SME FINANCING IN INDIA

SME FINANCING IN INDIA

-Issues & Challenges-

I. Introduction

In the current scenario, if we talk about the product and process innovation, the most ignored section of the industry that cannot be ignored any more is the Technology based Small and Medium Enterprise or popularly termed as SME industry. These enterprises play a vital role in egressing the latest technology based sectors of the industry and in preserving and enhancing the economic competitiveness of the established industries. The long term health of the economy of a country is highly dependent on the strong domestic technology sector.

Over the past decades, many developments have occurred in public and private sector markets serving SMEs in India. The definition of SMEs varies from country to country. The classification can be based on the firm’s assets, number of

employees or annual sales. The International Finance Corporation defines SMEs as firms with less than 300 employees and total assets less than

US$15 million. In smaller economies, SMEs are defined as less than 20 employees. Whatever the definition, and regardless of the size of the economy, the growth of SMEs throughout the region is crucial to regional growth.

The most premier and critical role that SMEs play is, ofcourse,

• in providing jobs to the needful
• enhancing the quality of human resources
• nurturing a culture of entrepreneurship
• breeding the creativity and
• opening up new business opportunities.

II. FUNDING THE SMEs – a vital issue

The major boost for the SMEs to spring up, to reposition, adjust themselves quickly in response to market and economic changes, has been as a result of flexibility, as well as low start-up and operating costs. To add to this , they can easily expand or contract in a short time. SMEs have not only survived the impact of big enterprises and the law of economies of scale but have carved out niches for themselves, which enable them to coexist with big enterprises. So far, the lack of access to market information and technology, the low quality of human resources and the lack of access to capital has proved to be few of the common problems of SMEs so far. Financial institutions and public-sector bodies have concentrated a lot to bridge the funding gaps but till the time they continue to experience difficulty in obtaining risk capital.

These funding gaps relate to firm size, risk, knowledge, and flexibility. SME borrowing requirements are small and frequently do not appeal to financial institutions. Collateral required may be more than what SMEs can pledge. What can be judged so far, is, that financial institutions may lack expertise in understanding small and medium Knowledge-based business. The terms and conditions of financing may still not be conducive in accordance to the requirements of SMEs.

III. FUNDING OPTIONS

Let us now have a brief overview of some of the possible funding options available their in the market.

Credit Unions, Leasing Companies

Options for funding at the start-up stage include credit unions, leasing companies, personal finance and contributions from family relations.

Private Equity and Venture Capital

The venture capital in the United States has developed without any official government policy and to finance high technology firms that are “informationally opaque,” often without tangible assets and established products and markets. If we take the case of United States, venture capital accounts for only a small part of SME financing (fewer than 2%) concentrated in certain industries considering private equity funds from institutional

investors (primarily pension funds and wealthy individuals), these are typically structured as limited partnerships with fixed lives (usually around ten years) and general partners responsible for making investments with incentive-based

compensation schemes.

To respond to issues raised by investors,

venture capital funds typically demand board representation and play an active management role, which may not be acceptable to some (family-owned) firms. There has been rapid growth in venture capital and private equity in Asia since

the Asian financial crisis.

Taxes, the regulatory framework, and

funding policies differ greatly across

economies, which affect the efficiency of

transfer of capital.

There is evidence that private equity in economies like Korea and Japan is used to replace sources of funding not available from traditional institutions which can also be implemented in India. Private equity is not restricted to finance blue-chipfirms only , but rather to finance therestructuring of established firms in the traditional industries. We can see this as an open opportunity to uplift, both, the morale and status of SMEs.

Banks

Industries that are traditional and are also possessing some tangible assets along with a well run business, can often raise funds from sources like banks. Indian banks, that are growing rapidly with their balance sheets often touching skies are both, keen and capable of lending money. Government needs to bridge this gap between the SMEs and the banks by considering the lending rates. Also the return period should consist some kind of relaxation to encourage more and more entrepreneur to come and raise their capital via loans. Analysis of SME financing in the U.S. suggests that banks and traditional credit-granting institutions still provide the largest source of outside financing. The constraints before the banks to go for the deal with SMEs are:

• Lack of accurate reliable information on the

financial condition and performance;

• Unconvincing and weak business plans;
• Weakness in SMEs management, market

links,

• Governance and information technology.

Therefore, we can conclude that banks need to adopt appropriate lending technologies and operation systems to enable them to realize the

market potential and to lend profitably to small businesses.

The government’s and banks’ recent commitment to a revised statement of principles on business

banking is an excellent opportunity to improve SMEs’ access to finance as well as the credibility of

lenders.

A revised Code of Practice for Business

Banking should include:

A commitment to give adequate notice of changes to terms of service. In particular, withdrawing or reducing credit facilities will require notice periods much longer than 30 days, allowing SMEs to plan their cash flow, seek advice and arrange alternative funding.

A commitment to facilitating access to independent financial advice. Information on

independent sources of financial advice should be offered to all new business customers.

A commitment to discouraging late payment of suppliers. Anecdotal evidence suggests that

businesses have, in some cases, been advised to use late payment as a formof free credit.

IV. RAISING FUNDS THROUGH CAPITAL MARKETS

The reason of separately discussing the funding of SMEs through capital market is because of its huge investment options. Avoiding the traditional funding option from banks, SMEs often or should turn to fund growth by raising equity on the Stock Exchange. They can spread and share the risk of high growth strategies by sharing equity ownership. The Stock Exchange facilitates marketable shares to

acquire other companies. Apart from the mention need of raising funds, listing on the Stock Exchange

can increase corporate profile.

