The Importance of Small and Medium-Sized Enterprises - Coursework Example

Explain what sources of finance are available for small to medium sized companies and explain why they sometimes face difficulties in raising financeContents Contents 2 Background of Small and Medium sized Enterprises 3 Sources of Finance for SMEs 5 Problems faced by SMEs in Availing Finance 10 Challenges for Banks in Offering Advances to SMEs 11 Possible Steps by Government & Policy-makers 12 Conclusion 15 Bibliography 19 Introduction Every country around the world has a set of policy objectives which summarise the importance of Small and Medium sized Enterprises (SMEs) in their overall economic development and the assurance that SMEs have access to sufficient capital. In many developed industrial economies, the employment generation depends upon the growth of small enterprises. This becomes even more important in developing nations such as China. Therefore the growth of SMEs is a crucial element in overall economic growth of a country. The major challenge faced by SMEs is to access the capital to take advantage of new investment opportunities. The studies on SME financing in the past showed the lack of financing a major constraint for start-ups as well as expansion but recent statistics show an improved capital access for SMEs. This essay aims to present the definition of SMEs from the point of view of European Commission, the sources of finances available to SMEs along with the suitable financing options according to the stage the SME is in, the barriers SMEs face in procuring the capital or if the financing constraints still exist, and the steps needed by policy makers to provide congenial environment to SME sector. Background of Small and Medium sized Enterprises The Small and Medium sized Enterprise can be defined in two ways- Quantitatively and Qualitatively. The quantitative definition is based on the various criteria set by the different countries. Qualitatively SME can be defined on the basis of ownership which is limited to a few individuals. SMEs are privately owned with low volume of sales and a very few employees. The definition regarding the number of employees varies from country to country with 15 employees in Australia under Fair Work Act 2009, 50 employees under EU and a little less than 500 employees in USA to qualify for Small Business Administration. The European Commission has given a definition of an SME which qualifies an enterprise to be small or medium sized enterprise if it fulfils the criteria of maximum ceilings in either one of staff headcount, turnover or balance sheet given in Table 1. Table 1: Qualification to be an SME (Source: European Commission-a, 2009, p.3) This new definition was adopted by EC in 2003 and came into effect in 2005. The main reasons behind adopting new definition were to improve availability of capital, to update thresholds and to improve access to R&D and promote innovation (European Commission-b, 2005, p.8-10). The European Commission works on policies regarding SMEs throughout Europe and assists them through business support measures. In 2010, the number of SMEs in EU was around 20.8 million, 99.8% of the total enterprises. These SMEs employed 87.5 million people, almost two-thirds of the total employed people producing GVA of 58.4% (Cambridge, 2011, p.8). In 2010, SMEs accounted for 60% of UK’s total public sector employment and 50% of the private sector turnover (Turner, 2010). In February 2011, UK ministry announced the reform measures specifically to open-up public sector markets for SMEs. This included the set-up of ‘contracts finder’ a source to access information regarding procurement, tenders and contracts and directives to government departments to set targets to increase businesses with SMEs. They also presented an SME Action Plan taking into account the limited means to increase non-UK business for SMEs in UK (Foreign & Commonwealth Office, 2011). Sources of Finance for SMEs Finance is considered a key element that drives the SMEs to successively build productive capacities and create jobs. Without capital, SMEs cannot acquire new technologies neither can they expand to create linkages with larger firms or compete globally. Financing is essential in expansion of operations, new product development and investment in new production facilities. The innovative SMEs with growth potential play an important role in development process. There are various examples of innovative SMEs such as Alpro Soya and Al Simpkins which have created a market of their own with innovative and healthy food products (Food and Drink Federation, 2010). The following are the major sources of finance for SMEs: 1. Own Capital: This is the major and most preferred source of funding SME where the owner invests his/her own capital and retains 100% control of business. When nutritionist Elaine Mummery started her online skincare clinic in Glasgow, she used her own saved funds along with a small grant from Business Gateway. According to her the start-up costs are small and small grants or subsidized rent on properties were given to successful entrepreneurs will be very helpful (Heraldscotland, 2011). 