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A different ball game altogether

A different ball game altogether

It is crucial to understand the financial behaviour and practices of SMEs which are totally separate from those of larger firms

Although capital is a scarce resource for any business, it is even more scant for small and medium enterprises (SMEs). Therefore, cash flow and working capital management are the most crucial challenges of organisations in general and SMEs in particular. Working capital is short-term in nature and refers to the funds required for the daily functioning of a firm. In business parlance it consists of accounts receivables (debtors and any pre-payments, stock or inventory) and accounts payable (creditors and short-term provisions). The lifeline of any enterprise is the flow of cash and other liquid assets through a business cycle — a journey of collecting receivables from the debtors to pay off the creditors. This is also known as the cash conversion cycle. The efficiency and, therefore, the success of a business depends upon how fast the goods are converted into cash.

SMEs differ in many ways from large firms in terms of their financial behaviour and decision-making, mainly because of their characteristics and ownership. This ultimately reflects in their financial habits. So, what are the factors that affect the availability of capital to small enterprises? One of the most important issues is the size. According to researchers, during the start-up phase, the owner’s personal savings are an important source of funds. Young and small firms do not have an established track record and may be characterised by informational opacity, making banks and other financial institutions reluctant to lend to them. In general, firms which are less than four years old, rely more on informal sources of funding.

However, when the SMEs increase in size and become larger, they have a greater network of banks willing to fund their business. The firm’s ability to deal with multiple banks and other credit agencies generally grows with size, too. So, they rely more on long-term debt and external financing, including bank loans.

Second, the type of ownership is another important determinant for the source of funding. Any SME with a concentrated ownership, like in a proprietorship, should be more prepared to use bootstrap financing, as it would have greater difficulty in accessing a formal source of credit. From the lender’s perspective, in such SMEs, there is no clear distinction between the owner and the firm, information asymmetry is prevalent and an ability to provide collateral is missing. On the other hand, a private limited SME may be viewed by financing agencies as more structured and credible. As a result, formal financing options are freely available to it. Third, the location of the start-up makes a huge impact. A firm’s proximity to the banks has an influence on its ability to gain external funding. Research also suggests that one of the reasons for a company’s failure is poor location that prevents customers and suppliers from reaching it. Therefore, despite high rentals, SMEs prefer to move to urban areas for the sake of better infrastructure and the ease of raising external finance.

Fourth, several researchers have provided evidence that the sector where the SME is operating has an impact on the short and long-term debt available to it. For example, short-term credit is used more in wholesale and retail trade as compared to manufacturing SMEs. Whereas the construction sector, hotel, hospitality and mining industries appear to depend more on long-term finance. And finally, availability of assets plays an important role in raising funds. From a lender’s point of view, collateral, which is also known as the lender’s second line of defence, is highly relevant while approving loans. Researchers Ono and Uesugi studied the Japanese SME loan market and found a positive relationship between the use of collateral and the ease of access to bank loans and external financing. It can also be understood that firms with lower tangible assets would face difficulties in accessing funds.

Additionally, the characteristics and gender of the owner too influence a firm’s capability to raise external funding. According to several researchers in different countries, men and women differ in the way they raise cash for their businesses. There is empirical evidence that women entrepreneurs start their business with a smaller start-up capital, in fact less than half of the amount used by men. In addition, women also face discrimination from banks and other financial institutions. This is evident from the higher rates of interest charged from women entrepreneurs, the requirement of additional collateral, higher loan denial rate and so on. The age of the owner, too, impacts the personal financing preference. Older SME owners are less likely to take additional finance into their firms. Younger owners tend to use a variety of external cash sources like loans, overdrafts, credit cards and personal savings.

SMEs are the backbone of any growing economy. Therefore, it is crucial to understand their financial behaviour and practices which are very different from the financial management of large corporations. This would help policymakers come up with ways to improve the external financing scenario for such firms, as stronger SMEs make a stronger economy.

