Why companies sometimes face difficulties in raising finance
Topic: Explain what sources of finance are available for small to medium sized companies and explain why they sometimes face difficulties in raising finance
Due to the establish of modern enterprise system and thoroughly in structural reforms of market economy, there are lot of opportunities contained in the market, but it is also existing many unexpected risks, particularly for the small to medium-sized enterprise (SMEs) which has limited resources to resist in this treacherous environment. To survive and adapts to the environment for a SME is to maintain its advantage in meticulous daily management and even more important is to have a long-term view strategic thinking especially in financial strategy. ‘A good finance strategy can help SME to set up and expand their operations, development and also investment’ (OECD, 2006), further to get funds which make them competitively and can get well results they desired (Park, 2010). Making a finance strategy is very significant to a company; company has to consider both of internal condition and external environment problem and even more factors which are related to company. However, the SME has its particular characteristic, it is not suitable to adopt the same action with a large company; they better to create a strategy which fits to the company according to its demand. Finding a proper financial strategy for a developing SME, not only can help SME to reinforce its essence, the more important is the sustainability of its development.
There is no accurate definition for small to medium-sized enterprise (SMEs) and most of countries define it according to specific condition by their way. Nevertheless, there are some particular characteristics (Bank of England, 2001& Brookfield, 2001) about SMEs and they are:
The enterprises are not quoted
Ownership is often connected between family and shareholder and the business is typically restricted to few individuals.
Most of SMEs are small group’s business and always achieve self-employment effectively.
In the past, the definition for SME’s from European Commission was unequivocal, it was defined by individual country, for instance, Germany regulated the amount of employee under 250 was part of SME, but in Belgium, the number was became 100. However, in the recent years, the data from European Commission shows that the definition has adjusted and is qualified as a SME by some criteria (see figure 1-1) (European Commission, 2010) in headcount, turnover and balance sheet total.
Figure 1-1 the definition of a small firm from European Commission
Importance of finance
Nowadays, the enterprise’s finance is facing a dynamic, diversification and complicated managing environment. Managing finance is not only to provide a specific method or device for a firm; it is to assimilate the principle and manner from strategic management. Start from the view of adapting to the environment and using the vantage, to pay much attention in financial long-term problem and strategic problem. In the situation of lacking of the resources for SME, to create a suitable financial strategic and well dominate the limited resource is significant since a better financial systems can help to improve the probability of successful innovation and bring accelerate economic growth.
(King, et al., 1993)
The focus of enterprise’s financial strategy is the basic path on future development, goal and goal accomplishment for the financial action; this is the difference between financial strategy and other strategies. The master objective of enterprise’s financial strategy is reasonably to assemble, dominate and use its resources, tend to balance and flow enterprise’s capital, also to build the core competitive strength and to achieve the maximization of enterprise value in the end. Some aspects of this goal are related/ connected to each other; from the view of a long-term performance, to seek the enterprise’s sustainability growth in financial resource and capability, and furthermore to accomplish the rising of enterprise’s capital value and make enterprise’s financial capability can sustained, quick and healthily increase, conduce to maintain and develop enterprise’s competitive advantage.
While enterprise building the core competitive strength for their strategic management, they need the support from financial management. The financial management which treats capital management as a significant content, it needs to express the requirement for enterprise’s strategy and to guarantee its practice. The value of practicing the financial strategy is to retain a health condition in enterprise’s finance and also effectively in controlling the financial risk.
There are twelve types of financing and growth in SMEs and it can be very usefully and provided a great help if it is supplied properly according to SMEs particular requirement (Brookfield, 2001).
Initial owner financing (Equity finance)
Business angel financing
Short-term bank loans (Debt finance)
Medium term bank loans
A company should manage its financing structure in a way that its debt and equity are in balanced manner. This fact helps company to avoid insolvency. Excess of either debt or finance could result in loss of wealth. I will be explaining some of the important methods of financing in following section.
Equity financing is that the shareholder sells the part of corporate control to introduce the new shareholder by raising the capital (Watson, et al., 2007). The enterprise does not need to pay the interest on principal if the capital is received from equity financing and the new shareholder can share the profit from enterprise as well. Equity financing includes stock issuance, allotment and debt for equity swap. Some features of equity financing, are:
Stock equity is firm’s first right of its property, it is the base for enterprise to absorb the civil liability and to responsibility for firm’s own profits and losses; furthermore, it is also the base for investor to control the enterprise and to distribute the profit.
Equity financing is the base of deciding an enterprise to the outward debt.
Certainly, there are some advantages of equity financing that help enterprise in investment and management.
Equity financing builds a good system in corporate governance structure, which consists of shareholders meeting, board of directors, Board of supervisors and executives. It is effectively in decreasing the risk of management.
In the modern finance theory, stock market is also called open market; it means that the standardization financial products are dealing in a trading area with an extensively institutionalization. It has its criterion and processes it in the condition of information revelation and fare dealing. In financial translation, the more important is publicity and availability of information; and that is why the stock market is better than loan market in both competitiveness of capital price and publicity of information.
