In their capacity as advisers to proprietors of small and medium-sized enterprises, accountants grapple every day with problems related to sources of funds to various business enterprises. Profitable investment opportunities fail to see the light of the day due to limited sources of funds to implement them. The issue of sources of finances to small and medium-sized enterprises is not a nightmare to proprietors alone. The issue is a cause of sleepless nights to candidates preparing for professional examinations who have to think of different ways of listing the available sources of finances for such enterprises (Brookfield, 200, para. 1). It is therefore imperative that accountants advise businesses on the available forms of financing. This essay will endeavor to list and explain the sources of finance available for small to medium-sized companies. The essay will also explain how these sources of funding can benefit the firms and why some companies sometimes find it difficult to raise finances.
The Sources of Funds for SMEs
Some of the sources of funds for SMEs include initial owner financing, business angel financing, trade credit, leasing, factoring, venture capital, short-term bank loans, medium-term bank loans, mezzanine finance, private placements, public equity, and public debt, among many other sources. It is important to note that the listing of these sources of funds follows each other sequentially. These sources of financing sometimes overlap. The list is also ordered in terms of information available on business growth.
Venture capital is an example of long-term finance for small and medium-sized businesses. Venture capitalists provide capital to small and medium-sized business enterprises that do not have access to stock markets and mainly target businesses in need of investments in excess of 100 000 pounds (Metcalf, et al, 1996, pp. 54). Quite often, the amount invested normally exceeds this figure. Venture capitalists also provide equity and loan finance for different business situations, especially startup capital that enhances liquidity for a commencement of trade purposes. This source of funding also provides group capital that helps in expanding business for expansion purposes. Buy-in-buy-out capital is instrumental to management teams in terms of acquiring an existing business. The share purchase capital finances acquisition of existing ownership interest. Finally, venture capital helps in turning around the fortunes of a business enterprise that is bogged with poor performance. Venture capitalists are more interested in financing growth businesses and managing buy-in-buy-out rather than investing in start-ups because they deem them high-risk businesses. In 1999, start-up businesses invested 128 million pounds into their ventures. Venture capitalists however pumped 7.8 billion pounds into their business enterprises the same year. Because start-ups require a relatively small amount of finance that calls for a high cost of investigating and monitoring investment opportunities, they have become unattractive to venture capitalists (Casson, 2003, pp. 12).
Custom system software developer Tessera Enterprise Systems has had its presence felt in Boston since 1995 has an executive team that has worked together for the past three years. Their target market included renowned retail and financial companies in America. The initial funding for the venture came from the founders. However, after a year they resolved that venture capital was needed for the expansion of the company. This was not to be as Tessera secured an investment offer from Greylock Management. This added legitimacy to the venture. It was now able to obtain contracts with target companies like Charles Schwab and other clients. It managed to expand to San Francisco because of third-stage funding. The company later established its office in Switzerland, a move that many criticized. They had expected Tessera to seek investment from technology corporations to leverage its investor networks and knowledge (Gompers and Lerner, 1999).
Business angels are individuals to invest in businesses that have the potential for growth. They do so through equity stake. About the UK, such people can invest between 10,000 and 100,000 pounds in start-up businesses or those in their formative stages of development. In most cases, this group of investors had formally engaged in business. Therefore, other than providing financial support, they bring along a wealth of experience in business and managerial aspects. This helps in expanding business horizons. They are instrumental in filling existing gaps in the market because the size of investment required may not be sufficient for a venture capitalist to consider. As a matter of fact, business angels are an informal source of equity finance and matching small business enterprises facing liquidity problems with suitable investors can be a big problem. As a remedy to the matching problem, numerous business angel networks have come to the fore over the past years such as the National Business Angels Networks (NABN). NABN is sponsored by myriad financial institutions and supported by the department of trade and industry. These networks provide regular bulletins with available opportunities to their members (Metcalf, et al, 1996, pp. 111). The NABN network associates examine and develop funding proposals. The network brings together investors and small business owners. The network’s e-commerce service matches small businesses with appropriate investors.
