SME FINANCING IN INDIA

Akshay Thusoo, Manu Goyal

MBA Department, Christ University Institute of Management
Bangalore

akshay.thusoo@mba.christuniversity.in
manu.goyal@mba.christuniversity.in

Contact Details: -

Akshay Thusoo (09663384924)

Manu Goyal (09379827954)

3

Abstract—
Small and Medium Enterprises (SMEs) have capacity to pay. Second, relative to large firms,
topped the agenda of all political parties, and SMEs are more likely to be informal. This not
policy makers of India since Independence. The only makes opaqueness worse. Third, capital
special thrust to this sector has been with the markets do not compensate for these deficiencies.
multiple objectives of employment generation, To the extent that “opaqueness” has received
regional dispersal of industries and as a seedbed special attention in the literature on SME
for Entrepreneurship. Furthermore, most large financing, so has “relationship lending,” with the
companies usually start as small enterprises The latter seen by the conventional view as the
contribution of SMEs has been remarkable in the obvious way to cope with the former
industrial development of the country. SMEs
contribute approximately 40% of India’s domestic In this paper, we explore whether and to what
production, almost 50% of total exports and 45% extent the Indian SME’s are facing problems in
of industrial employment. More importantly, they accessing finance, particularly in the financial and
are the second largest manpower employer economic crisis and suggestive measures to
overall after agriculture employing approximately overcome this problem.
19 million people.
Keywords— Financing, small and medium
The recent attention on SME financing also
enterprise, small business, technology-based
comes from the perception among academics and
SME, Malaysia
policymakers that SMEs lack appropriate
financing and need to receive special assistance.
Many studies find that SMEs are more financially I. INTRODUCTION
constrained than large firms. Many studies find In the current scenario, if we talk about the
that SMEs are more financially constrained than product and process innovation, the most ignored
large firms. The “conventional wisdom” argues section of the industry that cannot be ignored any
that the inadequate financing of SMEs is to a more is the Technology based Small and
significant extent rooted in “supply-side” Medium Enterprise or popularly termed as SME
features. The conventional view highlights a industry. These enterprises play a vital role in
number of factors that might constrain financial egressing the latest technology based sectors of
institutions. To start, financing SMEs is difficult the industry and in preserving and enhancing the
because they are opaque. Opaqueness means that economic competitiveness of the established
it is difficult to ascertain if firms have the industries. The long term health of the economy
of a country is highly dependent on the strong expand or contract in a short time. SMEs have not
domestic technology sector. only survived the impact of big enterprises and
the law of economies of scale but have carved out
Over the past decades, many developments have niches for themselves, which enable them to
occurred in public and private sector markets coexist with big enterprises. So far, the lack of
serving SMEs in India. The definition of SMEs access to market information and technology, the
varies from country to country. The classification low quality of human resources and the lack of
can be based on the firm’s assets, number of access to capital has proved to be few of the
employees or annual sales. The International common problems of SMEs so far. Financial
Finance Corporation defines SMEs as firms with institutions and public-sector bodies have
less than 300 employees and total assets less than concentrated a lot to bridge the funding gaps but
US$15 million. In smaller economies, SMEs are till the time they continue to experience difficulty
defined as less than 20 employees. Whatever the in obtaining risk capital.
definition, and regardless of the size of the These funding gaps relate to firm size, risk,
economy, the growth of SMEs throughout the knowledge, and flexibility. SME borrowing
region is crucial to regional growth. requirements are small and frequently do not
appeal to financial institutions. Collateral required
The most premier and critical role that SMEs play may be more than what SMEs can pledge. What
is, ofcourse, can be judged so far, is, that financial institutions
• in providing jobs to the needful may lack expertise in understanding small and
• enhancing the quality of human resources medium Knowledge-based business. The terms

• nurturing a culture of entrepreneurship and conditions of financing may still not be

conducive in accordance to the requirements of
• breeding the creativity and
SMEs.
• opening up new business opportunities.

III. FUNDING OPTIONS

II. FUNDING THE SMES – A VITAL ISSUE
The major boost for the SMEs to spring up, to Let us now have a brief overview of some of

reposition, adjust themselves quickly in response the possible funding options available their in the
to market and economic changes, has been as a market.
result of flexibility, as well as low start-up and
operating costs. To add to this , they can easily Credit Unions, Leasing Companies
Options for funding at the start-up stage include
credit unions, leasing companies, personal finance
and contributions from family relations.

