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Finance

What is SME financing?

The significance of Small and Medium Enterprise (SME) sector is well recognized across the globe owing to its contribution to the country’s economy through national output, exports and also by achieving diverse socio-economic objectives for e.g. employment generation, enhancing the entrepreneurship and to provide an industrial base to the economy.

 

Finance is the most important component of any general business. Fulfilling the funding requirements of the Small and Medium Enterprises is known as SME financing. While SMEs are the essential element of any economic system, they face several challenges, the prominent among them being the availability of low-cost finances and growing exposure to exchange rate risk.

 

Why Financing is crucial for SMEs?

Finance in the key element required to start a business. SME Financing is essential to support them in setting up their operations and further expansion. Only through access to sufficient and adequate finance they will be able to develop new products, invest in new staff, production and experiment with innovation. Generally SMEs are started by self financing or are family run businesses. Once they are successful in running their businesses there comes a time for all developing SMEs when they need more investment to expand or innovate further.

 

That is where they often run into problems, because they find it much harder than larger businesses to obtain financing from banks, capital markets or other suppliers of credit. The financial lag is all the more prominent in this everyday changing knowledge based economies because of the speed of innovation.

 

If SMEs do not get the financing they need at the right time, brilliant and original ideas can fall by the wayside and this loss is reflected in the possible growth of the economy. Already, dissimilarities are emerging between countries in terms of how easy it is for innovative SMEs to grow and develop. This sector has been very dynamic in the United States and a few other countries, but has lagged in many countries to the detriment of job creation and competitiveness.

 

What are the sources to access finance by SMEs?

It has been observed that in majority of SMEs, most of the financing comes from internally generated funds, and additional help comes by borrowings from family & friends. For SMEs also there are formal as well as informal sources of finance.

 

Informal sources are money local lenders, friends and relatives. Formal sources constitute banks, equity resources such as venture capitalists, business angels, stock exchange, trade credits (from suppliers) and government grants and aids.

 

There are various potential sources of finance to meet the needs of small and growing businesses which are as follows:

 

Self Financing: Most SMEs starts by the owner’s funds or by financial help from friends and relatives. Self financing is accessing personal funds without external borrowing or issuing shares. In this situation startup capital is required to run the business until profits can underpin the outgoings of the business.

 

Trade credit, promissory notes and bills of exchange: In most businesses, goods and services are invoiced by the seller and paid for by the buyer at the end of the month or with a credit of 30, 60, 90 days or more. The period between the date of delivery and the actual receipt of the payment by the seller is the most prevalent form of credit. Trade credit, as it is called, is a facility based on a pre-agreed arrangement between the buyer and the seller. It is the simplest, quickest to arrange and often the cheapest method for the buyer.

 

Trade credit does not normally involve pledging assets as security or drafting legal documentation. It is based on commercial practices and trust between parties. In case of Promissory Note, instead of paying by check or bank transfer, the buyer, with the seller’s consent, may issue a promissory note or a post-dated check. A promissory note is a contract where one party (the maker or issuer) makes an unconditional promise in writing to pay a sum of money to the other (the payee), either at a fixed or determinable future time or on demand of the payee, under specific terms.

 

Overdraft Financing

An Overdraft facility allows you to overdraw your business bank account up to an agreed maximum amount beyond what you have on deposit. An overdraft facility enables businesses to obtain short-term funding - although in theory the amount loaned is repayable on demand by the bank. The amount of an overdraft depends on the cash flows of the business, the timing of receipts and payments, seasonal trends in the sales and so on.

 

Cash advances

SMEs can also access finance through Cash Advances. In this arrangement SMEs can leverage to get cash advance from buyers if their product or service is urgently needed. A solid basis of trust is needed in these transactions. In return for providing a down payment, buyers may require SMEs to offer them more competitive prices.

 

Term loans

Banks are the main official avenue for raising finance for SMEs. Small and Medium Enterprises can avail loans from Banks, Financial Institutions or Financial Houses. Banks and other institutions may offer credit facilities in different forms. However, they consist of one or more disbursements by the lender with a fixed or variable repayment schedule over the year (monthly, quarterly, payment at the end of the period, etc.). Security is nearly always required, together with legal documentation.

 

Hire, purchase and Leasing

Is a contract that involves two parties, the lessee (the user) and the lessor (owner). This transaction, allows the business to use a certain fixed asset for which he must pay periodically for a fixed period of time. The lessee is the receiver of the services or the assets under the lease contract and the lessor is the owner of the assets.

 

The relationship between the lessor and the lessee can be for a fixed or an indefinite period of time defined by the term of lease. The payment for the lease is called rent. With a hire purchase agreement, after the user has made all the payments, he becomes the owner of the facility (equipment). This ownership transfer either automatically or on payment of an option to purchase fee.

 

Equity finance (Stock Shares, Business Angel Financing and Venture Capital)

Equity is also one of the sources of finance for Small and Medium Enterprises. Equity is the ordinary share capital of a business, which entitles the holders to all distributed profits following certain priority of payments. Equity can be raised from retained profits or by issuing shares through public offerings. Public offerings, however, are complicated for SMEs for various reasons. They can be intricate, protracted and expensive to complete, and the requirements for listing shares on stock exchanges can be daunting.