Another long-term source of finance for small and medium-sized business enterprises is government assistance. The government assistance is actualized through the government’s small firms’ loan guarantee scheme. The scheme helps small firms with viable business plans but are incapable of securing loans from financial institutions because of lack of security. The scheme guarantees loans to SMEs that have to be fully repaid within two to the ten-year period from lending financial institutions. Sums of up to 100,000 pounds can be awarded (Fraser, 2005, pp. 102). For businesses that have traded for at least two years, the sum can be increased to 250,000 pounds. The government guarantees up to 70 percent of the amount borrowed from lending institutions. Other than other sources of government funding like grants and improvement of tax incentives, the government provides information with regard to sources of funds available for small and medium-sized business enterprises.
Equity, trade creditors, factoring, line of credit, and short-term loans are considered short-term sources of financing to small and medium-sized business enterprises.
SMEs that are in the initial stages of operation does make use of equity as a source of finance. This implies that they have not become that profitable. This form of funding helps such enterprises to sort out their liquidity problems. The funds can be obtained from a proprietor’s personal money, their family members’ resources, friends’ contributions, or third-party investors.
When proprietors of SMEs have some good rapport with their creditors, they stand a better chance of soliciting their support with respect to financing such investment opportunities. Such creditors can provide short-term crediting capital. A proprietor has to build a reputation for repaying debts. This will build the confidence of the creditors. A proprietor who paid his creditors in time stands a chance of their orders being extended by creditors to enable him or her to meet a big order.
Proprietors do resort to factoring to sort out short-term liquidity problems. It is used in short-term working capital financing. After an SME has filled an order, the factoring company proceeds to buy their account receivable and finally does the collection. This type of short-term financing to SMEs can be very costly relative to conventional bank financing. However, this has not deterred new businesses from making use of it.
Line of Credit
New businesses that are well-capitalized by equity and have good collateral stand chances of benefiting from this source of funding. The line of credit enables small business enterprises to access loans to sort out short-term liquidity issues that businesses face (Levenson& Willard, 2000, pp. 89). The funds are awarded so long as the borrower collects accounts receivables realized from short-term sales peak (Petersen&Rajan, 1994, pp. 24).
Short Term Loans
Many start-ups do not qualify to get the line of credit loans. However, this should not be a deterrent whatsoever as such businesses can access some one-time short loan to finance their business enterprises’ working capital needs. This calls for the creation of good working relationships with banking institutions (De Meza& Southey, 1996, pp. 377; Fraser, 2005, pp. 98).
Share capital invested by the founder
The founding entrepreneur can invest the share capital of the company in order to enhance liquidity. This is only possible if the founder has 100% ownership of the business enterprise.
Financing from Banks
The most notable source of finance in this section is commercial banks. However, over the last few years, other non-banking institutions have assumed the role of provision of equipment loans. Indeed, half of UK SMEs in early 1990 used bank overdrafts, term loans, and leasing facilities to acquire assets (Ram et al, 2002, pp. 87). Of the nearly 3 million SMEs that had bank accounts in the early 1990s used banking facilities’ money transmission mechanisms. Statistics showed that about 50 percent of these SMEs had at one time borrowed from banking institutions. Once the enterprises had been set up, they opted for plowed-back profits over loans as the main source of their funding (Fraser, 2005, pp. 99). A survey that was done in the UK indicated that total borrowings from both overdraft financing and loans constituted 30% of funds used by private companies (Fraser, 2005, pp. 99). Bank Overdraft contributed was the principal source of finance as opposed to term loans. Small companies relied on overdrafts as their major source of funds. In the United States 94% of SMEs used commercial banks to cater to financial needs, while 35.5% preferred non-banking institutions for such services (Petersen&Rajan, 1994, pp. 19). The study attributed this finding to the banks’ locational convenience and their capability to offer checking services, which gave them some competitive edge. SMEs in the United States tend to make use of external credit by volume as they increase in size.
Lease is just but an agreement between parties, the one who is being leased to and the person doing the leasing. Payments are made in accordance with the terms of their agreement within a specified period. It is in a way a form of rental. Assets that are actually leased include plant machinery, cars and commercial vehicles, and in certain circumstances, computers and office equipment. There are many forms of lease. These include operating leases and finance leases. Operating leases are rental agreements between the lessee and lessor where the lessor to supplies equipment to the lessee. The lessor is compelled by agreement to service and maintain the leased equipment (Levenson & Willard, 2000, pp. 87). The period of lease when compared to the economic life of the asset is relatively shorter. This implies that at the end of the lease agreement the asset in contention can be leased to somebody else or sold as second-hand equipment. Finance leases are lease agreements between the lessee and lessor for most of the machinery or the equipment being leased expected useful life. The lessee bears the responsibility for the servicing and maintenance of the asset (Petersen&Rajan, 1994, pp. 10). After the expiry of the lease period, the lessor cannot lease the asset to somebody else because the asset already is won out. Because of this, the lessor has to ensure the lease payment covers the full cost of the equipment to ensure that the lessor is guaranteed of return on investment.
