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Business_finance_and_the_SME_sector

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Business_finance_and_the_SME_sector

    Business finance and the SME sector by David Brookfield

     04 Sep 2001

    One of the most important problems accountants are likely to deal with in acting as advisors to a small or medium sized enterprise (SME) concerns the issue of financing. More succinctly, directors and owner managers

    in SME’s often complain of the lack of finance for what are profitable investment opportunities. For candidates preparing for professional examinations, the problem of learning about sources of finance for small businesses is one of merely thinking of different ways of listing the available sources of finance. Of course, there is more to the problem than that although, in my experience, when directors and owner managers talk about sources of finance they do want to know what is available.

    Just as it is important for accountants to be able to advise on what financing is available and I will identify some below is the need

    to be able to understand and explain why the SME sector encounters difficulties in finding appropriate finance and what are the options in

    tackling the barriers that exist to financing. As I will argue, dealing with such barriers are natural territory for accountants acting in an advisory role and hence it is vital that aspiring professionals should understand the issues involved.

    Background

    There is no unequivocal definition of what is meant by an SME. McLaney (2000) identifies three characteristics:

    1. firms are likely to be unquoted;

    2. ownership of the business is restricted to few individuals,

    typically a family group; and

    3. they are not micro businesses that are normally regarded as those

    very small businesses that act as a medium for self-employment of

    the owners. However, this too is an important sub-group.

    The characteristics of SME’s can change as the business develops. Thus,

    for growing businesses a floatation on a market like AIM is a possibility in order to secure appropriate financing. In fact, venture capital support is usually preconditioned on such an assumption.

    The SME sector is important in terms of contribution to the economy and

    this is likely to be a characteristic of SME’s across the world. According to the Bank of England (1998), SME’s accounted for 45% of UK employment and 40% of sales turnover of all UK firms. This situation is

similar across the EU.

    Future developments mean that the importance of the SME sector will continue, if not develop. The growth in small, new technology businesses servicing particular market segments and the shift from manufacturing to service industries, at least in Western economies, means that

    economies of scale are no longer as important as they once were and, hence, the necessity for scale in operations is no longer an imperative. We know, also, that innovation flourishes in the smaller organisation and that this will be an important characteristic of the business in the future.

    The problem

    The obvious point to state is that directors and owner managers of SME’s often describe a situation of shortage of capital and consequential missed investment opportunities. At an economy wide level, if this is

    true, there is a reduction in the nation’s wealth through investment opportunities lost. Let’s see how this might be explained more fully.

    The market for finance

    Money for investment comes from savings. Taking a broad perspective

    initially, as individuals we can save money in the form of equity or debt. Equity is easy to understand and is represented in terms of stocks and shares. Debt saving is broadly everything else and is usually characterised as interest bearing. A bank deposit account is an example.

    As you will know, the form of business financing matches the methods of saving. Thus firms either have equity or a mixture of equity and debt in their capital structure.

    The total supply of savings is determined by disposable incomes and, in

    turn, tax policy. What is available to firms as sources of finance on a macroeconomic scale is determined by:

    ; the competition for savings from the government borrowing

    requirement (the higher the government debt, the more government

    borrowing required, the less savings available to finance the

    corporate sector);

    ; overseas opportunities and the leakage of money from an economy

    that is invested abroad (the better the overseas investment

    opportunities overseas the less capital available for domestic

    business);

    ; corporate tax policy and the incentives created for investment such

    as capital allowances and large disincentives on distributions

    (the more dividends are taxed the less income for investors).

    ; interest rate policy (the higher interest rates are, the more

    likely savers are to delay consumption and put money aside for

    future benefit).

    This last point is important because, whilst businesses do not like high interest rates, it must be recognised that without an interest rate no investment funds would be forthcoming. Just what might be the ‘best’ interest rate to have for the economy in terms of maintaining an appropriate balance between investing and saving involves deeper issues than need be covered here.

    In assessing why it is important to identify the factors that influence

    the supply of capital, accountants should appreciate that savers can only save what they don’t spend. This includes ‘spending’ or paying taxes, and there are many avenues that savers can use to invest their money. Thus, there is a competitive market for savers’ funds and SME’s are not immune to its effects. For example, in high tax regimes and low levels of disposable income there will be a shortage of funds made available by savers. Competitive pressure for the available funds may therefore

    mean that the cost of capital (the return paid to savers) is high.