2. Financing from Business Angels: Business angels are persons who have the business experience and capital required to fund a small or medium business. They are the most important source of capital for any SME. They are mostly used as a start-up source of funds and tend to invest only in those industries in which they have had previous experience. One recently emerged route for business angels is to act as co-investor in the publicly backed funds. This allows them to share risk and become a part of larger deals worth £250K to £500K. The UK has the largest angel investors in Europe (BIS, 2009, p.4-7). 3. Leasing: Leasing is preferred in developing countries where the capital markets are not much developed. The advantages of leasing include simpler security arrangements, little cash required and tax incentives. Leasing also promotes transferring new technology and investments in capital equipments. 4. Trade Credit: Not all small businesses go for external financing. They also finance their operations informally through trade credit which is like taking credits by delay in payments for purchases. 5. Venture capital: Venture capital is the funds provided by the investors to the small and medium businesses in anticipation of high growth of the business. This exposes the investors to high risk but the potential for above-average returns is high. This is a very important source of financing for the SMEs but the venture capitalists very rarely invest in start-up business but like to invest in those which are already established. Private equity is another term for venture capital. Figure 1 shows the country-wise data of SMEs using venture capital as a means of financing either in early stages or for expansion purpose. It can be seen that SMEs in most of the countries used venture capital for expansion purposes than for start-ups. Figure 1: Venture Capital Investment 2000-2003 (% of GDP) (Source: OECD, 2006, p.6) 6. Short to medium term bank loans: Short-term loans are those where the repayments are done within one year whereas in medium-term loans the repayments are done between one to five years. This can be in the form of bank overdraft where the bank lets the business take out the money even if its bank balance has become zero. But the bank overdraft’s flip-side is the high rate interest banks charge. However this is a flexible source of funds and can be used by SMEs when required urgently. 7. Factoring: This financial service involves the use of accounts receivables as a source of credit. The company’s invoices have credit worthiness as they represent the obligation from the counterparty who has already received goods and services. These invoices can be used by SMEs to raise working capital. 8. Mezzanine Finance: Mezzanine Finance is a hybrid of equity and debt finance and increasingly becoming preferred form of financing. Due to the credit crunch the SMEs are finding difficulties in raising finance in high-yield capital markets or from unwilling banks to lend. The cost of mezzanine finance is lower than equity because the interest is tax deductible. Many lenders consider a balance sheet having mezzanine finance to be stronger because as a subordinated unsecured debt it has common features with equity. 9. Public Equity: Financing is very important for SMEs to start the business or to expand it but very few consider the use of public equity. 10. Public Debt: This is the least preferred method by any start-up SMEs but in expansion this form of financing can be a good alternative. Firms issue debentures to public to raise funds. Phase of Growth and Financing Demands: 1. Start-up or Early Growth Phase: During the initial stage the business is only an idea with its primitive operational structure. At this stage, its major sources of funds are likely to be own funds, equity provided by family or friends and Business Angels. Business angels and venture capitalists are considered the riskiest on a risk-capital spectrum. Venture capitalists usually do not engage with SMEs in their early stages. 2. Normal Operations or Growth Phase: At this stage the SME has become organisationally advanced and manufacturing products or providing services. It may be generating positive cash, which becomes internal source of finance. Trade credit, short-term to medium-term loans, bank overdraft, factoring and leasing may be other sources of financing. 3. Stable Growth Phase: Bank loans and venture capital generally are not available until the SME has shown growth trends, stable track record and sufficient collateral. Mezzanine Finance is another form of financing which can be availed at this stage. 