Finance for Small & Medium Enterprise - Literature review Example

RUNNING HEAD: FINANCE FOR SMALL & MEDIUM ENTERPRISE Finance for Small & Medium Enterprise Name Institution Date Introduction Small and medium enterprises (SMEs) can described as the pillar of economic growth in many economies. In Australia Small and medium enterprises constitute 95% of all the businesses in the country. In addition SMEs provide employment for approximately 3.3 million people (Philemon, 2008). Finance is a crucial aspect for such enterprises in order to enable them set up and even expand their operations, invest in production or staff and also develop new products. Small and medium enterprises usually begin as an idea of one or more people who invest their capital in a certain venture. However, when the business is successful, there comes a time when there is need for expansion, and the challenges of acquiring finance either debt or equity capital begins. Some authors suggest that the challenge of accessing finance is not a case of insufficient capital available; but rather that most growth SMEs are not investment ready to access various financial options. This particular paper seeks to examine the factors that determine the investment readiness of growth SMEs. Furthermore, the paper will examine changes that could be undertaken by government and the finance sector to overcome the problems faced by SMEs in acquiring investment capital for growth. Factors that determine the investment readiness of growth SMEs Investment readiness depicts an enterprises capability of being able to raise external finance. If SMEs are able to raise external finance, then the enterprises can implement growth in their businesses (Mason, 2003). Investment readiness can also be defined as a set of deliberate processes that are undertaken by a business in order to ensure that it becomes suitable for financing by investors. A number of factors therefore influence the investment readiness of growth of SMEs. Financial Reporting McMahon, (2011) highlights that; financial reporting to external financers is a significant aspect that influences the investment readiness for SME that have the objective of growth. Financial reporting is significant based on the fact that they shed a light to lenders concerning the going concern of the business and its performance. Consequently, SME’s that seek to borrow finance form external sources have to be ready to present their financial information to the lenders. These include financial information such as; the profit and loss statement, the balance sheet, cash-flow statement and budget projections. McMahon, (2011) reveals that many Small and medium enterprises in Australia have not yet devised effective systems of financial reporting to external financers. In a study to examine financial reporting to financiers by manufacturing small medium enterprises in Australian, McMahon, (2011) revealed that not much empirical evidence existed to indicate that the growing SMEs in Australia were actively involved in financial reporting that is to be presented to external financers. However business that had a well devised system of financial reporting were eligible candidates for receiving finance from investors. Financial reporting is also significant in the sense that it assists investors to distinguish between low risk and high risk entrepreneurs without incurring costs. In order to prevent the costs that are linked to gathering such information, investors usually need borrowers to give proof of their financial track record together with their collateral which will act as the security for lending. With a sound financial reporting system, the lenders will be able to effectively evaluate the business based on its track record. If the track record is well presented; the business will be highly eligible for financing (Schans, 2012). The attitude of Entrepreneurs towards Finance (Equity Eversion) The attitude of entrepreneurs greatly influences the investment readiness of growing SME’s. According to Howorth (2001) there is usually a high percentage of equity eversion that exists amongst small medium enterprises. Although many of the SME’s have the aspiration of enhancing growth in their enterprises, they are very much reluctant to surrender control and ownership of their businesses. Mason, (2003) highlights that this particular attitude is depicted on a terminology used by SME business owners, who frequently describe the procedure of raising finance through equity as demanding them to give away a portion of their business. The attitude of eversion can be linked to the lack of knowledge by SME owners concerning the availability and characteristic of alternative sources of funding. The implication of the lack of adequate information results to the failure of many SME projects that would have enhanced the growth of the business. Mason, (2003) therefore argues that in order for SME’S to have effective investment readiness there is need to change the attitude of equity eversion which frequently causes the challenge of financing for many SME’s. The investability of the Enterprises seeking External Finance Many Small medium enterprises face rejection when they are seeking for external finance due to the aspect of lack of investability. The lack of investability mainly occurs in the when the SMEs can not attain the requirements of the external investors. The decision making process for investment mainly involves two major stages. Foremost the opportunity is evaluated against the parameters that are set by the investors. For instance the parameters may include the size of the investment, the stage of the business and its location. Mason, (2003) highlights that; investors usually discard investment opportunities that do not attain their investment parameters. After evaluating the opportunity presented by the SME against the parameters that are set by the investors, the second stage involves screening the business that has attained the investment parameters. In order for an SME to be selected for financing the business has to demonstrate its capability by having a strong management team that manages the finances