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.