Available via license: CC BY 4.0
Content may be subject to copyright.
Business Management and Strategy
ISSN 2157-6068
2023, Vol. 14, No. 1
45
The Impact of Debt Financing on Startup Profitability
Chengzhuo Zhang, Nik Hadiyan Binti Nik Azman (Corresponding Author)
University Sains Malaysia, Malaysia
Received: March 14, 2023 Accepted: April 17, 2023 Published: April 18, 2023
doi:10.5296/bms.v14i1.20842 URL: https://doi.org/10.5296/bms.v14i1.20842
Abstract
If a start-up company is unable to grow due to a lack of capital, it is prudent to investigate the
possibility of using debt as a source of funding. This study examines the impact of debt
financing on the profitability of start-ups using trade-off theory and pecking order theory and
uses regression analysis to select factors that are correlated with debt financing structure and
profitability for listed companies on the National Equities Exchange and Quotation System
(NEEQ) from 2012 to 2021. At the end of the theoretical and empirical analyses, the impact
of debt financing on the profitability of start-ups is analyzed and corresponding
countermeasures are proposed. Finally, the findings of the study are summarized and the
shortcomings of the study and the prospects for future research are outlined. The findings of
this study are that debt level structure is negatively related to profitability, indicating that
gearing has a negative impact on the profitability of start-ups. In terms of debt type structure,
mercantile credit has a positive effect on the profitability of start-ups and bank financing have
a detrimental effect on profitability. Overall, debt financing has a negative impact on the
profitability of start-ups, but business credit has a positive impact on profitability.
Keywords: debt financing, startup, profitability, trade-off theory, pecking order theory, fixed
effects model
1. Introduction
Financing is always one of the most difficult challenges for start-ups in their development
phase. Financing options must be matched to the appropriate stage of growth or level of
development to determine financing needs. According to Fama and French (2005), low
growth and high profit companies do not retire or issue large amounts of equity, and start-ups
are particularly vulnerable because they lack a track record of success. Financial institutions
are generally conservative and only lend to companies that have been in business for at least
five years and have a track record of financial statements. In many countries, lending
decisions are made by the state rather than on a commercial basis, which complicates debt
financing. Changes in the characteristics, activities, structure and environment of a business
Business Management and Strategy
ISSN 2157-6068
2023, Vol. 14, No. 1
46
have an impact on the determinants of its financial resources. As a start-up prepares to bring a
product to market, it will increase its expenditure, build relationships with partners,
customers and suppliers, and hire people, resulting in small or no revenue. At this point, a
start-up can assist the company in maximizing the benefits of financing costs by adjusting the
appropriate debt-to-equity ratio, which is essential to give the company an edge in continued
growth.
China put forward the slogan "Mass Entrepreneurship, Mass Innovation" in 2015. Policies to
encourage and promote innovation and entrepreneurship should also be encouraged and
promoted. As a result, a large number of start-ups emerged in China during this period. It has
not only boosted regional economic development, but also increased the number of patented
achievements and technological innovations. It has made an increasing contribution to
economic growth and has become a major channel for job creation. However, Chinese
start-ups are usually short-lived, small in size and have a small number of employees.
According to the latest 2018 China Economic Census statistics, the number of businesses in
mainland China has been statistically categorized into two statistical categories: number of
employees and time of establishment.
1515852
539447
341932
67052
45297
29666
2481
1317
20-49
50-99
100-299
300-499
500-999
1000-4999
5000-9999
10000 and above
Figure 1. Number of companies-by number of employees
*Source: China Statistical Yearbook databases (2018)
Figure 1 shows that the majority of businesses have fewer than seven employees. 21,641,460
businesses, or 99.33% of the total, have fewer than 300 employees. The total number of
medium and large enterprises with more than 300 employees was 145,813, accounting for
only 0.67% of the total. This result indicates that the majority of businesses in China are
small and that start-ups make a significant contribution to job creation.
Business Management and Strategy
ISSN 2157-6068
2023, Vol. 14, No. 1
47
314925
354648
396171
388612
446555
539125
693038
787918
907336
1107676
1598557
2000098
2729373
35486
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
NO YEAR
Figure 2. Number by companies-classified by time of incorporation
*Source: China Statistical Yearbook databases (2018)
Figure 2 shows that the number of businesses in China has increased rapidly over time as the
country has grown. A large number of entrepreneurship start-ups have been formed each year,
with growth accelerating especially since 2014, which is associated with China's policy of
"entrepreneurship for all". Although the census year of the data source is 2018 and does not
reflect the current actual situation, the data is still informative by extending the timeline.
Evidence of the growth of Chinese start-ups can be found in this timeframe, and the current
state of the Chinese economy shows that the establishment and rapid growth of start-ups has
a positive impact on the economy.
