Research proposal writers
2.1 Challenges of loan acquisition by SMEs
Adenuga, (2004). indicates that access to bank credit by SMEs has been an issue repeatedly raised by numerous studies as a major constraint to industrial growth. A common explanation for the alleged lack of access to bank loan by SMEs is their inability to pledge acceptable collateral.
The differences in the financial institution structure and lending infrastructure affect the availability of funds to SMEs (A.N, Berger & G.F Udell, 2004). These differences may significantly affect the availability of funds to SMEs by affecting the feasibility with which financial institutions may employ the different lending technologies (be it transaction lending or relationship lending) in which they have comparative advantage to provide fund to different businesses. Transaction lending technologies are primarily based on “hard” quantitative data such as the financial ratios calculated from certified audited financial statement among others. Relationship lending on the other hand is based on “soft” qualitative information gathered through contact overtime with SMEs. This soft information may include the character and reliability of the SME’s owner based on direct contact overtime by the financial institution.
Most SMEs in the country lack the capacity in terms of qualified personnel to manage their activities. As a result, they are unable to publish the same quality of financial information as those big firms and as such are not able to provide audited financial statement, which is one of the essential requirements in accessing credit from the financial institution. This is buttressed by the statement that privately held firms do not publish the same quantity or quality of financial information that publicly held firms are required to produce. As a result, information on their financial condition, earnings, and earnings prospect may be incomplete or inaccurate. Faced with this type of uncertainty, a lender may deny credit, sometimes to the firms that are credit worthy but unable to report their results (Stevenson, L., & St-Onge, A. (2005)..
SMEs face more challenges in doing business than large enterprises because of the difficulties in financing start-up and expansion. This is because the initial cost of starting any business in countries requires legal documentation which affects the ability of SMEs to be able to legalize and have the advantages of getting a loan from a financial Bank Olutunla, G. T., & Obamuyi, T. M. (2008).
Schiffer and Weder (1991) found that small firms tend to experience more difficulties than medium-sized firms, which also experience more difficulties than large firms. In most countries, especially developing nations, lending to small businesses and entrepreneurs remain limited because financial intermediaries are apprehensive about supplying credit to businesses due to their high risk, small portfolios, and high transaction cost.
The cost of transaction contributes to the inability of the SMEs to access finance. They are of the opinion that “if transaction cost of lending are high the net margin banks expect from loans operation do not compare favourably against safe investment represented by treasury bonds Adenuga, A. O. (2004). If a lender face information asymmetry, the issue often becomes somewhat persuasive authority he or she holds in ensuring repayment. These push up transaction cost as the probability of default is assumed to be high and has to be contained. Thus lenders may avoid lending to smaller or lesser known clients or impose strict collateral requirements when they do. They may perceive clients in ways that would overcome the latter own perception of the difficulty in obtaining formal finance.
The internal organization of most banks is such that SMEs applying for loans deal with branch staffs that have little say in the decision, whereas major decisions are taken at the head office of official who know little about the enterprise. This arrangement ensures that many potential SME borrowers do not have the chance to interact with the few trained project personnel before applications are made. There is a high probability that many potential good project are turned down because distant credit officers lack enough undocumented information to form an opinion on the projects and especially on entrepreneurs (Nelson & Victor 2009).
Despite SMEs strong interest in credit, commercial banks profits orientation may deter them from supplying credit to SMEs because of the higher transaction cost and risk involved. First, SMEs loan requirement are small so the cost of processing the loan tend to be high relative to the loan amounts. Second, it is difficult for financial institutions to obtain the information necessary to assess the risk of new unproven ventures especially because of the success of small firms often depends heavily on the ability of the entrepreneur. Third, the probability of failure for new small ventures is considered to be high (Chomisengphet & Liu 2006).
Atieno, R. (2006) however indicates that other alternatives to loans secured by real and movable property have practical constraints. For example, it is possible to take security interest in liquid assets, the foreclosure upon which is much quicker than that for real and movable property. However many debtors especially traders are not in the habit of saving money in liquid accounts, rather they turn to either move it into the informal economy or reinvest in their business. Another alternative would be for the banks to accept the assignment of contractual benefits from borrowers.
Loans enables the poor and excluded section of people in the society who do not have an access to formal banking to build assets this enables them to open up small scale business which enables them to have a better quality of life (Littlefield and Rosenberg, 2004).
There are broadly two sources of financial services. One of the sources is the formal banking sector while the other one is the informal sector. The formal banking sector serves less than 20% of the population in developing countries. The rest of the population, typically low-income households, has historically not had access to formal financial services (Chiumya, 2006).
Offering loans to SMEs helps in combating poverty especially in rural areas. Most countries offer loans to rural residents to help them engage in small scale business to help bridge the gap between the rich and the poor, this has been practiced in most countries in Africa and Asia were majority of the low income earners live, this has helped such people to set up small scale business to and created jobs in both rural and urban areas (Mwengei, & Ombaba 2013).
According to Waweru & Kalani (2009) financing decisions should not affect product market outcomes, as long as financial and product markets are perfect. So, Franck and Huyghebaert (2008) argue that leverage can affect firm performance only when some market imperfections pertain. When outside financiers according to Huyghebaert (2008), do not have the same information about firm quality as do firm insiders and when it is difficult for insiders to credibly transfer this information to outsiders, an important financial market imperfection arises.
Loans enables SMEs to expand their business operations . This enables the business organization to take up numerous new challenges hence helping the organization to achieve high level of profitability in the organization. As a number of authors have already shown that profitability is an important determinant of firm growth, through the use of retained earnings Setyawan, (2005). examining the link between leverage and internal cash generation in the context of business start-ups can make a further contribution to the literature. Other studies on small and medium enterprises have shown that small and medium-sized enterprises are financially constrained and face a financing gap.
