SME finance
Encyclopedia
SME finance is the funding of small and medium sized enterprises, and represents a major function of the general business finance market – in which capital for different types of firms are supplied, acquired, and costed or priced. Capital is supplied through the business finance market in the form of bank loans and overdrafts; leasing and hire-purchase arrangements; equity/corporate bond issues; venture capital or private equity
Private equity
Private equity, in finance, is an asset class consisting of equity securities in operating companies that are not publicly traded on a stock exchange....

; and asset-based finance such as factoring and invoice discounting.

However, not all business finance is external/commercially supplied through the market. Much finance is internally generated by businesses out of their own earnings and/or supplied informally as trade credit
Trade credit
Trade credit is an arrangement between businesses to buy goods or services on account, that is, without making immediate cash payment. The supplier typically provides the customer with an agreement to bill them later, stipulating a fixed number of days or other date by which the customer should pay...

, that is, delays in paying for purchases of goods and services.

Importance

The economic and social importance of the small and medium enterprise
Small and medium enterprise
Small and medium enterprises or small and medium-sized enterprises are companies whose headcount or turnover falls below certain limits.The abbreviation "SME" occurs commonly...

 (SME) sector is well recognized in academic and policy literature. It is also acknowledged that these actors in the economy may be under-served, especially in terms of finance. This has led to significant debate on the best methods to serve this sector.

Although there have been numerous schemes and programmes in different economic environments, there are a number of distinctive recurring approaches to SME finance
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...

.
  • Collateral
    Collateral (finance)
    In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...

     based lending offered by traditional banks and finance companies is usually made up of a combination of asset-based finance
    Asset-based lending
    In the simplest meaning, asset-based lending is any kind of lending secured by an asset. This means, if the loan is not repaid, the asset is taken. In this sense, a mortgage is an example of an asset-backed loan. More commonly however, the phrase is used to describe lending to business and large...

    , contribution based finance, and factoring
    Factoring (finance)
    Factoring is a financial transaction whereby a business job sells its accounts receivable to a third party at a discount...

     based finance, using reliable debtors or contracts.

  • Information based lending usually incorporates financial statement lending, credit scoring
    Credit score
    A credit score is a numerical expression based on a statistical analysis of a person's credit files, to represent the creditworthiness of that person...

    , and relationship lending.

  • Viability based financing is especially associated with venture capital.

Gap

A substantial portion of the SME sector may not have the security required for conventional collateral based bank lending, nor high enough returns to attract formal venture capitalists and other risk investors. In addition, markets may be characterized by deficient information (limiting the effectiveness of financial statement-based lending and credit scoring). This has led to claims of an "SME finance gap" – particularly in emerging economies
Emerging markets
Emerging markets are nations with social or business activity in the process of rapid growth and industrialization. Based on data from 2006, there are around 28 emerging markets in the world . The economies of China and India are considered to be the largest...

. At a workshop hosted by The Network for Governance, Entrepreneurship & Development (GE&D) in Geneva in July 2008, SMEs that fall into this category have been defined as Small Growing Businesses (SGBs).

There have been at least two distinctive approaches to try to overcome the so-called SME finance gap.

The first has been to broaden the collateral based approach by encouraging bank lenders to finance SMEs with insufficient collateral. This might be done through an external party providing the collateral or guarantees required. Unfortunately, such schemes are counter to basic free market
Free market
A free market is a competitive market where prices are determined by supply and demand. However, the term is also commonly used for markets in which economic intervention and regulation by the state is limited to tax collection, and enforcement of private ownership and contracts...

 principles, and they tend to be unsustainable. This sector is increasingly called the Meso-finance sector.

However, there are no evidence of any significant structural barriers to the supply of bank or private equity finance to suitable SME applicants on mutually satisfactory terms and conditions in Britain. The main obstacles to funding here appear to be on the demand rather than the supply side of the business finance market. This is mainly in the form of:
  • Lack of satisfactory business plans, accounting and other information;

  • Inadequate assets for use as security; and,

  • Insufficiently high levels of profitability, gearing, liquidity, stability, and other business-financial performance criteria on the part of funding applicants.