1.1 Research Objectives
In order to accomplish the objectives from various debt financing viewpoints, this study's
research goals are, in particular:
1. To identify the impact of size of a startup's debt financing on the profitability of start-ups.
2. To explore the impact of different types of debt financing on the profitability of start-ups.
2. Literature Review
The theory and literature on capital structure helps us to understand the impact of debt
financing on start-ups. This section is divided into subsections here, as described below.
2.1 Trade-off Theory
Trade-off theory evolved from Modigliani-Miller's MM theory in 1958 and refers to how
Business Management and Strategy
ISSN 2157-6068
2023, Vol. 14, No. 1
48
much debt financing and how much equity financing a company prefers to use, taking into
account costs and benefits. There are two types of MM theory, the MM theory without tax
and the MM theory with tax. The former asserts that a firm's capital structure has no effect on
firm value when the firm's debt financing rate is kept at the risk-free rate and there are no
transaction costs in capital market transactions. This means that when there is income tax,
interest expenses must be deducted. The higher the interest rate, the lower the income tax and
therefore the higher the profit and enterprise value. According to trade-off theory, although
interest expenses can be deducted from income tax, the higher the debt ratio, the greater the
leverage and therefore the heightened the risk to the firm. Debt exposes a company to the risk
of insolvency. Due to the presence of interest, business managers need to exercise caution
when selecting projects. According to trade-off theory, the optimal capital structure for a firm
is when the tax savings from the use of debt financing and the risk of insolvency from debt
financing are equal. The relationship between debt financing and corporate performance is a
crucial and often discussed issue in management finance. Debt financing is related to the
trade-off between costs and benefits (Harris et al., 1991). If firms are highly profitable, they
will prefer debt financing to increase shareholder wealth and further debt in the capital
structure of the firm provides more tax benefits. If a firm is highly profitable, the likelihood
of insolvency is increased if it uses more debt.
2.2 Pecking Order Theory
In the pecking order of financing in pecking order theory, endogenous financing is used first,
followed by debt financing and finally equity financing. When it comes to pecking order
theory, a start-up's desire to raise capital should be a key factor in determining a firm's capital
structure. Because priority financing theory puts this desire first, due to priority financing
theory, small firms are less likely to use bank financing and more likely to use internal
financing (Fulghieri et al., 2020). According to Cole and Sokolek (2018), most people in
start-ups start with low-risk debt and take equity once the situation changes. According to
pecking order theory, organizations do not have an optimal capital structure. The theory
advocates a financing hierarchy that includes earnings, debt and equity to maximize the
adverse cost options for securities issuance caused by the available asymmetric information.
The inverse relationship between profitability and leverage leads one to believe that debt will
be issued when revenues are insufficient. When it comes to debt financing, it is also worth
discussing what types of debt financing methods are used by start-ups. There are various
forms of debt financing, including bond issues, bank loans, mercantile credit and finance
leases. How you choose and decide on the order of use can help your business achieve the
lowest cost while maximizing the benefits. This should be studied by researchers. A financing
method contains many types of financing, and the cost of financing varies between different
types of financing. The order of the different types of financing for the same type of financing
is also worth deciding and considering by managers based on the principle of maximizing the
company's benefits. Because financing is expensive, how to leverage limited resources can
help a company find the most appropriate capital structure and maximize utilization, which is
very relevant for start-ups with limited resources.
Business Management and Strategy
ISSN 2157-6068
2023, Vol. 14, No. 1
49
2.3 Debt Financing
Debt financing is a type of external financing where the borrower receives financial
assistance through a credit or mortgage loan, which they then repay with principal and
interest when the loan matures. Unlike equity financing, it does not require the sale of shares
in the company and maintains concentration of management in the company. In comparison
to equity investments, creditor income is limited and business risk is high. If the company's
operations falter, it may choose not to pay dividends to shareholders but must still repay its
creditors' debts. This study will first go over three components of debt financing: debt levels,
debt maturity structure, and debt sources. The level of debt financing is defined as the ratio of
a company's total debt to total assets. The term "debt maturity structure" refers to the different
categories of debt arranged according to the time until maturity, including the long-term debt
ratio and the short-term debt ratio, with debt typically classified as short-term debt if it
matures in less than a year and long-term debt if it does so. The source of debt finance for
start-ups is referred to as the debt source structure. According to Hou (2009), the two most
common sources of startup capital are bank financing and commercial credit. A bank loan is a
business transaction in which the bank loans money to someone in need at a certain interest
rate in accordance with national regulation and then receives the money back within a
predetermined time frame. Mercantile credit is a loan relationship between enterprises formed
in a commodity transaction as a result of deferred payment or advance receipt of payment.
