Sources of Financing for Small and Medium Scale Businesses - Literature review Example

1248482 - Project (11 pages, 20 refs, Harvard) Examine critically sources of financing for small and medium scale businesses. Recent headlines suggest that there may be diverse effects of the global financial crisis on small business finance and microfinance industry. On what scale and in which particular ways do you believe the worldwide credit crisis will impact small business finance. Identify the measures taken by policy makers to minimize such negative impacts. Use examples to illustrate your answers. Assessment Criteria The following aspects of the essay will be assessed: Introduction The importance of small and medium enterprises to economies cannot be overemphasised. They generate employment and income, drive innovation and growth (Wehinger, 2014) and create competition (Shinozaki, 2012). SMEs account for more than half of private sector employment in OECD economies. They are a driving force of sustainable local economic development worldwide. The recent global financial crisis not only had significant impact on world economies but also businesses worldwide and worse for the developing countries whose financing of SMEs remains acute (Holtmann, et al., 2000). Market turbulences affect small and medium enterprises (Stomatovic & Zakic, 2010) more than they do the large firms especially as relates to their financing (ECB, 2014). It is therefore important to review the sources of finance for small and medium enterprises as well as the impact of financial crisis on financing of small and medium enterprises. According to Holton, et al., (2013) governments, central banks and development banks have always intervened in the credit market for small and medium enterprises. The authors note that such interventions are justified as businesses facing credit constraints are less likely to participate in investment, marketing, hiring, exporting and importing. This calls for a search for the government responses in terms of global financial crisis for small and medium enterprises. This paper seeks to achieve three main objectives: 1. To examine the sources of financing for small and medium enterprises; 2. To examine the impact of global credit crisis on financing of small and medium enterprises and microfinance industry; and 3. To identify the policy responses to minimise negative impacts of global credit crisis on financing of small and medium enterprises. It has been noted in literature that there is no universally agreed definition of small and medium enterprises (OECD, 2009). Every country has its own definition of what constitutes an SME. In this paper therefore, SME is not defined but papers regarding SME financing are reviewed. This paper is organised as follows. First, the sources of financing for SMEs is reviewed. This is followed by a review of the impact of global financial crisis on financing of SMEs and microfinance industry before the policy responses to minimise the impact of financial crisis on financing of SMEs are elucidated as revealed from various studies and reports. Sources of financing for SMEs There are numerous sources of financing for SMEs. These include both internal sources (owner investment, retained earnings and sale of assets) and external sources (debt, micro-credits, leasing, hire purchase, and risk capital) (Ruis, et al., 2009). According to a survey, half of German SMEs used leasing, hire-purchase or factoring, and 40% in France, while 25% in Spain and Italy (ECB, 2014). Bartholdy & Mateus (2008) examined financing of SMEs and revealed that the main sources of financing for SMEs are equity (internally generated cash), trade credit paid on time, long and short term bank credits, delayed payment on trade credit and other debt. A study by Vos, et al., (2007) focused on two data sets of UK and US to examine SME financing behaviour. As was shown, younger and less educated SME owners more actively used external financing while older and more educated (‘wiser’) SME owners are found to be being less likely to seek or use external financing. The study by Terungwa (2012) revealed that SMEs in Nigeria were significantly financed by informal than formal sources of finance. These included personal savings, cooperative credits, loans from friends and families, and ploughed back profits. Debt finance by banks has been the largest source for external finance for small and medium enterprises for many years (Ruis, et al., 2009). However, this method of financing has been problematic to small and medium enterprises (ECB, 2014) because most of those businesses lack a track record, have inadequate security, are likely to breach the threshold limit, and their credit ratings are outside the banks’ acceptable limits. These reasons make it hard for small and medium enterprises to access bank loans (Ruis, et al., 2009). While banks perceive SMEs as highly profitable, the main obstacles are their macroeconomic instability in developing countries and competition in developed countries (Beck, et al., 2008). Leasing and hire purchase is another source of financing for small and medium enterprises. This is a secured form of financing whereby the finance is secured on the leased asset (Ruis, et al., 2009). The requirements for leasing include provision of a few years of financial records especially if the lease is to be granted by a commercial bank. In most cases, the small and medium enterprises do not have the two to three year financial records demanded by the banks therefore making this method of financing inaccessible to most of them. Most small and medium enterprises may however get financing through leasing from the leasing companies which only require six to one year credit history before they can approve the lease (Ruis, et al., 2009). Factoring is also another source of financing for most of small and medium enterprises. This source of financing works by the SME selling its accounts receivable at a discount (Ruis, et al., 2009). This is a growing source of external financing SMEs as it is unique in the sense that “the credit provided by a lender is explicitly linked to the value of a supplier’s accounts receivable and not the supplier’s overall creditworthiness” (Klapper, 2005). This method is popular in countries with greater economic growth and development as well as with developed credit information bureaus. Another common source of financing for small and medium enterprises if trade credit where the businesses postpone payment for good and services purchased and thus helping them to manage their cash flows (Ruis, et al., 2009). However, this