This study aims to identify the relationship between the financial flexibility of small and medium-sized enterprises (SMEs) and their profitability and working capital management.
The empirical study is based on a statistical analysis of 15,079 firms from 9 Central and Eastern European (CEE) countries from 2014–2022.
SMEs from CEE build their financial flexibility on debt capacity, and accumulating a stock of financial flexibility increases their profitability. Financially flexible SMEs are characterised by a higher share of working capital in total assets. However, increasing the stock of financial flexibility does not change their cash conversion cycle. The relationship between working capital management and SMEs' profitability is negative and linear. Financial flexibility significantly moderates it. In more financially flexible SMEs, the increase in working capital reduces profitability to a lesser extent.
SME managers must be aware that investing in liquidity generally reduces profitability. They can mitigate this negative effect by building financial flexibility. By increasing financial flexibility, SMEs can improve profitability and adjust the working capital levels without either shortening or excessively extending the cash conversion cycle. By improving SMEs' access to capital, policymakers can increase opportunities for them to build financial flexibility, thereby improving profitability and the conditions for working capital management.
The study confirms that SMEs' financial flexibility affects profitability and working capital management differently than in large enterprises. The diagnosed dependencies provide evidence for extending the financial flexibility theory to the context of short-term SME activity.
1. Introduction
The problem of financial flexibility and its use first appeared in the study by Myers and Majluf (1984), who defined the concept of “financial slack” as “a high level of cash or fast-moving securities or the possibility of issuing risk-free debt”. Based on the constructed model of investment policy, they stated that financial slack, as understood in this way, is not a necessary condition for investments but rather a factor that greatly facilitates them. This statement has directed research on financial flexibility for many years. Currently, two theoretical approaches dominate the literature. The first one is embedded in the theory of corporate investment and refers to the positive impact of financial flexibility on investment capacity, especially in difficult financial conditions (e.g. Damodaran, 2001; Marchica & Mura, 2010; Ferrando, Marchica, & Mura, 2017). The second approach focuses on the financial flexibility as the ability of firms to obtain financing and carry out restructuring at the lowest possible cost (DeAngelo & DeAngelo, 2006; Gamba & Triantis, 2008; Byoun, 2008; Arslan-Ayaydin, Florackis, & Ozkan, 2014).
The above-mentioned theory of financial flexibility was developed based on theoretical and empirical research conducted in the large enterprise sector. The financial behaviour of small and medium enterprises (SMEs), whose importance to the market economy is unquestionable, has not been studied to a comparable extent. Meanwhile, limited access to capital is commonly recognised as a barrier to SMEs' development (Beck & Demirguc-Kunt, 2006; European Central Bank, 2014; Kersten, Harms, Liket, & Maas, 2017). Therefore, they have less ability to create and maintain financial flexibility.
The prevailing view in the literature, based on the main theory, is that the source of financial flexibility is excess cash accumulated and/or unused debt capacity (Budiman, Murtadho, & Ferrinadewi, 2023; Byoun, 2008; Denis, 2011; Ferrando et al., 2017). The impact of cash holdings on the investment capabilities of enterprises was studied, among others, by Martínez-Sola, García-Teruel, and Martínez-Solano (2018), La Rocca, Staglianò, La Rocca, Cariola, and Skatova (2019), Setianto and Kusumaputra (2019), and Islam, Haque, and Moutushi (2022). However, the most frequently identified source of financial flexibility among large enterprises is debt capacity (Byoun, 2008; Daniel, Denis, & Naveen, 2010; Marchica & Mura, 2010). To the best of our knowledge, the primary source of SME financial flexibility has not yet been empirically identified. Thus, the first research question can be formulated:
What is the primary source of financial flexibility in SMEs?
Although excess cash and debt capacity are related to working capital management and ongoing firm performance, financial flexibility theory does not address them directly. It focuses mainly on investment in fixed assets. Explanations of the relationships between corporate profitability, working capital, and financial flexibility rely on other theories, often yielding different results. However, one of the main theses of the financial flexibility theory is that flexible firms not only invest more, but also invest better (Marchica & Mura, 2010). A more efficient and effective use of investments suggests that the current performance of these companies should also be higher than that of companies without financial flexibility.
As evidenced by the literature reviews by Islam, Wang, and Dewri (2019), and Suciati, Sumiati, Indrawati, and Andarwati (2024), the positive relationship is most often empirically observed. The most convincing evidence for this relationship has been provided by Arslan-Ayaydin et al. (2014), Ma and Jin (2016), Cherkasova and Kuzmin (2018), Ali and Siddiqui (2020), and Wu, Alkaraan, and Le (2023). The negative relationship between financial flexibility and company profitability has also been observed, among others, by Islam et al. (2022), Ahmad, Kausar, Muhammad, Akram, and Kareem (2023), and Akbar and Setiana (2024). There is also evidence of a nonlinear relationship between financial flexibility and firm performance (Chang & Wu, 2022; Gu & Yuan, 2020; Yi, 2020; Zhang, Chang, & Wu, 2022). Most of the studies cited were conducted in the large-enterprise sector; research among SMEs is relatively rare, resulting in a lack of well-established knowledge on the relationship between SME financial flexibility and profitability. This justifies the formulation of the second research question:
What is the direction and shape of the impact of financial flexibility on SME performance?
