Business finance and the SME sector

by David Brookfield
21 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 SMEs 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 SMEs 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 SMEs 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 SMEs 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 SMEs is a problem of uncertainty. A defining characteristic of SMEs 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 SMEs, 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 SMEs. 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 SMEs 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 SMEs 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 SMEs to grow. Let’s deal with banks first.

If SMEs 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 SMEs

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 SMEs 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 SMEs 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 SMEs 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.

Business finance and sources of finance are very important subjects and are 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.