An Empirical Analysis of the Business Failure Process for Large and Small Firms

By Campbell, Steven V.; Choudhury, Askar H. | Academy of Entrepreneurship Journal, January 2002 | Go to article overview

An Empirical Analysis of the Business Failure Process for Large and Small Firms


Campbell, Steven V., Choudhury, Askar H., Academy of Entrepreneurship Journal


ABSTRACT

This paper investigates endogenous dependence in the business failure process for large and small businesses. After controlling for systemic growth, we find the momentum in business failures from their cumulative lagged effect over time influences other distressed business to fail and creates a domino-effect. For both large and small businesses, endogenous dependence is most effectual in the months immediately prior to failure and then gradually dissipates to a level of insignificance within a two year lag. We also find new business formations counterbalance to some degree the domino-effect of business failures; however, the lag effect for new business formations is twice as long for large firms compared to small firms. Our results suggest theories of business failure and bankruptcy prediction models would be enhanced by incorporating endogenous dependence in the business failure process as an explanatory variable.

INTRODUCTION

Empirical evidence suggests business failure is a combination of firm-specific (micro) factors (e.g.; Altman, 1968, 1971; Hambrick & Crozier, 1985; Duchesneau & Gartner, 1990; Lussier, 1996; Perry, 2001; Carland et al., 2001) and external (macro) factors related to the business cycle (e.g;. Altman, 1971; Carroll & Delacroix, 1982; Rose et al., 1982; Yrle et al., 2001). The common thread running through these prior studies is their focus on the exogenous determinants of business failure, which the literature suggests are many. As Carland et al. (2001) observe, "The study of small business failure has been so institutionalized, that the causes of failure have become cliches: managerial incompetence, undercapitalization, etc" [p.78].

The purpose of this paper is to analyze endogenous dependence in the business failure process. Specifically, we present evidence of lead times in two forces affecting the number of large and small business failures. One force is business failure momentum which we characterize as a domino-effect: one firm's failure causes other firms to fail which cause still more firms to fail and so on. We also present evidence of lead times in the competing force of new business formations: the formation of a new business prevents other established firms from failing which prevent still more firms from failing and so on. Research along these lines could add an important new dimension to the existing body of business failure research by enhancing existing bankruptcy prediction models, improving managerial decision making, and helping auditors, bankers, and financial analysts assess the failure risk of their clients.

While some specific hypotheses can be generated, our limited understanding of business failure endogenicity suggests an exploratory, inductive research approach is appropriate and this study takes such an approach. For our empirical analysis we use quarterly and monthly business failure data for the period January 1986 to September 1998. Separate regressions are estimated for large business failures and small business failures, and for each regression various lead-lag relationships are tested in order to determine the highest statistical correlation, on a multivariate basis, between variables. To control for systemic growth, our regression analysis includes a linear time trend control variable and, where appropriate, we adjust for the affects of autocorrelation.

Overall our evidence indicates significant endogenous dependence in the business failure process for both large and small firms, with the stronger correlations occurring in the case of small firms. For both large and small firms, endogenous dependence is most influential in the months immediately prior to failure then gradually dissipates to a level of insignificance within two years. Our results further suggest new business formations counterbalance to some degree the domino-effect of business failure momentum; however, the lag effect for new business formations is twice as long for large firms compared to small firms. …

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