CHAPTER 3 SMALL AND MEDIUM ENTERPRISE FINANCING
The previous chapter examined the definition and contributions of SMEs globally and to the South African economy in particular. It was found that SME definitions vary among different countries as well as in South Africa depending on the economic sector of interest. The issues of credit availability to SMEs have generated considerable interest among scholars and policy makers. Literature on small business financing has shown that in most developing and emerging economies, SMEs encounter challenges when accessing external finance in an effort to support growth and sustainable development (Abor and Biepke, 2007). The chapter also deals with the challenges faced by South African SMEs and lack of access to credit was found to be one of the prime factors contributing to the high failure rate of SMEs in South Africa. However, researchers have observed that the SME sector has a major role to play in the South African economy just as in other economies, essentially in terms of employment creation and income generation. As stated in chapter one, SMEs account for approximately 60% of all employment and 57% of the GDP in South Africa (DTI, 2008). For that reason, SMEs are thus seen as a vehicle through which the lowest income earners can gain access to economic opportunities at a time when the distribution of income and wealth is amongst the most unequal in the world.
This chapter reviews the issues relating to the capital structure of small businesses, the sources of finance, the factors affecting availability and accessibility of bank credit as well as the challenges faced by banks in making SME lending decisions. Several financial theories have been developed in an effort to explain the capital structure adopted by SMEs. These theories include the static trade-off theory, the agency theory and the pecking order theory. Numerous researches have been done on the capital structure of large publicly listed companies which are accessible to national and international capital markets (Li, Yue & Zhao, 2009). Such firms are legally required to disclose financial and accounting information to the general public; and are therefore not subject to the institutional constraints imposed by the domestic financial systems (Li et al., 2009). Contrary to this, the extent to which capital structure theories are applicable to SMEs in the developing economies has received less attention due to limited availability of SME information in these economies.
It needs to be pointed out that the financial requirements of SMEs vary in size, frequency and maturity depending on the growth stage of the small business (Newman, 2010). In addition, the sources of finance available to SMEs change with time (Berger and Udell, 1998). SMEs can initially be financed from internal sources such as personal savings and/or external “informal” sources of finance such as “soft loans” from family and friends. As the business grows, formal external sources are sought such as bank loans and overdrafts, venture capital, money markets, and lastly private equity firms. According to the FinMark Trust (2006) only 2% of SMEs in South Africa are able to access bank loans. Without sufficient long-term finance, small firms are unable to expand their businesses and it is even more challenging to introduce productivity-enhancing technology. These challenges could adversely affect the competitiveness of the sector and the economy as a whole, as the SMEs’ functionality is hindered and their innovativeness, hampered.
Firstly an overview of the theory of capital structure with regard to SME financing decisions is presented. Factors which determine the capital structure of SME are also discussed. Secondly, the literature which covers sources and types of funding available to SMEs is discussed. It is important to understand the financing preference of SMEs as the choice of finance at different stages of business growth affects their performance and contribution to the economy. Thirdly, the review explores the drivers of the banks’ involvement with SMEs and the obstacles they encounter in their bid to fund small businesses. Fourthly, the review examines the process of credit evaluations by banks and the factors that determine their credit rationing behavior towards SMEs. Fifthly, the lending techniques used by banks in SME funding are discussed and finally, implications of the reviewed literature to the present study are presented.
THE CAPITAL STRUCTURE OF FIRMS
Capital structure has been defined as the mix of debt and equity that a firm uses to finance its operations (Myers, 1984). According to Hutchinson and Xavier (2006), a capital structure decision is one of the most complex decisions facing a firm. The cost of capital of a firm can thus be lowered through the implementation of effective capital structure decisions and hence increase shareholder’s wealth. According to Gitman (2009), the corporate finance theory of profit maximisation stipulates that the value of the firm is maximised when its cost of capital is minimised. However, this is a difficult measure to determine the optimal combination of debt and equity financing of a company. Thus, the optimal capital structure is the combination of debt and equity at which the weighted average cost of capital of a firm is minimised and shareholder’s wealth is maximised. The weighted average cost of capital is the average cost of debt and equity funding weighted by the proportion of the firm’s capital structure that the two components constitute (Gitman, 2009). The major competing theories of capital structure are discussed in the next section.
