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Small privately held firms extensively use debt provided by principal owners and households (inside-debt) as an alternative capital source to straight equity capital. The purpose of the research study is to investigate inside-debt-bankruptcy relations.

Inside-debt-bankruptcy relation is tested on three prominent bankruptcy prediction models using correlation and logit regression analysis. Sample consists of 314 Estonian small firms. Financial reports of 2007 are modelled against bankruptcies declared in 2009.

Results imply that users of inside-debt are less profitable; they have weaker liquidity position and less retained earnings. Leverage is not found to be significant determinant between inside-debt users and non-users. Fundamental finding of the study suggests that the use of inside-debt is significantly and positively related to bankruptcy probability. While inside-debt carries no risk elements per se, findings are robust to indicate that the use of inside-debt has significant power to signal for increasing bankruptcy risk and as such, reducing information asymmetry of small firms.

This study is limited to single country data. Bankruptcy data fall to the period of economical recession. It is suggested to repeat the study in a normal economical situation and to extend sample size over different countries.

Findings contribute to the understanding of firms' financial risk, firm behaviour and capital structure development. In a lending industry, results shall supplement to prudent credit risk assessment techniques and design of bankruptcy models in general.

To the author's best knowledge, inside-debt-bankruptcy relation is not studied so far in the existing academic literature.

To investigate the relations between company‐specific financial factors and the capital structure decisions of Estonian non‐financial companies and to examine behavioral differences between companies of different sizes.

Totally 260 Estonian non‐financial companies are divided into small‐, medium‐ and large‐companies, each sample being analysed by correlation‐regression method in two aspects – impact of financial factors on static capital structure and capital structure dynamics. Companies' financial statements of 2002/2003 or 2003/2004 are used. Finally, capital structure adjustments in extreme boundaries are analyzed.

Capital structure decisions among Estonian non‐financial companies are driven by the pecking order theory, the evidences supporting optimal capital structure choices in long run remain weak. The robustness of the pecking order behavior significantly differs between smaller and bigger companies.

Limited number of companies surveyed due to hard manual work required to adjust financial accounts. Implication of findings is somewhat limited as the study covers a single country.

The paper helps to identify financial drivers and to understand motivations behind capital structure decisions of emerging market companies and it supplements earlier studies. Quasi‐equity debt distorts the observed capital structures. Capital structure is adjusted for operating leases and quasi‐equity debt to identify true amount put at risk and its mix between owners and external lenders.