Thus, the second approach has been to broaden the viability based approach. Since the viability based approach is concerned with the business itself, the aim has been to provide better general business development assistance to reduce risk and increase returns. This often entails a detailed review and assistance with the business plan
Business plan
A business plan is a formal statement of a set of business goals, the reasons why they are believed attainable, and the plan for reaching those goals. It may also contain background information about the organization or team attempting to reach those goals....

.

A common aim or feature of the viability based approach is the provision of appropriate finance that is tailored to the cash flow
Cash flow
Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.Cash flow...

s of the SME.

Although the returns generated by this approach in less developed countries
Developing country
A developing country, also known as a less-developed country, is a nation with a low level of material well-being. Since no single definition of the term developing country is recognized internationally, the levels of development may vary widely within so-called developing countries...

 may not be attractive to venture capitalists, they can be significantly better than conventional collateral based lending – whilst at the same time being less risky than the typical venture capitalist business. Thus, a new, distinct asset class, offering a new avenue for diversification, is available to investors. With higher profitability than traditional SME finance and lower risk than traditional venture capital, this sector has been named the "growth finance sector".

In the past, a significant obstacle to applying this approach in less developed countries has been getting the information required to assess viability, plus the costs of transferring and providing business development
Business development
A subset of the field of commerce, business development comprises a number of techniques and responsibilities which aim at:1. Researching new types of business/products/services with an emphasis on identifying gaps in the mitigation of needs of potential clients .2. Attracting new customers3...

 assistance. However, in the last several years, improved information and communications technology have made the process easier and cheaper. As technology and information sharing continue to improve, the approach could become significantly more cost-effective and attractive to established financiers with viability based approaches, and to consultants providing business development assistance to SMEs in other, more mainstream areas.

Some investors have promoted this approach as a means of achieving wider social benefits, while others have been interested in developing it largely in order to generate better financial-economic returns for shareholders, investors, employees, and clients.

A new organisation, Aspen Network for Development Entrepreneurs (ANDE), has been created to bring the growth finance stakeholders together, with the view to evolve into an association serving the sector, similar to what venture capital or microfinance associations do. They have declared their target audience to be Small Growing Businesses.

In 2008, a group of financial service providers and other stakeholders came together to form the Finance Alliance for Sustainable Trade (FAST). FAST is an association of financial service providers explicitly committed to improving access to finance
Access to finance
Access to finance refers to the possibility that individuals or enterprises can access financial services, including credit, deposit, payment, insurance, and other risk management services...

 for sustainable SMEs—defined as SMEs that are compliant with one or more of a host of growing sustainability standards (such as organics, fair trade, forest stewardship council etc.). FAST states that one of its objectives is to improve access to finance for SMEs by linking sustainable trading relationships with sustainable production practices—both of which have been observed to reduce the risk profile of SMEs in traditionally high risk sectors.

The management of business lending

The effective management of lending to SMEs can contribute significantly to the overall growth and profitability of banks. There has been considerable research and analysis into the methods by which banks assess and monitor business loans, manage business financing risks, and price their products – and how these methods might be further developed and improved.http://books.google.co.uk/books?id=qDsx9Omyh0gC&dq=isbn:0906321182

There has been particularly intensive scrutiny of the kinds of business financial information that banks use in making lending decisions, and how reliable that information actually is.

Banks have traditionally relied on a combination of documentary sources of information, interviews and visits, and the personal knowledge and expertise of managers in assessing and monitoring
Monitoring
To monitor or monitoring generally means to be aware of the state of a system. Below are specific examples:* to observe a situation for any changes which may occur over time, using a monitor or measuring device of some sort:...

business loans. However, when assessing comparatively small and straightforward business credit applications, banks may largely rely on standardized credit scoring techniques (quantifying such things as the characteristics, assets, and cash flows of businesses/owners). Using such techniques – and also centralizing or rationalizing business-banking operations generally – can significantly reduce processing costs. Standardized computer-based assessment may also be more accurate and fairer than reliance on the personal judgments of local bank managers. As a result, banks may now be able to offer more loans, faster and in larger amounts, and reduce previously high security requirements.

However, business lending as a whole is substantially more diverse and complex than personal and residential mortgage lending. This, coupled with the large size and inherently risky nature of many business loans, tend to limit the scope and desirability of computerized credit scoring in assessment and monitoring.

External links

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