method is usually more expensive than a bank loan. Venture capital is yet another source of financing for small and medium enterprises which is usually provided by venture capitalists or private individuals who invest in SMEs with the potential to develop into significant businesses (Ruis, et al., 2009). However, this method is not used by most of SMEs as a source of financing. Business angels are informal individual venture capitalists who provide funds to businesses which they had no previous relationship (Ruis, et al., 2009). This method of financing is an important one as a source of financing for small and medium enterprises. Impact of global credit crisis on financing of SMEs and microfinance During the recent financing crisis, there was a credit crunch where loans reduced and the conditions for obtaining a loan from a commercial bank were tightened. Credit rationing was therefore inevitable and the small and medium enterprises felt the brunt of this credit crunch. OECD (2009) agrees that SMEs were affected by the financial crisis across economies. One of the impacts of the last financial crisis was that market conditions for accessing credit were tightened for small and medium enterprises worldwide thereby affecting their working capital (Ruis, et al., 2009). The SMEs therefore had to access financing from elsewhere. During the crisis, bank loans to small businesses reduced by 5%, bank loans to medium enterprises reduced by 7.4%, factoring reduced by 17.1%, leasing reduced by 11.4% and venture capital financing reduced by 32.1% (Ruis, et al., 2009). The study by (OECD, 2009) noted that there were extended payment delays on receivables thereby depleting the working capital of SMEs in many countries. The study reported that this case the case for 43% of SMEs in Belgium, 50% in Netherlands, 30% in New Zealand, 25% in Denmark, Italy, Ireland, Norway and Spain, 17% in Finland, and over 50% in Sweden. The SMEs in these countries experienced extended payments delays and/or insolvencies and subsequent bankruptcies. These increased insolvencies show that the SMEs were increasingly unable to service their short-term financing. This hurt the credit standings of SMEs with banks and therefore led to banks tightening their credit conditions hence keeping only the strongest clients. The study reports a case of Korea where lending to blue-chip SMEs has increased while lending to those with poorer credit ratings has worsened. This has therefore made the bank loans inaccessible to most SMEs. Huovinen (2011) studied 2000 SMEs in Finland to determine the impact of financial crisis on SME financing. The results showed that at the peak of the crisis, 10 per cent of SMEs reported major financing difficulties and 21 per cent had solvency problems. The prevalence of financing problems was five times higher than before the crisis. The results showed that the incidence of solvency problems increased to 6 ‐ 8 per cent. Thus, the demand for short‐term financing increased rapidly while long‐term investments were postponed in many SMEs during this period. According to (OECD, 2009) the financial crisis led to stagnation in lending to SMEs even for banks that were deliberately facilitated by their governments to grant additional loans to SMEs or where credit guarantee schemes were in place. The incentives from governments for banks to lend to small and medium enterprises did not yield the intended outcomes. This may be attributed to the centralisation of and automation of credit assessment systems by large banks which denies the SMEs chance for a face-to-face contact with bank managers. OECD (2009) reports that the financial crisis has led to exploration of alternative sources of finance by SMEs such as mobilisation of reserves, self-refinancing and factoring. This is because both venture capital and private equity (or angel investors) access were hampered. The study reported that the global venture capital fundraising slowed down during the period of financial crisis. For instance, it decreased by 25% in 2007 in Canada, Australia and UK. The report by ECB (2014) shows that financially constrained firms replaced bank loans with other types of loan obtained from individuals and related companies and shareholders during the financial crisis. The report further noted that the SMEs tended to use trade credit. Carbó-Valverde, et al., (2013) analysed whether trade credit provided an alternative source of external finance to small and medium enterprises during the crisis. Using firm-level Spanish data, the study found that financially constrained SMEs depended on trade credit, but not bank loans, and that the intensity of this dependence increased during the financial crisis. Unconstrained firms, in contrast, were dependent on bank loans not trade credit. This offers enough evidence that trade credit became an alternative source of financing for SMEs during the global financial crisis. Fraser (2012) found that during the financial crisis, businesses with loan and overdraft demands were more likely to be rejected, paid lower margins during the period, paid higher arrangement fees, more or less likely to post collateral on overdraft or loan, and had higher collateral ratios than the periods before the crisis. This shows significant negative consequences of the financial crisis on SME financing. The rejection rates about are also confirmed in a study by (Sannajust, 2014) who concluded that SMEs suffer the most rejection of bank loans during a financial crisis. The study determined that small and young firms are hit the most when compared to others. The results also showed that family businesses had the most difficulties in obtaining loans. Stomatovic & Zakic (2010) found in a study in Serbia that SMEs experienced reduced demand, had difficulties accessing export markets and capital markets. Ono & Uesugi (2014) revealed that during the financial crisis period, the loans were first extended by main banks and later backed by government policy to enhance credit availability for SMEs in Japan. The study revealed that trade credit by main suppliers was relatively limited during the period. The study by Wan, et al., (2011) analysed responses from senior government officials to describe the impact of global financial crisis on SMEs in 12 APEC countries and to describe new programs that had been added specifically to deal with the global financial crisis. The study revealed that with global financial crisis, SMEs faced additional obstacles with respect to financing, working capital, and demand. Policy responses to minimise impacts of credit crisis on financing of SMEs and