4. Late Growth Phase: At this stage SMEs can consider issuing public equity through IPO (Initial Public Offer). The IPO can take two forms- either followed by listing on stock exchange or offered in OTC (Over The Counter) also referred to as junior equity. SMEs can also consider the corporate bond market by issuing debentures but eligibility requirements are strict (OECD Centre for Cooperation with Non-members, 1999, p.26-27). In a comparative study of UK and Chinese SMEs, findings suggested that the UK SMEs relied more on immediate relatives and savings for start-up financing and later switched to external financing for expansion purposes whereas the similar Chinese SMEs relied mainly on financing from relatives than the financial institutions (Hussain, Millman & Matlay, 2006, p.584). Problems faced by SMEs in Availing Finance The frequent cause of failures of SMEs is their undercapitalization. Carpenter and Petersen (2001) examined the internal finance of growth theory in relation to 1600 U.S. small firms and found that there is a strong relation between internal finance and growth for firms which are less dependent on external financing i.e. equity. This suggested that their growth was only constrained by internal finance whereas a small number of firms that issued equity showed less dependency on internal financing and not constrained by internally generated funds (Carpenter & Petersen, 2011, p.20). In 2002, statistics from middle and Eastern Europe revealed that as compared to developed countries the size of SMEs in these countries was much smaller and highly leveraged but more profitable. It was also found that these SMEs could only borrow short-term loans and lacked long-term outside financing (Klapper, Allende & Sulla, 2002, p.25). A study conducted by HM Treasury & Small Business Service in 2003, reported acute equity gap for businesses seeking finance between £250K to £1m extending to £2m whereas based on these findings a similar study was conducted was BIS for the period 2001-07 and found similar results with only the difference of the upper ceiling which had increased to £5m (BIS, 2009, p.79). In 2004, as opposed to previous results, a comprehensive survey in UK and US revealed that the SMEs initially do not go for external funding. They usually go for external financing for expansion and therefore not constrained by it (Yeh et al, 2004, p.2). Although it is a common knowledge that SMEs rely heavily on borrowings but a study conducted by BDRC Continental (2011) suggests that 68% of SMEs in UK never borrowed nor felt the need to borrow in the last 12 months. Bigger SMEs were likely to raise debt from banks and among those who will get a positive response from banks are big SMEs, applicants having low risk rating and likely to renew existing facilities rather than applying for new ones (BDRC Continental, 2011, p.8-31). Another key finding by the study was that only 2% of the SMEs cited lack of finance as a barrier while it was likely that such percentage will be higher for those planning to grow in the next twelve months (BDRC Continental, 2011, p.97). Contrary to this Li (2010) gave the reasons for difficulty in accessing finance by SMEs in China to be Chinese poor credit environment and unsuitable state-owned commercial banking operations (Li, 2010, p.265-266). A research on Canadian SMEs financing found that the discouraged borrowers (who needed capital but did not apply for financing to financial institutions) were more informed than those whom financial institutions denied financing. These discouraged borrowers dealt with institutions that specialized in relationship business which helped them understand when to ask for capital and when to refrain. This study showed that the focus group was not a victimized group as is generally believed (Chandler, 2010). Challenges for Banks in Offering Advances to SMEs 1. Financial irregularities and weak financial statements 2. Operational risk and liquidity risk assessment of SMEs 3. Assessment of the background of SMEs 4. Competition among banks for improvement of credit and interest spread while reducing risks in assets A recently released data shows that the bank loans approval to SMEs in UK has fallen from 88% in 2007 to 65% in 2010 where the UK SMEs seeking capital increased by 7% (Jones, 2011). The survival rate of SMEs is lower as compared to large corporations which might be the reason banks become reluctant in taking their applications. It is often very difficult for potential investors and creditors to assess the financial situation (assets of business different from that of owners) of the small businesses. For example, the owner might have re-mortgaged his house to procure start-up funds or the SME business might be run by the family members. If the owner dies, then will the new owner, probably the family member be able to run the business properly? The banks use 2 types of lending- transaction-based lending and relationship lending. The transaction based lending the financial statements of the borrower is analyzed to assess the risk whereas in relationship lending the banks use the borrower’s qualitative characteristics such as social status, and relationship with the bank. In a survey conducted in Japan the transaction based lending was found to be most common lending technology for Japanese SMEs and sometimes banks use different lending technologies at the same time such as the transaction-based and relationship-based (Uchida, Udell & Yamori, 2006, p.27-28). Studies show that banks prefer the legal, institutional and economic determinants to assess the smaller SMEs’ credibility in granting loans as compared to medium size firms (Hernández-Cánovas & Koëter-Kant, 2005, p.15-16). Possible Steps