Economics and Finance
Sources of finance for SMEs

Title: “Explain what sources of finance are available for small to medium sized companies and explain why they sometimes face difficulties in raising finance.” 

Introduction

Small and medium sized enterprises/ companies, or more famously abbreviated as SME, are important entities in the business landscape. In most of the countries around the world, SME is contributing to the growth of the economy. Particularly in the past 20 years, the importance of SMEs has been increasing (Hussain et. al., 2006). However, SME does face certain limitations of barriers to further growth and profitability. One of the most critical barriers adversely affecting SME is the difficulties faced by these SME in obtaining financing. In this report, the difficulties of obtaining financing from others among SME will be discussed. The difficulties affecting SMEs will be articulated. Then, the available sources of financing for SME will also be articulated. Among the sources of financing discussed include: financial support from family members, friends and relatives, bank loans, SME loans, business angels and venture capital.

Importance of SME

A review of the existing literature on the topic of SMEs found that the contribution and importance of SMEs to any society and economy is well acknowledged. Specifically, as asserted by Gebru (2009), SMEs are crucial in socio-economic and political development catalysts, both in emerging and developed nations around the world. As discussed by Hussain et. al. (2006), SMEs are often powerful and influential to the economy because their smaller sizes offer them greater flexibility and thus, more often, more readily to engage in innovation and responsive to market changes. The agile SMEs are proven to able to capture opportunities available in the marketplace faster than the larger corporations. Besides, according to Ma, Wang and Gui (2010), SMEs is expected to play greater importance in creating employment, training entrepreneurs, revitalizing the economy, increasing competitiveness of businesses and delivering value to the society in the future. Overall, it can be seen that SMEs is definitely an important element in any economy, and they are indeed value adding to the growth of society and nations.

Difficulties Facing SMEs

As argued by Gebru (2009), one of the key impediments to growth and success among SMEs, in various countries around the globe, is the lack of accessibility to financing. According to him, it is asserted that due to the smaller size of the SMEs, these firms usually have smaller size, and hence smaller financial reserve. Besides, due to smaller size, the firms are also lacking economies of scale, and a less diversified business activities, revenue sources or customers. Thus, SMEs are often more risky enterprises, as they exhibit higher business risks, and also greater probability of financial distressed if compared to larger publicly listed corporations. Understanding such a phenomenon, many financial institutions such as bank, tend to have more stringent assessment and requirements before making loans to SMEs. Not only is that, particularly in recessionary period, banks are less likely to extend credit for SMEs, as the many financial institutions perceived steeper increase in business and financial distress risks among smaller enterprises (Hutchinson and McKillop, 1992). Thus, ironically, in hard times, when the SMEs require most financial support, the banks offer least support to them, and if ever credit may be provided to them, higher interest rates or larger loan collateral ratios will be required. All of these views are also supported by a research conducted by Ma et. al. (2010), indicating that 62% of SMEs in China regard that getting financing is the main obstacle for growth in the country. However, it is worth mentioning that the situation of SMEs having lesser assess to loans or other sort of financing is more serious in developing countries. As discovered by Vos et. al. (2007), in a study on small business financing, it is found that SMEs in United States has least problems in getting financing, primarily due to the mature capital markets and system available in the nations. However, SMEs in emerging countries may not have such luxury, as pointed out by Hussain et. al. (2006), SMEs in China mainly only able to obtain financial support from their immediate family, whereby lesser support can be readily obtained from financial institutions in that country. Such notion is also well supported by a research from Beck and Demirguc-Kunt (2006); whereby the authors found that inability to access to financing is the main constraints limiting growth of SMEs across several countries around the world. Similarly, Agrebi (2009) asserted that without relevant supports from financial institutions, many lives of the SMEs are expected to be cut short.