Financial Theories of capital structure
Contemporary capital structure theory is based on the influential work of Modigliani and Miller (1958), who under the assumptions of perfect markets, proposed a model that suggests that any changes in a firm’s capital structure has no impact on the value of the firm. The theory is based on the assumption that firms operate in a completely free and competitive market, without taxes, or transaction costs, where information is readily and freely available. Under these conditions there is no optimal method of financing. Modigliani and Miller (1963) argue that, in the absence of taxes, the cost of capital remains constant as the benefits of using cheaper debt are exactly offset by the increase in the cost of equity due to increased risk.
When imperfect capital markets are taken into consideration, the capital structure of a firm becomes relevant. Since Modigliani and Miller’s (1958) work, a number of theories have been put forward to explain the determinants of the capital structure of firms. These include the trade-off, the agency and the pecking order theories. Such theories take into consideration factors such as taxes, agency costs and information asymmetry that may cause deviations from the efficient market thereby reinforcing the market imperfection hypothesis. Details of the static trade-off theory are outlined in the ensuing section.
The Static Trade-Off theory
The static trade-off theory builds on the work of Modigliani and Miller (1958) to propose the existence of the an optimal capital structure for a firm, assuming the management of a firm will aim to maintain an optimal debt/equity ratio in making capital structure decisions to minimise the cost of prevailing market imperfections (Kraus and Litzenberger, 1973; Kim and Sorensen, 1986). The market imperfections include the tax shield benefits of debt finance, and the agency and financial distress costs of maintaining high debt levels (Haris and Raviv, 1990).
According to tax-based theories of capital structure, the financing decisions of a firm are influenced by the tax benefits of using debt and bankruptcy considerations. Tax paying firms are assumed to prefer debt over equity financing due to the fact that interest payments on debt are tax-deductible. Although tax benefits may encourage firms to use increasing amounts of debt in their capital structure, this may lead to an increase in the costs of financial distress and agency costs, putting opposing pressure on firms to avoid debt.
Financial distress costs arise when the likelihood that the firm may default on loan repayments is greater than zero. The more debt the firm uses in its capital structure, the higher the costs of financial distress resulting in banks adjusting the costs of the loan to take into account the potential risk that the company may go bankrupt. Agency costs arise from the of interest between equity and debt holders due to asymmetry in risk-sharing. These costs also increase as the amount of debt in a firm’s capital structure increases (Jensen and Meckling 1976, Haris and Raviv, 1990). Equity holders tend to favour risky investments with a high rate of return whilst debt holders prefer less risky investments with guaranteed returns. Agency costs result from the need for debt-holders to monitor the behaviour of the equity holders so as to protect their own interests. Consequently, costly monitoring devices are often incorporated into loan agreements which result in higher costs of capital.
Under the static trade-off theory, firms trade-off the benefits and disadvantages of debt financing to maintain an optimal debt/equity ratio. Firms identify their optimal leverage by weighing-up the benefits and costs of using debt. Although there is empirical evidence that the static trade-off theory might provide a plausible explanation for the financing behaviour of firms in developed countries (Newman,2010), there is weak support for its applicability to SMEs in both developed and developing economies (Watson and Wilson, 2002, Klapper et al., 2006). According to Watson and Wilson (2002), the explanatory power of the static trade of theory is low and the results of empirical inconclusive. This may be due to the difficulties faced by SMEs in accessing adequate sources of debt finance in comparison to larger companies which renders managers’ inability to trade-off the benefits and costs of debt. Holmes and Kent (1991) purport that SME owners tend to operate without targeting an optimal debt/equity ratio. Thus the applicability of the trade-off theory of capital structure to SMEs is rather limited (Andree and Kallberg, 2008).
