Capital Growth, Financing Source
and Profitability of Small Businesses:
Evidence from Taiwan Small Enterprises
ABSTRACT. This paper examines the relationship between
profitability and financial capital for 1,276 small firms in
Taiwan over the period 1992–1997. The results indicate a
statistically positive relationship between profitability and
capital growth. When financial capital is further divided into
debt and equity, the results indicate a significantly positive
relationship between profitability and equity financing, but a
significantly negative relationship between profitability and
debt financing. Moreover, the profitability of small firms is
positively related to both the external economic conditions and
the firms’ previous profitability.
1. Introduction
This paper examines the relationship between
profitability and capital growth for small firms in
Taiwan. Specifically, we investigate if there exists
a positive relationship between profitability and
capital growth. Financial capital is an important
production factor that is of particular importance
for small firms. One major difficulty small firms
Final version accepted on May 4, 2001
Tze-Wei Fu
Graduate School of Financial Resource Management
National Defense Management College
Taipei County
Taiwan, ROC
Mei-Chu Ke
Department of Industrial Engineering and Management
National Chin-Yi Institute of Technology
Taipin, Taichung
Taiwan, ROC
Yen-Sheng Huang
Department of Business Administration
National Taiwan University of Science and Technology
43 Keelung Road
Section 4, Taipei
Taiwan, ROC
E-mail: yshuang@ba.ntust.edu.tw
Small Business Economics 18: 257–267, 2002.
 2002 Kluwer Academic Publishers. Printed in the Netherlands.
Tze-Wei Fu
Mei-Chu Ke
Yen-Sheng Huang
have is the lack of financial capital. Moreover, in
Taiwan, small firms usually are unable to issue
securities in financial markets. This constraint on
financial capital might have a significant impact
on the profitability of small firms. An under-
standing of the relationship between profitability
and capital growth will enhance our knowledge
concerning the determinants of the success and
failure for small firms.
Two major forms of financial capital are debt
and equity. If financial capital plays an important
role in the profitability of small firms, it would
be interesting to answer a further question on the
relationship between profitability and different
sources of financing. Specifically, we address the
issue of whether there exists a positive relation-
ship between profitability and equity financing,
and whether there exists a negative relationship
between profitability and debt financing for small
firms.
Small firms typically find it difficult to borrow
from a commercial bank due to inadequate col-
lateral value of assets and unstable cash flows.
Moreover, costs of debt financing are usually
higher for small firms than for large firms due to
the higher credit risk of small firms. Thus, heavy
reliance on debt financing for capital needs may
be negatively related to the profitability of small
firms. In contrast, internal equity such as retained
earnings is under the discretion of managers and
is a more convenient way of financing source for
small firms. Thus, if small firms are able to
support capital needs through equity financing,
they might be in a better position to undertake
profitable investment opportunities. If so, there
would exist a positive relationship between
profitability and equity financing.
Despite of its importance, the issue of the
258 Tze-Wei Fu et al.
relationship between profitability and financial
capital is not fully understood for small firms in
Taiwan. This paper examines this issue for 1,276
small firms in Taiwan over the period 1992–1997.
The results support the notion that financial capital
is significantly positively related to the prof-
itability of small firms. Moreover, profitability is
significantly positively related to equity financing,
and significantly negatively related to debt
financing.
The plan of this paper is as follows. The next
section provides a brief literature review. The third
section develops the relevant hypotheses. The
fourth section describes the data and the method-
ology. The fifth section reports empirical results.
The last section concludes.
2. Literature review
Previous researchers hypothesize a positive rela-
tionship between profitability and financial capital.
Geroski et al. (1997) suggest that the corporate
growth rate for the current period should reflect
the assessment of managers concerning the long-
term profitability of the company. Using data form
271 large firms in the United Kingdom, they find
a significantly positive correlation between the
corporate growth rate for the current period and
the changes in expectations about the firm’s long-
term profitability. Similarly, Echevarria (1997)
examines a sample of Fortune 500 industrial com-
panies over the twenty-year period from 1971
through 1990 and finds a positive relationship
between capital investment and profitability. These
results, however, are based on samples of large
firms.
For small firms, the issue of undercapitalization
has received much attention. Davidson and Dutia
(1991) note that small firms tend to have difficulty
to access the financial market. Thus, small firms
are usually forced to finance firm growth through
debt. The lack of capital tends to lead small firms
to lower profitability. Davidson and Dutia examine
financial data of small firms provided by Robert
Morris and Associates over the period from 1983
through 1987 and find that the heavy usage of debt
as a financing source is an important factor for the
lower profitability of small firms. Similarly,
Ballantine et al. (1993) examine the relationship
between financial structure and the profitability
for small firms. Using data from the IRS Corporate
Source Book of the Statistics of Income, they find
lower profits for small firms that use higher debt.
More recently, Hughes (1997) examines small
firms in the United Kingdom and reaches similar
conclusions that profitability for small firms is
lower due to their heavy reliance on debt.
Holmes et al. (1994) investigate the costs of
debt for small firms. They propose that the
application costs for debt is higher for small firms
than for medium and large firms. Using data from
425 small and large Australia firms, they find that
the cost of debt financing is higher for small firms
than that for medium and large firms. Since the
application cost for debt is higher for small firms,
this higher debt financing cost may deter small
firms from growth. Similarly, Binks and Ennew
(1996) examine the issue of financing constraint
on growing firms. They survey a sample of over
6,000 firms in the United Kingdom and find that
firms expecting to grow in the future do perceive
a rather tight credit constraint.
Given that debt financing is costly for small
firms, small firms may prefer to rely more on
internal equity as a source of fund. Chittenden et
al. (1996) examine 3,480 small firms in the United
Kingdom and find that small firms rely more on
internal funds. More recently, Jordan et al. (1998)
survey small firms in the England and find that
small firms tend to use retained earnings first, then
resort to debt when retained earnings are used up,
and finally to external equity when borrowing
limits are reached. These results are consistent
with the pecking order hypothesis for capital
policy adopted by firms.
3. Hypotheses
Capital growth and profitability
Capital growth refers to an increase in capital a
firm puts forth in investments. These investments
may involve both tangible assets, such as fixed
assets and current assets, and intangible assets
such as brand equity. In general, a firm should
invest only in an asset that generates positive net
present value. That is, an investment should be
accepted only if the expected rate of return
exceeds the relevant opportunity cost.
Aside from financial capital, two other factors