Accessing External Finance for SMEs - Essay Example

Entrepreneurial Finance Entrepreneurial Finance plays a significant role in helping managers to choose better financing and investment strategies relevant to their line of business. The business sector has been growing tremendously in the recent times. This is because of prevailing affirmative business and market factors. The ever-growing technological advancements, population, and economy has provided the requisite labor of production and increased the demand for the finished products. As a result, diverse businesses have come up to supply the needs of the demanding citizens in our economy. While some businesses are well-established entrepreneurs, most of them are small and medium sized enterprises that face many challenges in starting up, financing, management, and market competition. They require huge capital in establishment, management of the enterprise, purchase of raw materials, production, and marketing. Reasonable knowledge on entrepreneurial finance is fundamental to the start-up of any business and raising enough capital is the basis of any start-up. Entrepreneurial finance determines how much capital is required, when should it be raised, from whom, the actual value of an enterprise and its structural design. Entrepreneurs seek external financing from finance schemes, banks, and even friends. Since access to external finance depends on guarantees and collaterals for loans, not all entrepreneurs succeed in benefiting from external finance. However, governments are establishing financial measures that will quench the financial needs of the entrepreneurs as far as debt finance is concerned. The success of these measures is subject to debates and varies from one entrepreneur to another depending on a wide range of factors. This paper will look into the evidence of credit rationing and discouraged borrowers in accessing external finance. Credit rationing in this context refers to a situation where finance lenders limit the availability of additional funds to willing borrowers at the current lending rates. The paper will also analyze the governments’ intervention in the form of platforms such as the Enterprise Finance Guarantee (EFG) and the Small Firms Loan Guarantee Scheme towards facilitating access to external finance among the entrepreneurs and Small and medium sized enterprises with specific attention to debt finance. Debt finance in this context refers to a business strategy of borrowing capital from a lender with full knowledge that the principal amount plus accrued interest will be paid back in a given period. There is evidence of information and control limitations in financial markets especially in the process of seeking debt financing. There is significant credit rationing procedure that denies borrowers a chance to borrow all they want, or to borrow at all (Ghosh et al, 1999, p.2) However, many entrepreneurs have been seeking debt finance for the startup, expansion and the running of the enterprise by selling the bonds, bills, notes, debentures, or mortgages held by the business. Entrepreneurs use debentures to raise capital without selling the enterprise, giving up future profits, or having to use their assets. This unique method is a debt offering since the company remains in debt until the debenture converts into stock or until the price of the debenture plus interest are paid. There are two types of debt financing that entrepreneurs adopt in financing their working capital or capital expenditures. They adopt Long Term Debt Financing that is necessary in purchasing capital assets like machinery, land, and building. Since the amount is huge, the repayment schedule and maturity of the loan stretches to more than a year. Small and medium sized enterprises will adopt short term debt Financing that is necessary for purchasing inventory, paying the wages, supplies, and other daily expenses. Since the amount is relatively small, the repayment schedule and maturity of the loan stretches to less than a year. Entrepreneurs opt for debt financing because unlike equity financing, the entrepreneur do not have to give up future profits or ownership in the company. Additionally, the principal amount and interest payments on a business loan are business expenses and hence treated as deductions from the business income taxes. However, it has not always been advisable and easy to access debt finance from the banks, investors, or private individuals. The financial position of an SME, the profitability of the SME’s operations, level of competitiveness, and the maturity stage of the SME affects the decision of the lending regarding a loan application (Sheng et al, 2011, p. 230). In fact, analysts confirm that banks devices a loan contract in a manner that suits its interests and attract low risk borrowers. Education, ethnicity, and gender play a significant role in accessing external finance (Kon and Storey, 2003, p.37-49). Banks will most likely avail external finance to women because of their better record of accomplishment in repaying their loans. This is despite the fact that women owner-managers face discouragement in reporting their financial constraints and seek external finance because they demean the success of their application (Irwin and Scott, 2008, p.16-17). Repayment of debt finance is challenging and absolute. This is because even if the business fails, a borrower is under obligation to pay and this may lead to bankruptcy, loss of business or even prosecution. Additionally, the interest rates used by the lenders are unfairly high and vary with factors like the borrower’s history with the lender, business credit worthiness, and macroeconomic factors. Similarly, the borrower should ensure sufficient business cash flows and deposits of collaterals that may be hard to realize. Hence, the borrower is always under pressure. Unless one has huge capital assets, it is not advisable to source debt finance because it is stressful and not fruitful. Since credit ceilings depend on the collateral that the borrower will post, many willing borrowers who lack the ability to own collaterals or huge assets, could not access debt finance (Ghosh et al, 1999, p.10). Additionally lenders have put in place credit rationing measures that limit availability of additional capital to willing borrowers. Information and physical are some factors that limit credit accessibility. Banks would rather loan small businesses that are close to them a bank may not have all the information pertaining to a potential borrower. In the US, discouragement among the borrower has largely affected the accessibility of external finance. Though the discouraged borrowers do not affect the risk portfolio of any bank, high-risk borrowers are more likely to be discouraged than low risk borrowers are. In a survey carried out in the US involving 3,561 sample small business firms in 1998, 2,099 firms demonstrated no need for external finance, 962 firms were interested in external finance while 500 firms did not apply because of fear of rejection. One third of the sample is discouraged borrowers, which proves the existence of discouraged borrowers (Storey, 2008, p. 9). In another related national survey of 1980s in US, about 4.22 percent of firms faced discouragement