    The broad capital flow representing the supply of finance being provided to those who demand it can be represented in Diagram 1.

    Intermediation is represented by the banking sector that brings together savers and investors in a cost effective manner to allocate scarce funds.

    Accessing scarce funds for SME investment

    Thus we see that, even for the best firms, with the most effective management and the most original ideas there is a shortage of funds inasmuch that there will always be a limited supply. The market for available funds is competitive. Managers of SME’s who fail to recognise

    this do not understand an important part of their job which is to secure proper financing: this is the point at which accounting advisors are most useful.

    Beyond saying that there is a limited supply of funds there is a deeper issue. It is well recognised in the academic literature on this issue that the problem of adequately financing SME’s is a problem of

    uncertainty. A defining characteristic of SME’s is the uncertainty surrounding their activities. However much managers inform their banks

    of what they are doing there is always an element of uncertainty remaining that is not a feature of larger businesses. Larger businesses have grown from smaller businesses and have a track record especially in terms

    of a long term relationship with their bankers. Bankers can observe, over a period of time, that the business is well-run, that managers can manage

    its affairs and can therefore be trusted with handling bank loans in a proper way. New businesses, typically SME’s, obviously don’t have this

    track record. The problem is even broader. Larger businesses conduct more of their activities in public, or subject to external scrutiny, than do SME’s. Thus, if information is public, there is less uncertainty. For example, a larger business might be quoted on an exchange and therefore

    subject to press scrutiny, exchange rules regarding the provision of certain of its activities, and has to publish accounts that have been audited. Many SME’s do not have to have audits, certainly don’t publish their accounts to a wide audience and the press are not really interested in them. The problem of SME’s is how do they get over this barrier of conveying that they are a good business, can make profits if only they were provided with appropriate finance, and can grow large if given half

    a chance.

    Overcoming information barriers

    This is the point at which financial intermediaries enter. There are basically two forms: banks, and accountants acting in their role as activators. Thus, we see a vital role played by professionals in getting

    SME’s to grow. Let’s deal with banks first.

    If SME’s wish to access bank finance then banks will wish to address the information problem in three phases. First, by screening applicants to assess their product, the management team, the market they are to

    address and, importantly, any collateral or security that can be offered. This first phase is likely to involve properly prepared business plans, an audit of the firm’s assets, detailed explanation of any personal security offered by the directors and owner managers, and the experience and relevance of the skills of the management team. The second phase involves setting an appropriate contract for a loan. You should not forget basic finance at this point. Thus, in the first phase, a bank would make

    an assessment of the risk of the business and any loan interest rate, set in the second phase, will reflect that risk. A key feature for accessing bank finance is therefore in the assessment of risk from the information gathered in the first phase. Contract details will specify

    interest rate, term, the level and type of security offered, restrictive covenants, and repayment details. The third phase is the monitoring phase

    by which banks monitor the performance of any loan according to the contract details set-out in phase 2. Compliance comes to the fore at this point. It is also at this point that the key banking relationship can be established.

    There is still an important issue remaining. What about businesses that fail one of the screening or contracting tests? What about businesses

    that have few tangible assets to offer as security, which is very typical of high technology or Internet start-ups? These businesses are thus

    characterised by great uncertainty but still need that start-up finance

    to develop. Accountants play a crucial role at this point. In order to understand how this might be resolved it is important to see how the needs of SME financing change with their stage of growth.

    Types of financing and growth in SME’s

    A broad list of SME financing can be usefully provided at this point:

    1. Initial owner financing

    2. Business angel financing

    3. Trade credit

    4. Leasing

    5. Factoring

    6. Venture capital

    7. Short term bank loans

    8. Medium term bank loans

    9. Mezzanine finance

    10.Private placements

    11.Public equity

    12.Public debt.

    This list is loosely structured along growth lines. Thus, very small organisations start at point 1 and work through to point 10. Not all of the financing is successive and a number will overlap. Further more, as businesses grow, more information becomes known as they develop a track

    record. Thus the list is ordered as much in terms of information availability as it is in terms of growth.

    Diagrammatically, the relationship between type of finance and growth may be represented along a time line on the assumption that growth is

    related to age of business as shown in Diagram 2.

