Characteristics that Define Small Businesses - Assignment Example

a. What characteristics define small businesses? The characteristics of small businesses vary across countries. For instance, in the United Kingdom (UK), The Companies Act 1985 (Accounts of Small and Medium-Sized Enterprises and Audit Exemption) Regulations defines small businesses as those companies with turnover of not more that ₤5.6 million per annum. Aside from this, small businesses also have balance sheet total or asset component of not more than ₤2.8 million and employment size of less than 50 employees (Small and Medium Sized Enterprises 2004). The European Commission does not depart much from the UK definition. In particular, small businesses in the European Union are characterised with a headcount of only 10-49 employees. Their earnings or balance sheet ranges from €10 million to €49 million. (Europa 2003) On the other hand, in the United States (US), the standards for small businesses set by the Small Business Administration Size Standards Office are rendered more specific. In terms of employment size, small businesses in the mining and manufacturing industries employ less than 500 workers, while those in the wholesale trade industry hire not more than 100 employees. Small enterprises for most retail and services industries in the US post annual receipt of about $6 million. (Small Business Administration 2002) Given the above characteristics, it can be seen that similarities of small businesses generally lie in the small employment size and low volume of sales per year. Small businesses also have limited amount of assets. As such, their capitalisation requirements are not as great and demanding as the financing required by large businesses. b. How does financing of such businesses differ from that of large businesses? Financing for all types of businesses come in several forms. However, sources of funding are classified as either debt or equity. Utilisation of these primary funding sources depends upon the amount of capital required, nature of proposed investment and other terms that materially impact the financial position of businesses. Companies often used debt and equity in combination that would result in the maximisation of the value of the businesses. Debt Financing Short-term Debt Financing In order to raise the immediate financing need, owners of small businesses may opt to borrow funds from various sources. The main sources for debt financing include banks and other financial institutions (Lister & Harnish 1995). To defray the day-to-day expenses of their business, small business owners may consider availing of demand loan or utilising lines of credit. Demand loans usually have floating interest rate and are repaid within the year the loans were made. On the other hand, line of credit is an agreement executed between a bank and company owner to borrow at nay time up to an established limit (Brealey, Myers & Marcus 2004). Since small businesses are commonly organised as sole proprietorships or partnerships, owners may also opt to use personal credit cards or seek financial assistance from friends and relatives (Walter 2004). In addition, small business owners may file loan application in government agencies especially tasked to foster the establishment of small businesses. Similarly, large businesses may utilise short-term financial facilities such as demand loans and credit lines. However, the terms of loan may substantially differ for small and large businesses due to the varying risk exposure of banks and other financial institutions in extending short-term loan to these enterprises. For instance, blue chip companies may benefit from lower borrowing rates since lending to these companies exposes the banks to minimal risk of default. On the contrary, small businesses in the start-up phase may confront relatively higher rates and more stringent loan terms since the performance of these entities are still unproven, thus, risk exposure of banks is relatively higher. Furthermore, many short-term loans for large businesses are often unsecured but there may be instances when these companies’ inventory or receivables are used to secure the loans (Higson 1986). Meanwhile, loans for small businesses are normally secured by a personal guarantee or company assets (Lister & Harnish 1995). Long-term Debt Financing To procure capital equipment, undertake expansion activities or major renovation, companies require substantial funding. With this, they often resort to long-term debt-financing. Small businesses may opt to avail of business term loans that provide medium to long-term financing. Like short-term loan, term loans of small enterprises are often secured by the asset being financed. Term loans also come with well-defined repayment schedules and other loan conditions depending on the purpose for borrowing and credit rating of the business (Walter 2004). Large businesses may likewise take advantage of bank loans to finance their investment activities. In addition to this credit facility, large companies are deemed more flexible in sourcing long-term debt funding since they are capable of issuing debt instruments such as bonds. Similar to bank loans, financing through bond issuance entails fixed coupon payments annually until the bond matures (Brealey, Myers & Marcus 2004). It should be highlighted that there are various forms of bonds issued by large corporations that are subject to different terms. For example, bonds may vary in coupon rate, maturity, seniority and other features that would make the offering more marketable to investors or potential bondholders (Mclaney 2003). Some bonds may also be convertible to equity or ordinary shares at the behest of the bondholders. Furthermore, bonds are graded by investment companies such as Moody’s and Standard & Poor’s in order to help investors distinguish the magnitude of default risk to which they are exposed to. Bonds are described as investment grad if they qualify for one of the top four ratings from these investment companies’ rating services (Brealey, Myers & Marcus 2004). Issuing of bonds may be conducted through public or private placement. Publicly issued bonds, which could be freely traded in the securities market, should be initially registered with the country’s Securities and Exchange Commission before it can be sold to the public. Large corporations may also consider issuing bonds through private placement wherein bonds are sold directly to a select group of banks, insurance companies and other investment institutions (Pike & Neale 2003). Accountability of Business Owners When availing of debt-financing, small and large businesses alike shoulder