2.4 Profitability
Profitability is the process by which a company uses various economic resources to conduct
business activities in order to make money. It can help start-ups obtain funding quickly, as it
is not only used as a criterion for investors, but also a key indicator when seeking debt
financing. As long as the company can demonstrate viability, it may be eligible for funding
assistance. However, investors are often wary of investing in start-ups due to information
asymmetries, and the mere notion of a profitability model can be difficult to test. Financial
statements are usually used to examine whether a firm has the potential to continue growing
in the future and to assess whether a corporation can sustainably grow. Profitability is a
monetary indicator of performance that measures how effectively a company is utilizing its
assets to generate income. SMEs' economic performance can be measured in a variety of
ways, including profitability metrics, cash flow, and revenue growth (Singh & Kumar, 2017).
2.5 Empirical Review
An extensive discussion of existing theories on capital structure forms an integral part of this
work. The discussion of theories will therefore cover the benefits and drawbacks experienced
by firms using debt financing. These characteristics determine the reasons for the success or
failure of firms.
Most of the studies have focused on large firms. For example, according to Aziz and Abbas
(2019) who surveyed 360 firms in 14 industries in Pakistan, the findings suggest that debt has
a negative impact on the performance of firms in the non-banking sector in Pakistan because
Business Management and Strategy
ISSN 2157-6068
2023, Vol. 14, No. 1
50
debt is an expensive source of funding and therefore firms should rely on internal sources of
funding which are the most reliable and cheapest, a view that is consistent with pecking order
theory. However, there are also slightly different findings. Javed et al. (2014) selected 63
public companies in Pakistan and used a fixed effects model to conclude that capital structure
exhibits a positive effect on firm performance and debt to asset ratio exhibits a positive effect
on ROE.
Most empirical and theoretical studies have focused heavily on the impact of large companies.
Firms consider using debt financing when structuring their capital because of the many
advantages it offers over using equity as a source of funding. More importantly, big firms
consider debt financing because it allows them to save taxes (Miglo, 2016). This in turn
allows companies to increase their profits while increasing their debt, which has an impact on
cash flow in the long run. However, the results of these studies may not apply to SMEs, as
they have more limited access to finance and less access to formal finance than larger
companies. Debt financing is more accessible to start-ups as they do not have access to a
wide range of funding sources, such as business research or equity. As debt policy
significantly affects firm performance and thus firm value and survival, owners and managers
of start-ups should focus on finding a satisfactory level of debt. Existing empirical research
therefore focuses on whether there is an impact on the financial performance of start-ups
when they use debt financing.
Some findings suggest that debt can have a negative impact on the financial performance of
start-ups. For example, the findings of another study by Badi and Ishengoma (2021) looked at
the differences between start-ups that do not use credit and those that do, with one in five not
needing any form of credit at all. This study was conducted to examine the differences
between start-ups that do not rely on credit and those that do. Firms using equity financing
were found to be more profitable, have an acceptable level of earnings liquidity and have
improved credit quality compared to those using debt financing. Firms with debt financing
were found to be less creditworthy. The results of this study confirm this. Both studies came
to the same conclusion which is in line with the pecking order theory. Singh and Kumar
(2017) selected financial data of 254 manufacturing SMEs in India from 2010-2014 and used
an OLS model to conclude that sales growth has a positive impact on financial performance.
Operating cash flow and financial leverage were negatively related to financial performance.
There are also studies that reach the exact opposite conclusion. Yazdanfar and Öhman (2015)
This study uses OLS models and fixed effects models to analyses 15,897 Swedish SMEs
between 2009 and 2012, and this study confirms that debt ratios have a negative impact on
firm profitability in terms of trade credit, short-term debt and long-term debt. The study
confirms that debt ratios have a negative impact on firm profitability in terms of trade credit,
short-term debt and long-term debt. As high debt ratios appear to increase agency costs and
the risk of losing control of the firm, SME owners and managers tend to finance their
businesses to a considerable extent with equity capital. This study also shows that firm
performance and short-term debt are positively correlated, and that increasing short-term debt
ratios will, to some extent, reduce firms' borrowing costs and improve their profitability.
Business Management and Strategy
ISSN 2157-6068
2023, Vol. 14, No. 1
51
2.6 Hypotheses Development
The discussion of hypotheses is an instrumental part of determining the basic results of the
expected understanding and perception of the impact of debt financing on the profitability of
entrepreneurial companies.
Generally, startups use debt financing has two reasons: to expand their production operations
and to obtain the tax benefit of debt. Debt financing will contribute to the profitability of the
startup. However, in the actual course of business, the production and operation of the
enterprise will also be influenced by other variables. This will result in a gearing ratio that
does not necessarily have a positive impact on the profitability of the enterprise. Based on the
vicious circle hypothesis in Figure 3.1, this argument advances the view that debt financing
has a negative impact on the profitability of start-ups, which contradicts the reality of
start-ups financing their business objectives. An empirical analysis of the relationship
between debt and profitability indicators for start-ups is a fundamental basis for assessing
whether the impact of debt level structure on start-ups is negative. The asset level structure is
a reflection of a company's total debt level and is used to measure the level of debt of a
company. The extent of the return on assets ratio is a testament to a company's
competitiveness and capability. The level of return on assets directly indicates the
competitiveness and development ability of a company and is a key indicator in determining
the profitability of a company. Sun and Ouyang (2019) conducted a study with electronic
equipment manufacturing companies and found that an increase in total gearing leads to a
decrease in corporate financial performance. Based on the theoretical analysis and the results
of scholars' studies, the following hypotheses were made.