Loans provided SMEs is essential for the organizations to aquire new technologies in the current globalized ever changing world business. Acquisition for new technologies enables the organization to be able to attain high levels of cash-flow investment sensitivities are typically large for small and medium enterprises and particularly for the smallest and unquoted among them (Adenuga, 2004) .
By the use of loans SMEs are able to pay up the loans. According to Olutunla, & Obamuyi, (2008) a firm’s debt level and its value is positively related especially when shareholders have absolute control over the business of the firm and it is negatively related when debt holders have the power to influence the course of the business. However when the organizations has much debts it’s not able to cover up its expenses this will therefore affect the organizational performance. Debt is always desirable if a firm achieves relatively high profits as it results in higher returns to shareholders (positive leverage). If a firm incurs a major drop in income, employing more debt in the capital structure will be detrimental as the firm won’t be able to cover the cost of debt (negative leverage).
Steel & Andah (2004) point out that in the case of small firms, the expected costs of bankruptcy is quite high and the expected costs of financial distress may outweigh any potential benefits from tax shield. Also, the advantage of the tax shield of debt is limited for small firms. Many small firms have limited revenues and the variability of their operating income can be quite volatile therefore the ability to obtain loans by the organizations helps SMEs to be able to meet its tax obligations.
According to Quagliarello, (2007) asserts that loans helps in the improvement of livelihood of the people in a given society, which helps in improving on their capabilities and assets (including both material and social resources) and activities required for a means of living.
Od Consult Ltd. (2004) states that Small and medium sized enterprises are more innovative than larger firms. Many small firms bring innovations to the market place, but the contribution of innovations to productivity often takes time, and larger firms may have more resources to adopt and implement them.
Developing countries such as Zimbabwe have also identified the potential of small firms to turn economies with negative growth into vibrant ones. For this reason, several governments in developing countries offer funding to small firms either directly or by guaranteeing the payment of such loans as lack of funding is cited as one of the major challenges faced by small businesses
SMEs are often relatively new and lack a consistent track record of profitability that would demonstrate the capability to repay a loan. In addition, many SMEs lack assets that could be used as collateral.
2.3 Relationship between loan performance and development of SMEs
Due to the high collateral requirements, unfavorable interest rates and untimely delivery of credit
SMEs are reluctant to obtain loans. In addition, access to credit by SMEs is limited since banks have failed to expand SME loans due to imperfect information, high transaction costs, large number of borrowers and low returns from investments. This will result in reduced financial performance in terms of sales, profits and liquidity (Olutunla and Obamuyi, 2008).
Shortage of finance and the high cost of loan funds negatively affect financial performance of SMEs. Indeed, in Njanike, K. (2009), it is reported that the persistent constraints on SMEs financing, and the restrictive terms and conditions on approved loans, are a universal and significant problem among SMEs in developing countries. In presence of favourable credit terms, access to finance is enhanced. Hence a firm can invest in more ventures and increase its sales volume.
Majority of SMEs still face inadequate financing to support their private initiatives. This is due to the high transaction costs and inability of SMEs to provide collateral required by banks. Higher sales volume and production will lead to increased revenues and profitability which means improved financial performance (Beyene, (2002).
The strong relationship between lenders and borrowers it is highly unlikely that the borrower fails to honour his debt, otherwise it would be very difficult to find other banks willing to grant loans at the credit terms. Consequently when SMEs meet their loan obligations financial performance is improved (Berger and Udell, (2015).
Due to limited access to long-term loans SMEs find it difficult to finance their capital investment and daily operational needs. SMEs have to pay a higher rate of interest and comply with more restrictive requirements on institutional credit obtained by them. In the presence of favourable credit terms, there is improved access to credit and therefore financial performance will be enhanced (Setyawan, 2005).
Additionally, the coefficient of loan amount is associated with financial performance of SMEs. This implies that bank loan is positively related to firm’s profitability and that profits of SMEs tend to increase with increasing amount of loans. The financing decision impacts upon the profitability of an enterprise affecting the performance of SMEs the use of banks‟ financing by SMEs is associated with higher business performance (Quagliarello, M. (2007).
Small and medium enterprises (SMEs) are always constrained in accessing capital, especially from the formal financial institutions. The lack of accessibility to finance the enterprises, therefore, is attributed to both the supply and demand factors in lending. On the supply side, banks are reluctant to grant loans to SMEs because of lack of reliable information on borrowers, low transparency of operations and poor accounting standards, lack of discipline in the use of credit facilities, the perception of the SME sector as risky, and difficulties in enforcing loan contracts (Saba, & Azeem,2012).
On the demand side, borrowers are constrained by the absence of collateral, improper bookkeeping, high rates of loan diversion and their inability to prepare feasibility studies. In less developed countries where there is a dearth of information on the operations of SMEs, there is always risk aversion by the financial institutions in funding the sector (Ogujiuba, 2004).
2.4 THEORETICAL FRAME WORK
The study Will be guided by the two theories; the principal -agent model and budget theory by John Forrester and the open systems theory by Ludwig Von Bertalanffy. Forrester (1974) observed that at the heart of public financial management practices are relationships among those who provide agency services and those who allocate resources to service providers. In other words those who make claims on government resources are agents and those who allocate and ration resources are principals. In this relationship, the principals contract with agents to provide Loans to SMEs.
On the other hand, in 1956, Ludwig Von Bertalanffy developed an open systems theory in which he recognised that one way to study an organization was to consider it as an open system in constant interaction with the internal and external environment. According to Bertanlanffy as cited in Basu (1998), Open systems theory constitutes both inputs and outputs. For the purpose of this study, inputs will include Loan performance and the growth and development of SMEs.
