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by Rajen Kumar

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SEMINARY - Special Supplement, Oct-Dec'2011

Literature Review of “Innovative Financing for SMEs”

Dr. Ipshita Basu Guha
Nov 2011

Importance of SMEs Globally

There is ample empirical evidence that SMEs are present in all countries across the globe and significantly contribute (directly) to

Total No. of Firms/ Businesses in a country
Employment generation
Contribution to GDP

In advanced countries, SMEs form a bulk of the number of active business ventures and therefore have serious contribution to GDP. The following data reaffirms the statement.

According to World Bank data, the percentage contribution of SMEs to GDP is as follows:

High Income Countries – 50 – 55% of GDP

UAE, Singapore, Qatar, Austria, Germany, Denmark, France, Norway, US, UK (many countries of the EU)

Middle Income Countries – 35 – 40% of GDP

China, India, Brazil, Malaysia, Mexico, Russia, Large parts of Latin America, Angloa, Ghana, Belarus, Romania, Ukraine, Malaysia, Philippines and Thailand

Low Income Countries – ~ 15% of GDP

Bangladesh, Cambodia, Kenya, Mozambique, Uganda, Zimbabwe, Mainly Sub-Saharan Africa and South Asia select countries

(The above countries are few examples from an exhaustive list)

The contribution of SMEs to GDP in select countries for reference purpose is:

China 60%
Germany 57%
Japan 55%
Korea 50%
Malaysia 47%

* All these figures are close approximation and might change

And finance is the most crucial concern for SMEs in every country.

Business Finance – Multiple Aspects

Selected period of requirement of Finance in Business

Initial Setup
Scaling up of Operations
Technology Upgradation/ Modernization
Renovation
Diversification
Periods of Strained Earning like high receivables outstanding (reasons maybe buyer default or delay), high payables, need for urgent machinery, temporary civil/ electrical improvements

Main Types of Business Spending

There are 2 main types of expenses in business operation for which funds are required:

Capital Expenses – Purchase of Land, Shop etc and Plant and Machinery (mostly required one time)

Operating Expenses – Payment of raw materials, statutory payments including electricity and water, salaries (required periodically like each month or quarter)

Revenue generated in business is available only at the operating stage. A huge part of financing is required at the initial setup phase. The difficulty is establishment of trust and availability of collateral to seek loans. Working capital loans and bank overdraft facility is needed at the operating phase to support between the delivery and payment receipt gaps.

Financing Options

There are simply two straight financing options:

Internal
External

Key Financial Concepts

Concepts like Internal Rate of Return (IRR), Return on Investments (ROI), Return on Equity (ROE), Capital Turnover, Cost of Sales, Rate of Interest, Interest Coverage, Debt to Equity Ratio, Opportunity Cost, Time Value of Money, Cost of Capital and Owner's Equity.

Debt to Equity Ratio shows the overall financial health of a company and a low ratio means share of external creditors is comparative to that of owner's capital.

Time Value of Money is significant for both borrowing as well as setting credit period to buyers (such that if the money is received in those many days, there is no loss). It is used while pricing of items in conjunction with cost of sales.

Calculation of Opportunity cost is what works behind each business decision. It is the cost of the foregone opportunity in lieu of the one that has been chosen.

Increasing owner's equity in a balance sheet shows the independence from too much external borrowings or loans.

For more info, visit – http://en.wikipedia.org/wiki/Category:Financial_terminology and

http://financial-dictionary.thefreedictionary.com/

Introduction

The SME sector has been the cynosure of research in many countries. Each and every aspect of SME businesses have been studied using a fine tooth comb type approach. Countries have tried to find and employ all possible avenues of financing options. This seminary aims to present and discuss the highlights of random domestic and international papers, articles, research and view-points to add to the knowledge of our esteemed readers.

Assorted Wisdom

The Problems

Asymmetry of Information

This term is used to explain the unevenness of information and knowledge between the entrepreneur seeking loan and the lending agency (bank, NBFC, angel etc) due to the type of industry or product/ service and the insufficient exposure of the administrative officer handling the loan application.

This is a bigger issue in case of innovative enterprises compared to standard businesses which have more prevalence and thus significantly more common insight and process knowledge. This works against a loan request.