The agency theory
Pioneered by Jensen and Meckling (1976), the agency theory proposes that under conditions of information asymmetry, self-interest and uncertainty, principals lack reasons to trust their agents and will therefore adopt measures to align the interest of the agents to those of the principal (Newman, 2010). Agency costs, resulting from the conflict of interest between equity and debt holders due to asymmetry in risk sharing also arise as the amount of debt increases in the capital structure. Jensen and Meckling (1976) identify two types of agency conflicts. The first focuses on the conflict between shareholders and managers and the second on the conflict between equity and debt holders. In the first instance, managers are tempted to pursue the profits of the firms they manage to their own personal gain at the expense of the shareholders. Thus managers cannot capture the entire gain from their value-maximising activities. According to Falkena, Abedian, Blottnitz, Coovadia, davel, Madungandaba, Masilela & Rees (2002) and Padachi, Narasimhan, Durbarry and Howorth (2008), the agency theory gives vital insights into the problems of ownership, management interrelationships and credit rationing.
The second type of costs, which arise as a result of conflicts between equity and debt holders, ultimately increases the cost of capital. In more practical sense, when firms are on the verge of bankruptcy, there is no incentive for shareholders to invest more equity capital, even if profitable projects are available. This is because the value derived from the projects will accrue mainly to the debt holders. The implication is that high debt levels may result in the rejection of value increasing projects.
For a large enterprise, the evaluation of an application for finance may be limited to the assessment of an audited set of financial statements and supporting documentation provided by the applicant. However, for SMEs the assessment normally goes beyond this, implying substantially higher transaction costs. Agency costs result from the need for debt-holders to monitor the behaviour of the equity holders in order to protect their own interests (Jensen and Meckling, 1976). Costly monitoring devices are therefore often incorporated into loan agreements which result in higher costs of capital for SMEs.
Two agency problems arising from information asymmetry include adverse selection and moral hazards, which can impact on the availability of credit and hence the capital structure of SMEs (Stiglitz and Weiss, 1981). These authors termed this phenomenon as credit rationing. Thus, credit rationing is said to occur firstly among loan applicants who appear to be identical, but discriminated against as some receive credit while others do not. Secondly, there are identifiable groups in the population that are unable to obtain credit or can only obtain credit at much higher prices. This underlying principle is at variance with the postulation that suppliers of finance may choose to offer a range of interest rates that would leave a significant number of potential borrowers without access to credit.
In terms of the agency cost theory, SMEs are expected to have the least debt and thus depend on internal equity. Debt levels gradually rise as the firm develops and becomes established. However, some authors disagree with the pattern of relationship as suggested by the agency theory. Frelinghaus, Mostert & Firer (2005) argue that whilst it is true that firms in latter stages do have more debt than firms in prime, the agency theory cannot explain why firms in the early stages of development have more debt than firms in prime. This argument therefore suggests the inadequacy of internal equity as a form of SME financing and the unavailability of external equity. The reliance of SMEs on debt finance therefore becomes inevitable.
According to Jensen and Meckling, (1976) fixed wage contracts cease to be the only means by which a relationship can be organised between banks and entrepreneurs under conditions of adverse selection and moral hazards. To ensure an agent’s cooperation, principals may adopt measures such as monitoring and rewards tied to an agent’s performance (Chittenden, Hall & hutchinson, 1996). Such measures are expected to reduce the problems of information asymmetry and agent opportunistic behaviour. However, the agent’s motives may be influenced by factors such as financial rewards, labour market opportunities and other relationships outside the agent-principal relationship. Therefore, firms with relatively higher agency costs due to inherent conflict between the firm and debt-holders should have lower levels of external debt financing and financial leverage (Cassar and Holmes, 2003).
