Explain what sources of finance are available for small to medium sized companies and explain why they sometimes face difficulties in raising finance
The SME (Small and medium enterprise) sector is one of the crucial important contributor to economic growth in terms of Gross Domestic Product(GDP) and job creation worldwide(IFC,2010). According to OECD(2006), SMEs had created more than sixty percent of the job opportunities for OECD countries. That situation for developing counties are even more obvious. There is no doubt that the development of SMEs is closely linked to national economy. The growth of SME sector, however, presents a stalled tendency, even recession situation, owing to the deficiency of accessing to finance.
This circumstance may restrict and hinder the development of small and medium-sized companies, then indirectly affect the country’s economy. Therefore, how to financing efficiently and overcoming fund-raising barriers for its ongoing progress becomes a indispensable part and parcel of their operation activities. The aims of this article is to demonstrate what funds-raising techniques could be adapted by SMEs, then examine what obstacles are faced by them in the financing activities, and lastly, giving a conclusion.
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2. Funds-raising sources available for SME 2. 1 Internal financing
At the initial stage, SMEs have to obtain capital, internally, from owners, relatives, friends and existing partner or firm’s retained earnings (Abdulaziz& Andrew, 2013), inasmuch as the shortage of transparent and “hard” information, for instance, permanent track records from bank, financial statement, credit scoring as well as higher intangible assets. After that, they tend to seek alternative sources, such as external ways, for financing for the sake of its progress in the later phase. 2. 2 External equity-based financing External equity financing includes venture capital, business angels and public equity.
In general, they are more suitable than debt for the young SMEs since they experiencing capital gap and unable to raise loans via security(Abdulsaleh & Worthington, 2013), inasmuch that equity capital has no special refund date(Ou & Haynes, 2006), and without mortgaging items for its supplier. A study written by Hogan and Hutson (2005) demonstrates the similar views that when TBSFs (technology-based small firms) suffering from information asymmetries, especially in its start-up stage, they would like to slove its capital gap through equity-based financing instead of debt.
2. 2. 1 Venture capital Venture capital(VC) is the funds provided to firms at their early phase to exploit its business, thus investors intend to obtain long-term capital gains(McLaney, 2009). Nowadays, the high-tech small enterprises attract more attention to venture capitalist, as they are more likely to generate interests in a relatively short-term. And this can be illustrated by a study written by Bozkaya & Van (2008). It demonstrates that technology-based small enterprises obtain more money from venture capital than other sources of financing in European.
Moreover, VC is a proper way for small and medium enterprise who were in the process of lack of permanent and effective track records and high quality of collateral (Abdulsaleh & Worthington, 2013 cited by Gompers, 1995). 2. 2. 2 Business angels Business angels are direct investment launched by individual capitalist, rather than venture capitals who are mainly supported by investing institutions(McLaney, 2009). Furthermore, angels are not merely a kind of capital investing, also a participant investment.
Investors tend to actively participate, in other words, in routine operations, such as enterprise strategic decision, strategic design as well as hiring managers. 2. 2. 3 Public equity Public equity is a kind of relatively effective financing way for SME in a mature stage, it mainly is through the way of open recruitment to access to funds, and with equity as a return for investors. This approach extremely relies on a transparent perfect company financial mechanism. 2. 3 Debt financing Debt financing is a appropriate way for enterprises to raise external capital with specified repayment date to return the principal and interest. It includes trade credit, public debt, bank financing as well as nonbank financial institution debt. Unlike equity financing which would dilutes the owner’s equity, and consequently, may partly deprives the owner of control of the firm. (Abdulsaleh & Worthington, 2013). Debt financing would be a proper approach for SMEs owners to maintain full proprietorship as well as management(Abdulsaleh & Worthington, 2013). 2. 3. 1 Trade credit
According to Garcia-Teruel & Martinez-Solano (2010), trade credit is a paying agreement which made by seller and buyer, that allow the buyer to,in a specified period, make a deferred payment after the good or services having been provided. In this way, small firms would have a relatively short-time to arrange its cash flow and eventually overcoming shortage of cash or funds. Moreover, trade credit would be a substitution when other financing techniques unavailable. That is to say, small and medium firms will gain their opportunity of survival.
2. 3. 2 Non-bank financial institution debt Non-bank financial institution’s(NBFI) role of lending is similar as bank financing to a certain extent, their biggest differences are the mode of borrowing audition and the length of the loan terms. Generally speaking, the loans of NBFIs are longer than the duration of the commercial bank,accordingly, they require higher interest rate, and more strict choice of borrowing enterprise credit and collateral. The other role of NBFIs are mainly lending via fixed assets or equipment.
2. 3. 3 Leasing According to Berger&Udell (2006), leasing is that the fixed assets are purchased by the lender and then loan to lessee, in the form of rental, under an pre-specified contract which shows that the fixed assets can be bought by borrowers at the end of the leasing. Correspondingly, lender should be responsibility of purchasing item, while, lessee will be responsible for maintenance of equipment. Opaque firms can use leasing to help for their production, this is because that the underwriting decision is mainly based on the value of leased items, rather than ‘hard’ information, when they have limited money for operating(Berger&Udell, 2006). 2. 3. 4 Public debt Although public debt is a possible way of financing for SMEs, but in reality, it is not too widely used. Because it is prohibitive for SMEs to issued public debt in many counties, such as in china. 2. 4 Bank finance for SMEs Financing in bank are variable, it involves financial statement lending, small business credit scoring, asset-based lending, fixed-asset lending, relationship lending and factoring.