The impact of financial flexibility on working capital management is the least studied relationship. According to the main theory, financial flexibility enables quick and low-cost financing of enterprise expenses. This suggests it can positively impact working capital management by providing additional liquidity. Such a relationship was empirically discovered among large companies by, e.g. Le Quang (2016), Mahmood, Rizwan, and Rashid (2018), and Karimi, Karami, Basirat, and Karam (2023). However, because fixed assets are a competitive alternative to working capital, using financial flexibility to finance fixed assets may reduce the efficiency of working capital management. Evidence for the negative relationship between financial flexibility and working capital management in large companies was provided by Budiman et al. (2023) and Ratnawati and Yuana (2021). Considering the narrow overall scope of research on the impact of financial flexibility on working capital management and the lack of evidence from the SME sector, an important research question is:
Does financial flexibility affect SME working capital management and how?
In turn, the literature provides ample empirical evidence and widely accepted theoretical concepts on the relationship between profitability and working capital management, see, e.g. (Li, Dong, Chen, & Yang, 2014; Jaworski & Czerwonka, 2022). However, assuming that financial flexibility affects profitability and working capital management simultaneously, it may also moderate the relationship between these variables (Ouma, 2022). This moderating effect is relatively rarely evidenced, especially among SMEs, which is the basis for the last research question:
Does financial flexibility moderate the impact of working capital management on the profitability of SMEs?
The research gap outlined by the research questions also has a geographical context. SMEs from Central and Eastern Europe (CEE) have not been investigated in any of the described directions. Meanwhile, this part of Europe is characterised by a market economy with less development and relatively little tradition in the SME sector, which may lead to differences in the creation and use of financial flexibility compared to developed economies. Therefore, our empirical study used statistical and econometric methods based on financial data of 15,000 SMEs from nine CEE countries.
The study contributes to existing knowledge in two ways. First, several new stylised facts regarding financial flexibility of SMEs from CEE were detected: (1) debt capacity is the main source of SME financial flexibility, (2) financial flexibility increases SME profitability, (3) the higher financial flexibility, the higher share of working capital in total assets, and (4) financial flexibility positively moderates the relationship between SME profitability and working capital management. Secondly, the diagnosed dependencies provide evidence for extending the financial flexibility theory to the context of short-term SME activity. Accumulating financial flexibility not only positively influences SMEs' investments in fixed assets but also, according to the trade-off theory, helps maximise their profitability. Financially flexible SMEs are more likely to build higher levels of working capital without changing their cash conversion cycle, providing a link between financial flexibility theory and working capital adjustment theory. Simultaneously, building financial flexibility reduces the strength with which working capital management negatively impacts SME profitability.
The paper is divided into five parts. The first is a literature review that provides a theoretical background on the impact of financial flexibility on firm performance and working capital management, along with a summary of the most important empirical studies in the SME sector. Based on this, the research hypotheses have been formulated. The second part of the article describes the research material and the method used. In the third part, the results of the empirical study are presented. Their discussion and main conclusions are in the last two sections of the article.
2. Theoretical background and research hypotheses development
Financial flexibility theory holds that a company maintaining financial flexibility reserves has the potential to undertake future investments despite existing constraints arising from information asymmetry and high agency costs (Ferrando et al., 2017). However, it is more often stated that financial flexibility enables a company to obtain financing and carry out restructuring at the lowest possible cost (DeAngelo & DeAngelo, 2006; Byoun, 2008; Gamba & Triantis, 2008; Arslan-Ayaydin et al., 2014). This means that a financially flexible company can avoid financial difficulties in the face of negative shocks and obtain financing relatively easily, at minimal cost, when profitable investment opportunities arise.
Prior research has shown that companies can achieve financial flexibility through (1) managing the company's liquidity, (2) capital structure policy or/and (3) dividend payment policy (DeAngelo & DeAngelo, 2006; Denis, 2011; Arslan-Ayaydin et al., 2014; Ferrando et al., 2017). The first method consists of maintaining high liquidity of current assets and, consequently, high cash holdings. It is rooted in the liquidity preference theory (Keynes & Moggridge, 1973), which holds that investors who invest in liquidity also expect higher returns from long-term investments. The study by Martínez-Sola et al. (2018) on Spanish SMEs operating from 1998 to 2021 confirmed the existence of a target cash position that ensures appropriate financial flexibility. Similar conclusions were reached by La Rocca et al. (2019), who studied SMEs across 36 European countries from 2008–2015. Enterprises with higher cash holdings achieved better company performance. However, maintaining high cash holdings requires a flexible short-term financial policy that involves greater employed capital (equity and long-term debt). For SMEs, access to this capital is difficult due to the sector's high business risk, insufficient creditworthiness, and limited opportunities to secure loans. This situation is observed mainly in countries with relatively underdeveloped financial markets. In this case, some SMEs incur small debts below their potential capabilities. This is how a “forced” debt capacity is created. This situation is confirmed by research, among others by Bilyay-Erdogan (2020), who showed, using a mixed sample of 6,000 SMEs from 21 European economies, which in less developed economies debt capacity has a more substantial impact on increasing enterprise value. The third method of building financial flexibility, i.e. through dividend policy, is less relevant to SMEs, which by their nature rarely pay dividends. Therefore, considering the Q1 research question, the following hypothesis can be formulated:
Debt capacity is the primary source of financial flexibility for SMEs from CEE.