the fixed interest and principal payment. They are committed to abide by the loan terms agreed upon regardless of their financial condition (Brealey, Myers & Marcus 2004). As mentioned, many owners of small businesses initially start up as sole proprietors or partners. With this, they have unlimited liability such that if they borrow from the bank, the banks would have a claim on their personal belongings or properties (Horngren, Sundem & Elliot 2001). On the other hand, as businesses expand so does their financing requirements. Thus, large businesses are commonly organised as corporations to allow for more flexible financing options. Corporations have limited liability, which means that in the event corporations’ finances are insufficient to service debt payments, shareholders or owners have the right to default on debt and hand over companies’ assets to the lenders including banks and bondholders. The shareholders are not held personally accountable for the obligations arising from debt unlike sole proprietors and partners. (Brealey, Myers & Marcus 2004) Equity Financing Sources of equity financing for small businesses would highly likely come from the owners with their personal savings. They may also convince their relatives and friends to invest in the business to become part-owners or business partners (Lister & Harnish 1995). Moreover, equity capital may be provided by investment institutions or venture capital firms which typically target businesses with high growth potentials (Walter 2004). As operations commence, small enterprises may utilise internally generated funds and reinvest it in the business. Using internally generated funds is deemed as the most convenient way of financing the business as this entails less hassle and does not create additional obligation for owners. In the same way, large businesses may utilise internally generated funds or retained earnings to finance operation. However, some assert that using retained earnings for large businesses may be detrimental for the companies since this leads to the management being lax about sourcing out optimum funding source. (Brealey, Myers & Marcus 2004) As some large businesses become far too large to be owned by one investor, another funding alternative available to large businesses is the issuance of shares that represents percentage ownership in the firms. It is in this aspect that equity financing for large businesses become more complex as compared to small enterprises with simple capital structure. During the initial stage, large businesses or corporations may opt to issue shares for only a small select group that may include founders, managers and small number of backers. As the corporations grow, new shares may be issued to raise additional capital. Shareholdings in a corporation entitle shareholders to exercise the right to vote in making major corporate decisions and receive dividends. Like bonds, shares of large businesses may be publicly traded when these firms decide to become publicly listed corporations (Pike & Neale 2003). There are also different classes of stock, although most companies issue only one class of ordinary share. The classes of stock mainly differ in voting rights and dividend payout. In this regard, aside from the ordinary share, large companies may also issue preferred shares, which can be a useful method of financing in mergers and other special situations (Brealey, Myers & Marcus 2004). Preference shares are similar to debt as fixed payment to preference shareholders paid out by issuing companies. Given its name, this type of shares take priority over ordinary shares in the payment of dividends and in the event of liquidation. However, preference shareholders are rarely granted full voting privileges (Pike & Neale 2003). Should additional funding be required, large companies may issue more shares to interested investors. It should be noted though that these companies may opt to offer these shares through rights issue to existing shareholders so as to minimise the dilution of their shareholdings resulting from the share issuance. (Brealey, Myers & Marcus 2004) As large corporations generate steady revenues with positive earnings outlook, the companies’ Board of Directors through the recommendation of the management may consider paying out dividends to shareholders. However, corporations are not in any way obliged to pay dividends to shareholders and may instead consider reinvesting earnings in their operations. It should also be highlighted that the shares of companies derive its value from its current price as determined in the market. The trend in the market price of shares is influenced by various factors including earnings outlook and financial condition. How firms’ finance their funding requirements also has a significant impact on the market price of shares. To illustrate this point, it is noted that the issuance of additional shares of a company is deemed to have an adverse effect on the price of its shares. In this regard, the pecking order theory is formulated. This financial theory posits that the company should first utilise internally generated funds over externally generated funds. Should internal funds be inadequate, a company should initially resort to debt before equity to minimise the negative signaling effect relative to share issuance. However, a company should be cautious with debt utilisation since using debt depletes earnings per share as the firm becomes committed to the servicing of fixed interest and principal payment obligation. This also has adverse effect on the price of shares. (Brealey, Myers & Marcus 2004) References Brealey, R.A., Myers S.C. and Marcus, A.J. (2004). Fundamentals of Corporate Finance, 4th ed., McGraw-Hill Inc. European Commission. (2003). Available: http://europa.eu.int (Accessed: 19 May 2006). Higson, C. J. (1986). Business Finance. London: Butterworth Publisher. Horngren, C.T., Sundem, G.L. and Elliot, J.A. (2001). Introduction to Financial Accounting, Prentice Hall. Lister, K and Harnish, T. (1995). Finding Money: The Small Business Guide to Financing. Wiley McLaney, E. J. (2003). Business Finance: Theory and Practice, 5th ed., London: Pearson Education Ltd. Pike, R and Neale, B. (2003). Corporate Finance & Investment: Decisions and Strategies, 4th ed., London: Pearson Education Ltd. “Small and Medium Sized Enterprises”, University of Strathclyde Library. (2004). Available: http://www.lib.strath.ac.uk/busweb/guides/smedefine (Accessed: 19 May 2006). Small Business Administration. (2002). Available: http://www.sba.gov (Accessed: 19 May 2006). Walter. R. (2004). Financing Your Small Business. Barrons Business Library. Read More