Difficulties and Alternative Sources of Raising Finance to Small Businesses - Literature review Example

Difficulties and Alternative Sources of Raising Finance to Small Businesses Undoubtedly, small business sectors, better known to be the Small and Medium Enterprises (SMEs), have gained immense significance as a key contributor to the overall economic growth. As stated in the report published by OECD in 2004, “These firms typically account for more than 90% of all firms outside the agricultural sector, constitute a major source of employment and generate significant domestic and export earnings” (OECD, 2004). Even though, in common instances, credit has been rendered to the small businesses of developing countries such as India, Brazil, China, and South African states among others, the small businesses sectors in developed nations including the US and the UK can also be noted as major constituents of economic growth (Mahembe, 2011). Source: (Mahembe, 2011) Enthusiastically, based on these statistical findings and economic affirmations, small businesses have been connoted as the “powerhouse” and even as “most powerful engines of growth and jobs” within an economy (Banks, 2012). It is certainly for this particular reason that authoritative bodies, in the global economy today, intends to render greater emphasis and strategic support to these sectors, helping them to grow, sustain and compete. However, in the realistic scenario, these ‘powerhouses’ often have to face various hazards which are mostly concerned with the availability of adequate resources required to sustain the business in the long-run. Finance is an important requirement for the formation of any business allowing it to explore and take advantages of opportunities with the purpose of expansion and support to the daily operations. Literally stating, finance is a lubricant for any business to sustain their functions successfully in highly dynamic modern business circumstances (INFLIBNET Centre, 2010). As a matter of fact, without adequate availability of finances, business cannot grow which eventually results in its failure. In the current business scenario, operating environment for small business has become quite challenging fundamentally owing to the increasing complexities influenced by the rapidly altering external environmental elements. In recent times, the government bodies and the financial institutions have realized the importance of small businesses in the development of national economy and thereby have been focusing on rendering support to the sector with a greater motive to augment economic prosperity in the global platform. Contextually, several sources have become available to small businesses today, through which they can meet their financial requirements effectively, e.g. bank lending, mortgages, credit facilities and others (The Economist Intelligence Unit Limited, 2009). However, procurement of finance from various sources itself requires some expenses (Department of Economic Development, Tourism and the Arts, 2011). Additionally, owing to the variances, raising finance for small scale businesses has become more sophisticated than it was earlier. Difficulties in Raising Finance for Small Scale Businesses There are various issues that contribute towards the challenges faced by the small businesses. In relation to this, one of the vital and common issues faced by the small businesses today has been their limited access to adequate finance (Soni, 2005). One of the potential explanations for apparent difficulties experienced by small businesses can be related with nominal credit risk management practiced by finance providers. It is completely rational for bank managers to take into account the various risk factors associated with pricing of loans. From the point of view of various banks, loans that have larger default risks or certain loans where borrowers are deemed to fail to meet interest payments have relatively lower chances to be approved. Even though, these requests are approved, lenders often attempt to mitigate such additional risks by issuing loans with shorter maturity period or by minimising the numbers of such riskier loans to be approved for small businesses (Bank of England, 1999). Furthermore, small businesses have relatively lesser number of available assets that can be used by them as security when applying for bank loans. Contextually, the finance providers may be reluctant towards sanctioning loans to small businesses with a fear that they might lose considerable amount of money in case the small business gets bankrupted or fail to profitably sustain their business in the future. Another common reason that contributes towards this problem is the poor presentation of documents and business proposals as well as poor accounting presentations to finance providers that eventually fail to adequately impress the lenders to believe the credit to involve low risk which ultimately leads to the rejection of loans and other finance requirements. It is in this context that small enterprises are often operated by inexperienced people with inadequate professional knowledge regarding the business environment. Hence, it becomes too difficult for these entrepreneurs to recognise and likewise interpret or rather make use of the available opportunities in availing the required finances through credit lending facilities (Economic Commission of Africa, 2012). Moreover, governmental failure to issue effectual schemes and subsidies are also some of the major factors obstructing small businesses in easily raising their financial requirements (Bank of England, 1999). In relation to the aforesaid statement, Mr. David Cameron stressed that they wanted “nothing less than a wholesale change in attitude” from the government officials towards the small businesses (BBC, 2013). Presenting a very similar phenomenon concerning the challenges witnessed by small businesses when obtaining adequate finances, the report published by OECD (2004) revealed that, Source: (OECD, 2004) Alternative Sources of Finances There are various alternative sources of finance when banks are unwilling to provide necessary funds to small businesses to meet their financial resource requirements. One of the vital alternative sources of finance for small businesses, in the current day phenomenon includes venture capital funds (Department for Business Innovation & Skills, 2010). Venture capital is source of finance wherein money is provided by other firms or outside investors in order to finance a new and relatively small business. Furthermore, venture capitalists tend to grant funding, despite the existence of potential risks in relation to the borrower enterprise’s future profits and its limited ability to repay the lent amount. It is important to remember that venture capitalists do not provide loans to the borrower enterprises; rather, they invest in exchange for equity shares in businesses with the expectation that the investment shall yield better than average returns obtainable from other business sectors involving minimum terms and conditions (MyCapital, Inc., 2013). In addition to Venture capital, another popular mode of finance to small businesses comprise of Community Development Finance Institutions (CDFIs) and similar other groups. CDFIs are particularly known as the financial institutions that operate in certain markets which are underserved by traditional financial institutions or main