The financial flexibility theory does not directly address the relationship between financial flexibility and profitability. However, according to the trade-off theory (Kraus & Litzenberger, 1973; Myers, 1984), higher profitability, which increases self-financing possibilities and reduces the costs of issuing capital (equity and debt), lowers the risk of financial difficulties. In turn, higher financial liquidity and greater opportunities to obtain capital increase external opportunities and promote enterprise growth. This means that financial flexibility positively affects profitability.
On the other hand, the pecking order theory indicates that investments in fixed assets are competitive with working capital (Myers & Majluf, 1984). This means that if a company builds its flexibility by increasing cash holdings, it does not invest in fixed assets, causing overinvestment in working capital. In turn, if it uses debt to build financial flexibility, this may lead to underinvestment in working capital. Both situations usually reduce the company's profitability (a negative relationship between financial flexibility and profitability).
The last, nonlinear relationship between financial flexibility and profitability is explained by the theory of corporate liquidity management, which claims that firms adjust their capital structure to maintain liquidity, first and foremost by maintaining financial flexibility. This in turn supports profitability by allowing them to respond to market opportunities (Almeida, Campello, Cunha, & Weisbach, 2014). This theory is consistent with another concept, the theory of adjustments in working capital management (Baños-Caballero, García-Teruel, & Martínez-Solano, 2013). Low levels of financial flexibility enable quick adjustments to optimal working capital levels, thereby achieving maximum profitability. Exceeding a certain threshold in financial flexibility increases working capital management costs and decreases profitability when used.
Consistent with the trade-off theory, a positive relationship between profitability and financial flexibility is often diagnosed empirically among SMEs (Baños-Caballero, García-Teruel, & Martínez-Solano, 2016; Martínez-Sola et al., 2018; La Rocca et al., 2019). The negative impact of financial flexibility on SME profitability has not been empirically diagnosed, and no research has been undertaken on the nonlinear impact. To answer the Q2 research question and investigate whether the remaining theories may also explain SMEs' financial behaviour, two alternative hypotheses should be verified:
Financial flexibility has a positive linear effect on SME profitability.
or
The relationship between financial flexibility and SME profitability is nonlinear.
According to the theory of working capital adjustment (Baños-Caballero et al., 2013) and the cash conversion cycle theory (Richards & Laughlin, 1980), effective working capital management enables achieving the optimal cash conversion cycle without the need to engage additional capital. This translates into creating internal financial flexibility by increasing debt capacity and/or cash holdings. These theories, therefore, explain the positive relationships between financial flexibility and levels of the cash conversion cycle and working capital.
An alternative concept assumes that, in the short term, creating financial flexibility by maintaining debt capacity and increasing cash holdings reduces the risk of liquidity loss but simultaneously reduces investment in other working capital components (inventories and receivables). According to the operating cycle theory (Park & Gladson, 1963), this means that limiting the company's credit policy while reducing inventory turnover and shortening the cash conversion cycle is necessary. Yet another approach to the impact of financial flexibility on working capital management results from the pecking order theory. This theory indicates that investing in working capital is competitive with fixed assets. Therefore, if financial flexibility is used to finance investments in fixed assets, it may imply lower capital involvement in working capital. Both theories (the operating cycle theory and the pecking order theory) explain the negative impact of financial flexibility on working capital and the cash conversion cycle.
The literature lacks empirical research on the direction of financial flexibility's impact on working capital management in SMEs. However, because they operate with limited access to capital, which puts them under high pressure to maintain liquidity, investing in working capital seems to be a priority over investing in fixed assets. Therefore, according to the working capital adjustment and cash conversion cycle theories, maintaining and utilising financial flexibility should support SME working capital management. This suggests a likely answer to the Q3 research question:
Financial flexibility positively affects the indicators of working capital management in SMEs.
The impact of working capital management on a company's profitability has been described theoretically and studied empirically in depth. Three basic concepts derived from the company's financial strategy have been established in the literature (Li et al., 2014; Jaworski & Czerwonka, 2022).
The first concept is based on the assumptions of a flexible financial strategy. Increasing working capital and extending the cash conversion cycle, combined with greater financial liquidity, allow the company to conduct sales more flexibly, positively affecting revenue dynamics and negotiation possibilities when purchasing. Consequently, this improves the company's profitability (positive impact of working capital management on profitability) (Deloof, 2003; Raheman, Afza, Qayyum, & Bodla, 2010). The second concept concerns the implementation of a restrictive financial strategy. Companies with a high level of working capital incur higher costs related to more expensive financing of assets with employed capital and a high level of current assets. This causes negative dynamics in the company's profitability (negative relationship between working capital management and profitability) (Shin & Soenen, 1998; Kieschnick, Laplante, & Moussawi, 2013). The third concept explains the simultaneous presence of positive and negative relationships between WCM and profitability. The resultant relationship is a non-linear, resembling an inverted U-shape. Enterprises characterised by low working capital are trying to increase their payment capacity and are investing primarily in working capital (a positive relationship between working capital management and profitability). After exceeding a certain level of working capital management indicators, further investment in working capital increases costs and decreases profitability (negative relationship) (Baños-Caballero, García-Teruel, & Martínez-Solano, 2012; Jaworski & Czerwonka, 2022).