Sources of Financing for SMEs

There are many possible sources of finance for SMEs. One famous theory about SMEs getting financing is the ‘Pecking Order Theory’. According to the theory, business managers, whom are often the business owners, will likely to choose financing options in the following order: self savings, family members, short term borrowings, long term borrowings and lastly, equity financing (Jordan et. al., 1998). In the following section, the sources of financing available for SMEs will be discussed in such sequence.

Borrowings from Family Members, Friends and Relatives

Perhaps the most easy and lowest costs of capital can be obtained from family members, friends or relatives. In fact, a lot of SMEs in the developing countries tend to rely on such financing method for financial support to their companies. According to the study conducted by Hussain et. al (2006), in both United Kingdom and China, family support is the main sources of funding for SMEs start up. Not only is for those new start up, those entrepreneurs running successful SMEs may often rely on their own  savings to fund expansion of the businesses during the early years. However, the drawback of such method is often due to the limited amount of capital available from the family members or relatives. In order to growth the business to a larger scale, alternatives sources of financings are often required.

Debt Financing

Debt financing is often necessary, to exploit opportunities available when the business owners unable find other sources of financing from family or friends. Two types of borrowings are available. Short terms borrowing often referred to those borrowing lesser than 1 year; usually required for usage as working capital in SMEs. Long term borrowings, technically often defined as borrowings longer than 1 year, and are often used to purchase property and equipments by SMEs. It is undeniable that taking loans from banks can be one of the options for SMEs. However, the trust and relationships with the bank for a particular SME is very important if the enterprise has enhanced and ready access to financial sources. As found by Hernandes et. al. (2010), the existence of long term relationships and trust between SMEs and banks will often improve the access to financing, while also reducing the costs of borrowing for that particular SME. Thus, SMEs thinking of having long term financing from any bank should build rapport with the officers and executives in the banks – and have a long term track records in the bank. Besides, taking loans from banks can be expensive options, particularly during recessionary times, where as discussed before in paragraphs above, banks tend to charge higher interest rates in hard times, when the SMEs require support the most. As such, some other back-up plan or options should never be neglected by SMEs in managing the business prudently and effectively.

SME loans

As discussed by Beck et. al. (2011), there is also many types of SME loans available for the application of business owners of small and medium enterprises. Many of the times, SME loans are made available by government to support the SME sector, to assist them for growth and expansion in the respective countries, as government understand that SME indeed play crucial roles in economic health of any nation. For example, in 1999, SME loans are provided by the Chinese Ministry of Finance in China. Then in 2000, SME loans are provided by Ministry of Science and Technology to SMEs dealing with technological products or services (Hussain et. al., 2006). However, such types of loans provided by government may not readily available or properly structured in certain nations. This is supported by findings from Klonowski (2010), arguing that the Polish government support programs for SMEs are badly structured, and yet, the programs do not meet the needs of these sectors. Apart from that, it is well understood that not all SMEs may be successful in getting SME loans from government or other agencies. There is only so much offered by governments, leaving may SMEs desperate for funding have to find other options.

Business Angel Financing

As commented by Kuratko et. al. (2006), business angels are often the ideal sources of financing for entrepreneurs. Many forms of financing methods, be it debt or equity financing, can be negotiated with the business angels. Many successful businessmen may indeed simply want to help the growth of a business or to support of certain highly potential managers or business owners. Besides, Ramadani (2009) argued that one of the more important benefits of getting financing from business angels are that the business angels are often hands-on investors as well as business persons, who can readily contribute useful ideas, skills, expertise, network and other form of strategic support to the SMEs. Thus, besides getting the financing from business angels, there are many other opportunities available to those SMEs successfully getting financial support from the relevant business angels. However, not all SMEs may be lucky enough to locate financing from business angels, as network and friendship factors may be highly important in getting funded from business angels. Apart from that, the availability of funds from business angels may be limited. Thus, unfortunate SMEs may have to turn to other sources of financing.