by Government & Policy-makers Government policies for SMEs should be focused on providing incentives to the private sector to play an active role in SME finance. If required, the banking system policies should be reformed to provide the small businesses better access to capital. The government should make efforts to spread awareness among entrepreneurs about the financing options available from private investors and banks. In 2010, Al Simpkins wanted to start a new tinning line to expand but due to shortage of funds it was a risky step. They had to rely on government funding and grant (The Telegraph, 2010). The government should make efforts in improving the operating efficiency of the existing business angel systems. Policymakers should make sure that the tax system does not put the SMEs at disadvantages. They should regularly review the taxation, legal and regulatory framework in a way that it encourages the venture capitalists. Hernández-Cánovas and Koëter-Kant (2005) observed a number of SMEs in 19 European countries and found that the firms in those countries that have better property rights for creditors are more likely to get long-term debt from banks (Hernández-Cánovas & Koëter-Kant, 2005, p.16).The policymakers should encourage various forms of institutional savings. The markets should be allowed to work efficiently for the domestic as well as foreign entities. To assess the success of above mentioned measures, the government should be able to measure the size of ‘SME Financing Gap’. Financing gap, which is the difference in the finance required by SMEs and finance available to SMEs, needs to be reduced in a technology-driven fast-paced economy due to speed of innovation. The SME policy given by European Commission (EC) focuses on identification of good practices in partnership with EU member states. Some of the examples are: The principle of Think Small First: This principle asserts that the legislation takes SMEs’ interest into consideration in the beginning of policy making to make the legislation more SME favourable. Simplified Start-up Procedures: A significant barrier to entrepreneurs is the time and costs involved in start-up and run a small business. In order to facilitate the hassle free start-up throughout Europe, the council set a number of guidelines in 2006, which were renewed in 2008 by SBA (Small Business Act). Internationalisation of SMEs: International activities enhance competitiveness and reinforce growth. Therefore, the internationalisation and increased SME performance simultaneously, understanding which the commission made bilateral SME policy dialogues with China and Russia. This resulted in following: 7% employment growth in international SMEs compared to 1% in domestic SMEs. 26% of the SMEs involved in international activities introduced new products and services new to the sector as compared only 8% for non-international SMEs. 16% SMEs are aware of support programmes for internationalisation. European SMEs have greater international presence as compared to Japanese or US SMEs. Policies to reduce the administrative burden on SMEs: This is a top priority for EC as research indicates that SMEs are over burdened by regulations (European Commission-c, 2011). One of the many examples of European Union’s financed project through European Regional Development Fund is Antonelli, which is a cone ice-cream manufacturer in UK (Antonelli, 2008). Conclusion SMEs are very important source of employment generation and development of developing economies and government play a crucial role in alleviating the major problem of undersupply of capital through credit supplements, export finance schemes, directed loans etc. The highly innovative entrepreneurs are not able to prosper due to unavailability of proper funds. This essay is an attempt to provide the definition of SMEs, which things qualify a business to be an SME, as it indirectly assists in improving access to research and development, improve innovation and enhanced access to capital. Further the essay describes the various finance options available to the SMEs and which type of option is suitable according to the stage the SME is in. Studies from year 2001-2003 indicate that the SMEs were constrained by lack of financing for start-up and growth in Europe and USA. The more recent studies show the contrary results. The study by BDRC showed the reluctance of SMEs to ask banks for funds and only 2% of SMEs stating the financing as a barrier. Similar trends were shown by comparative US and UK data. Another interesting fact came to be known that the SMEs relied only on internal financing as well as on relatives for start-up but for expansion they opted for banks financing. There is a discussion over the steps which government and policy makers can take in developed as well as transition economies to boost the SME sector. Lastly, the policy measures taken by European Commission to boost small and medium businesses are discussed with the achieved results. References Antonelli. (2008). Antonelli “Cones for Connoisseur Since 1912”. [Online]. Available at: http://www.antonelli.co.uk/index.php. 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