microfinance The study by Ruis, et al., (2009) reports of two policy responses to stimulate access to finance for small and medium enterprises following the recent credit crunch. First, new measures were adopted to address market failures in the future. The European Union (EU) for instance has set in place a number of financial instruments in order to stimulate improved access to finance for SMEs. These instruments include the EU Structural Funds and the Competitiveness and Innovation Programme 2007-2013. The instruments provide a stimulus to increase the supply of finance to SMEs with a budget of over one billion Euros under the CIP supported financial instruments (Ruis, et al., 2009). The second policy measure has undertaken by the EU was to stimulate access to finance for SMEs and fight cyclicality in the SME’s access to finance. This was done through increase in the commitment by EIB and working through the EIF to extend the volume of loan guarantees for SMEs (Ruis, et al., 2009). The OECD (2009) also reports that anti-crisis packages have been put in place by governments for three main reasons: stimulate demand, enhance credit, and for recapitalisation of banks. Measures to stimulate demand such as consumption packages, infrastructure programmes and tax policies were meant to support sales and prevent depletion of SMEs’ working capital. The measures to enhance credit facilities for small and medium enterprises were through bank recapitalisation and expansion of loans and credit guarantee schemes. The measures were also aimed at maintaining the investment level of small and medium enterprises and their capacity to respond in future to a surge in demand. Governments also implemented measures to maintain or increase cash flows (OECD, 2009). These included allowing for accelerated depreciation for investments undertaken and giving tax credits, cuts, deferrals and refunds. For instance, Japan cut the corporate tax rate from 22% to 18% per cent for small and medium enterprises. Netherlands cut the rate from 23% to 20% and Canada increased the taxable income bracket for which the SME rates applied. On the other hand, Czech Republic, France and Spain made immediate VAT refunds for SMEs. OECD (2009) noted that a number of countries such as Australia, France, Hungary, Italy, Netherlands and UK were taking moves to shorten payment delays for public procurement and enforce payment discipline by asking the public to settle bills within 30 days. The study reports that the UK cut government payment times to 10 days. Governments have also put up policy measures to enhance access to finance by SMEs through extension of loans and loan guarantees (OECD, 2009). Greece, for instance, put up new credit guarantee scheme for working capital. The study by (Ono & Uesugi, 2014) showed that Japan introduced an Emergency Credit Guarantee (ECG) program to help increase credit availability. OECD (2009) also noted that countries have resorted to discipline measures to complement the incentives for banks to lend to SMEs which have so far been unsatisfactory. These discipline measures pressure commercial banks to lend to SMEs. They include the use of credit mediators which France and Belgium have utilised. The credit mediators intervene to ease financing to SMEs by banks. The US strictly monitors the credit activities of banks that were bailed out. This includes a requirement for the banks to report on quarterly basis. Ireland on the other hand has a legally binding code of conduct on SME bank lending while Belgium has a Ministry for SMEs which gives pre-fund agreements directly to SMEs. These can then be taken to the banks by SMEs to obtain guaranteed loans. The study by Holton, et al. (2013) offers a summary of policy responses across OECD countries by grouping the responses into three distinct classes: policies to improve bank credit intermediation offered by the government (loan guarantee schemes, lending targets, export finance support, credit mediation/code of conduct, and credit registry), policies to improve bank credit intermediation offered by central banks (bank funding schemes and securitization support), and policies to promote alternative sources of credit offered by the government (direct lending 100%, direct lending with private sector involvement, peer-to-peer support, and retail bond markets). Ireland is the only country among the OECD that does lending targets and the only one that does not support export finance. The ECB (2014) article shows that in order to promote SME financing in the Euro area, the EU has responded with two broad solutions – capital market solutions and regulatory initiatives. The EU has worked to increase confidence in securitisation markets to enhance banks’ lending capacities by establishing transparency requirements at the capital markets. These have helped to mitigate stigma effects. The EU financial regulations have also been amended in order to facilitate the financing of SMEs, and national development banks are being active in facilitating SMEs’ access to finance, including by fostering cooperation among themselves. Conclusion This paper has analysed the sources of financing for SMEs. These include a combination of internal and external sources of finance. Mostly, it was revealed that external sources are the most used sources of financing for majority of SMEs. These include bank loans, credit terms, factoring among other financing options. Some of these are better for developed countries while others are popular with the developing countries. This paper has also reviewed papers that examined the impact of financial crisis on SME financing. Most of the impacts are negative and include reduced demand for products and services, inaccessibility of financing as sources shrink, insolvencies and bankruptcies among others. The recent global financial crisis was therefore shown to have had devastating consequences of SMEs across the globe. Finally, this paper has examined the policy responses of various government and non-government institutions regarding financing for SMEs following the recent global financial crisis. As the review has showed, the governments ensured that credit was available for SMEs by bailing out banks and offering other incentives to lenders so as to keep them lending to SMEs. However, most of these incentives did not work as SMEs opted to find other alternatives to financing. The governments also responded with regulatory changes as well as changes to the stock markets. References Bartholdy, J. & Mateus, C., 2008. Financing of SME’s: An Asset Side Story. 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