CHAPTER ONE

INTRODUCTION

1.1 Introduction and Background

In Nigeria, available data from the Registrar General Department indicates that 90% of companies registered are micro, small and medium enterprises (Mensah, 2004). This target group has been identified as the catalyst for economic growth of the country as they are a major source of income and employment to many Nigeriaians. According to Mensah (2004) Small enterprises employ between 6 and 29 employees with fixed assets of $100 Thousand with Medium enterprises employing between 30 and 99 employees with fixed assets of up to $1 Million, Hallberg (2001) put forward that SMEs account for majority of firms in an economy and a significant share of employment. Like other countries of the world, SMEs in Nigeria have the tendency to serve as sources of livelihood to the poor, create employment opportunities, generate income and contribute immensely to economic growth. Small firms are the engines for economic development of several developed countries such as the US and Japan (Hallberg, 2001).

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. Obert and Olawale (2010) argues that due to limited resources by governments, not all small firms receive funding from the government; therefore, the other option would be to go for bank loans Obert and Olawale (2010). Despite its increasing roles, access to credit by

SMEs remains one major constraint to Nigeriaian SMEs. According to Augusto et al (2008), most large companies usually start as small enterprises, so the ability of SMEs to develop and invest becomes crucial to any economy wishing to prosper.

Although countries’ definitions of what constitutes an SME for legal or statistical purposes are typically based on the number of employees, banks generally define SMEs in terms of average annual sale; an indicator that is more easily observable, a good proxy of an SME level of business activity, and, thus, more useful to banks’ business and risk management purposes (Augusto et al 2008). Augusto et al (2008) further points out that the threshold of annual sales used by banks varies by country, according to the size of the economies and structure of their corporate sector. Augusto et al (2008) hints that in Argentina, a company is considered to be an SME when its average annual sales are approximately between 300,000 and 30 million US dollars. In Chile, the range goes from around 90,000 to 24 million US dollars.

In Colombia, banks consider SMEs those firms with annual sales between 400,000 and 13 million US dollars (although for most domestic banks the range is between 100,000 and 5 million. In Serbia, SMEs are typically defined as having annual sales between 500,000 and 10 million Euros. A vast number of data on SMEs in Nigeria also suggest SMEs are more financially constrained than large firms. For example, using data from 10,000 firms in 80 countries, Beck et al (2006) showed that the probability that a firm rates financing as a major obstacle is 39% for small firms, 38% for medium-size firms, and 29% for large firms.

Mensah (2004) states that a major barrier to rapid development of the SME sector is a shortage of both debt and equity financing. However Mensah (2004) postulate that equity shortage occurs because Equity investors seek highest return consistent with the risk of the investment and since SME investments are difficult to evaluate, their investments take time to mature and among others major institutional investors such as insurance companies are not allowed to invest in private SMEs. Hence there are many who believe that the single most important factor constraining the growth of the SME sector is the lack of finance.

There are many factors that can be adduced for this lack of finance according to Mensah (2004). For instance a relatively undeveloped financial sector with low levels of intermediation; Lack of institutional and legal structures that facilitate the management of SME lending risk; High cost of borrowing and rigidities interest rates. Thus Because of the persistent financing gap, many interventions have been launched by governments and development partners to stimulate the flow of financing to SMEs over and above what is available from exiting private sector financial institutions. Karimunda and Barumwete (2006) put forward the fact that, there are several reasons why a SME need a loan such us the financing of new branches, of new projects and more. Companies do not always have the capacity for finance their own business that is why they have sometimes to turn to other financers. However, when companies need new capital, they firstly resort to their internal generated funds.

After these sources, SMEs turn to equity financing by addressing closely related investors. These sources exhibit very low costs and may be for example equity capital from the owner, family or friends. Despite these, there are others types of financing that one can use: external equity financing and external debt financing. For SMEs, possibilities for using external equity finance are limited since the majority of these companies are privately managed. Companies can also use venture capitalist as alternative means of equity financing.

However, these possibilities are difficult for SMEs since most of them do not always meet the return expectations. They thereby become less attractive for this group of investors. Other alternatives to financing are private placements and corporate bonds. Unfortunately, these types of financing are too expensive for SMEs or have limited resources. Therefore bank loans seem to be an appropriate way to finance SMEs’ capital requirements and seem to be an appropriate way. As a result, SMEs prefer most frequently debt funding by bank loans. The bank financing is tremendously attractive and seems to be realistic and a more reliable source to SMEs. Mensah (2004) states that recently, as banks and other financial institutions have sought to broaden their loan portfolio, SMEs have become an increasingly attractive customer group. Traditionally, however, financial institutions in Nigeria have been cautious with lending to SME groups because of high default rates and risks associated with the sector. Few banks have therefore developed an explicit policy for SME target groups taking the particular requirements and needs into consideration, an example is the development of customized financial products and appropriate credit management systems.