Hypotheses 1: The level of debt financing has a negative impact on profitability.
There is a link between the type of debt a business is expected to incur and the nature of its
business. The argument for this hypothesis focuses on whether the use of bank financing
versus mercantile credit as a source of resources for start-ups has a different impact on the
profitability of start-ups. Bank financing are more formal and safer than mercantile credit.
Bank financing look at the potential of the business, i.e., the ability to continue to grow in the
future, future profitability, etc. Banks assess startups at a slightly lower value in this respect
compared to larger companies. Mercantile credit is mainly money borrowed by start-ups from
companies with which they have financial dealings in the course of their business. This form
of financing has limited access to funds and needs to be measured. Too much mercantile
credit can also damage the economic interests of other companies, and excessive use of this
type of debt financing can leave a bad impression on the other party and damage the goodwill
of the start-up, which can have a negative impact on the start-up. Therefore, the focus is on
whether different types of debt financing have the same impact on startups. The types of debt
can be classified according to various financial indicators. According to Sun and Ouyang
(2019), both the business credit rate and bank financing rate are significantly and negatively
related to financial performance. The study by Yin and Pi (2017) found that bank financing,
mercantile credit, or bonds payable, which have a negative effect on performance, are not
Business Management and Strategy
ISSN 2157-6068
2023, Vol. 14, No. 1
52
conducive to improving performance. Based on the above analysis, the following hypotheses
were made.
Hypotheses 2: The debt type structure has a negative impact on profitability.
3. Research Methodology
This study draws on the wind database and the China Statistical Yearbook, and the startups
selected are those listed on the National SME Stock Transfer System (NEEQ), 850 in total
(except for ST companies, finance-related companies and companies with missing data). The
NEEQ was chosen because it is a national unlisted equity trading platform for Micro, Small
and Medium Enterprises, which is characterized by relatively low barriers to entry, a
relatively short time to listing and a concentration of healthy growing but illiquid start-ups in
the market. This is because the National Stock Exchange and the Quotation System have
listing criteria set by law, have been in operation for two years and have the capacity to
continue as a commercial institution, which is consistent with the objectives of the study of
start-ups in this study.
The model in this study was built using panel data. Panel data is a type of sample data which
is formed by selecting a sample of observations from numerous components of a time series
simultaneously. Due to the research characteristics of this work, it is necessary to collect
financial data from each organization each year and panel data meets the requirements.
Ordinary Least Square (OLS), Random effects model (REM) and Fixed effects model (FEM)
are the three panel data measures, Fixed effects model (FEM) was selected for this study. The
dependent variables for this study will be return on total assets and return on equity. Gearing
ratio, bank financing ratio and mercantile credit ratio will be studied as independent variables.
Market value of the company, revenue growth rate and board size will be studied as control
variables. The model was developed to test the effect of debt financing on the profitability of
Business Management and Strategy
ISSN 2157-6068
2023, Vol. 14, No. 1
53
start-ups.
(1)
Where
In the formula, represents the dependent variable, which is the rate of return on total
assets. On the right-hand side of the formula, is a constant term, is the debt to asset
ratio, is the bank financing rate and is the mercantile credit financing rate. And
, and are control variables, where M is the market value of the company, G
is the revenue growth rate, B is the Board size and represents a random disturbance term.
Table 1. Description of Variables
Type
Name
Symbol
Description
DV
Return on assets (%)
A
Net income / Total assets
Return on equity (%)
E
Net income/Total equity
IV
Debt to assets ratio
(%)
AR
Total liabilities / Total assets
Bank financing ratio
(%)
F
(Short-term liabilities + long-term
liabilities) / Total liabilities
Mercantile credit ratio
(%)
T
(Bills payable + Accounts payable +
Accounts received in advance) / Total
assets
CV
The market value of
the company (million)
M
The total market value of the company
at the end of a period
The company's assets
(million)
C
The stock of assets owned by the
company
Board size
B
number of board members
Revenue growth rate
(%)
G
the increase in operating income this
year / total operating income last year
*Source: wind database (2021)
4. Results
Descriptive Statistics
Business Management and Strategy
ISSN 2157-6068
2023, Vol. 14, No. 1
54
Table 2. Descriptive Statistics
Variable
Obs
Mean
Std. Dev.
Min
Max
A
6,507
1.891
11.771
-49.116
29.068
AR
6,507
38.428
20.113
2.388
93.511
L
6,507
4.413
7.490
0.000
38.180
S
6,507
33.880
18.642
1.942
86.954
F
6,507
1.592
6.655
0.000
41.372
T
6,507
14.198
11.813
0.001
54.704
M
6,502
963000000
2380000000
7950000
16300000000
G
6,507
15.844
58.421
-85.670
345.936
B
6,507
6.103
1.475
5.000
10.000
Note: this table provides descriptive statistics for all continuous variables of the present study.