The pecking order theory
The Pecking Order Theory (POT) was proposed by Myers (1984) and Myers and Majluf (1984) as an alternative approach to capital structure. The POT builds upon information asymmetry between managers and investors. According to the theory, due to agency costs, most firms prefer internal funding to external funding. Preference is given to funding sources with the lowest degree of information asymmetry as borrowing costs increase when obtaining funds from external financiers who do not have complete information on the borrower. The POT therefore implies that firms opt first, for internally generated funds in the form of retained earnings, then for debt, and only as a last resort for external equity (Degryse, de Goeij and Kappert, 2012). According to Myers (1984) there is no optimal debt-to-equity ratio to capital structure, and if there is, it is insignificant as compared to the cost of external financing. Baker and Wurgler (2002) therefore argue that raising external finance becomes costly as firm owners have more information about the prospects of the business than outside investors.
Internally generated finance is preferred because there are no problems of adverse selection. However, acute adverse selection problems are associated with equity. Therefore, in the mind of the investor, equity is considered riskier than debt and hence the investor will demand higher rates of return for equity investments than for debt (Myers and Majluf, 1984; Frank and Goyal, 2003). Another reason for equity investors demanding high rates of return is that it is costly and burdensome to float shares on the stock market. In addition, small firm owners avoid the use of equity finance for fear of losing control of their businesses to new external shareholders (Chittenden et al., 1996). Due to their small size and the high cost of issuing securities, SMEs are thus unable to issue publicly-held debt. Hence, SMEs tend to rely heavily on debt in the form of bank financing and trade credit (Coleman & Cohn,2000). If debt financing becomes necessary, the SME managers are assumed to favour short-term debt because this does not tend to involve any demand for collateral security.
The applicability of the POT to SME financing in developing countries has been examined by a number of studies in recent years (Sorgorb-Mira, 2005). There is a general consensus in the empirical literature that the POT provides a much sounder theoretical explanation than the static trade-off theory for the capital structure adopted by SMEs (Sorgorb-Mira, 2005). A more constrained version of the pecking-order theory is suggested for SMEs than is the case for larger firms. It is thus indicated that smaller firms rely overwhelmingly on internal sources of finance in the start-up and development phases of the business life cycle.
In making a financing choice for the business, Newman (2010) argues that an entrepreneur considers the current situation in both the debt and equity markets. The current condition which is more favourable to the entrepreneur determines the financing decisions made. Businesses therefore are likely to defer fund raising in instances where debt and equity markets are unfavourable. Funds may however be raised even when they are not needed, when the current market conditions are conducive (Frank and Goyal, 2003). In their bid to sustain firm-growth, entrepreneurs borrow from both formal and non-formal institutional sources. The implications of this theory are that SMEs have a preference hierarchy for different types of finance in their financial policy. The factors that determine the capital structure of SMEs are discussed in the following section.
DETERMINANTS OF CAPITAL STRUCTURE OF SMES
The capital structure decisions of firms, especially SMEs, have important implications for their performance, growth, risk of failure and potential for future development (Cassar, 2004). The inability to secure adequate sources of finance has been cited as the primary cause of SME failure (Coleman, 2000). It is therefore important to understand the entrepreneurial and business characteristics that determine the capital structure of SMEs. These factors are reviewed in sub-sections 3.3.1 to 3.3.2.
Owner manager characteristics
According to Irwin and Scott (2010), the personal characteristics of the owner-manager influence the firm’s ability and likelihood of accessing finance. The entrepreneur’s financing decisions may be influenced by the strong desire to maintain business ownership and independence. To achieve this objective entrepreneurs prefer to use internal sources of capital (Abdulsaleh and Worthington, 2013) and reduce the use of external finance. Owners might perceive that any external providers of funds can interfere in the management of their business (Padachi et al., 2012). Characteristics such as owner’s education, experience and age are reviewed in the following section.