of the business effectively. In essence the investability of the enterprise seeking external finance greatly influences the investment readiness of the growth in SMEs. Presentation of the Investment Plan Investment readiness can also be influenced by the manner in which a business presents its investment plan. According to Harrison and Mason (2002) small medium enterprises sometimes fail to raise funding due to the fact that business plan was poorly drafted and presented. Apart form the business plan other shortcomings may also occur in other written documents that give details about the investment plan. Also, incase the business was giving an oral presentation, sometimes the presentation may bring about negative implication to the investors, instead of positively communicating to the investors. Shepherd and Douglas (2002) therefore propose that in order to enhance investment readiness of growth, SMEs should work towards ensuring that the business plans and the presentation they present before the investors will thrive in persuading the investors to seriously deliberate on assisting the business to raise the finance for the SME. In a scenario whereby the presentation is not properly displayed, investors may interpret the situation as a lack of competence on the part of the management and also the likelihood of a failure of the intended project. Consequently it is essential for SME to ensure that their presentation can actually sell to the investors and also convince them (Shepherd & Douglas, 2002). Internal capabilities Internal capabilities entail the competencies that are displayed by the management and also the internal controls and operations of the business in order to attain the identified potential of growth and thus be eligible for equity finance. The management of the business greatly influences investment readiness is the sense that the information and the attitude they have towards finance will greatly influence their potentiality to attract investors for the purpose of funding. Baum et al (2004) highlight that if the management of SME’s view growth as an essential task, then they will not develop attitudes which may result to equity eversion. In addition secondary activities such as coming up with a good business idea, selecting the right kind of inventors and also presenting the business idea will be undertaken effectively. Silver et al (2010) formulate a hypothesis that highlights that investment readiness is usually viewed as a function for growth. If the management of SME’s perceive growth as significant, they will acknowledge the importance of investors and also aim at networking with investors in order to create a steadfast relationship that will assist the business in acquiring finance. The hypothesis can be stated as the higher the management’s ambition for growth, the higher the probability of the business to accept private inventors. In addition, the higher the management’s ambition for growth, the closer the working relationship between the management of the business financiers, which will further lead to the suitability of the business in terms of receiving funding. Changes that could be undertaken by government and the finance sector to overcome the problems faced by SMEs in acquiring investment capital for growth Policy Changes One of the changes that can be implemented by the government in order to overcome the problems faced by SMEs in acquiring investment capital for growth is that of policy changes. Hawtrey, (1997) argues that the exceptional financial problem of small medium enterprises has been a policy issue for a long period. According to Hawtrey, (1997) despite of the existence of various financial deregulations by the government, SMEs have not yet fully profited from an improved finance supply. Consequently, Hawtrey, (1997) argues that there is need for policy reforms that will enable small business to acquire finance. The Australian government has in deed been committed in developing polices that enable SME’s to access funding. For instance in 2004 the government established the Committed to small business statement which was a legislative reform to encourage funding for small medium enterprises. Another policy includes Commercial Ready programs that aim at the enforcement of measures that can increase the supply of capital for SMEs that are looking for financial assistance. Furthermore changes in the Australian corporation’s law after the Willis report have also enabled SMEs to raise finance through fundraising (Stanger, 2007). In addition, the government has in the recent year’s devised policies that enhance direct lending to SMEs, limited guarantee of small loans and also the funding of venture capital. In despite of such initiates what is evident is that small medium enterprises still fact the challenge of accessing finance, this then implies that there is still a gap that exists essentially in resolving the problem of funding for such business. There is need therefore for policy changes to be implemented in order to enable SME’s to easily access funding. For instance the government should develop proactive polices that are able to boost primary capital markets and secondary debts for SMEs. In addition due to the implications of the recent global financial crisis the lending rates of many banks had increased. In addition Schans, (2012) reveals that there has been a significant decline in terms of lending to SMEs by many banks. The implication of the increase in lending rates and minimal lending is that small medium enterprises get challenges when it comes to payment of the debts. The government should therefore devise policies that will enable a reduction in the lending rates within the banking system. Also the government should come up with more policy interventions that can intensify the supply of lending to small medium enterprises. Furthermore, the government should also invest in the creation of more non-bank channels that can assist small medium enterprises to access finance at lower costs. Also, based on the fact that many SMEs have expanded their operations to the extent of operating within the internal markets, the