Determinants of SMEs’ financial performance in an emerging economy: an econometric view

In the wake of the COVID-19 pandemic, small and medium-sized enterprises, the engine of economic growth in emerging economies like India, struggled to achieve sustainable financial performance. It is, therefore, understanding the complex determinants of the financial performance of this sector that is of paramount importance. Using a panel dataset of 100 Indian SMEs from 2013 to 2023, this study employs “Two-Step System Generalized Method of Moments regressions” to provide robust, endogeneity-corrected results. This study utilizes two crucial facets of performance. Return on Assets (profitability), reflecting managerial efficiency unaffected by financing distortions, and secondly, Value Creation Efficiency (productivity), capturing a firm’s ability to generate value from human and capital assets. The analysis reveals that “Human Capital Efficiency” remain a significant driver of productivity, but its direct link to profitability becomes statistically insignificant. Instead, profitability is more robustly determined by “Structure Capital Efficiency” and “Capital Employed Efficiency”. Further, the analysis uncovers a strategic trade-off where liquidity enhances productivity at the cost of profitability, while debt capital consistently weakens profitability. Furthermore, Intense market competition erodes profitability and weakens the value creation, stressing the need for strategic policy support. Indian SMEs are highly susceptible to macroeconomic disruptions like the COVID-19 pandemic and inflation, which significantly undermine their financial health. The findings compel a strategic re-evaluation for SME stakeholders, urging managers to shift focus from merely acquiring talent to architecting robust organizational systems that effectively embed and leverage human capital. The findings highlight the need for policymakers to ensure macroeconomic stability and strengthen SMEs’ access to technology, marketing infrastructure, and innovation support to survive in high market competition. Finally, this research advocates for investors and lenders to consider value creation metrics not just as a performance metric but potentially as a leading indicator of a firm’s long-term viability and creditworthiness.