Impact of Financial Literacy on the Debt Trap of Micro, Small, and Medium Enterprises in the Northern Province of Sri Lanka

The financial vulnerability of Micro, Small and Medium scale Enterprises (MSMEs) in Sri Lanka threatens both organizational survival and community livelihoods, particularly within the post-conflict socio-economic landscape of the Northern Province. Grounded in Resource-Based Theory (RBT) and the Knowledge Based View (KBV), this study investigates the influence of financial literacy on debt traps, which are operationalized as over-indebtedness of firms, where new credit is utilized primarily to service existing debt. While existing studies examine financial literacy in isolation, this study addresses a critical gap by examining the mediating role of financial decision making. Data was collected from MSMEs operating in manufacturing and industry, trading, and service sectors in the five districts of Northern Province, using a structured survey, with a sample 400 which was determined through statistical power analysis to ensure adequate sensitivity for complex modeling. A multidimensional Financial Literacy Index (FLI) was computed, revealing competency levels between 25% and 32% based on aggregated scores of financial knowledge, behavior, and attitude was below the average rate in Sri Lanka (57.9% in 2021). Analysis using Partial Least Squares Structural Equation Modeling (PLS-SEM) reveals that financial literacy serves as a vital internal resource that exerts a significant negative direct effect on MSME debt trap. Furthermore, financial decision-making acts as a significant partial mediator; the findings demonstrate that the total effect of financial literacy on debt traps is achieved through both cognitive knowledge and the optimization of behavioral choices. The findings of the study provide constructive awareness for policymakers and financial institutions in Sri Lanka to design targeted financial literacy programs that cater to the specific needs of MSME owners.