street banks. The goals of CDFIs primarily include offering banking services to those small enterprises which have been struggling with the procurement of finances with a further intention to promote the overall economic development. CDFIs grant wide array of financial products and services to their various customers including individuals along with profit making enterprises and non-profit making enterprises. CDFIs also provide technical support, counselling and training in various financial areas to the entrepreneurs with the intention to increase the effectiveness of fund utilization by its borrowers. Furthermore, such organisations entail various other types of institutions such as Community Development Banks and Community Development Credit Unions among others. Contextually, Community Development Banks are regarded as for-profit institutions that operate in much similar ways as the commercial banks operates. On the other hand, Community Development Credit Unions also function similar to Community Development Banks (The Federal Reserve Bank of Richmond, 2011). In addition to the aforesaid two alternatives, the Enterprise Finance Guarantee (EFG) has also emerged as an important source of finance alternatives for small businesses. EFG is primarily regarded as a government initiative or a scheme framed and initiated to provide access to finances for small businesses which have viable plans but do not have sufficient financial resources to implement these plans and thereby obtain the desired advantages at the marketplace. Lack of availability of adequate securities, which are normally required for qualifying and availing credit facilities, often act as major constraints that deter small businesses from extracting requisite financial resources from the financial institutions. Contextually, EFG intends to remove the financial challenges faced by small businesses by providing additional security and thereby dividing a degree of the liability, assuring early repayment of the existing loan. It is worth mentioning that in the UK the EFG scheme provides 75% of government guarantee to the lender subject to all the eligibility criteria being met by the small business enterprises (Department of Business Enterprise & Regulatory Reform, n.d.). Borrowing from friends and families also act as an alternative source of finance in certain cases where banks are reluctant to provide finances for setting up or for the purpose of expansion of small businesses. This source of alternative finance does not require any sort of business plan or projection of financial statements. Loans from friends and families are often considered to have lesser impact on the business that can be easily obtained at time when financial providers like banks become reluctant to provide adequate financial support to small businesses (University of Wisconsin, 1999). Information Required By Finance Providers Prior To Granting Business Expansion Loans Practically, small businesses are more dependent on banks for their financial requirements in order to sustain and grow their business steadily than other large companies. On the other hand, finance providers in the recent years have shown their aversion towards granting loans to small businesses considering those as high-risk ventures. Consequently, the challenges faced by the small businesses have become more complex and difficult to further expand their business successfully. Nevertheless, in many instances, being pressurised by the government or other economic factors, when finance lenders attempt to assist small businesses, they focus upon various elements which may either directly or indirectly influence the future prosperity of the entrepreneurial initiation. The foremost thing which the finance providers may be willing to know may primarily include the type of business that the entrepreneur is engaged in. The finance providers may require this information in order to make sure that applicant is viable and the entity possesses a unique identification either in terms of government registration or may be in terms of other legal specifications (CPA Australia Ltd., 2009). However, when analysing the viability of a set-up firm, lenders might also enquire the loan repayment capability of the entrepreneur. Furthermore, the finance providers may also be interested in knowing the business history of the applicant small business which shall make the finance providers aware of the small business’ past successes providing an insight to the managerial experiences of the entrepreneur. Additionally, the finance providers may also be keen to identify the potential opportunities and risks related with the industry in which the small business operates and intends to expand. The finance providers may also be interested in seeking ownership details of the applicant small business which can certainly have an impact upon the loan repayment capabilities of the firm. Assets owned by the small business, small business’s tax records and personal banking details, past, present as well as forecasted or projected account details along with loans and deposits can also prove to be of substantial interests to the entrepreneurs in this regard (CPA Australia Ltd., 2009). Nonetheless, the aforementioned options to avail adequate amount of finances required for the small businesses are quite time consuming as well as complex in nature which can further discourage small entrepreneurs, limiting their reach to better growth. Even though, governmental bodies have mentioned various measures to support SMEs in the economic budget allowing tax exemptions, lower interest rate facilities along with other noteworthy discounts in comparison to the large-sized businesses, it has been viewed that banks are relatively reluctant to provide finances to small businesses. Such reluctance can be fundamentally examined as the results of limited assets to prove the repayment capability of the small businesses which further disqualifies these players on the basis of the criteria prescribed by the lenders as necessary when availing the credit facility. Nevertheless, there are various alternative sources of finances to small businesses, when banks refuse to provide the required amount. Such alternatives may include venture capital, Community Development Finance Institutions (CDFIs) Enterprise Finance Guarantee (EFG) and loans from friends and family members. However, as it shall be quite unrealistic to assume that small entrepreneurs will easily have the virtues of such adequate funding sources, governments have been appealing banks to play the fundamental role of a financial source to the small businesses. Regarding this particular concern, along with other authoritative personalities, Mr. David Cameron also appealed banks to come forward and help these small businesses to expand their business and further advocated that "...A lot of this should be the job of banks, but frankly after the terrible problems of 2008-9 ... there are gaps in the market” (BBC, 2013). References Banks, M., 2012. SMEs Represent Powerful Engine of Economic Growth. The Parliament. [Online] Available at: http://www.theparliament.com/policy-focus/economic-affairs/economics-article/newsarticle/smes-represent-powerful-engine-of-economic-growth/#.UPJQ6eTryIU [Accessed January 12, 2013]. Bank of England, 1999. The Financing of Ethic Minority Firms in the United Kingdom. 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