Opacity

A continuation to the above point is the problem of opacity which shrouds the functioning of SMEs. It is a common perception that many areas of a SME business are not clear to evaluate its true potential and rightly judge its health. Disclosure of financial information is often insufficient.

Thus, even a loan extended to a SME is considered an 'opaque' asset which definitely is undesirable for the lending agencies.

Lack of Client's Equity (Debt Equity Ratio)

All lending agencies look for the equity share in a business which is the capital brought into the business by the owner which is either his (her) money or borrowed from family and relatives. In many instances when the equity participation is less, it is construed as lower risk undertaken by the entrepreneur and the lending agency has more exposure.

Measurement of Organization Health

Organization health displays the direction in which the investments are going. Prior to obtaining any funds, if the health is robust, it works in favor. Post access to loans, it exhibits the reliability of repayment. There are various factors which influence organization health. It is a serious perception issue which actually underlies many quantitative data backed decisions.

Type of Industry/ Sector

The type of industry or sector in which the entrepreneur deals in seriously impacts the probability of obtaining a loan. The problem of the dot com businesses in the end 90s created a negative impact about that industry. Today IT and ITES businesses are again booming and getting some serious debt funding to grow. Generic industries like say auto, pharmaceuticals, textiles, electrical items etc. are extremely common and lot of knowledge is available in the public domain. There are ample cases of lending to these businesses and benchmarks for evaluating applications and measuring repayment health has been established. Hence, the opacity or information asymmetry factor is low which works in favor of loan applicants. The same does not hold true for innovations and industries which are emerging and such businesses are considered to be high – risk and undesirable for disbursement of loans or any financing.

Stage of the Enterprise

Enterprises at the initial stages need maximum funding to survive the growth curve and the burden of huge capital investment for setting up the venture. The revenue is yet to pour in and retained earnings that of the owner is possibly limited. As the firm starts moving to the growth phase, there is some internal fund that is created and a track record of sorts established partially to allow lending bodies to evaluate the state of the firm. Hence, the prime problem is at the very beginning of the firm's life. Lack of funds at this stage is also a cause of the downfall of many enterprises.

Ownership Pattern

SMEs are usually single or multi-promoter (from the same family) or a 2-3 partner venture. In many instances, multiple promoters include wife, children or their spouse as co-owners or partners who have no say in the decisions. They are around to sign on papers as directed by the figurehead. He is the main decision making body. The direction of the firm's growth and security of the invested funds depend on the decisions made by the owners and their wisdom. This again depends on their experience and education. The issue here is that nothing much can be done about this in SMEs.

Organization Structure

The human resource aspect of SMEs is very simple. There is one (or two) owner and selected few core people working under them co-handling main functions like accounts, production and sales. There is no clear process of functioning, workflow, and information or instruction flow. Everything is random. This ticks off the lenders because the same randomness affects the handling of funds.

Business Plans

Good projects and business ideas need the backing of an equally in-depth business plan. Entrepreneurs in the zeal of setting up their venture, quite often overlook many details of the project. Superficial business plans do nothing to gain the trust of the investors.

Low Technology Adoption

Technology has become the cornerstone of all businesses today. It has invaded the smallest parts of our lives. The same does not hold true for SMEs especially the micro and small businesses who do not use lot of automation in their operation as well as administration and data management. This again contributes to the opacity factor. It also affects productivity and output which means that it hurts the bottom-line.

Low Profit Margins

SME businesses are often considered to be insufficiently managed. Cost of production is also comparatively higher as technology adoption is low. The smaller size of operation means that the bargaining power with suppliers is limited. Quite often, SMEs are into sectors where there are too many players hence it is not a suppliers market. They cannot 'demand' a specific price. Due to weaker control over their clients, receipt of payment is irregular. All these factors add up to low profit margins

Handling Qualitative Information

The employees (administrative or loan officers) banks and lending bodies usually work on a very straight path without any imagination or creativity. They are not at all equipped (or maybe authorized) to vet qualitative data like future business prospects, owners intention and objectives, team capabilities and client views into the qualification criteria for loan applications. They are also incapable of handling the qualitative information, measuring it and incorporating the same while making recommendations for loan applications to the head office. Everything is not about clear figures, numbers and ratio.

