January 10th, 2018
Challenges Associated with SME Financing
The challenges that face the financing of SMEs arise out of various factors. A core impediment for such entities is their inability to meet conditions required to source equity financing via public markets. In China, for instance, entities that apply for listing need to meet conditions such as having a total share capital equal to or higher than 50 million Renminbi and having been in business and made profits for three consecutive years prior to the application (Shanghai Stock Exchange, 2002). Other conditions include those on the proportion of total shares to be issued (more than 25 percent of total shares) and other stipulations by the State Council, which may be influenced by the nature of the entity (e.g. one that trades in new technology) (Shanghai Stock Exchange, 2002). With such requirements, many SMEs lack the capacity to source finances from the public markets, thus are restricted to other modes of financing, the main alternative being debt financing (Berger & Udell, 1998). For start-ups, the main source of financing is the owners funds, augmented by funds sourced from family members; such sources may not provide adequate funds for these businesses to launch their operations effectively in a highly competitive market (Wu, Song & Zeng, 2008).
Even with debt financing, SMEs face various restrictions in accessing funds, especially in times of economic crises. In such crises, the availability of cash that would ensure the firms are able to continue their operations unabated is affected by two factors. Firstly, market downturns lead to decreased sales thus decreasing the cash flows from operating activities. This could result in SMEs’ inability to service short-term obligations thus making them susceptible to failure since they have limited reserves (Yu & Wang, 2010). With increasing uncertainty that arises with economic crises, banking institutions impose more stringent conditions on loans thus locking out some of the SMEs from lending (He, 2010). Go to part 3 here.
Caution by banks to lend to SMEs, even when the economy is doing well, is attributed to the information asymmetry that exists between the lenders and such firms. Information asymmetry in this respect refers to the fact that, generally, the individuals running the entity (either the managers or owners) have a greater knowledge of the state of the entity than that available to such lenders. Since SMEs are not publicly traded, information such as their workforce, customers and suppliers remain largely private, a situation that is aggravated for those SMEs that do not have audited financial statement (Berger and Udell, 1998; Wu, Song & Zeng, 2008). On the other hand, financial institutions require such information to gauge the creditworthiness of a particular lender. Therefore, lacking practices that avail information required by lenders to enhance evaluation of their credit rating, SMEs are limited in regard of the amount of credit they can acquire, unless they hold assets that would suffice as collateral (Berger and Udell, 1998).
In China, the lack of access to credit facilities for SMEs is augmented by government’s influence on the financial market. The government, by owning various banks and other sources of credit facilities such as rural credit cooperatives, skews the lending towards inefficient state-owned enterprises, as compared to the more efficient private entities (Wu, Song & Zeng, 2008). Estimates for instance indicate the state to own between 95 and 99 percent of the country’s banking-sector assets out of its direct ownership of commercial banks or indirect ownership of banking institutions through the enterprises it controls, local governments and joint holdings with private entities (Wu, Song & Zeng, 2008, p. 963). Such a scenario creates an enhanced challenge for SMEs to acquire adequate credit to finance their operations and investment opportunities.
SMEs’ financing challenges are however aggravated by lack of systems to control the use of existing funds. In china, for instance, SMEs are noted for their aggressive pursuit of investments in real properties, thus depleting the cash flows required to expand their operations (He, 2010; Liu, 2010). In the event of financial crisis, firms that have pursued such a strategy may face challenges in sustaining their operations or even servicing debts acquired (Yu & Wang, 2010). Such may be the case especially where the cost of raw materials and labor increase whereas the entities revenues decrease as sales plummet. An effective financial management strategy that aims to diversify the sources of finance for SMEs and controls the application of funds can thus help SMEs to survive periods of adversity