It’s a common belief on Wall Street that small businesses struggle to get loans or credit at reasonable rates due to their perceived high risk. However, new research from Harvard Business School suggests that small firms may actually be more fiscally cautious than banks realize. Businesses with fewer than 10 employees often hold back on spending their available credit to maintain a financial cushion, even when banks offer larger credit lines or long-term loans. This conservative approach might mean these firms aren’t growing as quickly as they could.

“If you’re looking to boost investment, targeting businesses that appear to have financial slack could lead to significant growth because it seems they’re passing up opportunities,” the researchers explain.

Vital cogs

Small businesses, whether they’re tech startups or local shops, are a vital part of the economy, making up 44% of the United States’ gross domestic product. When banks increase their credit limits, these companies have room to expand, yet they still keep a buffer in their borrowing capacity.

“I knew small firms were careful with financing, but I was surprised by just how cautious they are. The actual use of credit was much lower than I expected,” one of the researchers noted.

The study examined how small businesses manage their debt by analyzing lending data from a large European bank in Turkey in 2014, during a period of economic stability. The researchers focused on 3,169 small firms, 2,414 of which were randomly offered surprise credit expansions. The other 755 firms were not, serving as a control group.

Long-term investments

The results showed that most firms held onto a financial buffer and used their expanded credit primarily for long-term investments, such as capital improvements. Although they were offered more credit, companies only used about 35% of the extra borrowing capacity in the first year.

Some key findings include:

• Less than 10% of the firms were heavily constrained by credit, with most using only about 39% of their available credit before an expansion.
• Firms that received credit increases borrowed 61% more over the next year.
• Over two years, companies shifted towards using more long-term debt for investments, leading to 35% annual profit growth, particularly among firms further from their debt limits.
• Importantly, higher borrowing didn’t lead to increased delinquency or debt restructuring.

“This is striking because even though firms don’t fully draw down their credit lines—only about 55 cents for every dollar of capacity—the mere option of borrowing more encourages growth,” the researchers said.

The findings challenge assumptions that small businesses avoid credit because they lack access or sophistication. In fact, the cautious approach seems to reflect a deliberate strategy to preserve financial security.

Given the economic stability during the Turkish study period, the results are relevant for small businesses and banks worldwide, including in the U.S. The firms in the study resemble the 80% of U.S. companies that rely on bank loans for financing.

The researchers suggest that this behavior—maintaining a financial buffer—was holding back sales and growth. “Policymakers should take note. Targeting these cautious firms could be a way to drive economic growth,” they conclude.