Venture capital is the fund which is collected by private placement and set as the type of organization; invest to unlisted small and medium-sized newly emerging enterprises and in the capital type of both high risk and high reciprocation. Venture capital is different from mutual fund, unit trust and securities investment fund; it has its features in operating of investment and collection, such as,
Venture capital absorbs the venture with enterprise; the venture capitalist needs to cooperate closely with entrepreneur and help the firm to make a plan. Management is part of investment.
Venture capital is an investment in long-term and poor flowability; venture capitalist and entrepreneur become a common destiny once they invest.
Venture capital is high risk and requires the venture capitalist with specialized skill, and need to achieve specialization and programmed in choosing the project, tend to avoid the risk.
Before inspect the financial index, the venture capitalist pays more attention in market prospect, development strategy and managing quality.
Sharing the bonus from enterprise is not the purpose of venture capital, they make it as a return by increasing the capital when they are exiting; the time for exiting is always when go on public or sell it.
Debt financing is also called bond financing, it is the way which the firm can raise money for enterprise’s external finance; and debt can also be conducted and fitted to the requirement of issuing companies and investors (Watson, et al., 2007). It is included long-term bank loans, short-term financing (such as bills, debt receivable, and letter of credit), enterprise Bond and short-term financial bonds, also long-term bond financing, finance lease, discount government loans, government loan, Loans from international financial organizations and private bond fund.
The first expense enterprise needs to pay is the interest of capital which receives from debt financing and the principal on the debt will be paid to creditor at maturity (Davis, et al., 1994). The feature of purpose for debt financing is to solve the problem of deficiency in working capital rather than the expenditure under the capital account. Debt financing can be described by two features,
The received capital from debt financing is only for using, it is not the property of the enterprise, and the firm needs to pay interest and the principal is repayable.
Compare to equity financing, except some specific situations that debt financing may bring creditor the problem of intervention or controlling, otherwise it is barely to have the problem of corporate control.
However, debt financing has its advantage for helping the firm in investment and management,
The lenders have ability to collect and analyze the states of investment, also can have long-term investigate and oversee the enterprise to avoid the moral hazard.
The function of the creditor’s right is when firm can pay off the debt, the firm will hold the corporate control, whereas of the enterprise cannot offer the debt, the corporate control will be turned to lender.
Why do SME’s find financing a problem?
Due to SME’s small size capital, the capability for defending the market risk is not as strong as a large firm, plus a faulty finance system, it causes the problem into SME’s finance management (Pissarides, 1999). The main reasons and problem are:
No criterion in SME’s finance accounting system
In application of finance system in SME exist some problems, which make loose financial control. A loose inventory control can lead to the stagnation of capital and excessive final inventory; the capital of final inventory always in a high proportion if compare to sale revenue. The firm usually loses a large number of assets due to focus on capital much more than assets and even wastes it seriously; moreover, to control the finished products, semi-manufactured goods and low-value expendable without a faultless system.
It is negligent in managing the cash and weakness in debt receivable
Some of enterprises think that it is good to hold cash (including bank deposit), and better to have more; the proportion of reserve is too high, it makes lot of capital cannot really run in operation, and also causes the capital idleness. In addition, some firms invest too much in real estate and lead to finance difficulty due to could not handle the emergent need of management. Also deficiency in managing working capital creates problems problem capital withdrawal.
Difficulty in funding, the capital is insufficient
It is not easy to run the SME in a practically environment, especially the unequal treatment in funding between SME and larger enterprise. The banks are not willing to loan to them, particularly the difficulty in guarantee and lack of the specialized agency to offer the assurance service is still the main problem for SME and it obviously happens in some huge investments.
Unrestraint in investment
The SME is lacking of the ability to analyze the investment accurately and to evaluate the effectiveness of operating the capital. The majority of investment in SME is from banking, due to the respectability of a SME is not as high as a large company, it is an obstacle in attracting the banking to invest or loan to the SME.
The mode of management is backward
Most of SME is running the business as a family workshop; they are operation the management in a backward way and an old-fashioned thinking way, do not understand and even not willing to understand or learn the modern financial management. The proprietor always treats the enterprise as an extension of family’s property; in order to control the business entirely without decentralize the ownership, it causes the lost of the opportunities in growing.
SMEs play an important role in the general macroeconomic environment, and provide the enormous opportunities for employment. However, due to the small size and limited source, usually SMEs has to face to the challenge in financing problem. For solving the problem, the major impact is from government and the law (Industrial Systems Research). In existing policy has to be adjusted by government; the government needs to reinforce the related law and regulation to implement SMEs development strategy and preferential clause. Furthermore, have to set up the institution for managing and supporting SMEs development. To increase the method for financing; SMEs need to respect the debt from bank and to pay back the debt on time; then to healthy the internal system and raise the handling of material. Lastly, to improve accountants’ structure and criterion of financial management; enhance the punishment for the illegality to makes they pay attention in financial system.