Lack of Sufficient Collateral

When businesses commence, there is hardly any collateral to present for obtaining financial aid. Lending without collateral to SMEs is extremely risky from the lender's viewpoint. Where will SMEs get their collateral from when the loan is to obtain those plant and machinery which form part of the collateral!

Availability of Lending Bodies

In many areas the problem is not only about getting financial aid or loans but even the presence or reach of lending bodies. Many MSMEs dot the rural landscape of India and need funds there.

Credit Rating System

All banks have their own credit rating system. There are credit rating agencies which claim that their evaluation is accepted by banks. The trouble is how do SMEs, already burdened with basic survival figure their way out through these serpentine processes and come out with a good rating. And will they still manage to get the loan? The parameters and process of rating is also covered under a shroud of pointless secrecy. SMEs in most cases are unclear what they are up against or what will help gain better ratings.

Subtle Cartel of Lending Bodies

Most banks and lending bodies have more or less similar rates of lending finance or higher. The lending agencies create a façade of being a cartel in the minds of the borrowers. There is no competition between lenders to snatch borrowers unless they are large robust companies where every bank wants to park a pie of their funds and gain through returns.

High Interest Rates

Interest rates for non-collateral as well as collateral backed loans to SMEs are often very high and at times prohibitive. The reason is attributed to high risk of lending to SMEs.

High Administrative and Transaction Costs

Due to low level of technology adoption, and poor record – keeping and lack of efficient systems and processes, the whole process of evaluation of loan application is extremely resource intensive for the lending agencies. The poor efficiency of the loan officers is also to blame.

Diversion of Funds for Repayment

Repayment of expensive loans by SMEs also unleashes a vicious cycle. Quite often funds are cut from various functions of the business to ensure timely repayment. This affects operation and if not checked starts hurting the business in a bad way.

Bureaucracy

This is a no – brainer point. Most SMEs suffer from the setup stage due to systemic problems of bureaucracy at most government agencies/ bodies like taxes to labor. The ease of setting up a business index measured for various countries considers this as a major make or break parameter.

Lack of Grounded Policy Decisions and Problem Resolution

The problems faced by the sector are nothing new. Sadly, the government bodies and think – tanks have not done enough to help in resolving the problems of finance for SMEs. The policies are contradicting and insufficient. One arm of administration is unaware of what the other is doing. There is no synergy. Legal system in India is also a huge factor. Simple cases of cheque bouncing also get dragged in the courts for years. The amount of time and money spent on it is a waste. Bankruptcy laws are also weak and do not cover the interest of lenders whose money is stuck.

Economic Health and Country-specific Risks

Last but not the least, economic health of the country and its global exposure as well as internal strengths also add to the problems of SMEs. They impact interest rates, spending, taxation and investments therefore growth.

Suggestions/ Alternatives for SMEs

Establishment of Strong Accounting System

Invest in a strong accounting and reporting system from day one of incorporation or before. Use good and genuine accounting software to manage data. Hire a suitable accountant. Accept the fact that some functions need dedicated personnel for handling on a daily basis. Helps reduce opacity.

Detailed Business Plan

Develop a comprehensive business plan. There are many free resources on the Internet to help you with an overall template. The more detailed plan the better chance of a loan getting sanctioned. It also shows your understanding and analysis as well as depth of knowledge in vetting various aspects of the business. This works in resolving certain amount of information asymmetry.

Mandatory Disclosure of Information

Proactively disclose financial and company information. It works in a positive frame with creation of a notion that the business is clean and everything is on the table with no hidden surprises. Lenders get assurance that they will be kept in the loop about the functioning of the business.

Strategic Local or Foreign Partner

Having a strategic partner in business is always desirable provided both can work in unison. The other partner often brings his/ her specialty which adds to the strength of the enterprise. Sometimes investors would like to become partners not to run the business on a day to day basis but have enough control to question larger decisions and the way funds are being utilized. It can be a win-win option. In case of exports, one should look for partner who might have presence in more than one country so that multiple markets can be tapped at the same cost. For e,g. a partner having access to Kenya, Uganda and Tanzanian market might be a better fit compared to someone who has presence in only one)

Sell/ Outsource Part Process like Distribution, Post-Sales (Franchisee Model)

Business has many functions. In order to manage costs, enterprises should look out for partners or companies who can share or outrightly manage part of the functions like distribution or post-sales service. It is the sharing of strengths and spreading the cost to multiple companies. Suzuki was working with Maruti for four wheels and TVS for two wheelers in India.