A denotes return on assets. AR denotes debt to asset ratio. L denotes long-term debt ratio. S
denotes short-term debt ratio. F denotes bank financing ratio. T denotes mercantile credit
ratio. M denotes the market value of the company. G denotes revenue growth rate. B denotes
board size. Obs denotes the number of observations. Std. Dev denotes standard deviation.
Min denotes minimum values. Max denotes maximum values.
Table 2 presents the descriptive statistics for the variable of the study. It shows that on
average return on assets of the China’s startups is 1.891 percent of net income by total assets.
Return on assets has a standard deviation of 11.771 with a maximum value of 29.068 and a
minimum value of -49.116, indicating a wide range of returns on assets across start-ups. The
mean and standard deviation values for the debt to assets ratio are 38.428 and 20.113
respectively, with maximum and minimum values of 93.511 and 2.388 respectively. The Debt
to asset ratio indicates that the total liabilities by total assets that mean the lower the debt to
asset ratio suggests stronger the solvency of companies.
The mean and standard deviation for long-term debt ratio is 4.413 and 7.490, respectively.
The mean value suggests that on average, long-term debt ratio is at a low level in China's
startups. The mean and standard deviation for short-term debt ratio is 33.880 and 18.640,
respectively. The average value shows that the short-term debt ratio is at a high level. The
maximum value reaches 86.954% and is higher than the long-term debt ratio.
Business Management and Strategy
ISSN 2157-6068
2023, Vol. 14, No. 1
55
The structure of debt types, as measured by the bank financing ratio and the mercantile credit
ratio, has a mean value of 1.590 and 14.198 and a standard deviation of 6.655 and 11.813.
According to Table 4.1, it shows that, on average, the mercantile credit ratio is higher than the
bank financing ratio. Also, in terms of standard deviation values, the mercantile credit ratio is
higher than the bank financing ratio, which indicates that the difference in the use of
mercantile credit by Chinese start-ups is more pronounced than the difference in the use of
bank financing.
The control variables used in this study are the market value of the company, revenue growth
rate and board size. On average, the market value of the company is 963,000,000 with a
standard deviation of 238,000,000. The minimum value is 7,950,000. This indicates that the
size of the companies listed on the NEEQ varies greatly. The revenue growth rate is 15.844
with a standard deviation of 58.4206. The high standard deviation implies that the revenue
growth rate varies significantly between companies. In addition, on average, board size is
6.103 with a standard deviation of 1.475. The lowest value of sample board size is 5 and the
highest value of sample board size is 10. This clearly shows that board size varies
considerably from firm to firm.
Correlation Matrix
Table 3. Correlation Matrix
Variables
A
AR
F
C
M
G
B
A
1
AR
-0.236***
1
F
-0.144***
0.275***
1
C
-0.039***
0.545***
-0.061***
1
M
-0.0150
0.152***
0.585***
-0.060***
1
G
0.280***
-0.002
-0.015
0.0200
0.061***
1
B
-0.028**
0.083***
0.313***
-0.036***
0.363***
-0.026**
1
Note: this table provides the correlation among the independent variables. A denotes return on
assets. AR denotes debt to asset ratio. F denotes bank financing ratio. C denotes mercantile
credit ratio. M denotes mercantile credit ratio. G denotes revenue growth rate. B denotes
board size.
Table 3 shows the pairwise correlations between the variables. This was done to check for
multicollinearity between the variables, as the variables may be strongly correlated with each
other and may lead to multicollinearity problems. According to Javed et al. (2014) if the
correlation value is less than or equal to 0.2 then the correlation is weak, if the correlation
value is less than or equal to 0.4 but greater than 0.2 then the correlation is poor, if the
correlation value is between 0.4 and 0.6 then the correlation is acceptable, if the correlation
value is between 0.6 and 0.8 then the correlation is acceptable, and if the correlation value is
higher than 0.8 then the correlation is strong. However, in the coefficient correlation table, the
correlations between the variables were relatively low, not exceeding 0.6, and the variables
all had an autocorrelation coefficient of 1. Therefore, the results suggest that multicollinearity
Business Management and Strategy
ISSN 2157-6068
2023, Vol. 14, No. 1
56
was not an issue in this study.
Regression Analysis
Table 4. Impact of debt financing on return on assets
VARIABLES
A
AR
-0.218***
(-19.56)
F
-0.159***
(-4.28)
T
0.055***
(2.92)
M
0.000***
(7.13)
G
0.057***
(28.44)
B
-0.109
(-0.71)
Constant
8.864***
(8.55)
Observations
6,502
Number of companies
865
R-squared
0.200
Note: This table determines the results of impact of debt type structure on return on assets
(Eq.3) using fixed effects model. A denotes return on assets. F denotes banking financing
ratio. T denotes mercantile credit ratio. M denotes the market value of the company. G
denotes revenue growth rate. B denotes board size. t-statistics in parentheses. Which is the
p-values. *** p<0.01, ** p<0.05, * p<0.1.