Private Equity and Venture Capital

The venture capital in the United States has

developed without any official government policy
and to finance high technology firms that are
“informationally opaque,” often without tangible
assets and established products and markets. If we
take the case of United States, venture capital
accounts for only a small part of SME financing Taxes, the regulatory framework, and
(fewer than 2%) concentrated in certain industries funding policies differ greatly across
considering private equity funds from institutional economies, which affect the efficiency of
investors (primarily pension funds and wealthy transfer of capital.
individuals), these are typically structured as
limited partnerships with fixed lives (usually There is evidence that private equity in economies
around ten years) and general partners responsible like Korea and Japan is used to replace sources of
for making investments with incentive-based funding not available from traditional institutions
compensation schemes. which can also be implemented in India. Private
equity is not restricted to finance blue-chipfirms
To respond to issues raised by investors, only , but rather to finance therestructuring of
venture capital funds typically demand board established firms in the traditional industries. We
representation and play an active management can see this as an open opportunity to uplift, both,
role, which may not be acceptable to some the morale and status of SMEs.
(family-owned) firms. There has been rapid
growth in venture capital and private equity in Banks
Asia since
the Asian financial crisis. Industries that are traditional and are also
possessing some tangible assets along with a well
run business, can often raise funds from sources banking is an excellent opportunity to improve
like banks. Indian banks, that are growing rapidly SMEs’ access to finance as well as the credibility
with their balance sheets often touching skies are of
both, keen and capable of lending money. lenders.
Government needs to bridge this gap between the
SMEs and the banks by considering the lending A revised Code of Practice for Business
rates. Also the return period should consist some Banking should include:
kind of relaxation to encourage more and more
entrepreneur to come and raise their capital via A commitment to give adequate notice of
loans. Analysis of SME financing in the U.S. changes to terms of service. In particular,
suggests that banks and traditional credit-granting withdrawing or reducing credit facilities will
institutions still provide the largest source of require notice periods much longer than 30 days,
outside financing. The constraints before the allowing SMEs to plan their cash flow, seek
banks to go for the deal with SMEs are: advice and arrange alternative funding.

• Lack of accurate reliable information on A commitment to facilitating access to

the independent financial advice. Information on
financial condition and performance; independent sources of financial advice should be
• Unconvincing and weak business plans; offered to all new business customers.

• Weakness in SMEs management, market A commitment to discouraging late payment of

links, suppliers. Anecdotal evidence suggests that

• Governance and information technology. businesses have, in some cases, been advised to
use late payment as a formof free credit.
Therefore, we can conclude that banks need to
adopt appropriate lending technologies and
operation systems to enable them to realize the IV. RAISING FUNDS THROUGH CAPITAL
market potential and to lend profitably to small MARKETS
businesses. The reason of separately discussing the funding of
SMEs through capital market is because of its
The government’s and banks’ recent commitment huge investment options. Avoiding the traditional
to a revised statement of principles on business funding option from banks, SMEs often or should
turn to fund growth by raising equity on the Stock
Exchange. They can spread and share the risk of
high growth strategies by sharing equity V. SME-FINANCING--ISSUES AND
ownership. The Stock Exchange facilitates STRATEGIES
marketable shares to
SMEs, if developed and practiced on modern
acquire other companies. Apart from the mention
lines shall primarily remain profitable options for
need of raising funds, listing on the Stock
banks and can guarantee earning for banks at a
Exchange
rate higher than the lending to corporate clients.
can increase corporate profile.

