that when tangibility of a
firm increases, then so does Long -term debt (Constand et al ., 1991; Chittenden et al ., 1996;
Hutchinson et al., 1998; Michaelas et al., 1999); Booth et al., 2001; Sogorb, 2002). This was
especially true for West German SMEs as their Eastern counterparts have faced higher financial
restrictions from financial institutions and have bee n shown to be one of the highest impediments
to firm foundation in East Germany (Steil, 1998). Besides that fact, in East Germany, many
SMEs complained of severe financing restrictions because of lack of equity capital and the low
willingness of banks to g rant loans (Hummel and Ludwig, 1994), which in most part explains the
existence of a the lending gap between East and West Germany (Lehman et al , 2002). Even
though both Germanys made use of long -term debt, because of the finance gap, firms located in
East Germany pay significantly higher loan interest rate and were required to provide
significantly more collateral than firms located in West Germany (Harhoff and Körting, 1998;
and Lehmann and Neuberger, 2001). Results for firm size also confirm the hypothes es as it did
for short -term debt, which suggest that as German SMEs grow, they tend to rely more on longer
maturities of debt financing, especially for West German SMEs. The obvious reason for this
would be the economic and financial conditions present whi ch in comparison to East Germany
were at the time substantially better.
Stock level was not a significant factor to determine long -term financing for firms in the
earlier periods but became more significant as convergence advanced through the years.
Moreo ver, there is a notion that stock and asset structure co -exist in their role as collateral. West
German SMEs faced less rationing problems and asymmetric information consequently posing
less information constraints on banks. Therefore, East German firms ha d to pay significantly
higher loan interest rates and providing significantly more collateral than firms located in West
Germany (Harhoff and Körting, 1998; and Lehmann and Neuberger, 2001). Furthermore, net
debtors like stock level was not significant in determining capital structure financing when it
came to long -term debt and remains unsupported. However, the negative results could however
explain that there seems more to the German SMEs than just the effects of the finance gap but
also the information c onstraint on banks which consequently causes the financing constraint of
Germany’s small and medium sector.
Non-debt tax shields however was an important determinant for long -term financing for
German SMEs across the sample periods. The negative associati on results for German SMEs are
supported by DeAngelo and Masulis (1980), Chiarella et al (1991), Mira (2002) and Mira and
Garcia, (2003), in the simple notion that the existence of non -debt tax shields, such as
depreciation, reduces the importance of the f iscal advantage of debt. Profitability was only a
significant factor for German SMEs in the earlier years post -unification in comparison to later
years. The statistics confirm that Western German SMEs were three times more profitable in the
earlier study y ears. These results are consistent with Myer’s (1984) Pecking Order Theory and
supports many of the previous literature (including Wijst and Thurik, 1993; Chittenden et al ,
1996; Jordan et al, 1998; Colema and Cohn, 1999; Michaelas et al, 1999). Agarwal an d Elston
(2001) explained that banks’ rent -seeking behaviour is responsible for the dominance of long
term-liabilities in German firms’ balance sheets as was evident in the statistics. Finally, liquidity
was important for firms in the East much later in th e convergence while equally important for
West German SMEs through the years after unification. Anderson (2002) and Sinikov (2004)
support this result suggesting that firms with high liquid assets prefer higher levels of long -term
debt if the positive rela tion to liquidity and profitability holds. Therefore, it seems that German

SMEs are affected not only by their own characteristics, but also by the external environment in
which they operated.

CONCLUSION

The empirical evidence from this study suggests th at asset structure, size, stock and
liquidity are important influences upon SME financing and capital structure in Germany. There
was also weaker evidence for net debtor, non -debt tax shields and profitability. The results
obtained reconcile with the theor ies developed in finance to explain capital structure choice
within the firm, especially with the arguments of the pecking order theory which relies on
information asymmetries.
The small size of the German SMEs generates financial problems due to limited equity
and also limited access to bank financing, especially to long -term funds and venture capital.
Their low credibility in addition to their small size is often attributed to high asymmetric
information costs between lenders and the small firms, as well as to the lack of collateral. In
addition, the liquidity of the assets in these firms was also important when it came to financing
their operations with external debt.
Germany has a more unique historical facet to it which distinguishes it from the rest.
These distinguishing features reflect onto the SMEs’ attitudes towards borrowing, the present
banking relationships and other economic, social and cultural differences which affect the
behaviour of these firms. What distinguishes Germany from other countr ies dwells within the
divergence between the two regions which share significantly different economic situations. This
in turn touches on the different levels of information asymmetries, agency costs and signalling
costs that affect the SMEs in the two reg ions. Access to the financial market in Germany seems
to be a major factor in determining the capital structure of its small firms.
The unsound banking relationships these SME had with their local banks, especially in
the case of the East German firms and the lack of availability of information on these firms to the
banks contributed to an information and financial gap which further added to the financial
constraints put on these firms. The long -term debt that was available to these firms in the
financial market was usually provided on the basis of collateral in its different forms, rather than
on profitability.
The German SMEs in West Germany in particular showed higher levels of profitability
which gives an indication to the fact that these firms also ma de greater use of short -term
liabilities in their capital structure than the East German SMEs. The majority of the firms in
Germany did not have stock market floatation where if it did, would render them capable of
taking on long -term debt finance. In this case, collateral could become less important and the
relationship between profitability and the liquidity of these firms would diminish.

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1 This research wa s partially funded by the Arab Open University, Kuwait Branch [Grant Number: 17081].

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