[We’re pleased to welcome author Dr. Marco Botta of the Università Cattolica del Sacro Cuore, and the Università degli Studi dell’Insubria. Dr. Botta recently published an article in Cornell Hospitality Quarterly entitled “Financing Decisions and Performance of Italian SMEs in the Hotel Industry,” which is currently free to read for a limited time. Below, Dr. Botta reflects on the inspiration for conducting this research:]
The Global Financial Crisis that started in 2008 in the US and soon spread globally has highlighted how financial decisions can have a strong impact on the real economy. The way firms (and people as well) raise capital may produce important consequences on their future. The European debt crisis in 2011 showed how even governments cannot escape the consequences of bad financial decisions.
In this respect, hotel companies are extremely capital-intensive, needing to devote large amounts of funds to buy and furbish real estate properties where to run their hotel business. This implies that they often have to raise significant amounts of funds from external sources, as internal resources may not be sufficient to cover their investment needs. This may be particularly troublesome for small and medium companies (SMEs) that, in the Italian experience, tend to rely heavily on bank loans to cover their capital needs. This is what is known as a pecking-order type of behavior: firms first use internal resources, and then debt. Additional equity capital is used only as a last resort, and this may induce firms to constantly run high levels of debt.
My research shows how firms should instead adopt more sophisticated financial decisions: having a systematically higher-than-optimal level of debt induces firms to reduce their investments, as shown by the lower growth in assets, and this ultimately results in lower performance. On the other hand, firms using too little debt also experience a decrease in performance, due to a lower operating efficiency: the lack of pressure from mandatory debt repayments may produce a more “relaxed” atmosphere, so that hotel companies end up losing effectiveness in their ability to maximize revenues and keep costs under control.
Overall, my research shows how managers of hotel SMEs should target an optimal level of debt that should be achieved by balancing two contrasting effects. On the one hand, avoiding excessive levels of debt allows maintaining financial flexibility, so that a company is able to pursue investment opportunities whenever they become available. On the other hand, having a moderate amount of debt induces firms to operate more efficiently, likely because of the pressure of mandatory debt repayment and of the scrutiny of external debtholders who want to protect their investment.
From an academic perspective, the research sheds light on the long-standing debate on the existence of an optimal capital structure. My results show that Italian hotel SMEs do not appear particularly keen at targeting an optimal level of debt. Their behavior is instead mostly in line with the predictions of the pecking order theory: they used internal funds as their primary source of capital, and they prefer debt over equity when they need to raise new external funds. However, the relationship between capital structure and financial performance shows that firms indeed face an optimal level of debt, providing evidence in favor of the empirical validity of the trade-off theory of capital structure.