Unlike other sources of bank-financing, relationship lending mainly depends on the ‘soft’ information collected from SMEs via directly continuous access to the firms and its owner performance(Berger & Udell, 2006). While, financial statement lending, asset-based lending and fixed-asset lending are quite similar in the field of evaluating credits and repayment abilities of enterprise. They focus on ‘hard‘ information about the company, such as financial statement, assets, fixed-assets respectively, which may more suitable for SMEs without suffering from information asymmetric.
However, small business credit scoring primarily depends on ‘hard’ information about both corporation and its proprietor, and the data about the owner are mainly via their consumer and commercial credit, then there will generate a score after a series of performance evaluation(Berger & Udell, 2006). However, factoring is a short-term financing methods that a financial institution or bank purchased the SME’s accounts receivable with pre-specified fees and interests (Soufani, 2002). 2. 5 Government assistance and initiatives
In view of great contribution of SMEs in terms of a nation’s employment and GDP, more and more countries implement different forms of financing, such as giving tax exemption policy, providing lower interest of loan and creating a good financing environment, for small and medium-sized enterprises, in order to help its exploitation. 3. Reasons for SME sector facing difficulties of financing 3. 1 Financing environment Financing environment includes not only the financial, legal and the credit rating system, also includes national economy, social environment.
SME sector in a developed financing environment is more easy to access to financing, because it provides a more flexibility financial evaluation system, financing channels as well as better rights protection. Moreover, Beck(2005) found that the development of the small firms are more easily affected by the financial, legal, and corruption. Additionally, In a stronger information system, GDP is increased with the increase of bank loans, and the credit crisis and the formal information sharing measures is presented inverse growth (Jappelli and Pagano, 2002). 3.
2 Firm characteristics In the process of SME’s financing, the significant barrier lies in its information opaque. Because of shorter operation time, and small in its size, they could not offer a permanent effective credit history or financial statement, and also unable to provide the high-quality collateral, accordingly leads them to financing difficulties. According to a study conducted by Beck and Demirguc-Kunt (2006), Small businesses were 7% and 3% higher than the large and medium-sized enterprises in terms of the probability of facing financing obstacle.
What’s more, Fatoki and Asah (2011) conclude that small and medium-sized enterprises setting up more than five years have a better chance of success in their credit application than those less in five years. In addition, small and medium-sized firms in different industries may choose different types of financing and then encounter different levels of funding constrains. A study analysis 3500 samples which were randomly selected across ten sector of SMEs in UK, and concluded that the length of loan are varies in different industry(Abdulsaleh & Worthington,2013 cited in Michaelas et al, 1999).
Moreover, collateral has greatly contribution in the process of fund-raising for SMEs, particularly for debt financing. Accordingly, assets structure of a firm is an important factor for financing. Odit and Gobardhun (2011) revealed that SMEs with more tangible assets are more likely to obtain funs because of the ability to mortgage its fixed-asset. 3. 3 Owner-manager’s characteristics Gender of the SMEs’ managers or owners, generally, affect the options of financing sources and fund-raising difficulty to a large extent.
Coleman (2007) proved that women entrepreneurs is more vulnerable to discrimination in the process of lending, since they are more often pay higher interest rates, to be required to provide additional collateral to obtain loans. The education levels of owners may be a important factor to deal with financing choices, owners with high degree would successfully to persuade the bankers or capitalists to provide fund for its business or investors think highly of educated owners(Irwin & Scott, 2010).
This could be proved by a survey conducted by Irwin & Scott (2010), they found that the proportion of Advanced-level(23%) and professional, trade or vocational qualifications(21%) managers facing difficulties of financing are quite similar, however, that for O-level and graduate owners present a large gap, with accounting for 19% and 8% respectively. Owning a the higher degree means that owner-mangers may knowledgeable and having ability of scientific management to reasonably use possible financial resources to conquer the financing obstacles that they had encountered.
4. Conclusion In conclude, financing modes varies. Bank-depending lending is primarily based on ‘hard’ information, financial statement, asset lending, factoring as well as the relationship lending etc. while, non-bank financial institutions financing offer tangible-asset lending, such as leasing. Venture capital and business angels is mainly funding in private marketing. Accordingly, other modes,for instance,public equity and public debt, obtain capitals from public marketing.
National funding, sometimes, such as low interest loan and subsidizing, helps SME sector to overcome the equity gaps. Even though, there are plenty of funding modes being supplying to SMEs, funding gaps are always affect the development of small and medium-sized firms, whether at its start-up stage, or development stage, or mature stage. For instance, in the early stages, most of the start-up funds are from owners’ savings as well as family or friend’s help, it is hard for SMEs to obtain external sources of financing as shortage of effective bank records and opacity information and high risk of failure rate. On the other hand, their own characteristics and the individual elements of its owner-managers are also affect the success or failure of corporate financing, various industries, company size and age, or owner’s gender, education, etc. Also overwhelming factors, such as nation’s financial environment, will lead to varying degrees of equity gap of small and medium enterprises in different regions and countries.