Why do small and medium-sized business enterprises find it difficult to raise finances
There may be sources of funds for small and medium-sized business enterprises; however, there is a rampant shortage of capital that leads to missed investment opportunities.
It is common knowledge that money that is pumped into investment basically comes from savings. Individuals can save money through equity or debt. Debt saving is normally characterized as interest-bearing. Bank deposit account is a typical example of debt saving. A firm’s capital structures are normally made up of a mixture of equity and debts. Tax policy and disposable incomes determine the total supply of savings. Therefore what is available for SMEs as a source of financing gets determined by the competition for saving from the government borrowing requirement. When the government debt is higher, these financing institutions prefer borrowing from the government hence fewer savings to enable them to finance the liquidity problems of SMEs. Opportunities that exist abroad and leakage of money from the economy is another factor that determines whether there would be enough savings that SMEs can borrow. When overseas investment opportunities are promising, there would be less capital available for domestic businesses. Corporate tax policy and incentives created for investment determine the amount of savings that would be left for domestic borrowing. These policies and incentives include capital allowances and large disincentives on distributions. When more dividends are taxed there would be less income for investors. Higher interest rates delay savers’ consumption and in many cases, the savers tend to put money aside for future investment. It is pertinent to note that whereas businesses tend not to like high-interest rates, interest rates impact albeit negatively, investment funds. Without it, no investment funds will be forthcoming. Accountants of these SMEs have to appreciate that one can only save whatever they do not spend. High tax regimes with low levels of disposable income tend to experience a shortage of funds made available by savers. When there is the shortage of funds and the demand is high, there is a likelihood that the cost of capital will be high. The shortage of funds occasioned by a limited supply affects even firms with the most original ideas and effective management. Because of the competition that is there in the market for available funds SME managers must realize this and work towards improving the situation.
Another major barrier to financing SMEs is the issue of uncertainty that surrounds SMEs ‘ operations. The managers of these business enterprises may take the initiative of updating their financiers on whichever activity they are engaging in but there still will be some element of uncertainty. This is not a feature of larger businesses who enjoy a long-term relationship with financial institutions who over time can observe that the business is well run hence can handle bank loans. SMEs do not have this track record hence the uncertainty issue cropping in. larger businesses as opposed to SMEs conduct their activities in public hence not immune to external scrutiny. Information that is in the public domain does not raise issues of uncertainty. The press can easily access any information that they want about such large businesses that are often quoted in the stock exchange market as opposed to SMEs. Companies listed in stock exchange market must have their accounts audited and published. Many SMEs do not publish their books of accounts. They do not also publish their audited accounts hence lack of attention from the press (Small businesses omnibus survey 1). The SMEs have to grapple with the responsibility of having to convince financiers that they are indeed good businesses that can be very profitable when given adequate funds (Brookfield, 2001, para. 1).
Informational barriers are also a major impediment to the growth of SMEs. Financial intermediaries like banks and accountants have a role to play in the growth of SMEs. Banks can solve the informational problem for SMEs that wish to access banks financing by screening applicants in need of funds. Management teams are normally brought into perspective just like the market the SMEs are to address, and collateral or security that can be offered, in screening process. This involves the issuance of SMEs ‘ business plans, their audited assets, and a detailed explanation of their security. The experience of the management team will be looked at. The second phase will entail setting appropriate contract for the loan. Accessing bank financing entails an assessment of risks associated with the intended venture. The third phase will involve monitoring the performance of any loan about contract details in phase 2. SMEs may fail to screen or contract tests. Those enterprises with few tangible assets to offer as security are characterized by uncertainty. At this point, accountants play a greater role in ensuring that these businesses that are engulfed in uncertainty but dearly need financing to get them. As firms grow in size, they get greater access to information (Brookfield, 2001, para. 3).
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