Table 4 presents the results of the impact of debt financing on return on assets (Eq.1) using a
fixed effects model. The study discusses the results to determine whether debt has an impact
on startup profitability. Table 4.4 examines the impact of debt level structure and debt type
structure on the profitability of start-ups. The results show that the impact of gearing on the
return on total assets of start-ups is negatively related, in line with hypothesis 1 of this study,
and the results are extremely significant. It would seem that the more debt a firm uses, the
more its profitability declines.
The table 4 also shows that the bank financing ratio and the mercantile credit ratio have
different effects on the return on total assets, with the bank financing ratio having a negative
effect on the return on total assets and the mercantile credit ratio having a positive effect on
the return on total assets, and the results are extremely significant. This also implies that there
is an inverse relationship between the profitability of a start-up and the bank financing ratio,
but a positive relationship with the mercantile credit ratio. This means that the higher the
Business Management and Strategy
ISSN 2157-6068
2023, Vol. 14, No. 1
57
bank financing ratio of a start-up, the lower the profitability and the higher the mercantile
credit ratio, the higher the profitability. This indicates that the impact of the various types of
debt financing on the profitability of start-ups is different and does not fully comply with
Hypothesis 3 of this study.
Robustness Test
The robustness test in this study was conducted by swapping variables. This was done by
swapping the dependent variable from ROA to ROE and by reversing the control variable
from company market value to company assets. This was done to ensure that the results were
reliable.
Table 5. Impact of debt financing on return on equity
VARIABLES
E
AR
-0.632***
(-26.57)
F
-0.512***
(-6.47)
T
0.227***
(5.60)
M
0.000***
(10.45)
G
0.104***
(24.17)
B
-0.033
(-0.10)
Constant
20.128***
(9.08)
Observations
6,502
Number of companies
865
R-squared
0.230
Note: This table determines the results of impact of debt type structure on return on equity
(Eq.3) using fixed effects model. A denotes return on equity. F denotes banking financing
ratio. T denotes mercantile credit ratio. M denotes the market value of the company. G
denotes revenue growth rate. B denotes board size. t-statistics in parentheses. Which is the
p-values. *** p<0.01, ** p<0.05, * p<0.1.
Table 5 presents the results of the impact of debt level structure on return on equity (Eq.1)
using a fixed effects model. By swapping the dependent variable from ROA-ROE, the study
can examine the impact of debt financing on the profitability of start-ups. The impact of debt
financing on the profitability of startups was examined by reversing the dependent variable
Business Management and Strategy
ISSN 2157-6068
2023, Vol. 14, No. 1
58
from ROA-ROE. The results show that after swapping the dependent variables, the effect of
gearing on return on equity is negative. The results are extremely significant, in line with the
results of the regression analysis. This further establishes that there is an inverse relationship
between the profitability of a start-up and the gearing ratio, with the more debt a start-up uses,
the less profitable it is. Hypothesis 1 was further confirmed.
It is also evident from the results that the impact of the bank financing ratio and the
mercantile credit ratio on the return on net assets continues to be different, with a negative
correlation between the bank financing ratio and the return on net assets and a positive
correlation between the mercantile credit ratio and the return on net assets, and the results are
extremely significant and consistent with the results of the regression analysis. This also
implies that the higher the bank financing ratio used by a start-up, the lower the profitability,
while the higher the mercantile credit financing ratio used, the higher the profitability.
Table 6. Impact of debt financing on return on assets (company’s assets)
VARIABLES
A
AR
-0.227***
(-20.36)
F
-0.129***
(-3.39)
T
0.059***
(3.10)
C
0.000***
(0.28)
G
0.059***
(29.23)
B
-0.043
(-0.28)
Constant
9.268***
(8.19)
Observations
6,507
Number of companies
865
R-squared
0.192
Note: This table determines the results of impact of debt type structure on return on assets
(Eq.3) using fixed effects model. A denotes return on assets. F denotes banking financing
ratio. T denotes mercantile credit ratio. C denotes the company’s assets. G denotes revenue
growth rate. B denotes board size. t-statistics in parentheses. Which is the p-values. ***
p<0.01, ** p<0.05, * p<0.1.
Table 6 presents the results of the impact of debt financing on return on assets (company's
assets) (Eq. 1) using a fixed effects model. By swapping, the impact of debt on the
profitability of start-ups is examined by reversing the control variables from the firm's market
capitalization to the firm's assets. From the results, it can be seen that after swapping the
control variables, the effect of gearing on total assets return is negative. This is with a
significance of 1% indicating that the results are extremely significant, in line with the results
of the regression analysis. This also implies that there is an inverse relationship between
Business Management and Strategy
ISSN 2157-6068
2023, Vol. 14, No. 1
59
profitability and gearing of start-ups, with the higher the gearing of start-ups, the lower the
profitability, in line with hypothesis 1.