Assuming a direct impact of financial flexibility on profitability and working capital management of SMEs, it may also indirectly affect the relationship between these two variables (Ouma, 2022). This assumption is consistent with theories of corporate liquidity management and working capital adjustment, which hold that financial flexibility is a catalyst for achieving maximum profitability while maintaining payment capacity.
Among SMEs, Baños-Caballero et al. (2016) examined financial flexibility as a moderator of the relationship between working capital management and profitability. Based on 3,735 observations of Spanish SMEs in 1997–2012, the authors showed a significant, positive moderating effect of financial flexibility on the nonlinear relationship between profitability and WCM for the pre-crisis period (before 2008). Considering Bilyay-Erdogan's (2020) observations, which showed a much greater sensitivity of SMEs in developing economies to changes in financial flexibility, it can be expected that this effect will be even more substantial for SMEs from CEE. Therefore, considering Q4 research question, it can be hypothesised that:
Financial flexibility moderates the relationship between working capital management indicators and profitability.
3. Research material and methodology
The empirical study used financial data from the ORBIS database [1]. The research sample was based on the European Commission's definition of SMEs (European Commission, 2003). Microenterprises were excluded due to a lack of reliable financial data. Consequently, small and medium-sized enterprises meeting three conditions were qualified for the research sample: (1) assets from EUR 2 to 43 million, (2) revenues from EUR 2 to 50 million and (3) employment from 10 to 249 persons. The territorial scope of the study was limited to CEE countries. As a result, a database of enterprises from nine countries was obtained: Bulgaria (741), the Czech Republic (1345), Estonia (694), Croatia (1453), Hungary (3299), Poland (3800), Romania (681), Slovakia (1825), and Slovenia (1241). In total, we collected financial data of 15,079 entities marked in the Orbis database as “corporate” divided into industries according to the NACE Rev. 2 classification (75 industries) completed for the research period 2014–2022. Due to the specificity of the activity, the following industries were excluded: Financial and Insurance Activities (K), Real Estate Activities (L), Public Administration and Defence, Compulsory Social Security (O), Education (P), and Other Service Activities (S). From the research sample prepared in this way, we excluded companies whose data indicated an incorrect entry in the database (e.g. exceeding the 0–1 range for share of debt in all sources of financing, share of fixed assets in total assets, or having negative values, e.g. equity). The sample was also truncated by 1% of the observations in each tail to avoid the impact of outliers. In total, we obtained 135,711 observations. The source of macroeconomic data was the International Monetary Fund databases (International Monetary Fund, 2024).
Table 1 presents the definitions of the variables used in the study.
Variables used in the study
| No. | Variable | Abbreviation | Measures |
|---|---|---|---|
| 1 | Profitability | ROA | |
ROE | |||
| 2 | Working capital management | CCC | |
WC | |||
| 3 | Financial flexibility | FF | – excess cash – debt capacity |
| FF1 | 0 when 1 when | ||
| 4 | Cash flow proxy | CF | |
| 5 | Growth opportunities | GROW | |
| 6 | Size of the enterprise | SIZE | |
| 12 | Annual growth of GDP | GDP_GROW |
The ROA and ROE variables characterise SMEs' short-term financial performance and are dependent variables in measuring the impact of financial flexibility and working capital management on SMEs' profitability. Working capital management is described by the CCC and WC variables. They are dependent variables in models that identify the relationship between working capital management and financial flexibility, and independent variables in models that explain the impact of working capital management on profitability.
Two variables also measure financial flexibility. The first one (FF) is a continuous variable equal to the sum of excess cash (EC) and debt capacity (DC). The reference values for calculating EC and DC were the medians of cash holdings and total debt in a given industry and country, respectively, in the previous year (Ghosh & Cai, 1999; Kale & Noe, 1992; Lev, 1969). FF1 is the second variable characterising financial flexibility. It is a dichotomous variable taking the value of 1 when the company maintained financial flexibility (), and 0 when it did not have it (). The company's size (SIZE), GDP growth dynamics (GDP_GROW), cash flow (CF) and a firm's growth (GROW) were assumed as control variables.
Table 2 presents descriptive statistics for the variables used in the study, calculated from the research sample.
Descriptive statistics of the research sample
| No. | Variable | Mean | Median | Std. Dev. | Min. | Max. |
|---|---|---|---|---|---|---|
| 1 | ROA | 0.0841 | 0.0643 | 0.0913 | −0.1620 | 0.4766 |
| 2 | ROE | 0.0877 | 0.1076 | 22.3 | −4 914.3 | 4 539.5 |
| 3 | CCC | 84.7 | 64.5 | 86.4 | −79.7 | 602.6 |
| 4 | WC | 0.0396 | 0.1378 | 71 494 | −4 540.0 | 882.4 |
| 5 | FF | 0.0240 | 0.0246 | 0.2600 | −0.9738 | 0.9473 |
| 6 | FF1 | 0.5349 | 1 | 0.4989 | 0 | 1 |
| 7 | CF | 0.1123 | 0.0962 | 0.0884 | −0.1288 | 0.4702 |
| 8 | GROW | 0.0679 | 0.0493 | 0.2047 | −0.4962 | 1.0244 |
| 9 | SIZE | 8.7 | 8.5 | 0.9633 | 6.2 | 12.9 |
| 10 | GDP_GROW | 0.0362 | 0.0405 | 0.0358 | −0.0820 | 0.1873 |
The arithmetic means of ROA and ROE are similar. The remaining statistics show a much higher variability of ROE. Similarly, CCC and WC are characterised by relatively high variability. In the case of FF, the arithmetic mean is almost equal to the median. CF and GROW also have values that are pretty close to each other, but with a significant standard deviation. SIZE and GDP_GROW have very similar median and arithmetic mean values. The minimum values of all continuous variables, except SIZE, are negative. Negative ROA, ROE, and CF occur in the case of losses. A negative CCC indicates that the company repays its current liabilities only after receiving payment on receivables, whereas a negative WC indicates that current liabilities exceed current assets. A revenue decrease in the following years causes a negative GROW. Negative GDP_GROW values mean an economic downturn in the country included in the study.