Venture Capital

There are also many SMEs turning to financing from venture capital funds for growth and assessing to other supports provided by the venture capitalists. There are some evidences, presented by Berger and Schaeck (2011) that certain SMEs (in Italy, Germany and United Kingdom) do indeed turn to financing from venture capital to exploit rent seeking behaviors from the big banks. From another viewpoint, it is also possible that the venture capitalists may be able to provide certain management skills and expertise in growing the businesses of the SMEs. However, according to Agrebi (2009), to obtain financing from venture capital, is often not preferred by entrepreneurs, as their shares or equity portion in the business will be diluted. In certain instances, the entrepreneurs may lose huge influence or control in the business. However, in many cases, there is really not many viable choices for the SMEs, causing them to turn to venture capital funds for financial support.

Conclusion

In summary, it can be observed that SMEs are important contributors to the economy, society and the growth of any nation. They are agile, flexible, and responsive and bring many innovations and improvement to the society. Many researchers and governments around the world acknowledge such phenomenon, and is providing certain degree of supports to the SMEs. However, there are many difficulties for SMEs in getting the necessary financial supports. That is particularly true when during recessionary and hard times, when the SMEs required financial support the most. SMEs may be harder to obtain supports because they have shorter track records, less of trust and relationships building with the banks, more risky, higher chances of facing financial distresses, and less information available on the firm – making the many financial institutions more risk adverse in extending loans to the SMEs. However, as shown in this report, there are many ways in which SMEs can obtain relevant finance from various parties. As articulated in brief above, among the sources of financing available to the SMEs include: financial support from family members, friends and relatives, bank loans, SME loans, business angels and venture capital.

References

Agrebi, M. (2009). Financing SMEs. Organisation for Economic Cooperation and Development. The OECD Observer,(275), 22-23.

Beck, T., & Demirguc-Kunt, A. (2006). Small and medium-size enterprises: Access to finance as a growth constraint. Journal of Banking & Finance, 30(11), 2931.

Beck, T., Demirgüç-kunt, A., & Pería, M. (2011). Bank Financing for SMEs: Evidence Across Countries and Bank Ownership Types. Journal of Financial Services Research, 39(1-2), 35-54.

Berger, A., & Schaeck, K. (2011). Small and Medium-Sized Enterprises, Bank Relationship Strength, and the Use of Venture Capital. Journal of Money, Credit, and Banking, 43(2/3), 461.

Gebru, G. H.  (2009). Financing preferences of micro and small enterprise owners in Tigray: does POH hold? Journal of Small Business and Enterprise Development, 16(2), 322-334.

Hernández-cánovas, G., & Martínez-solano, P. (2010). Relationship lending and SME financing in the continental European bank-based system. Small Business Economics, 34(4), 465-482.

Hussain, J., Millman, C., & Matlay, H. (2006). SME financing in the UK and in China: a comparative perspective. Journal of Small Business and Enterprise Development, 13(4), 584-599.

Hutchinson, R. W., & McKillop, D. G. (1992). Banks and Small to Medium Sized Business Financing in the United Kingdom: Some General Issues. National Westminster Bank. Quarterly Review,84.

Jordan, J., Lowe, J., & Taylor, P. (1998). Strategy and financial policy in UK small firms. Journal of Business Finance & Accounting, 25(1/2), 1-27.

Klonowski, D. (2010). The effectiveness of government-sponsored programmes in supporting the SME sector in Poland. Post – Communist Economies, 22(2), 229.

Kuratko, D. F., & Hodgetts, R. M. (2007). Entrepreneurship: theory, process and practice (Seventh Edition). USA: Thomson South-Western.

Ma, J., Wang, S., & Gui, J. (2010). A Study on the Influences of Financing on Technological Innovation in Small and Medium-Sized Enterprises. International Journal of Business and Management, 5(2), 209-212.

Ramadani, V. (2009). Business angels: who they really are. Strategic Change, 18(7/8), 249.

Vos, E., Yeh, A. J. Y., Carter, S., & Tagg, S. (2007). The happy story of small business financing. Journal of Banking & Finance, 31(9), 2648.

 

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