applying because of expected denial (Levenson and Willard, 2000,p. 83-94). However, the new technological advancements help the bank in accessing the crucial information relating to the credit worthiness of a borrower. The lenders have established credit rationing by raising interest rates way above the market rates regardless of the market equilibrium. This has discouraged potential borrowers from accessing external finance due to the huge interest amounts attached to the principal amount. The measurements of the credit worthiness of a business and the requirements of collaterals are also modes of credit rationing. Additionally, credit rationing manifests where the borrower is willing to acquire the capital at the current interest rates but the lender is neither willing to lend more nor to raise the interest rate. In fact, credit rationing categorizes into redlining and pure credit rationing. In redlining credit rationing, a common group of borrowers cannot get a loan even if they were willing to pay higher interest rates but can only get it if the loan supply was increased. In pure credit rationing, the borrowers are distinct and some will get the loan while others will not even when willing to pay a higher interest rate. The banks will not increase interest rates, or collateral requirements, or the size of loan able amount since this would increase the risk of the bank in loan portfolio thus decreasing the bank profits. They will therefore limit the size of a loan instead of the number of loans (Stiglitz and Weiss, 1981, p.394). This is common where there is no market equilibrium and the lenders are maximising profits. In such a case, credit rationing features as an extreme level of capital market misallocation. These discriminations, limitations, and unstable market equilibriums, deny willing borrowers access to external finance. Hence, though the entrepreneurs are willing to borrow at any costs, they face disappointment from the unwilling lenders that apply credit-rationing procedures. Therefore, despite of serious government efforts to avail debt finance through its own banks or by regulating commercial banks, many entrepreneurs and small and medium sized enterprises cannot access external finance due to the prevailing credit rationing. The UK government has put some considerable efforts to collect this anomaly. The government is aware that the entrepreneurs and the small and medium sized companies play a major role in building and maintaining the economy. Some of the factors that hindered access to external finance include credit-rationing, lack of collaterals, high segmentation in the credit market, high lending rates, and repeated lending to friends. The most significant step that the government has initiated is availing the debt finance monies to the entrepreneurs for willful borrowing. The government has done this by debt finance via its own banks like the central bank or by regulating private commercial banks. The government observes that credit facilities are however, limited to the poor due to lack of collaterals required in guaranteeing the loans. Hence it came up with various platforms like the Enterprise Finance Guarantee (EFG) and the Small Firms Loan Guarantee Scheme (SFLGS) to enable the willing and poor citizens access external finance from given lenders. The government introduced the SFLGS in 1981aimed at helping businesses with insufficient security or collaterals to access external finance from conventional bank lenders. Though the SFLGS has gone many revolutions in the recent times, it has reserved it purpose. Through an agreement between the Department of Trade Industry and defined lenders in the scheme, the UK government acts as a guarantor for 75% of the proposed loan payable over a period of 2 to 10 years. Additionally, the scheme guarantees a leeway for repayment holidays when the cash flows are not favorable. This scheme is applicable to UK sole traders, Partnerships, and limited companies. As a measure of control, the government has put restrictions on how to use the loan. In fact, not all businesses are eligible for the scheme. Indeed, companies with more than employees are not eligible and a premium of at 2% on the outstanding balance is payable every year. This scheme has been of help to many entrepreneurs with a viable business plan in starting-up and expanding their businesses upon applying and servicing the remaining 25 % loan guarantee. It is the duty of the borrower to demonstrate the viability of his business proposal and comply with the requirements of the scheme. Additionally the guarantee rises to 85% for businesses trading for two years or more. This helps the Small and medium enterprises to advance their operations and markets hence more sales turnovers. In making the SFLG accessible to the citizens, six new lenders, representing the banking, community development finance, and factoring sectors, joined SFLG in 2008. Although the 2007 SFLG utilization registered a decrease, there was an increased variation in utilization of lending limits and default performance (SFLG, p.3). It has registered great significance to both the entrepreneurs and small businesses. It has led to increased sales, reduced costs, employment change, increased productivity, and the introduction of new or improved products (Cowling, 2010, p. 27-40). On the other hand, Enterprise Finance Guarantee (EFG) was an improvement of the Small Firms Loan Guarantee. Its launching was in 2009 with concerns on exporters and a broader approach to the economy. The EFG aims at viable business plans, credit-worthy firms with no financial record of accomplishment and struggling to access the external finance (Hughes, 2011, p.1). SMEs that qualify can borrow between £1,000 and £1 million, repayable over a period of 10 years. The Government will guarantee 75% of the loan applicable to individual and small businesses in the UK (Business link, 2009, p.8). Under the EFG, businesses will also be able to convert long-term debt into term loans and enjoy varying interest rates (The Royal bank of Scotland, 2012, p.1). The EFG also provides an invoice finance guarantee, which avails a guarantee on invoice finance facilities to support an agreed additional advance on an SMEs debtor book. Equally, the EFG finances existing loans in addition to providing new loans. This service is available in many banks. The EFG has evolved, from biding restrictions to increases for funds available to the willing borrowers. However, at the initial stages there was a lack of clarity over what the scheme actually represented and the qualifications. This largely hindered its ability to benefit many borrowers. EFG will provide more than £600 million of additional lending to around 6,000 SMEs in 2011-12 (BIS, 2011, p.1). This proves the significant contribution the scheme has made in the business sector. Additionally, the government has given the EFG a going concern of up 2014-15. In conclusion, I find that the government’s interventions were necessary and justified as they rescued the willing yet unsecured borrowers. As a result, they were able to access external finance, start-up businesses, expand the existing ones and by extension, improved the economy of the country. 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