Strong Organization Structure and Chain of Command

Create a clear and clean organization structure with clear chain of command for information flow as well as financial decisions. This will help lenders understand who and how decisions will be made in the firm. It also helps in executing the growth plan of the firm.

Succession Planning

SMEs are often one man show. What happens if that man is ill or expires? What happens to the business and investments? It is like keeping all the eggs in the same basket. Succession planning is the solution. There should always be a second rung of personnel to take over key functions in case of any disaster or unforeseen circumstance. The same should be conveyed to the lenders.

Strong Cash Flow and Receivables

Enterprises are sometimes consumed with sales that they lose track of receivables. A clear well-defined system of debtor management should be established and communicated. There should be a process of identifying possible risky parties and issuing internal red flags. Analysis of outstanding while processing purchase orders should be internally set in stone in the business. Lenders look at cash flow and not just pure sales. Thus, having a strong cash flow is a plus.

Use of ICT

Information and communication technology helps in establishing a process and transaction trail. Be proactive in adopting technological solutions to bring in transparency in the business. It helps in sharing of information and letting lenders sift through data and do their own analysis.

Co-Create Product, Market and Technology Transfer

Co-creation of products and marketing them can help in sharing cost. For example an IT company can work with an engineering company and develop software to track all information. This software once it passes the rigors of testing and proves its usefulness, can be sold to others in the market. Thus, it increases value for both parties. Many smaller ERPs have been developed this way. Technology transfer by companies is also an effective way of circumventing the financial requirement of enterprises.

Demonstrate Good Corporate Governance

There is nothing better than demonstrating honesty and openness in business. It can be done through certification like ISO, HAZOP and other specific certification pertaining to the business. Many diamond companies go for the Forevermark to indicate that they are not using blood-diamonds. Proper filing of financial records and making it available in the public domain, timely payments and deliveries to suppliers and buyers go a long way in creating a good image of the company.

Use of Retained Earnings

Whatever is said and done, businesses “bank” on retained earnings. They help in a well balanced Debt Equity ratio. When equity is considerable, lenders get the message that the owners are equally serious, committed and have high stakes which would motivate them to perform and pay – off their loans.

All clean and clear transactions through Bank

Till recent times, cash was often used in transactions by SMEs. This should be replaced with a system of all transactions through banks, cheques and electronic fund transfer so that it leaves a clear trail and the lenders are assured of their money that they have put in for financing. Government has issued directives to pay workers' wages through banks to their bank account. Complying with it will definitely strengthen the case of SMEs.

Asset-backed Securities

The true story is that collateral is the only way of maximizing the chances of getting a loan sanctioned.

Lean Manufacturing

Companies involved in production and sales of products should spend some serious time in checking each part of the procurement, production and distribution process to cut out any waste that is visible. Implementation of Kaizen, TQM and Six-Sigma etc. would really help in proper utilization of scarce resources. The Japanese systems of production and productivity improvement would work in any other culture provided they are carefully understood and diligently implemented. Any activity that does not add any value to the end – product is unnecessary and should be immediately isolated.

What-if Analysis

There are a lot of financing options. Each has its own peculiarity. SMEs need some sound financial brain to do the what-if analysis of each option and decide that for a given requirement and circumstance what would be the most judicious one. If it is a dire need, then it makes sense to borrow at a high rate from the grey market to tide over the situation. If the SME survives then there is a chance of making money and remaining in black.

Education

Entrepreneurs must invest in education. It is common in certain business communities to ensure one of the son or daughter goes ahead to do commerce and possible chartered accountancy course and enter the business. Even with consultants, it always makes sense to have your own internal strengths. After all it is your business.

Tapping Microcredit

Micro businesses should look out for micro-credit finance. They are especially useful in the rural areas where the magnitude of the business is limited but significant.

Understanding applicable Laws and Acts

SME owners and key employees must invest time in understanding the applicable laws and Acts. Much of the business and financial woes can be tackled if you are aware of the implication of your act or lack of act.

Tap Trade Credit

Everyone has a credit period. Work towards building a relationship with your suppliers to get good credit period. Even an additional ten days can make a huge difference to your working capital needs.