There exists strong evidence that SMEs

But the unpopularity or refraining of SMEs from
expansion boosts employment more than large
the Stock Exchange so far is understandable. The
firm growth because SMEs are more labour
cost of listing to raise a small amount of funds has
intensive. In Pakistan, the SME sector contributes
proved to be as costly as raising large amounts of
30 percent towards the country’s GDP, along with
funds. The increasing pressure for continuous
agriculture provides 90
disclosure places great pressure on small
percent of the jobs, accounts for 35 percent of the
management teams.
value added in the manufacturing industry and
generates 25 percent of manufacturing sector
The costs of listing and ongoing compliance costs
export earnings ($ 2.5 billion). Given its huge
combined with requirements for continuing
potential for generating employment, the
disclosure have been a disincentive to small
Government has identified the SME sector as one
growing companies with limited management
of the leading sectors along with agriculture and
skills. The high-risk nature of these small
construction and housing which will spearhead its
businesses and the limited information
efforts towards generating employment to
they can provide has not attracted support
alleviate poverty in the country within the
from the brokers so far.
framework of the Pakistan Poverty Reduction
Strategy Paper. While the sustained and long-term
The major aspect in public securities market, that
growth of the SME sector in Pakistan remains
is most required is “disclosure". Track record is
constrained by a number of factors that include
important when investors are comparing options.
skills shortage, scarcity of capital goods, poor
The lack of such disclosures in a proper manner is
management, lack of data on the sector, resistance
a major reason for the investors showing their
to change and marketing difficulties especially for
back to SMEs.
export-oriented SMEs; by far the biggest problem
facing the sector is the unavailability of adequate VI. ROLE OF GOVERNMENT
financing facilities. The problem of limited access
Government can uplift the status and working
to credit for the SMEs is not exclusive to Pakistan
capital of SME by modifying the supply of
as a recently conducted World Business
funding for SMEs. It can do so by introducing
Environment Survey covering 4000 firms in 54
rules and regulations to encourage banks, venture
countries found that SMEs cited
capitalists and capital markets to create uniquely
inadequate access to finance as their primary
tailored programs, for example, directing venture
constraint to growth. This sector is characterized
capital to seed firms in growth sectors and
by information asymmetries; the creditors’ search
supporting pension funds participation in venture
costs, information acquisition and processing
capital funds and
costs exceed the returns. Hence, there is risk
tax incentives. Impacts of globalization such as
aversion by the banks towards extending credit to
global competition, rapid changes in technology
small and medium enterprises.
and the evolving market conditions add to the
high risk of funding fast-growing small
businesses. R&D costs are rising. Strategic
It is relatively easy to lend to large corporates
alliances are increasing,
where the economies of scale, published financial
particularly, cross-border alliances. Mergers and
information, collaterals and creditworthiness
acquisitions cross borders. Information networks
parameters favour such types of lending. As the
are becoming more sophisticated, for example,
small businesses cannot offer adequate collateral,
through development of clusters.
the banks are unable to determine whether the
borrower possesses technical, managerial and
In working with the Small Business Finance
marketing skills that will allow him to generate
Forum, the government has correctly identified
adequate cash flows and repay the loan on time.
access to advice as being central to SMEs’
The process of financial intermediation therefore
financing problems. Its efforts to provide free
breaks down for the SME borrowers. Therefore,
credit management advice must be
the need of the hour is that we take more holistic
complemented by encouraging the use of
view of this problem, instead of looking at the
professional financial
issue of financing to the SMEs in isolation. We
advice, especially as the credibility of lenders
actually are in need of a large number of players
diminishes. SMEs taking financial advice from
to work for the uplifment of the SME sector.
accountants, the most popular source, are still themselves can act as trusted, unbiased mentors to
outnumbered by those that take no advice at all. SME owner managers and regional development
Yet agencies (RDAs) should show more strategic
those with access to accountants and financially leadership by
qualified managers are likelier to secure the supporting more high quality, sustainable local
finance they need, from a wider variety of mentoring services.
sources. In preparation for an even sharper
downturn in
2009, these professionals need to work with VIII. RECOMMENDATIONS
SMEs to help them manage their resources,
• Creation of a flexible environment for
navigate
the venture capital specific to SMEs
the range of finance products, build stronger
to flourish
relationships with lenders and, if necessary,
compare and switch between banks.
• Tailor credit in banks and other
similar institutions to the need of
VII. THE ROAD TO RECOVERY
small firms

Themarket for SME finance is under a great deal

of strain; it will take government support and • Give a greater emphasis on training
commitment fromlenders to restore it to health. programs to help banks’ staff
But the SME sector has entered this recession in understand the unique requirements
good financial health.With adequate advice and of SMEs better
targeted support it should recover before too long.
This, however,will requiremore than government • Harmonization of the financial policy
funding and signposting. Effective support must framework across economies will promote
engage small business owners within their peer cross-border strategic alliances including
groups, relying on support and mentoring SMEs and facilitate transfer of
networks embedded in the local enterprise experiences between the regional
community.15 At the heart of these, open and economies.
honest communication between lenders and
SMEs, mediated by the accounting profession,
can yield enormous benefits. Entrepreneurs