Appendix 1 includes a correlation matrix of Pearson's coefficients for all pairs of variables. These coefficients were also calculated for squared variables used in nonlinear models and products of variables included in models with moderators. Most variables do not show a strong or very strong correlation. Exceptions to this rule are pairs (FF, FF1), (ROA, CF), (WC, WCˆ2), (WC, FF1×WC) and (, FF1×WC) where correlation coefficients exceed the level of 0.80. This means that these variables should not be included as independent variables in the same model. The last rows of Appendix 1 include VIF (Variance inflation factor) coefficients calculated for the models used in the study. Values below 10 indicate no multicollinearity among independent variables (Cleff, 2019).
The study is divided into four stages, ordered by the formulated research questions and hypotheses. The first is to identify the primary component of SMEs' financial flexibility (H1 hypothesis). For this purpose, we used the analysis of descriptive statistics of the FF variable and its components (EC and DC). To examine the statistical significance of the diagnosed differences, we used the T-test (Lynch, 2013). This analysis was supplemented by calculating the Pearson correlation between the resultant variable and partial variables.
The remaining three research hypotheses (questions) address the identification of relationships among assumed variables. All three relationships examined relate to SME short-term financial policy. Therefore, it is justified to use static panel models (OLS, fixed and random effects models) to assess them. They allow for analysing data for a single year without taking into account variable values from previous years. The Breusch-Pagan test was used to diagnose the presence of individual effects. The Hausman test was used to determine whether effects were fixed or random. To assess the model's fit to the data (model goodness), we used the Schwarz Bayesian Information Criterion, Akaike Information Criterion, and Hannan-Quinn Criterion (Greene, 2003). Heteroscedasticity- and autocorrelation-consistent (HAC) standard errors were applied to prevent misjudgement of variable significance due to heteroscedasticity and autocorrelation in the models (Gujarati & Porter, 2009).
Models with the following structure were used to verify the H2 hypothesis (the impact of financial flexibility on profitability):
Four linear models corresponding to the declared dependent variables and financial flexibility measures:
and two nonlinear models:
The first models address the linear relationship between SME financial flexibility and profitability. They allow identifying its sign – positive, resulting from the trade-off theory, or negative, consistent with the pecking order theory. The second group of models allows for the assessment of the non-linearity of the relationship between the adopted measures, derived from the theories of corporate financial liquidity management and working capital adjustment. SIZE and GDP_GROW are control variables, commonly used as determinants of company profitability (Jaworski & Czerwonka, 2022; Li et al., 2014).
In the third stage of the study, we tested the relationship between financial flexibility and working capital management (H3 hypothesis). For this purpose, we estimated the parameters of four models:
The linear relationships assumed in the models between variables characterising working capital management and financial flexibility allow for the assessment of their statistical significance and sign, and, consequently, for determining which of the theories of the working capital adjustment and the cash conversion cycle or the pecking order and the operating cycle theories better explain the behaviour of SMEs in this respect. CF, GROW, SIZE, and GDP_GROW are assumed to be control variables representing the remaining main determinants of working capital management (Baños-Caballero et al., 2013; Le Quang, 2016; Mahmood et al., 2018).
The final stage of the research is to verify hypothesis H4, which posits that financial flexibility moderates the relationship between profitability and working capital management. Considering that this relationship may be linear or nonlinear, we estimated the parameters of the following eight models:
Four nonlinear:
and four linear:
The models' structure is based on three main theoretical concepts commonly used to identify the relationship between profitability and working capital management: nonlinear, linear, positive, or negative (Baños-Caballero et al., 2012; Jaworski & Czerwonka, 2022; Li et al., 2014). Additionally, the FF1 variable was used as a moderator of the main relationship (e.g. Baños-Caballero et al., 2016).
4. Research outcomes
Table 3 presents descriptive statistics of the FF variable and its components (EC and DC). Table 4 is the correlation matrix between these variables.