The impact of debt maturity structure on the profitability of start-ups varies, as seen in the
results, with the bank financing ratio having a negative impact on the return on total assets
and the mercantile credit ratio having a positive impact on the return on total assets, and the
results are extremely significant and consistent with the regression results.
5. Discussion
Firstly, from the perspective of debt level structure, the gearing ratio has a statistically
significant negative impact on the return on total assets. This suggests that when a start-up
has a need for financing and chooses to increase the proportion of debt financing, the
profitability of the firm decreases. Although debt has the advantage of being tax deductible
and debt financing does not require the sharing of excess profits with creditors, it is difficult
for a start-up to be profitable in the beginning stages of its operations and the fact that debt
financing requires interest repayments and the repayment of principal and interest within a
specified period of time leads to an increased risk of bankruptcy if the borrowed funds are not
repaid on time, which is supported by trade-off theory. This is in sharp contrast to empirical
studies by Badi and Ishengoma (2021); Singh and Kumar (2017); and others. In line with the
results of Yazdanfar and Öhman (2015).
The final findings show that different types of debt financing methods have different effects
on the profitability of start-ups. The results indicate that early-stage firms choose bank
financing, which can reduce the profitability of the firm. Due to the strict vetting procedures
of banks and other financial institutions for loans to start-ups, coupled with the high threshold
for firms to issue bonds in the market, start-ups may face higher interest rates for loans than
larger firms or firms with superior credit when using bank financing, resulting in a situation
where bank financing reduce the profitability of start-ups (Yin, Jianzhong, and Jundan Pi,
2017). But the use of mercantile credit instead increases the profitability of startups because
mercantile credit usually occurs in commodity transactions and has a low financing threshold
and no interest payment compared to other financing methods, making financing costs lower
(Yan, 2017).
This study concludes that debt financing can reduce the profitability of start-ups and that the
use of debt financing when revenues are insufficient may pose risks to start-ups, with the
exception of mercantile credit. The limited financing resources, narrow access to finance and
high risk of debt financing for start-ups are constraining the economic growth of start-ups and
hindering their economic progress. Effective identification of debt financing risks for
start-ups and timely control of the sources of risk are necessary to promote the healthy and
sustainable development of start-ups.
Business Management and Strategy
ISSN 2157-6068
2023, Vol. 14, No. 1
60
6. Conclusion
The findings of this study have several practical and policy implications. Companies should
use debt capital wisely and actively leverage their financial resources, thus helping them to
use their capital efficiently. Startups should strengthen their businesses when raising capital,
and the first thing they should consider is endogenous financing. Startups have relatively low
earnings, so retained earnings are low and therefore internal source financing is insufficient.
To solve such a problem, start-ups must focus on their own development and improve their
overall business operations. Improve the ability of the business to continue as a going
concern. Furthermore, a reasonable dilution of equity at the early stage of corporate
development does maintain the stability of the company to some extent, since a higher
concentration of equity allows the company to resist hostile mergers and acquisitions in the
external market, but this situation is also prone to undemocratic and unscientific
decision-making. Therefore, start-ups should dilute the company's equity reasonably and
strategically bring in external investors to allocate resources appropriately for the betterment
of the company while ensuring sound growth.
Finally, start-ups should enhance their credit awareness. Corporate credit is fundamental to
the survival and development of a company, and good credit is crucial to the basis for
cooperation in business development. As one of the main suppliers of financing for start-ups,
banks play a crucial role in financing start-ups. Therefore, a positive banking relationship
also determines the success of start-up financing, and the credit of the company is a decisive
factor for a positive banking relationship. Start-ups should apply to their banks for a credit
rating of their company to enhance their understanding of the overall situation of the start-up
and to reduce information asymmetry. In addition, start-ups should actively cooperate with
banks to enhance mutual trust and understanding, so that by generating a positive credit
record and maintaining an excellent credit rating, they can obtain timely approval for loans
when they need funds, thus reducing intermediate steps and gaining valuable time for the
company; and when using business credit between companies, start-ups should also value
their own credit and repay loans in a timely manner to avoid credit rating When using
business credit between companies, start-ups should also value their own credit and repay
their loans in a timely manner to avoid a decline in credit rating and a loss of good credit
history, which could affect their ability to refinance. Before debt financing, start-ups should
determine the financing process in strict accordance with the established investment direction
and the required funds; at the same time, they should also measure their maximum financing
capacity according to their own strength and debt-servicing capacity, not only to analyses the
economic benefits and development opportunities brought by the investment project, but also
to adjust the financing method and financing structure to the maximum extent to ensure the
scientific nature of the decision.