It is important also that to realise that with age and growth comes greater

    information and larger firm size. There is no significance to the vertical ordering. The horizontal ordering is flexible inasmuch that the exact timing of the relevance of different types of finance will vary according to circumstances. Financing that appears on a single line, such as

    business angel finance, venture capital and public equity is meant to represent a succession. Other forms of finance may intervene in the line if appropriate to a particular business such as private placement or mezzanine finance. The one curiosity is that often, with small businesses, longer term loans are easier to obtain than medium term loans because the longer loans are easily secured with mortgages against property. The fact that medium term loans are hard to obtain is a well

    known feature of SME’s and is known as the maturity gap. Its main problem arises in a mismatching of the maturity of assets and liabilities.

    Initial owner finance is nearly always the first source of finance for a business, whether from the owner of from family connections. At this

    stage many of the assets may be intangible and thus external financing is an unrealistic prospect at this stage, or at least has been in the past. In fact, what the diagram illustrates is what is referred to as the equity gap. With business angel finance unformalised in terms of a market and sometimes difficult to set-up there are limited means by which

    SME’s can find equity investors. Trade credit finance is important at this point too, although it is nearly always very expensive if viewed

    in terms of lost early payment discounts. Also, it is inevitably very short term and very limited in duration (except that always taking 60 days to pay a creditor will obviously roll-over and become medium term

    financing). Business angel financing is extremely important and is

    represented by high net worth individuals or groups of individuals who invest directly in small businesses. Candidates for the examination

should make themselves aware of the principal features of all of the types

    of finance identified. McLaney (2000), and tutor texts, with which you will be familiar, are a good source of information. A chapter in a forthcoming set of readings by Jarvis (2000) provides an excellent assessment of the importance of different sources of finance.

    The role of accountants

    Explaining and supporting businesses in identifying and accessing appropriate finance is a key role for accountants throughout the development of an organisation. This is particularly important at the business angel financing stage (one of the earliest stages at which external financing arises). Accountants, as professionals have a range of contacts from individuals or businesses with surplus funds they wish to invest. Accountants are also in contact with businesses that need

    finance. Matchmaking is therefore important and accountants can be crucial activators in developing businesses in this way.

    Also, it is important that businesses manage their finance, not just in terms of adequacy, but also with respect to type. Financing can vary

    significantly in many ways. For example, the cost of financing will vary and it is well known that debt is generally cheaper than equity, even for owner finance which will mostly be equity based. Another example is with working capital. Besides highlighting the expensive nature of trade credit as a source of finance when early settlement discounts are involved, accountants should realise that maturity matching of working capital is important too. Thus, to the extent that current assets exceed

    current liabilities then, by definition, the excess must be funded by longer term financing. I will leave you to think about that one.

    Most importantly, accountants can assist in the provision of information for their clients looking to access funding. If, as has been identified

    above, information uncertainty is the biggest problem facing SME’s then accountants should respond to that and aspiring accountants should be aware of the issues involved. Thus, for example, a significant way in which accountants can assist is in the development of business plans.

    In the future I plan to write further articles on the subject of business finance and sources of finance. It is a very important subject and is becoming more so in the light of the financing needs of new technology

    businesses with virtually no tangible assets. This particular problem is causing headaches for the investment community too. For the time being, understanding the basics, as outlined above, will be enough to begin with. What this article provides for examination candidates is a macroeconomic context to understand the market for finance and a method of analysis in terms of information uncertainty, growth and financing types that will

enable candidates to address some of the important issues involved.

    References

    1. Bank of England, Quarterly Report on Small Business Statistics,

    Business Finance Division, Bank of England, December (1998).

    2. Jarvis R, (2000), ‘Finance and the small firm’, Chapter 19,

    published in Enterprise and Small Business principles, practice

    and policy’, S Carter and D Jones-Evans (Editors), Financial

    Times/Prentice Hall.

    3. McLaney E J, (2000), Business Finance: Theory and Practice,

    Financial Times/Prentice Hall, 5th Edition.

    Acknowledgements

    Thanks are due to Professor Robin Jarvis, Kingston University, for

    assistance and comments in preparing this article.

    David Brookfield is Examiner for Paper 2.4

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