Show good health and persistent growth in the Company

It is not possible to show growth if there is none. SMEs are therefore, required to work from growth so that it shows on the balance sheet and sways the decision of lenders in favor of the enterprise. All lenders seek companies with good health and steady growth if not exponential in nature to feel secure about their finance.

Suggestions/ Alternatives for Government, Bank and Other Lending Bodies
Long-Term Relationship Building

Businesses are the reason economy grows and people have jobs. They are reason why banks have the job of managing money and government has the role of managing the nation. Hence, it makes incredible sense of banks, government and lending bodies understand the necessity of building long-term relation with SMEs. They will be privy to information of the enterprises and secure the prospect of the loans extended by them. It is the best way of combating opacity and information asymmetry. Everyone can be on the same page. They must spend time on periodic health assessment and suggest measures for improvement.

Clarity of Credit Rating System and Communication

Credit Rating agencies and banks' systems should be transparent. They should clearly state what they are looking for, how they will be convinced, what information SMEs can provide to ensure that the rating is favorable. Rejection of a loan application should not be the end. Lenders should strive to explain what the shortcomings were and allow SMEs to provide further information to ensure compliance. Lenders and government must invest in networking and mentoring of SMEs. Banks must create separate free cells to provide consultancy to SMEs to teach them how to function and manage data such that their performance can be analyzed easily and thus expediting the loan sanctioning process. Lenders should also share instances of companies who have got loan to show what one can do to get the right points. (An off track example: Canadian visa has point system. They openly state what age, gender, education, qualification will help get certain amount of points and whether adding up all, one will be eligible for visa or not)

Credit Bureau

Presence of Government and Bank approved credit bureau like CIBIL will help SMEs proactively share information and create a good track record for themselves thus increasing their chances of getting loans.

Competition

Government through legislation and policies must enforce competition in the banking and NBFC segment. There should be a scramble to woo SMEs and their investments. The entire risk of investment and hard-work cannot be solely on the enterprise and all benefits to the lenders.

SME Database and Regular Maintenance

Certain countries are building a strong SME database and maintaining it regularly to trap information about their finances, performance and problems faced by them in accessing loans etc. Malaysia is one such country. It can be a very useful repository of information for banks and government to evaluate their effectiveness.

Development of System for Analyzing Companies

There should be a well-defined system of analyzing companies for their credit-worthiness. It must take into account both quantitative and qualitative data as well as other miscellaneous additional information to strengthen the loan application and its favorable disbursement. This checklist must be available to SMEs too so that they align their business in the same way.

Planters Development Bank Case by Ambassador Jesus P. Tambunting, Chairman, Planters Development Bank, International CEO Forum, KL, Malaysia – 13.08.2004
“Plantersbank Philipines – looked at SME financing as business opportunity, made fine use of governments schemes, international funding options etc and remained profit oriented. They created methods and processes to build financial information of firms and a process to do it. The loan officers were trained to do it properly by reconstructing financial information through an of an internal procedure of checklists. They created a diversified loan portfolio since all borrowers do not default and they are bankable. Plantersbank handheld new SMEs to work through the initial phases. They build a “know your customer” culture, interaction forums and sharing of information. The loan officers became financial adviser.”

Strengthening Institutional Capabilities of SME Credit Evaluation, Training of Internal Bank/ Lending Staff to handle SMEs

There is a dire need of quantitative and emotional training of loan officers, administrative staff with an ingrained philosophy of trying to sanction loans instead of finding the first cause of rejecting it. The previous two points work in conjunction with this one. Credit evaluation system development and training will improve the institutional capabilities of the lenders. There should be vigilance to check that there is no bias for particular parties, companies at the cost of neglecting others. There should be strong Regulatory System of checks and balances in Banks.

Percentage of Corporate Deposits and Loans

Banks should routinely present their level of corporate deposits and the amount of loan that they have sanctioned. This should be seen in light with overall credit guarantee schemes and government objectives and finally assessed based on actual impact on SMEs. Banks must continuously maintain clear data on share of high and low risk loans.

SME Exchange

The creation of a SME exchange would be a good move though we must be prepared for its slow acceptance and role in alleviating the finance issues of SMEs.

