Financing of Small and Medium Size Enterprises - Essay Example

Financing of Small and Medium Size Enterprises Table of Contents Introduction 3 Funding Requirements ofSMEs 3 Sources of Finance for SMEs 4 Informal Sources of Finance for SMEs 5 Formal (External) Sources of Finance for SMEs 6 Influence of the Financial Crisis on the Financing of SMEs 9 Measures taken by policy makers to minimize negative impacts 10 Conclusion 10 References 11 Introduction Small and Medium Sized Enterprises (SMEs) are considered a critical component of the business fraternity and they contribute significantly to the success of the economies of most countries across the world. SMEs have also in the recent past been seen to increase their contributions to the economies through an increased employment of an increasing proportion of the available workforce in different countries. The number of SMEs that are privately owned has continued to grow at a tremendous rate across the world although there are various challenges that have served to slow down this pace. One of the most significant challenges that most SMEs have faced regardless of their country of origin is the problem of access to financing for their operations as well as for their growth and development. Studies reveal that most SMES are characterized by very tight budgets and liquidity constraints and are therefore constantly in search of new sources of financing (Jiang, Li & Lin, 2014). Funding Requirements of SMEs According to Abereijo and Fayomi (2005), the generation of entrepreneurial ideas is not normally a difficult challenge for most people, however, the generation or availability of funds to translate the idea into a running business is another. A lot of ideas have that were considered excellent and innovative have been known to die simply due to the fact that the entrepreneurs who came up with them lacked funds to translate them to businesses and also due to the fact that financial institutions could not agree to invest in them. It is therefore important to note that finance from whichever source, is critical for the growth and development of SMEs and in order to maximize the profits realized from the business. Given the nature of SMEs as shown above, there is therefore critical need for the financing of their activities mostly from external sources of finance (Briozzo, 2012). It has been suggested that on a general scope, SMEs normally have four main financing requirements: these are the initial investments on infrastructure, the operational costs which are sometimes required in lump sum amount, growth and expansion, and finally, unexpected opportunities that arise during the course of operations requiring a quick access to finances. It is however noted that despite the glaring need for finances, most SMEs often choose to use internal sources of finances for example from the entrepreneurs own funds or from the cash flows from operations instead of choosing external sources of finance. This choice is normally determined by the relative availability of funds and also by the opportunity costs involved. It should be noted that in most cases, the internal sources of finance are rarely sufficient for the operations of the business and therefore the dire need for external sources of finance in order to fill this gap. This paper therefore evaluates the various sources of finance that are available for SMEs across the world as well as the likely impact of the financial crisis on these sources of finance and their availability (Casey & OToole, 2014). Sources of Finance for SMEs There are various sources of finances for SMEs across the world although it is important to note that they vary depending on the country. This is due to the fact that the financial markets and the financial institutions in every country are at different stages of development and this therefore means that some sources of finance may be available in some countries while they might not be in others. From the onset, it is important to note that there are two main sources of finance, debt and equity and these can either be informal from friends or from formal sources such as financial institutions (commercial banks, Micro Finance Institutions and other formal institutions such as the government (Rupeika-Apoga, 2014). Every SME is normally financed through the use of either debt or equity and in most cases; it is normally a combination of the two. Both of these two sources of finance are either sourced from the informal financial sector (IFS) or from the formal financial sector (FFS) in each country. It has been suggested that in the formal financial sector, the most common sources of finance for SMEs are the commercial banks, development banks and Micro Finance Institutions. In the informal sector on the other hand, the most common sources of finance for SMEs include owner’s savings, and borrowing from friends and relatives. It is important to note that these sources of finance vary for each SME depending on their situation and location although financing from private savings and borrowing from friends and family are common in all countries (Khalid & Kalsom, 2014). Informal Sources of Finance for SMEs As noted above, the various sources of informal financing for SMEs are mainly from the entrepreneur’s savings or from borrowing from friends and family. Various studies have noted that personal savings are the most common form of financing for SMEs since in most cases entrepreneurs come up with ideas alone and try to move forward with the idea with little or no input from other people. It is also the cheapest source of finance since one does not need to consult anyone or pay one back with some interest. It is also important to note that this is considered the fastest way of financing ones business ventures since the decision is made by only one person. Another issue to consider is that SMEs are in