UNDERSTANDING TWO CATEGORIES OF FINANCING FOR SMEs
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- Category: SME toolkit
- Written by with Bridget Olotu
- Hits: 1211
Finance has been identified in many business surveys as one of the most important factors determining the survival and growth of small and medium enterprises (SMEs) in both developing and developed countries.
Access to finance allows SMEs to undertake productive investments to expand their businesses and to acquire the latest technologies, thus ensuring their competitiveness and that of the nation as a whole. Poorly functioning financial systems can seriously undermine the microeconomic fundamentals of a country, resulting in lower growth in income and employment.According to an SME finance and development company, world-wide the majority of small and medium enterprises fail due to a lack of capital and a lack of appropriate management skills. Of those that fail, one out of four fail because of a lack of capital while three out of four fail because of lack of management skills. In developing countries like Nigeria, the situation is worse as there are very few, if any, specialist finance companies that serve entrepreneurs with finance based on business viability.
Also, many SMEs do not qualify for financing for reasons such as lack of collateral, lack of financial accountability, lack of management and entrepreneurial ability and commitment, lack of corporate governance, lack of business structure, among other reasons. And without access to capital and quality business development support, the entrepreneur is unable to improve his/her management skills and knowledge. Similarly, without access to capital and business support, the growth of the small and medium enterprise sector is hampered and entrepreneurs have limited success. There are two categories of financing. They are:
1. Capital
2. Other People’s Money (OPM)
What is capital?
Capital is that form of financing for a business that is provided by the owner of the business. It is also called equity. Examples are personal savings, cash gifts, income from investments, income from sale of assets, etc. This form of financing is cheap, attracts little or no cost and puts the business owner in a comfortable position to build his/her business. However, like we hinted earlier, there are situations where the business owner needs to inject more funds into the business and cannot raise this personally. There are two options open to the business owner in this area:
Debt financing: This is when the business borrows money from an individual or institution and agrees to pay it back over a specific period of time at a specific interest rate. Companies sell debt in the form of bonds or debentures (which are long-term debts given to an individual or institution for business or developmental purposes). The entrepreneur could also borrow money from family and friends to finance their business. In this case, the entrepreneur signs a promise to repay the borrowed sum with interest. That promise is called a promissory note. Interest is calculated by multiplying the principal by the interest rate. The principal is the amount of loan, not including interest payments. If N100,000 is borrowed at 25%, to be paid back over one year, the interest on the loan is N100,000 X 0.25 = N25,000. The entire sum to be paid back then becomes = N125,000 after one year. This form of financing can be cheap; but in some cases it can also be expensive.
Advantages of debt financing
1. The lender has no say in the future or direction of the business as long as the loan payments are made.
2. Loan payments are predictable – they do not change with the fortunes of the business.
Disadvantages of debt financing
1. If loan payments are not made, the lender can force the business into bankruptcy (a situation where the business owner admits that it can no longer run the business as a result of unpaid debts).
2. To settle a debt, the lender can take the home possessions of the owner of a sole proprietorship or a partner in a partnership.
Equity financing is when part of the ownership of a business is given out or given up for a specific amount of funds injected in the business. It means that in return for money, the investor receives a percentage of ownership in the company. Companies seeking funds for expansion, growth and asset acquisition purposes go public by selling their shares to the members of the public through public offerings. Small companies can sell their shares to investors too through private placements or private arrangements.
Advantages of equity financing
1. If the business doesn’t make a profit, the investor does not get paid. The equity investor does not force the business into bankruptcy in order to get paid.
2. The equity investor has an interest in seeing the business succeed, and may therefore offer helpful advice and valuable contacts.
Disadvantages of equity financing
1. Through giving up ownership, the entrepreneur can lose control of the business to the equity holders.
2. Equity financing is riskier for the investor, so the investor frequently wants both a say in how the business is run and a higher rate of return than the lender.
Mixed Financing Option
Most businesses make use of a bit of equity and debt to run their businesses. However, smart businesses insist that in their financing arrangement, the percentage of debt to capital should be lower in order for the business not to suffocate when loan repayments are done.
Although some businesses use debt financing for their business operations, I would advise readers to consider smart ways to build up funds for their business before going for any form of borrowing.
