Exploring Financing for Small and Medium Enterprises (SMEs)

How do we define SMEs?

The SME Policy Framework developed by the Ministry of Industries of Sri Lanka in 2017, defines SMEs as any business entity or enterprise which has less than 300 permanent employees and has an annual turnover less than Rs 750 million.

SMEs play a major role in economic development of a country and are identified in most countries as the “backbone” of the economy. SMEs in Sri Lanka, varies from well-established and structured companies to extremely small-scale operations which are run with one or two employees.

How are SMEs financing requirements unique compared to large businesses

It is good to set context as to why SMEs financing requirements are unique compared to large corporates. Let’s focus on following distinctive points related to SMEs:

1. Lack of formality in approach to work with overlap between the owner’s personal income, assets/expenses and liabilities with the business. This is also caused by the lack of understanding of the importance of financial reporting and auditing.

2. Heavy reliance on one individual/owner to run the show.

3. Lack of awareness to manage the working capital needs and weak focus on cash, debtor and creditor management.

4. Reliance on self-funding the business or relying on informal sources to keep the business afloat. This causes SMEs to take loans at higher borrowing rates and unfavorable repayment terms.

SMEs should try to strengthen these areas to improve their business and develop resilience to face challenging times such as on-going pandemic.

Why should SMEs focus on Working Capital Management?

SMEs are always exposed to various changes in the external environment, and therefore they need a sharp focus on working capital and day to day cash management. It is important to note that the working capital is considered the “lifeblood “of any business where the company should be fully focused on business priorities. Any slight disruption to working capital could lead to the failure of a business. Also, it is important to understand that most SMEs operate with very thin profit margins and, therefore, any increase in the cost of production could erode their profits as well as capital. Therefore, SMEs should keep in mind that they need consistent financing provided by credible sources to support operations at all times.

How can SMEs overcome some of the challenges in accessing finance?

Accessing affordable finance for SMEs is always challenging due to several reasons. As highlighted before, it is important to maintain a proper set of accounts to assess the profitability and financial position of a SME clearly.

It is also important to understand the role of credit worthiness in obtaining finance for SMEs. Certain SMEs may avoid maintaining proper financials due to the fear of paying taxes. However, this makes it difficult for financial institutions to assess the creditworthiness of the company. Financial institutions are under the strict regulation of the Central Bank as they are operating with the general public’s deposits. Hence, when lending, unless SMEs establish their creditworthiness and the repayment ability, formal institutions cannot lend freely.

The lack of assets to be used as security for loans, commonly known as “collaterals’ also make it difficult for SMEs to access finance. This has resulted in financial institutions becoming further careful and restrictive in lending. When SMEs are unable to seek facilities from formal institutions like banks and registered finance companies, they have no options but to seek support from informal sectors at unaffordable interest rates and credit terms, which is severely affecting business growth. This can lead to a deep deterioration of their income and profitability.

Therefore, maintaining financial records is important for a SME. These financial records need not be perfect, but a simple recording of income, expenditure, assets, and liabilities would go a long way. Additionally, every SME should have a clear written business plan for themselves as these will help them obtain financial support from the formal financial institution.

What should SMEs know about Financing facilities?

SMEs should always have a basic understanding of bank facilities and various types of financial instruments that are available for them. In this context, SMEs should know their requirement in advance, to decide whether they need short-, medium- or long-term facilities. The golden rule here is that short term facilities such as bank overdraft or short-term loans should be used for short term use such as payment of salaries, utility bills, financing a supplier etc.

The medium-term requirements such as purchasing a vehicle, soft machinery, should be backed by medium-term financing arrangement such as a finance lease or term loan.

Finally, long terms requirements such as investments in land, building and machinery should be financed through long-term loans or owner’s capital which is referred to as ‘equity’.

At the same time, it is crucial that the SMEs should critically evaluate their debt serviceability as high debt levels would be detrimental to the sustainability of any business. In addition, the ‘gearing ratio or debt to equity ratio should always be maintained at healthy levels.

In conclusion, these are just a handful of business tips on exploring finance for SMEs. However, in any complex situation, businesses should obtain expert advice accordingly to the specific requirement. The focus of this article is to help businesses to structure themselves for long term continuity of their business and seek professional advice for individual financing requirements.

This article is a part of the Business Tips for Trading Across Borders series — A collaborative effort of 
The Ceylon Chamber of Commerce and United States Agency for International Development (UASID) Partnership for
Accelerating Results in Trade, National Expenditure and Revenue (PARTNER) Activity
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