Descriptive statistics of FF, EC, and DC
| FF | DC | EC | |
|---|---|---|---|
| Mean | 0.0240 | 0.0085 | 0.0139 |
| Median | 0.0246 | 0.0099 | 0.0019 |
| Min | −0.9738 | −0.9715 | −0.4565 |
| Max | 0.9473 | 0.7496 | 0.4599 |
| Std. deviation | 0.2600 | 0.2281 | 0.0846 |
| Variation coef | 10.82 | 26.95 | 6.08 |
| Skewness | −0.0349 | −0.0664 | 0.8156 |
| Curtosis | −0.0349 | −0.4665 | 1.7929 |
| Percentile 5% | −0.4041 | −0.3663 | −0.0846 |
| Percentile 95% | 0.4434 | 0.3324 | 0.1735 |
| Q3-Q4 | 0.3744 | 0.3324 | 0.0938 |
Correlation matrix of FF, EC, and DC
| EC | DC | FF | |
|---|---|---|---|
| FF | 0.5266 | 0.9501 | 1.0000 |
| DC | 0.2352 | 1.0000 | |
| EC | 1.0000 |
The T-test showed statistically significant differences in the means of all three variables, indicating that both components (EC and DC) play an important role in creating SME financial flexibility. However, the relatively high correlation between FF and DC (0.95) compared to that between FF and EC (0.52) indicates that debt capacity is the dominant factor shaping FF size. This is confirmed by the high similarity of the descriptive statistics of FF and DC compared to the parameters of the EC variable (in particular, std. deviation, skewness, kurtosis, percentiles 5 and 95%, Q3-Q4).
Estimating the parameters of the assumed panel models was the next step in the study. Breusch-Pagan and Hausman tests indicated that the fixed effects panel model (FE) is the most efficient estimator in all cases. This approach eliminates the most important channel of potential endogeneity in the analysed context: omitted, unobservable time-invariant variables. It does not alleviate potential simultaneity or the influence of omitted time-varying variables, but for the short-term processes analysed (up to 1 year), it has limited substantive significance (Wooldridge, 2010).
Table 5 presents the model parameters for the impact of financial flexibility on profitability. Five out of six models indicate that financially flexible companies achieve higher profitability. Models 2 and 5 indicate a nonlinear relationship between profitability and financial flexibility. However, for ROE, lower information criteria for the linear model suggest it fits the data better. In the case of model 2, the relationship between the squared variable FF and ROA is positive. Larger companies are characterised by higher profitability, which is also supported by faster GDP growth.
Relationship between profitability and financial flexibility
| Dependent variable | ROA | ROE | ||||
|---|---|---|---|---|---|---|
| Model | 1 | 2 | 3 | 4 | 5 | 6 |
| Panel model type | Fixed | Fixed | Fixed | Fixed | Fixed | Fixed |
| Const | −0.5329*** (0.0089) | −0.5377*** (0.0089) | −0.6115*** (0.0101) | −0.9521*** (0.0331) | −0.9056*** (0.0329) | −1.0715*** (0.0344) |
| FF | 0.2626*** (0.0024) | 0.2597*** (0.0024) | 0.3849*** (0.0122) | 0.4149*** (0.0131) | ||
| FF2 | 0.0645*** (0.0052) | −0.6490*** (0.0399) | ||||
| FF1 | 0.0596*** (0.0008) | 0.0596*** (0.0026) | ||||
| SIZE | 0.0704*** (0.0010) | 0.0704*** (0.0010) | 0.0765*** (0.0012) | 0.1252*** (0.0038) | 0.1248*** (0.0038) | 0.1365*** (0.0040) |
| GDP_GROW | 0.0419*** (0.0034) | 0.0416*** (0.0034) | 0.0227*** (0.0041) | 0.0917*** (0.0159) | 0.0935*** (0.0156) | 0.0573*** (0.0163) |
| No. of obs | 112 344 | 112 344 | 112 344 | 112 866 | 112 866 | 112 866 |
| Joint test on named regressors (F test) | 5834.91 p < 0.001 | 4 521.45 p < 0.001 | 3 427.67 p < 0.001 | 699.31 p < 0.001 | 577.99 p < 0.001 | 573.43 p < 0.001 |
| Breusch-Pagan test | 128876.40 p < 0.001 | 127043.30 p < 0.001 | 112154.70 p < 0.001 | 23880.67 p < 0.001 | 24642.38 p < 0.001 | 23139.69 p < 0.001 |
| Hausman test | 3960.48 p < 0.001 | 4361.94 p < 0.001 | 2454.28 p < 0.001 | 1083.39 p < 0.001 | 1162.99 p < 0.001 | 751.93 p < 0.001 |
| SBC | −223323.31 | −223984.21 | −190342.37 | −166251.79 | −164037.76 | −169551.34 |
| AIC | −366203.17 | −366873.70 | −333222.23 | −23235.71 | −21021.04 | −26535.25 |
| HQC | −323068.23 | −323735.85 | −290087.29 | −66402.83 | −64182.08 | −69702.38 |
Note(s): * dependence is significant at the level of 0.1
** dependence is significant at the level of 0.05
*** dependence is significant at the level of 0.01
(standard errors in parentheses)
Table 6 presents the results of estimating models describing the impact of financial flexibility on working capital management. Financial flexibility has a negative effect on CCC length and a positive effect on WC value. However, in the case of CCC, this impact is statistically insignificant. These relationships are observed for the analogue variable FF and the dichotomous variable FF1. Conclusion: financially flexible companies are characterised by a higher share of working capital in total assets than other entities. However, this does not cause significant changes in CCC length. CF and GROW have a negative impact on it. Faster enterprise growth (GROW) also favours lower WC levels. The larger the enterprise, the shorter the CCC and the lower the WC level. A more dynamic growth in GDP leads to increases in both working capital management indicators.