(The writer is Associate Professor, Amity University, Noida)

A different ball game altogether

A different ball game altogether

It is crucial to understand the financial behaviour and practices of SMEs which are totally separate from those of larger firms

Although capital is a scarce resource for any business, it is even more scant for small and medium enterprises (SMEs). Therefore, cash flow and working capital management are the most crucial challenges of organisations in general and SMEs in particular. Working capital is short-term in nature and refers to the funds required for the daily functioning of a firm. In business parlance it consists of accounts receivables (debtors and any pre-payments, stock or inventory) and accounts payable (creditors and short-term provisions). The lifeline of any enterprise is the flow of cash and other liquid assets through a business cycle — a journey of collecting receivables from the debtors to pay off the creditors. This is also known as the cash conversion cycle. The efficiency and, therefore, the success of a business depends upon how fast the goods are converted into cash.

SMEs differ in many ways from large firms in terms of their financial behaviour and decision-making, mainly because of their characteristics and ownership. This ultimately reflects in their financial habits. So, what are the factors that affect the availability of capital to small enterprises? One of the most important issues is the size. According to researchers, during the start-up phase, the owner’s personal savings are an important source of funds. Young and small firms do not have an established track record and may be characterised by informational opacity, making banks and other financial institutions reluctant to lend to them. In general, firms which are less than four years old, rely more on informal sources of funding.

However, when the SMEs increase in size and become larger, they have a greater network of banks willing to fund their business. The firm’s ability to deal with multiple banks and other credit agencies generally grows with size, too. So, they rely more on long-term debt and external financing, including bank loans.

Second, the type of ownership is another important determinant for the source of funding. Any SME with a concentrated ownership, like in a proprietorship, should be more prepared to use bootstrap financing, as it would have greater difficulty in accessing a formal source of credit. From the lender’s perspective, in such SMEs, there is no clear distinction between the owner and the firm, information asymmetry is prevalent and an ability to provide collateral is missing. On the other hand, a private limited SME may be viewed by financing agencies as more structured and credible. As a result, formal financing options are freely available to it. Third, the location of the start-up makes a huge impact. A firm’s proximity to the banks has an influence on its ability to gain external funding. Research also suggests that one of the reasons for a company’s failure is poor location that prevents customers and suppliers from reaching it. Therefore, despite high rentals, SMEs prefer to move to urban areas for the sake of better infrastructure and the ease of raising external finance.

Fourth, several researchers have provided evidence that the sector where the SME is operating has an impact on the short and long-term debt available to it. For example, short-term credit is used more in wholesale and retail trade as compared to manufacturing SMEs. Whereas the construction sector, hotel, hospitality and mining industries appear to depend more on long-term finance. And finally, availability of assets plays an important role in raising funds. From a lender’s point of view, collateral, which is also known as the lender’s second line of defence, is highly relevant while approving loans. Researchers Ono and Uesugi studied the Japanese SME loan market and found a positive relationship between the use of collateral and the ease of access to bank loans and external financing. It can also be understood that firms with lower tangible assets would face difficulties in accessing funds.

Additionally, the characteristics and gender of the owner too influence a firm’s capability to raise external funding. According to several researchers in different countries, men and women differ in the way they raise cash for their businesses. There is empirical evidence that women entrepreneurs start their business with a smaller start-up capital, in fact less than half of the amount used by men. In addition, women also face discrimination from banks and other financial institutions. This is evident from the higher rates of interest charged from women entrepreneurs, the requirement of additional collateral, higher loan denial rate and so on. The age of the owner, too, impacts the personal financing preference. Older SME owners are less likely to take additional finance into their firms. Younger owners tend to use a variety of external cash sources like loans, overdrafts, credit cards and personal savings.

SMEs are the backbone of any growing economy. Therefore, it is crucial to understand their financial behaviour and practices which are very different from the financial management of large corporations. This would help policymakers come up with ways to improve the external financing scenario for such firms, as stronger SMEs make a stronger economy.

(The writer is Associate Professor, Amity University, Noida)

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