Enforcement of MSMED Act (Especially 45 days payment)

This is one of the best solutions for reducing the finance need of average SMEs if they get their dues on time. Government instead of coming out with Credit Guarantee Schemes and tweaking with other finance tools should make the MSMED Act vicious like FERA, FEMA or COFEPOSA. Majority of the credit problem crops up from delayed payments. SMEs might (and will) still need funding for capital investments but they can manage much of their day to day function with their internal reserves and earnings.

Strengthening Legal System

India needs an extremely strong and swift legal system where both investors and loan recipients and aware of their legal recourse and obligation and the knowledge that there will be fast justice and solution to any possible default or problems.

Soundness of Credit Guarantee Schemes and level of utilization and reach and benefits to SMEs

Credit Guarantee Schemes should be assessed for their usefulness and actual impact on SME financing issues. How manyenterprises have truly benefitted and in what way? Why have others not gained? What should be changed in the schemes to bring more people under the umbrella of financial aid?

Separate Lending Mechanism for Collateral and Non-Collateral Lending

SMEs with or without collateral must be given option to obtain finance. Banks and other lenders can have customized lending mechanism to suit the needs to the SMEs. A high rate loan from a bank is still acceptable than no loan at all.

Specific Schemes for Women and Young Entrepreneurs, Innovative Companies which are high risk

Government, agencies and banks must come together with schemes to aid women, young entrepreneurs and innovative companies. A youth not seeking a job but setting up an enterprise and employing others is any day desirable to one seeking employment.

Simplified Government Policies and Acts so SMEs can understand and comply

SMEs need simple and clear policies and acts to understand them and utilize as well as implement them in the business for compliance and secure benefits. There are many schemes out there but most SMEs do not understand how they can take benefit of them.

Basel III norms

These norms regulate banks to a certain extent. The norms must have stronger and stricter provisions to help address the credit requirement of SMEs.

Modify Labor Laws to bring efficiency in SMEs

India needs new age labor laws which are contemporary and relevant in the present globalized scenario. We cannot make incessant progress in one direction and leave out the other.

Ease of setting up business

This is a common refrain. It means fast clearance and fewer licenses and requirements of compliance, tax subsidies in the setup stages.

Investment readiness of SMEs for smooth sailing

Government should have agencies which help SMEs prepare themselves for getting investment by preparing their business plans and developing systems to definitely pass the requirements of the lenders.

Joint bodies with International Funding, Government and Local banks to create special funds for SMEs in EU

European Union gives due consideration to the need for SMEs and their sustainability including impact on the economy. They have used international funding bodies, their own resources and pooled in the banking system of EU to create funds to help SMEs, their R&D activities as well as floated specialized Innovation Funds for high risk projects.

Information Dissemination

Government agencies through their websites should list the current programs/ schemes and their actual reach and benefit to SMEs. It will help them compare various options and choose the rightful one. SMEs must be provided with prevailing best practices to enable them to emulate. The information through release of honest papers on problems and opportunities in the existing economic climate in the country and the problems faced by banks and SMEs will help people make their own assumptions and speculate on how they plan to deal with it.

(Note: The above list of issues has been compiled based on review of random literature and recurrence of the points in them. Thus, it is not a comprehensive list.)

Epilogue

There are problems aplenty regarding finances for SMEs. There are issues with SMEs themselves, the lenders as well as lacunae of the government. But an honest finding is that that initial stage of business will most likely be self, families and friends funded with occasional aid from external grey lender (high interest) or a business angel. As the business grows, based on cash flow and profits, existing debts, collateral items, bank loans or other lending funds can be opted for. There will also be creation of internal reserve which can be pooled in.

If the product/ service is really remarkable and garners a good amount of the market (even if niche) then possibilities of strong VC funding exists.

Banks have a long way to go in relation to actually financing SMEs and doing it effortlessly without making it look like a Herculean endeavor for the entrepreneurs. A change is needed in approach and will to help the SMEs.

Government can still do a lot more to make the environment conducive. Imagine the burden on the economy and infrastructure if SMEs were non-existent and only large companies functioned. Where would they have got the revenues in the form of taxes? How would the municipal bodies function without the bulk of earnings from MSMEs? Would we have achieved or strive to achieve 9% growth?

All three have to come together, collaborate and hammer out strong solutions which are authentic and genuinely effective.

1 Comments >>

waseem abbas

06 Apr 2012 (02:36:57)

its superb article i have ever seen .....

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