Relationship between working capital management and financial flexibility
| Dependent variable | CCC | WC | ||
|---|---|---|---|---|
| Model | 7 | 8 | 9 | 10 |
| Panel model type | Fixed | Fixed | Fixed | Fixed |
| Const | 343.0236*** (9.7700) | 342.1586*** (9.7143) | 0.4155*** (0.0883) | 0.5164*** (0.0888) |
| FF | −2.9306 (2.1279) | 0.5073*** (0.0150) | ||
| FF1 | −0.2635 (0.5386) | 0.0872*** (0.0035) | ||
| GROW | −15.0731*** (0.9186) | −14.9785*** (0.9160) | −0.0487*** (0.0062) | −0.0622*** (0.0063) |
| CF | −15.8525*** (4.4026) | −19.8008*** (3.3271) | −0.5320*** (0.0315) | 0.0587** (0.0245) |
| SIZE | −29.4172*** (1.1370) | −29.2596*** (1.1250) | −0.0216** (0.0103) | −0.0447*** (0.0103) |
| GDP_GROW | 40.6869*** (3.1279) | 40.8707*** (3.1263) | 0.0937*** (0.0245) | 0.0660*** (0.0247) |
| No. of obs | 109.554 | 109.554 | 110.851 | 110.851 |
| Joint test on named regressors (F test) | 379.25 p < 0.001 | 378.58 p < 0.001 | 291.07 p < 0.001 | 208.94 p < 0.001 |
| Breusch-Pagan test | 199652.80 p < 0.001 | 198481.10 p < 0.001 | 227819.10 p < 0.001 | 221441.00 p < 0.001 |
| Hausman test | 491.12 p < 0.001 | 571.62 p < 0.001 | 148.81 p < 0.001 | 608.51 p < 0.001 |
| SBC | −1250311.71 | −1250317.35 | −150931.64 | −153955.00 |
| AIC | −1108333.22 | −1108338.86 | −8279.13 | −11302.50 |
| HQC | −1151244.27 | −1151249.91 | −51371.20 | −54394.57 |
Note(s): * dependence is significant at the level of 0.1
** dependence is significant at the level of 0.05
*** dependence is significant at the level of 0.01
(standard errors in parentheses)
Appendix 2 presents the results of parameter estimation for the models explaining the relationship between profitability and WCM, with the dichotomous variable FF1 as a moderator. Models were estimated for linear and nonlinear relationships. In all cases, introducing a squared variable characterising working capital management increased the model's goodness (most information criteria decreased). However, the squared variable was statistically insignificant in three models and significant at the lowest level in one model. This means that the relationship between variables characterising profitability and working capital management indicators in the case of SMEs from CEE is linear and primarily negative.
All models indicate a statistically significant and positive moderating effect of financial flexibility on the relationship between profitability and working capital management. This means that in financially flexible companies, the negative impact of CCC on both profitability indicators is milder than in the remaining companies. The same direction of moderation applies to the negative effect of WC on ROA. In the case of a positive relationship between WC and ROE, it is stronger in companies with financial flexibility. Similarly to the models in Table 5, increases in the control variables SIZE and GDP_GROW are associated with higher ROA and ROE.
5. Robustness check
In the primary study, two variables were used to describe all key values, thereby increasing the certainty of the results. This applies to (1) profitability of the company and (2) working capital management as explained features, as well as (3) financial flexibility as an explanatory feature. Similar results were obtained in all variants of the measurements performed for specific pairs of variables.
Extending the robustness check, we recalculated analogous models using differently defined variables. SIZE, GROW, and WC, based on revenues in the primary models, were replaced with asset-based variables. In models 1–6, this did not change the signs of any individual parameters. For the remaining models, in some cases, there were changes in sign, most often for the SIZE variable. However, as shown by Dang, Li, Frank, and Yang (2018), when the definition of the SIZE variable changes, these signs may change, potentially altering the signs of other independent variables. Our results do not differ from those of other studies using the SIZE variable.
The use of robust HAC standard errors to assess variable significance reduced the influence of heteroscedasticity and autocorrelation on the outcomes. By analysing multiple models with different variable definitions, we confirmed the stability and invariance of the relationships for the key phenomena under study, which also mitigates the potential impact of endogeneity on the obtained results.
6. Discussion and recommendations
The study showed a very strong correlation between SME financial flexibility and debt capacity and, as a result, a high similarity of their distributions. This means that SMEs build their financial flexibility mainly by increasing debt capacity. This is consistent with the financial flexibility theory, confirms results of Bilyay-Erdogan's research (Bilyay-Erdogan, 2020) and supports the H1 hypothesis, indicating remarkable similarities in this respect with the large-enterprise sector (Byoun, 2008; Daniel et al., 2010; Marchica & Mura, 2010). However, significant differences between the average values of financial flexibility and its components may indicate that, for SMEs, excess cash is also an essential factor in maintaining financial flexibility. This may be a specific feature of this business sector. Still, this hypothesis requires an extension of research - analysis of financial flexibility components of SMEs from countries with a more developed economy and comparisons with large enterprises.
