Financing of small and medium-size enterprises (SMEs) is a subject of great interest
Sanderson Abel
The financing of small and medium-size enterprises (SMEs) has been a subject of great interest to both policy-makers and researchers because of their significance to private sectors around the world.
Given their heterogeneity, SMEs include a wide range of businesses, which differ in their dynamism, technical advancement and risk attitude.
Many are relatively stable in their technology, market and scale, while others are more technically advanced, filling crucial product or service niches. Others can be dynamic but high-risk, high-tech “start-ups”.
The provision of finance to the SME segment is a topic of crucial policy importance. While diversifying from reliance on loans from banks is desirable, it is important that policy makers mitigate the risk that firms are merely turning to other under-developed and costly forms of financing due to an inability to access bank credit.
Policy must aim simultaneously to stimulate the flow of bank credit and to create well-developed markets for a range of alternative financing sources to complement the role of banks in financing the SME segment.
The policy should try and ensure that there is need for increased co-ordination amongst various and often disconnected stakeholders interested in sustainable SME financing. Institutions with objectives to stimulate and promote private capital to alleviate poverty and promote sustainable development could be used as platforms for a co-ordinated mechanism for various stakeholders including investors from philanthropic institutions, public and private sectors active in SME financing and seeking synergies with players from complimentary sectors.
Against all odds, the existence of marked informational asymmetries between small businesses and lenders, or outside investors; the intrinsic higher risk associated with small scale activities and the existence of sizeable transactions costs in handling SME financing are some of the inherent challenges faced by institutions that have an appetite to finance SMEs.
It is therefore important that policy frameworks governing the operations of these SMEs should be able to proffer potential solutions so that these factors cease to be the stumbling block for those with the appetite to finance this group of entrepreneurs.
Policy makers and other stakeholders including SMEs themselves should understand that while banks have a comparative advantage in credit information processing and intermediation, a more diversified mix of funding options than those currently available would represent a more sustainable long-run in the country’s SME financing environment.
At the national level, a range of policy actions have to be put in place which aims to create a more diversified set of viable funding options for SMEs.
It is then imperative that the SMEs critically evaluates these various financing mechanisms before settling on those they think will best suit their business models.
To achieve this, the SMEs should develop a checklist of their potential sources of financing.
It is always important that they continuously evaluate to check on the proportion of their working capital and new fixed investment that has been financed from some of the following sources during their subsistence bearing in mind that financing innovation and small businesses requires a funding system that sustains entrepreneurship and drives job creation. The potential sources of financing would include
Internal funds/Retained earnings;
Equity (i.e. issue new shares);
Borrowing from local private commercial banks;
Borrowing from foreign banks;
Borrowing from state-owned banks, including state development banks;
Loans from family/friends;
Money lenders or other informal sources (other than family/friends);
Trade credit from suppliers;
Trade credit from customers;
Leasing arrangement;
The government (other than state-owned banks);
Non-bank financial institutions;
Non-Governmental Organisations;
Venture capital is also an important part of such a framework;
Any other appropriate funding mechanism.
It has been observed that the majority of SMEs once they find business opportunities, they apply for loans from banks.
And they ask banks to offer loans as soon as possible in order to organize materials and so that they deliver on time.
However, commercial banks have to follow strict procedures and operational standards before issuing loans.
This is the standard procedure everywhere which sometimes could not satisfy SMEs’ needs for financing though necessary from a Banks point of view.
It is in light of this urgency that the informal sector players should resort to other sources of financing so that they don’t jeopardise their business deals.
Although bank loans will certainly remain the dominant source of external financing for SMEs, long-term investments are better financed by equity capital.
In particular, share capital is preferable to foster innovation and growth in businesses with uncertain results and pronounced information asymmetries.
While banks can count on guarantees and long-term relationships with firms to reduce the information asymmetries, equity capital enables investors to benefit in full from the returns to successful innovation.
Can the establishment of the SME stock exchange become a panacea to the challenges of financing the SME sector as pronounced in the budget statement? I will attempt to answer this question in my next article.
Sanderson Abel is an Economist. He writes in his capacity as Senior Economist for the Bankers Association of Zimbabwe. For your valuable feedback and comments related to this article, he can be contacted on abel@baz.org.zw or on numbers 04-744686 and 0772463008