most cases owned by one person and are based on a simple idea and this therefore means that the entrepreneur is the only person willing to invest in that business idea (Kaousar & Wehinger, 2014). Another source of informal finance for SMEs is borrowing from friends and family. Once an entrepreneur has exhausted the personal savings, the only other immediate and easily accessible source of finance is from borrowing from the family members as well as from close friends. This is due to the fact that friends and family are easily convinced and are driven by emotion to want to support one’s business. Studies actually reveal that most SMEs are either funded from personal savings or from the family members and this is normally across different countries. It is also important to note that friends and family may have formed informal savings groups which have the capability of lending to their members and this therefore becomes an easier option for the entrepreneurs to source for capital (Briozzo, & Vigier,, 2014). Formal (External) Sources of Finance for SMEs There are various formal sources of finance for SMEs and it is important to note that these are normally dependent on the development of the financial markets and institutions in a country. A study by Ipsos MORI (2013) noted that the most common sources of external financing for SMEs in the EU were bank overdrafts with 39%, trade credit with 32%, bank loans with 32% and leasing or hire purchasing with 35%. The study also notes that 75% of all the SMEs in the EU had used external sources of financing in 2012. This therefore means that external sources of finance are a common source of finance for SMEs due to the fact that internal sources such as personal savings and borrowings from friends and family are rarely enough. One of the most common sources of finance for SMEs is commercial banks. Commercial banks in most countries are considered the main financial institutions and these are therefore the run to organizations by SMEs when they need external sources of finance. In the EU for example, 85% of all the SMEs had sought financing from commercial banks in 2012 while in 2011, the rate was 87%. It is important to note that commercial banks normally make a lot of loans to small and medium sized enterprises in most countries although they are normally the most difficult to access loans for start-up businesses since one of the main requirements for commercial banks before they can extend a loan is to evaluate the payment ability as well as the ability to make money. This means that before the bank can extend a loan to an SME, thy need to be reasonably sure that the SME will have the ability to repay the money and since most do not have that history, they end up not getting finance from commercial banks. In this case, those SMEs that have personal assets and have prepared a good business plan are normally able to access finance even if it is a start-up business (Kuntchev et al., 2013). Another source of finance for SMEs particularly in emerging markets are Micro Finance Institutions. These are financial institutions that specialize in lending to small businesses and individuals in form of groups. One characteristic of these firms is that they lend to members based on the member’s savings and this means that for entrepreneurs who do not have savings or guarantors cannot access funds for their SMEs. Another issue to note is the fact that these Micro Finance Institutions deal with micro loans that are small in nature and therefore in most cases are not sufficient for the operations of SMEs. One of the main reasons why they are more popular than commercial banks is due to the fact that they charge lower interest rates and therefore the costs of borrowing are generally lower. It should be noted that most of these Micro Finance institutions are mainly found in emerging markets such as South America and Africa and mainly focus on lending to specific groups of people such as women or the youth (Beck, 2013). Another source of finance for Small and Medium Sized enterprises are venture capital firms. These are firms that are mostly involved in the provision of funds to businesses that they feel have exceptional growth potentials. It is important to note that before a venture capital firm can extend credit to any form of business, the business must prove beyond reasonable doubt that the business can make money and become profitable in an acceptable number of years (Liu & Wang, 2013). They therefore subject the businesses to rigorous evaluation processes in order to determine issues such as the risk involved in investing in the company as well as the expected rate of return from the company’s operations. One way of making sure that venture capital firms extend credit to a business is ensuring that the business has a well written business plan. It is important to note that most SMEs lack articulate business plans due to the fact that most are borne out of ideas from entrepreneurs who in most cases lack prior business knowledge. This therefore means that very few SMEs actually access financing from venture capital firms due to these constraints. Another important issue to note is that these venture capital firms are mostly available in countries with developed financial markets such as the US and UK and this therefore means that they are not common sources of finance for SMEs particularly in emerging markets such as Africa (Zeneli & Zaho, 2014). Another source of external financing for SMEs is Investment banking firms. These are banks that are mainly involved in providing investment opportunities for both firms and individuals. In terms of providing funds to SMEs, this normally happens when an SME approaches an investment bank with the idea of taking the company public. This process involves the investment bank offering a portion of the SME or stock (ownership interest) of