Articles
UNDERSTANDING TWO CATEGORIES OF FINANCING FOR SMEs
Category: SME toolkit Written by with Bridget Olotu Hits: 1211
Finance has been identified in many business surveys as one of the most important factors determining the survival and growth of small and medium enterprises (SMEs) in both developing and developed countries.
Access to finance allows SMEs to undertake productive investments to expand their businesses and to acquire the latest technologies, thus ensuring their competitiveness and that of the nation as a whole. Poorly functioning financial systems can seriously undermine the microeconomic fundamentals of a country, resulting in lower growth in income and employment.According to an SME finance and development company, world-wide the majority of small and medium enterprises fail due to a lack of capital and a lack of appropriate management skills. Of those that fail, one out of four fail because of a lack of capital while three out of four fail because of lack of management skills. In developing countries like Nigeria, the situation is worse as there are very few, if any, specialist finance companies that serve entrepreneurs with finance based on business viability.
Also, many SMEs do not qualify for financing for reasons such as lack of collateral, lack of financial accountability, lack of management and entrepreneurial ability and commitment, lack of corporate governance, lack of business structure, among other reasons. And without access to capital and quality business development support, the entrepreneur is unable to improve his/her management skills and knowledge. Similarly, without access to capital and business support, the growth of the small and medium enterprise sector is hampered and entrepreneurs have limited success. There are two categories of financing. They are:
1. Capital
2. Other People’s Money (OPM)
What is capital?
Capital is that form of financing for a business that is provided by the owner of the business. It is also called equity. Examples are personal savings, cash gifts, income from investments, income from sale of assets, etc. This form of financing is cheap, attracts little or no cost and puts the business owner in a comfortable position to build his/her business. However, like we hinted earlier, there are situations where the business owner needs to inject more funds into the business and cannot raise this personally. There are two options open to the business owner in this area:
Debt financing: This is when the business borrows money from an individual or institution and agrees to pay it back over a specific period of time at a specific interest rate. Companies sell debt in the form of bonds or debentures (which are long-term debts given to an individual or institution for business or developmental purposes). The entrepreneur could also borrow money from family and friends to finance their business. In this case, the entrepreneur signs a promise to repay the borrowed sum with interest. That promise is called a promissory note. Interest is calculated by multiplying the principal by the interest rate. The principal is the amount of loan, not including interest payments. If N100,000 is borrowed at 25%, to be paid back over one year, the interest on the loan is N100,000 X 0.25 = N25,000. The entire sum to be paid back then becomes = N125,000 after one year. This form of financing can be cheap; but in some cases it can also be expensive.
Advantages of debt financing
1. The lender has no say in the future or direction of the business as long as the loan payments are made.
2. Loan payments are predictable – they do not change with the fortunes of the business.
Disadvantages of debt financing
1. If loan payments are not made, the lender can force the business into bankruptcy (a situation where the business owner admits that it can no longer run the business as a result of unpaid debts).
2. To settle a debt, the lender can take the home possessions of the owner of a sole proprietorship or a partner in a partnership.
Equity financing is when part of the ownership of a business is given out or given up for a specific amount of funds injected in the business. It means that in return for money, the investor receives a percentage of ownership in the company. Companies seeking funds for expansion, growth and asset acquisition purposes go public by selling their shares to the members of the public through public offerings. Small companies can sell their shares to investors too through private placements or private arrangements.
Advantages of equity financing
1. If the business doesn’t make a profit, the investor does not get paid. The equity investor does not force the business into bankruptcy in order to get paid.
2. The equity investor has an interest in seeing the business succeed, and may therefore offer helpful advice and valuable contacts.
Disadvantages of equity financing
1. Through giving up ownership, the entrepreneur can lose control of the business to the equity holders.
2. Equity financing is riskier for the investor, so the investor frequently wants both a say in how the business is run and a higher rate of return than the lender.
Mixed Financing Option
Most businesses make use of a bit of equity and debt to run their businesses. However, smart businesses insist that in their financing arrangement, the percentage of debt to capital should be lower in order for the business not to suffocate when loan repayments are done.
Although some businesses use debt financing for their business operations, I would advise readers to consider smart ways to build up funds for their business before going for any form of borrowing.