But the unpopularity or refraining of SMEs from the Stock Exchange so far is understandable. The cost of listing to raise a small amount of funds has proved to be as costly as raising large amounts of

funds. The increasing pressure for continuous

disclosure places great pressure on small management teams.

The costs of listing and ongoing compliance costs combined with requirements for continuing disclosure have been a disincentive to small growing companies with limited management

skills. The high-risk nature of these small

businesses and the limited information

they can provide has not attracted support

from the brokers so far.

The major aspect in public securities market, that is most required is “disclosure". Track record is important when investors are comparing options.

The lack of such disclosures in a proper manner is a major reason for the investors showing their back to SMEs.

V. SME-FINANCING--ISSUES AND STRATEGIES

SMEs, if developed and practiced on modern lines shall primarily remain profitable options for banks and can guarantee earning for banks at a rate higher than the lending to corporate clients.

There exists strong evidence that SMEs expansion boosts employment more than large firm growth because SMEs are more labour intensive. In Pakistan, the SME sector contributes 30 percent towards the country’s GDP, along with agriculture provides 90

percent of the jobs, accounts for 35 percent of the value added in the manufacturing industry and generates 25 percent of manufacturing sector export earnings ($ 2.5 billion). Given its huge potential for generating employment, the Government has identified the SME sector as one of the leading sectors along with agriculture and construction and housing which will spearhead its efforts towards generating employment to alleviate poverty in the country within the framework of the Pakistan Poverty Reduction Strategy Paper. While the sustained and long-term growth of the SME sector in Pakistan remains constrained by a number of factors that include skills shortage, scarcity of capital goods, poor management, lack of data on the sector, resistance to change and marketing difficulties especially for export-oriented SMEs; by far the biggest problem facing the sector is the unavailability of adequate financing facilities. The problem of limited access to credit for the SMEs is not exclusive to Pakistan as a recently conducted World Business Environment Survey covering 4000 firms in 54 countries found that SMEs cited

inadequate access to finance as their primary constraint to growth. This sector is characterized by information asymmetries; the creditors’ search costs, information acquisition and processing costs exceed the returns. Hence, there is risk aversion by the banks towards extending credit to small and medium enterprises.

It is relatively easy to lend to large corporates where the economies of scale, published financial information, collaterals and creditworthiness parameters favour such types of lending. As the small businesses cannot offer adequate collateral, the banks are unable to determine whether the borrower possesses technical, managerial and marketing skills that will allow him to generate adequate cash flows and repay the loan on time. The process of financial intermediation therefore breaks down for the SME borrowers. Therefore, the need of the hour is that we take more holistic view of this problem, instead of looking at the issue of financing to the SMEs in isolation. We actually are in need of a large number of players to work for the uplifment of the SME sector.

VI. ROLE OF GOVERNMENT

Government can uplift the status and working capital of SME by modifying the supply of funding for SMEs. It can do so by introducing rules and regulations to encourage banks, venture capitalists and capital markets to create uniquely tailored programs, for example, directing venture capital to seed firms in growth sectors and supporting pension funds participation in venture capital funds and

tax incentives. Impacts of globalization such as global competition, rapid changes in technology

and the evolving market conditions add to the high risk of funding fast-growing small businesses. R&D costs are rising. Strategic alliances are increasing,

particularly, cross-border alliances. Mergers and acquisitions cross borders. Information networks are becoming more sophisticated, for example, through development of clusters.

In working with the Small Business Finance Forum, the government has correctly identified access to advice as being central to SMEs’ financing problems. Its efforts to provide free credit management advice must be complemented by encouraging the use of professional financial

advice, especially as the credibility of lenders diminishes. SMEs taking financial advice from

accountants, the most popular source, are still outnumbered by those that take no advice at all. Yet

those with access to accountants and financially qualified managers are likelier to secure the

finance they need, from a wider variety of sources. In preparation for an even sharper downturn in

2009, these professionals need to work with SMEs to help them manage their resources, navigate

the range of finance products, build stronger relationships with lenders and, if necessary, compare and switch between banks.

VII. THE ROAD TO RECOVERY

Themarket for SME finance is under a great deal of strain; it will take government support and

commitment fromlenders to restore it to health. But the SME sector has entered this recession in good financial health.With adequate advice and targeted support it should recover before too long. This, however,will requiremore than government funding and signposting. Effective support must engage small business owners within their peer groups, relying on support and mentoring

networks embedded in the local enterprise community.15 At the heart of these, open and honest communication between lenders and SMEs, mediated by the accounting profession, can yield enormous benefits. Entrepreneurs themselves can act as trusted, unbiased mentors to SME owner managers and regional development agencies (RDAs) should show more strategic leadership by

supporting more high quality, sustainable local mentoring services.

VIII. RECOMMENDATIONS

• Creation of a flexible environment for

the venture capital specific to SMEs

to flourish

• Tailor credit in banks and other

similar institutions to the need of

small firms

• Give a greater emphasis on training

programs to help banks’ staff

understand the unique requirements

of SMEs better

• Harmonization of the financial policy

framework across economies will promote cross-border strategic alliances including SMEs and facilitate transfer of experiences between the regional economies.