 

There are also private equity sources for raising finances which are Venture Capital financing and Business angels. Venture capital is a means of equity financing for rapidly-growing private companies that is given by an outside investor to finance a new, growing, or troubled business. The venture capitalist provides the funding knowing that there’s a considerable risk associated with the company’s future profits and cash flow.

 

Capital is invested in exchange for an equity stake in the business rather than given as a loan, and the investor hopes the investment will yield a better-than-average return. Whereas, an angel investor or angel (also known as a business angel or informal investor) is generally a wealthy individual, who offers capital for a business start-up, usually in exchange for convertible debt or ownership equity by taking a high personal risk.

 

Angels usually wants hands on involvement with the business where they have invested. Typically, venture capitalists fund long-term and large investments, while business angels provide medium-sized amounts.

 

Factoring and invoice discounting

The arrangement in which receivables created out of sale of goods or services are sold to an agency (known as a factor), is called the factoring. Under a typical factoring transaction, the factor collects the accounts on due dates, effects payments to the firm on those dates and also assumes the credit risks associated with the collection of the accounts.

 

Grants/aids and subsidies

A number of grants and subsidies are available to Small and Medium Enterprises of any country by their government. Government provides grants and subsidies to support business expansion, for research and development, for training initiatives etc. In many developing countries, grants and subsidies depends whether the enterprise falls in Priority Sector, whether it is from rural or urban sector etc.

 

What obstacles are faced by SMEs in accessing finance?

SMEs’ access to capital markets is very limited and that is why they largely depend on borrowed funds from banks and financial institutions. Without adequate capital SMEs are incapable of developing and to seize the advantage of business opportunities. The major problems among perceived obstacles in accessing finance by SMEs in surveys across the globe that hampers SMEs’ emergence and eventual growth are as follows;

 

High transactional cost – Small loans availed by SMEs generally are high cost transactions. They are time consuming as well as costly for banks to monitor and administer. Also these transaction costs are directly related to their profitability. Especially in the start up businesses, difficulties such as delays in repayment, defaults or other derogatory information in credit reports etc, are common problems. These are the reasons for bank’s resistance to provide loans to small businesses.

 

Regulatory obligations or rigidity in the legal framework – Most of the developing countries still have highly concentrated and uncompetitive banking sectors. This is often the result of restrictive government regulations. This leads to the tendency of lenders to follow very conservative lending policies or to charge high interest rates from the small businesses.

 

Informational asymmetries between small businesses and lenders - Informational asymmetries are always present in Small Business transactions. SMEs lack of financial expertise in terms of identifying where to approach for loans always limits them from accessing finance. For availing loans from banks, SMEs needs to have audited financial statements for every year to be accessed by banks for providing loans.

 

Lack of these statements leads to excluding SMEs from consideration by lenders. SMEs financial accounts are not managed in a way which can easily be accessed by banks. This financial opaqueness of small businesses makes it difficult for lenders to understand if the borrower has the capacity and capability to repay the loan. Also lack of public information and credit histories, particularly in developing countries where credit bureaus are not established adds to the complexity banks face to identify high growth potential SMEs.

 

Risk profile less favorable than large firms - SMEs are more vulnerable to external market forces than larger enterprises as they have fewer resources to fall back on. In most cases they lack management expertise to look forward to in adversity. The greater probability of defaults by SMEs is another reason for bank reluctance to loan to this sector. Even in the recent financial crunch, many SMEs faced bankruptcies compared to larger firms.

 

Lack of sufficient collateral – For banks and financial institutions, collateral is a source of security for the loan given in case of default in the form of an asset. Through collateral banks protect their loaned asset. Generally SMEs’ lack collateral, specially the start ups businesses and new entrepreneurs. Banks require government guarantees or other government support to mitigate their risk and to augment the limited collateral available from SMEs which are not available and tedious in many cases.

 

Lack bankable proposals to banks – Small businesses due to inadequate resources in general lack the capacity to draft and present convincing bankable projects to the lenders. They do not possess the technical capacity through which they can reflect their potential in their proposals. To compensate for sufficient collateral and strong credit history, SMEs should come up with strategic business plans which normally they are not able to portray to the potential lenders.

 

What is the Role of Equity in SME financing?

Equity financing is one among the different sources of raising funds. Equity means ordinary share capital of a business which entitles the holders to all distributed profits following certain priority of payments.

 

Equity can be raised from retained profits or by issuing shares through public offerings. Public offerings though have been difficult for SMEs to raise funds.The sustainability of an SME depends largely on its financing structure (Debt, Equity).

 

Strong base of equity capital in a SME means reduced reliance on the debt which leads to reduced financing cost of the enterprise.There are other private equity sources for SMEs which are:

 

Business Angels

Venture Capitalists: Business Angels and venture capitalists are generally successful business people who invest their money and time in promising young businesses and are willing to take risks. Business angels generally provide medium sized amounts whereas the latter funds for long term and puts large investments.

 

What is the Role of Foreign Direct Investment in SMEs?

Foreign Direct Investment is considered as a significant growth strategy and important avenue for the growth of SMEs. It has been observed that FDI can play a significant role in development and internationalization of Small and Medium Enterprise (SMEs). The majority of FDI instigates from the developed countries in the world.

 

Developing countries are the focal destinations for FDI. FDI broadens a firm's customer bases through entering into new markets, enables the firm to achieve a larger volume of production and growth. Clusters provide small scale enterprises the opportunity to take advantage of FDI and global value chains by being able to position themselves to access capital, technology and markets.