the company to the public. One important issue to note here is that this source of financing is only available to SMEs that have shown a track record of excellent performance and also have a strong growth history and potential (Vermoesen, Deloof & Laveren, 2012). This is a major limitation to most SMEs since most are new start-ups and most often struggle to make substantial returns that can lead to profits as well as growth and development. This source of financing is therefore only considered by SMEs that are already established and are seeking to grow into large enterprises since the entrepreneur is normally ready to let go of a part of their company in order to achieve the growth they desire and to take the company to the next level. This source of external financing, therefore, locks out new SMEs and start-ups from accessing funds for investments. Another common source of financing for SMEs is trade credit. This source of financing involves a situation where the suppliers and other business partners are willing to offer supplies and goods to the SME on credit terms. It should be noted that this source of financing is considered a superior form of financing for both existing SMEs as well as start-ups since the collateral is the stock that is extended to the business. It can be noted that most of the external sources of finance involve the acquisition of debt since most are in the form of loans (Kira, 2013). Influence of the Financial Crisis on the Financing of SMEs It should be noted that the financial crisis of 2008/09 affected the credit markets in a major way as commercial banks and other lending institutions moved to reduce their exposure in terms of loans. This means that most of these lending institutions put up strict measures for extending loans while others made it virtually impossible to lend. Since it has been established from the discussion in the previous section that most external sources of finance for SMEs are in the form of loans from commercial banks, this means that SMEs may have a lot difficulties accessing financing from commercial banks (Chen, et al., 2013). Another issue that should be noted is the fact that after the credit crunch or the financial crisis, most governments put up various regulations to limit the percentage of commercial bank’s funds that could be given out as credit in order to protect such firms from the risk of bankruptcy in case another financial crisis occurred. This means that commercial banks as well as other formal lending institutions now have a limited ability to issue loans and this is expected to affect the SMEs in a major way since banks may opt to set aside funds for their more valuable customers such as large businesses and leave no funds for loans to SMEs. This will affect SMEs in a negative manner since they will no longer be able to access credit from commercial banks which are vital for their growth and development (Beck, Demirgüç-Kunt & Pería, 2010). It is however important to note that in the UK for example, the financial crisis resulted in more commercial banks focusing their lending activities to SMEs. This is due to the fact that the regulations that the government put in place were more punitive to large borrowers than to small borrowers. These commercial banks were therefore left with no option but to redirect their focus into lending to SMEs as these required less amounts of funds. It should be remembered that most of the commercial banks had lost a lot of finances during the crisis in the form of delinquent loans and therefore in order to recoup these losses, the SME sector became more appealing due to the low amounts that they borrowed (Serrasqueiro, Nunes & da Silva, 2012). Measures taken by policy makers to minimize negative impacts In order to ensure that the financial crisis does not have such negative impacts on the financing of SMEs, governments and the policy makers of various countries have put up different measures and interventions. In Europe for example, policy makers have put up measures and strategies of bailing out banks that faced bankruptcy and failure due to the financial crisis. This is also the case in the UK where Congress passed laws to allow the government to bail out some of the commercial banks and lending institutions that were facing the risk of failure and bankruptcy as a result of the financial crisis. It is also important to note that some governments put up regulations on the scope and nature of loan extension activities of commercial banks which required a balance in the nature of the loans extended and this has served to increase the amount of loans available to the SMEs particularly in the UK (Amon & Dorfleitner, 2013). Conclusion It is clear from the discussion presented above that SMEs from across the world have several sources of both internal and external sources of finance. The internal sources of finance are common across the world since they are mostly from the personal savings of the entrepreneurs or from borrowings from friends and family while external sources differ depending on the development of the financial markets in each particular country. It can also be argued that the financial crisis of 2008 led to various negative effects in terms of the availability of funds for SMEs although there have been various efforts to ensure that these negative effects are minimized (Nguyen, Nguyen & Yin,, 2014). References Abereijo, I.O. & Fayomi, A. O. (2005). Innovative approach to SME financing in Nigeria: a review of small and medium industries equity investment scheme (SMIEIS). Journal of social science 11(3), Pp.219-227. Amon, N. & Dorfleitner, G. (2013). 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Zeneli, F. & Zaho, L. (2014). Financing SMEs in Vlora City, Albania: between Game Theory and Lack of Information. Procedia - Social and Behavioral Sciences, 150, pp.126-131. Read More