• Education and experience
Theoretically the educational background of the SME owner-manager is often used as a proxy for human capital and has been found to be positively related to the firm’s usage of leverage (Coleman and Cohn, 2002). In a study of SMEs owner-managed by men across the US between 1976 and 1986, Bates (1990) established that owner-managers with high levels of education were more likely to retain their firms operating throughout the period of study. Similarly, experience as measured by the number of years in an industry, has been found to enhance the availability of credit to SMEs (Cole, 1998). Empirical evidence indicates that prior experience of SME owner-managers in the industry is positively correlated with the share of external financing in the firm (Nofsinger and Wang (2011). In addition to that, the cumulative experience of entrepreneurs plays a significant role in mitigating problems like information asymmetry and moral hazard that hinder SME access to external finance. Therefore, the level of education and work experience provide the business with adequate human and social capital. According to Coleman and Cohn (2000), entrepreneurs with higher levels of formal education and business skills are more likely to source external finance.
• Owner’s age
Similarly, the age of the business owner is likely to influence the capital structure decision of SMEs (Romano, et al., 2001). Unlike younger entrepreneurs, older business owners are less likely to invest additional finance into their firms.
Consequently, they are more reluctant to accept external ownership in the firm. Using data sets from the US and the UK, Vos, Yeh, Carter and Tagg (2007) affirm that younger owner-managers tend to use more bank credit than older entrepreneurs who appear to be more dependent on retained earnings
TABLE OF CONTENTS
List of tables
List of figures
List of acronyms
CHAPTER 1: INTRODUCTION AND BACKGROUND TO THE STUDY
1.2 Background to the study
1.3 Problem statement
1.4 Objectives of the study
1.5 Research questions
1.6 Research hypotheses
1.7 Significance of the study
1.8 Scope of the study
1.9 Outline of the study
CHAPTER 2: SMALL AND MEDIUM ENTERPRISES – AN OVERVIEW
2.2 Definition of SMEs
2.3 Characteristics of SMEs
2.4 Role and importance of SMEs to the economy
2.5 Challenges facing SMEs in South Africa
2.6 Constraints to accessing bank credit
2.7 Determinants of access to funding by SMEs in South Africa
2.8 Chapter summary
CHAPTER 3: SMALL AND MEDIUM ENTERPRISES FINANCING
3.2 The capital structure of firms
3.3 Determinants of capital structure of SMEs
3.4 Sources of finance for SMEs
3.5 Drivers of SME bank financing
3.6 Obstacles to SME bank financing
3.7 Credit evaluation by commercial banks
3.8 Factors determining the credit rationing behaviour of banks
3.9 Techniques used in SME bank lending
3.10 Chapter summary
CHAPTER 4: CREDIT RATIONING AND RISK MANAGEMENT: A CONCEPTUAL FRAMEWORK
4.2 Imperfect markets and information asymmetry
4.3 Credit risk management for SMEs
4.4 Innovative Risk Management in SME financing
4.5 Chapter summary.
CHAPTER 5: RESEARCH DESIGN AND METHODOLOGY
5.2 The research process
5.3 Research approach
5.4 Research Design and methodology
5.5 Validity and reliability of the instrument
5.6 Methodological limitations
5.7 Ethical considerations
5.8 Chapter summary
CHAPTER 6: EMPIRICAL RESULTS
6.2 Part One: Analysis of the results of the bank survey
6.3 Banks involvement with SMEs
6.4 Obstacles to SME financing
6.5 Validity and reliability tests for the bank survey
6.6 Reliability test: Conbach’s Alpha
6.7 Correlation analysis
6.8 Regression analysis
6.9 Structural equation modelling
6.10 Summary of the results for the bank survey
PART TWO: ANALYSIS OF RESULTS FOR SME SURVEY
6.12 Characteristics of the sample
6.13 Financial information
6.14 Validity and reliability test for the SME survey
6.15 Reliability test for the SME survey
6.16 Correlation analysis
6.17 Regression analysis
6.18 Structural equation modelling
6.19 Discussion of results
6.20 Summary of the results of the SME survey
CHAPTER 7: SUMMARY OF FINDINGS, CONCLUSION AND RECOMMENDATIONS
7.2 Revisiting the research problem and objectives and hypotheses
7.3 Key findings of the research
7.5 Contribution to study
7.6 Limitations of the study
7.7 Suggestion for further study
7.8 Final conclusion
LIST OF REFERENCES
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