We have unequivocally confirmed the H2.1 hypothesis. SMEs that build financial flexibility achieve higher profitability. The linear relationship is dominant, meaning the study results do not support hypothesis H2.2. Regarding return on assets, a certain tendency towards a non-linear relationship is noticeable but also positive. Therefore, the study provides strong evidence that in CEE countries, SME financial flexibility positively impacts profitability growth. These results are consistent with previous studies in countries with more developed economies (Baños-Caballero et al., 2016; La Rocca et al., 2019; Martínez-Sola et al., 2018) and provide evidence that the trade-off theory best explains the SME financial behaviour in this respect.
Research on the impact of financial flexibility on working capital management has not yet been conducted in the SME sector, while among large enterprises, the positive effect of financial flexibility on all measures of working capital management is the most frequently diagnosed (Baños-Caballero et al., 2013; Karimi et al., 2023; Le Quang, 2016; Mahmood et al., 2018). The cash conversion cycle theory explains this phenomenon. In this respect, our study only partially supports the H3 hypothesis. SMEs building financial flexibility invest more in working capital. An increase in flexibility raises the share of working capital in total assets. Hypothesis H3 was not confirmed for the second measure of working capital management. Despite the positive impact of SME financial flexibility on working capital levels, we did not detect an effect on the length of the cash conversion cycle. This may indicate that by increasing investments in working capital, SMEs mainly increase sales. At the same time, they try to maintain the time relations among inventory turnover, receivables and liabilities by increasing the value and terms of trade credits taken out. This behaviour is consistent with the working capital adjustment theory and may point out that the optimal cash conversion cycle is more significant for SMEs than for large enterprises. However, the growing share of working capital in total assets, along with a stable cash conversion cycle, may also indicate that SMEs build financial flexibility not only to improve working capital management but also to invest in fixed assets. This hypothesis requires further research.
The estimation results for the last group of models showed a negative, linear relationship between SME working capital management and profitability. This observation differs from those made for large enterprises (Jaworski & Czerwonka, 2022) and partially confirms results among SMEs from more developed economies (Baños-Caballero et al., 2012). However, the results support the H4 hypothesis. Financial flexibility has a statistically significant positive moderating effect on the relationship between working capital management and SME profitability. A similar, positive moderating effect of financial flexibility on the relationship between working capital and profitability was detected by Baños-Caballero et al. (2016). However, in this study, a nonlinear relationship between working capital and profitability was diagnosed in a relatively small research sample (Spanish SMEs) for a short period (before the financial crisis of 2008–2012). This may mean that financial flexibility is a stronger moderator of the relationship between working capital management and profitability for SMEs in less developed economies. However, these conclusions require confirmation through further comparative studies between SMEs from economies at different levels of development, and examination of this relationship in the large-enterprise sector as well.
The diagnosed positive moderating effect of financial flexibility on the generally negative relationship between SME working capital management and profitability provides further evidence that the decisions of SMEs from emerging markets within the framework of short-term financial policy are consistent with the working capital adjustment theory.
7. Conclusions
The study identified several stylised facts on SME financial flexibility, which can be divided into three main parts:
We confirmed several similarities between the financial flexibility behaviour of SMEs from CEE and enterprises from more developed economies (including large enterprises). Like large enterprises, SMEs in CEE base their financial flexibility on maintaining debt capacity. The higher this flexibility, the higher SME profitability. It is also observed for large and small enterprises in countries with greater market traditions.
To the best of our knowledge, this study is the first attempt to diagnose the relationship between financial flexibility and working capital management in SMEs. For enterprises from CEE, we detected a positive impact of financial flexibility on working capital level, but did not confirm the effect on the length of the cash conversion cycle. The combination of these two phenomena is rare in the large-enterprise sector, so, in this respect, our study revealed sectoral differences.
However, we observed the most significant differences when examining the moderating impact of financial flexibility on the relationship between working capital management and SME profitability. First, this relationship is linear, distinguishing SMEs from CEE from large enterprises and SMEs from more developed economies. Second, the moderating effect of financial flexibility on this relationship has not been confirmed in countries with more outstanding market traditions. In the case of CEE, it is significant. Building financial flexibility weakens the negative impact of the cash conversion cycle and working capital level on operating profitability while strengthening the positive effects of the latter on SMEs' return on equity.
Considering the identified relationships and their grounding in other corporate finance theories, the study's results provide evidence for extending the financial flexibility theory to the context of short-term financial policy for SMEs. SMEs that maintain financial flexibility maximise their profitability. Financially flexible SMEs can reach an optimal level of working capital without changing the cash conversion cycle. The higher the level of SME financial flexibility, the weaker the negative impact of working capital management on profitability.
The extension of the financial flexibility theory has practical implications. SME managers must be aware that investing in working capital generally reduces profitability. They can mitigate this negative effect by building financial flexibility. By increasing financial flexibility, SMEs can improve profitability and adjust the working capital level without negatively shortening or excessively extending the cash conversion cycle. The smaller the enterprise and the faster its growth dynamics, the more acute these relationships become.
The study also provides further evidence for policymakers that creating facilities for capital access and, consequently, increasing the chances for SMEs to build financial flexibility can increase their profitability while improving working capital management. In turn, it can affect the survival of SMEs on the market.
The study's main limitations include (1) the inclusion of only nine countries from Central and Eastern Europe in the sample, and (2) taking into account a relatively small number of external determinants of SMEs' performance.
Note
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