government should also devise policies that will extent the borrowing capabilities of the business at an international level. For instance just like big enterprises SMEs should also be linked to international agencies that can facilitate lending. Changes in addressing the problem of market failure Market failure is one of the key challenges that influences the problems faced by SMEs in acquiring investment capital for growth. Mason, (1999) highlights that; a clear mismatch exists between the needs or requirements of SMEs in terms of measure of equity investment and the supply of the investment. In most cases venture capital is usually large however the angle of business finance for many SMEs is under developed. This scenario results to what is referred to as the ‘equity gap’ or market failure. The problem of market failure derives its roots from economic realities such as operation and administration costs, whereby the capital fund of a venture are fixed in despite of the size of the equity that is needed by a business. This particular problem has commonly affected SMEs. Although the government and the financial sector have for along period identified this particular problem there is need to devise adequate corrective measures that can address the problem of market failure. One of the approaches that can facilitate the implementation of change is through devising schemes such as enterprise finance guarantees. This particular scheme has been adopted by the U.K government and has assisted many SMEs that have difficulty in securing funding. The scheme address the market failure problem that arises due to lack of collateral which affects many viable SME’s to access finance. The scheme works by assisting banks to lend small medium enterprises that are viable but are unable to give security to the bank. In the event that the business defaults or does not pay for the lending, the government steps in and provides certain percentage to clear the outstanding loan (Schans, 2012). Creation of changes in the Information asymmetry between entrepreneurs and Financers The basis of most of the challenges that face SME’s in terms of access to finance can be traced from the principal agency theory (Meckling and Jensen, 1976). In many incidences information asymmetry that exists between entrepreneurs and investors is usually perceived as a hindrance when it comes to accessing external finance. One of the basic reasons is due to the fact that inventors usually draw back from financing SMEs at early stages due to the risks that can be linked to investment at initial stages. Potential risks that face SMEs are usually high based on the fact that inventors can not precisely evaluate the market potential of the business. On the other hand the SMEs do not supply adequate information that can assist investors to determine the market potential of the business. In order to reduce the problem there is need for the financial sector to lower the information asymmetry through strategies such as increasing greater interactions between entrepreneurs and investors. This can be undertaken through increased investment networking between the two parties, also more information seminars should be organized. In addition, more training programs should be organized in order to coach business people about how they can present their business ideas and plans to investors in order for them to gain financing (Aernoudt, 2004). Conclusion From the discussion above what is evident is that SMEs are significant to the economy however there is an impending challenge of accessing finance by such businesses. The paper has discussed the concept of investment readiness of growth SMEs as a process that indicates the capability of a business in terms of being able to raise external finance. Some of the factors that influence investment readiness for growth that have been discussed by the paper include financial reporting, the presentation of the investment plan, internal capabilities, the attitude of entrepreneurs towards finance and the presentation of the investment plan. In conclusion the paper acknowledges the fact that changes need to be devised by the government and the financial sectors in order improve the level of access to funding to SMEs. References Aernoudt, R. (2004). "Incubators: Tools for Entrepreneurship." Small Business Economics. 23 (2): pp. 127-135. Baum, R.J. and E.A. Locke.( 2004). The Relationship of Entrepreneurial Skill ,Traits and Motivation to Subsequent Venture Growth." Journal of Applied Psychology 89 (4): pp. 587-598. Howorth, C.(2001). Small firms demand for finance :a research note. Internal Small business Journal.19(4), 78-86. Harrison, R and Mason, C.(2002). Barriers to investment in the informal venture capital sector. Entrepreneurship and Regional Development. 14,p271-287. Hawtrey, M.(1997). Finance for Australian SMEs: policy issues. Journal of applied economics and policy. 16, (2), pages 39–50. Mason, C.(2003). Facilitating access to finance ; Discussion paper o investment Readiness Programmes . Routledge . Mason, C.(1999). Market failures in SMEs. DTI press. McMahon, R.(2011).Financial reporting to financiers by Australian manufacturing SMEs. School of Commerce :Flinders University. Meckling , H and Jensen, M.(1976). "Theory of the Firm: Managerial Behavior, Agency Costs, And Ownership Structure." Journal of Financial Economics 3 (4): pp. 305-360. Philemon , L, Raar, J and Tangey, G.(2008). Accounting Services and SMEs: An Australian Study. Faculty of Business, Deakin University. Silver, Lars,S, Bjorn, B and Fatima, V.(2010).The impact of investment readiness on investor commitment and market accessibility in SMEs. Journal of Small Business and Entrepreneurship. 23(1), p10-7. Shepard, D and Douglas , E.(2002). Exploring investor readiness : Assessment of investors in Australia and Entrepreneurs; Venture capital. An international Journal of Entrepreneurial Finance, 4,219-236. Schans, D.(2012). SME access to external finance. Finance Expert Group. Stanger, A.(2007).Developments in SME Financing in Australia: Wallis Report Findings . School of Commerce, Flinders University of South Australia. Read More