7. Suggestions for Future Research
Based on the findings, this study suggests future research in the following areas. Firstly, this
study only looks at start-ups in China. Future research could be expanded to include Asian
Business Management and Strategy
ISSN 2157-6068
2023, Vol. 14, No. 1
61
companies as a whole or worldwide, but it is important to note that different countries use
different However, it is important to note that different countries use different tax systems and
have a different level of financial development, and this study could be extended by
examining the impact of debt financing on the profitability of start-ups in the Asian region.
Secondly, and secondly, with the diversification of financing methods, the impact of
alternative financing methods on profitability could be evaluated. Again, this can be done by
examining the different sources of debt and by subdividing banks into different kinds of
banks based on the institutions from which they borrow. Additionally, this can be
accomplished by comparing the differences and offering ideas for bank reform. Future
research could also be conducted on investor behavior, in the early stages of a business, to see
whether investors are interested in investing in debt-financed start-ups or equity-financed
start-ups.
References
Aziz, S., & Abbas, U. (2019). Effect of debt financing on firm performance: A study on
non-financial sector of Pakistan. Open Journal of Economics and Commerce, 2(1), 8-15.
Badi, L., & Ishengoma, E. (2021). Access to Debt Finance and Performance of Small and
Medium Enterprises. Journal of Financial Risk Management, 10(03), 241-259.
https://doi.org/10.4236/jfrm.2021.103014
Chen, X. P., & Zou, N. F. (2019). A study on the impact of debt financing maturity structure
of listed agricultural companies on corporate performance. Journal of Yunnan Agricultural
University (Social Science) (02), 108-113.
Cole, R. A., & Sokolyk, T. (2018). Debt financing, survival, and growth of start-up firms.
Journal of Corporate Finance, 50, 609-625. https://doi.org/10.1016/j.jcorpfin.2017.10.013
Fama, E. F., & French, K. R. (2005). Financing decisions: who issues stock? Journal of
Financial Economics, 76(3), 549-582. https://doi.org/10.1016/j.jfineco.2004.10.003
Fulghieri, P., García, D., & Hackbarth, D. (2020). Asymmetric Information and the Pecking
(Dis)Order. Review of Finance, 24(5), 961-996. https://doi.org/10.1093/rof/rfaa005
Hall, G., Hutchinson, P., & Michaelas, N. (2000). Industry effects on the determinants of
unquoted SMEs' capital structure. International Journal of the Economics of Business, 7(3),
297-312. https://doi.org/10.1080/13571510050197203
Harris, M., & Raviv, A. (1991). The theory of capital structure. The Journal of Finance, 46(1),
297-355. https://doi.org/10.1111/j.1540-6261.1991.tb03753.x
Hou, J. R. (2009). Research on the financing of high-tech entrepreneurial enterprises: policy
design and practical development [D]. University of Electronic Science and Technology.
Javed, T., Younas, W., & Imran, M. (2014). Impact of capital structure on firm performance:
Evidence from Pakistani firms. International Journal of Academic Research in Economics
Business Management and Strategy
ISSN 2157-6068
2023, Vol. 14, No. 1
62
and Management Sciences, 3(5), 28. https://doi.org/10.6007/IJAREMS/v3-i5/1141
Miglo, A. (2016). Capital Structure in the Modern World. Springer International Publishing.
https://doi.org/10.1007/978-3-319-30713-8
Miller, M. H. (1977). Debt and taxes. The Journal of Finance, 32(2), 261-275.
https://doi.org/10.2307/2326758
Singh, H. P., & Kumar, S. (2017). Working Capital Requirements of Manufacturing SMEs:
Evidence from Emerging Economy. Review of International Business and Strategy, 27.
https://doi.org/10.1108/RIBS-03-2017-0027
Sun, J., & Ouyang, Q. J. (2019). An empirical study on the impact of debt financing structure
on firm's financial performance - An example of listed companies in electronic equipment
manufacturing industry. Guangxi Quality Supervision Herald, (11), 105-106.
Yan, R. (2017). Analysis of the impact of debt financing structure on financial performance of
listed companies in the transportation industry (Master's thesis, East China Jiaotong
University).
https://kns.cnki.net/KCMS/detail/detail.aspx?dbname=CMFD201801&filename=101781981
6.nh
Yazdanfar, D., & Öhman, P. (2015). Debt financing and firm performance: an empirical study
based on Swedish data. The Journal of Risk Finance, 16(1), 102-118.
https://doi.org/10.1108/jrf-06-2014-0085
Yin, J. Z., & Pi, J. D. (2017). Debt financing structure and firm performance - An empirical
test based on manufacturing listed companies. Journal of Urbanism, (01), 19-23.
Copyright
Copyright for this article is retained by the author(s), with first publication rights granted to
the journal.
This is an open-access article distributed under the terms and conditions of the Creative
Commons Attribution license (http://creativecommons.org/licenses/by/4.0/).
