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SME finance

Category: Business & Economy

Funding small and medium-sized enterprises is a major function of the general business finance market – in which capital for firms of types is supplied, acquired, and costed/priced. Capital is supplied through the business finance market in the form of e.g.:

  • bank loans and overdrafts;
  • leasing and hire-purchase arrangements;
  • equity/corporate bond issues;
  • venture capital or private equity; and
  • asset-based finance such as factoring and invoice discounting.

However, it should be noted that not all business finance is external/commercially supplied through the market. Much finance is internally generated by businesses out of their own earnings and/or supplied informally as trade credit (i.e., delays in paying for purchases of goods and services).

Importance of SME finance

The economic and social importance of the small and medium enterprise (SME) sector is well recognized in academic and policy literature.[2] It is also recognized that these actors in the economy may be underserved, especially in terms of finance. This has led to significant debate on the best methods to serve this sector.
There have been numerous schemes and programmes in markedly different economic environments. However, there are a number of distinctive recurring approaches to SME finance.
Collateral based lending offered by traditional banks and finance companies is usually made up of a combination of asset-based finance, contribution based finance, and factoring based finance, using reliable debtors or contracts.
Information based lending usually incorporates financial statement lending,credit scoring,and relationship lending.
Viability based financing is especially associated with venture capital.

SME finance gap

A substantial portion of the SME sector may not have the security required for conventional collateral based bank lending, nor high enough returns to attract formal venture capitalists and other risk investors. In addition, markets may be characterized by deficient information (limiting the effectiveness of financial statement-based lending and credit scoring). This has led to claims of an "SME finance gap" – particularly in emerging economies.
There have been at least two distinctive approaches to try to overcome the so-called SME finance gap.
The first has been to broaden the collateral based approach by encouraging bank lenders to finance SMEs with insufficient collateral. This might be done through an external party providing the collateral or guarantees required. Unfortunately, to the extent that the schemes concerned run counter to basic free market principles they tend to be unsustainable.
However, there is no evidence of any significant structural barriers to the supply of bank or private equity finance to suitable SME applicants on mutually satisfactory terms and conditions in contemporary Britain. The main obstacles to funding here appear to be on the demand rather than the supply side of the business finance market – mainly in the form of:

  1. lack of satisfactory business plans, accounting and other information;
  2. inadequate assets for use as security; and
  3. insufficiently high levels of profitability, gearing, liquidity, stability, and other business-financial performance criteria on the part of funding applicants.

The second approach has been to broaden the viability based approach. Since the viability based approach is concerned with the business itself, the aim has been to provide better general business development assistance[7] to reduce risk and increase returns. This often entails a detailed review and assistance with the business plan.

A common aim or feature of the viability based approach is the provision of appropriate finance that is tailored to the cash flows of the SME.
Although the returns generated by this approach in less developed countries may never be attractive to Western venture capitalists, they can be significantly better than conventional collateral based lending – whilst at the same time being less risky than the typical venture capitalist project. Some investors have promoted this approach as a means of achieving wider social benefits,[8] while others have been interested in developing it largely in order to generate better financial-economic returns for shareholders, other investors, employees, and clients.

In the past, a significant obstacle to applying this approach in less developed countries has been getting the information required to assess viability plus the costs of transferring and providing business development assistance. However, in the last several years improved information and communications technology have made the process easier and cheaper. As technology and information sharing etc. continue to improve, the approach could become significantly more cost-effective and attractive to established financiers with viability based approaches and to consultants providing business development assistance to SMEs in other, more mainstream areas. With higher profitability than traditional SME finance and lower risk than traditional venture capital, this might even be dubbed the new "Growth finance sector".

The management of business lending
The effective management of lending to SMEs can contribute significantly to the overall growth and profitability of banks. There has been considerable research and analysis into the methods by which banks assess and monitor business loans, manage business financing risks, and price their products – and how these methods might be further developed and improved.
There has been particularly intensive scrutiny of the kinds of business financial information that banks use in making lending decisions and how reliable that information actually is.
Banks have traditionally relied on a combination of documentary sources of information, interviews and visits, and the personal knowledge and expertise of managers in assessing and monitoring business loans. However, when assessing comparatively small and straightforward business credit applications banks may largely rely on standardized credit scoring techniques (quantifying such things as the characteristics, assets, and cash flows of businesses/owners). Using such techniques – and also centralizing or regionalizing business-banking operations generally – can significantly reduce processing costs. Standardized computer-based assessment may also be more accurate and fairer than reliance on the personal judgments of local bank managers. As a result, banks may now be able to offer more loans, faster and in larger amounts, and reduce previously high security requirements.

However, business lending as a whole is substantially more diverse and complex than (say) personal and residential mortgage lending. This coupled with the large size and inherently risky nature of many business loans tends to limit the scope and desirability of computerized credit scoring in assessment and monitoring.

Date Added: May 29, 2008 05:13:14 PM
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