Only few banks have SME specific loan products, and many of these are donor funded. Since SMEs are scarcely finance by equity due to risk in its operation amongst others, the last resort is thus debt financing and this is usually financed by financial institutions through the granting of loans. Debt financing according to Ayadi et al (2009) continues to be the primary source of financing for SMEs in Europe, much more important than venture capital. This implies, for one thing, that an efficient functioning of credit markets is of utmost importance for SMEs – and the economy at large – to thrive. This problem seems to be particularly severe in transition economies, whose catching-up may suffer from continued wide-spread exclusion of SMEs from external bank finance. Of recent, there has been an increase in the recognition of the role played by small firms in national economies. Their contribution to job creation and poverty alleviation has been recognized by several governments of developing countries to the extent that they now include them in their development plans.

Abor (2005) proposed among the support structures include offering funding to the small firms’ sector, usually at concessionary rates. But whether the use of such debt improves the profitability, thereby enhancing sustainability, is not well known Abor (2005). However, despite the importance of the small business sector, access to finance is a frequently cited problem. Sources of capital are more limited for SMEs compared to large firms.

Therefore, unlike large, particularly publicly-listed firms, SMEs do not have the option of issuing shares or debentures in the capital market. Even if they are allowed to participate in the capital market, the high transaction costs associated with publicly issued debt and equity will be too expensive for them. Owing to their inability to access the public debt and equity markets, SMEs tend to be heavily reliant on commercial banks as a source of debt financing (Berry et al., 2002). Research by Berry et al. (2002), documents the reliance of SMEs on bank debt as a source of financing. These researchers, however, point out that access to bank debt is, paradoxically, a frequently cited challenge for SMEs.

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. SMEs are also more prone to financial distress and failure. Commercial banks, because of these factors, consider lending to SMEs a high risk. Therefore, commercial banks often deny loans or offer loans to SMEs at higher rates of interest to accommodate the perceived high credit risk of SMEs according Coleman and Cohn (2001). The inaccessibility of debt finance to SMEs can further be attributed to information asymmetry. Rwelamila et al. (2004) indicates that this arises when one party to a transaction has better information than the other.

SMEs may have more information about their future prospects than the banks. Since banks do not have the necessary information, even small firms with profitable investment opportunities are turned down when requesting credit facilities. Banks, therefore, introduce restrictive covenants and also collect collateral from small firms to mitigate this problem Bose and Cotheren (1997).The question is what the impact of this loan on these SMEs is? Traditionally, debt finance has been viewed as less expensive than equity. It furthermore has been used both to decrease the average cost of capital and enhance shareholders returns.

However, there is a negative side to debt, since interest payments must be made regardless of market conditions. This vulnerability is an important factor that firms must consider when making capital structure decisions. In addition Glen (2004) states, there is a very strong economic and statistical link between macroeconomic variables and a firm’s ability to meet debt obligations. The macro-economic environment implies the level of aggregate demand, the level of interest rates, and the level of inflation. A positive macro-economic environment results in a rise in aggregate demand and positively impacts on the ability of a firm to meet debt obligations.

The ability to service debt becomes problematic when the macro-economic environment deteriorates; resulting in the insolvency of firms (Glen, 2004). Rwelamila et al. (2004) affirm that, during the early stages of starting a firm, many owners commit themselves to the use of debt, which might be one of the sources of finance available to them. The use of debt can be disastrous, as high interest rates and unfavorable repayment schedules are often overlooked due to the pressure of financing the firm.

Against this background, the study investigates whether SMEs in developing countries can use debt and still remain solvent in this era of high interest rates. Furthermore, SMEs often pay interest premiums and a host of non-interest fees such as application and other transaction fees when borrowing from commercial banks. The cause of this is that SMEs are considered a high credit risk compared to large firms. This high cost of funds because of increased risk increases the costs of debt for small firms.

1.2 Problem statement

Inferring from the above, SMEs serve as sources of livelihood to the poor, create employment opportunities, generate income and contribute to economic growth. There is also the potential of small firms to turn economies with negative growth into vibrant ones, not to mention the fact that most large companies usually start as small enterprises, so the ability of SMEs to develop and invest becomes crucial to any economy wishing to prosper. From the argument above the only easier finance options for SMEs are loans (Debt financing) assess from financial institutions, thus it’s necessary to examine the impact of these loans on the performance of SMEs. Are they having negative or positive impact on their performance .this is worth investigating because majority of the businesses fall within the SME category especially in developing countries.

1.3 Objectives

The general objective of this work therefore is to investigate the contributions of loans to SMEs performance.

The specific objectives of the study are:

1. To find out what SMEs classify as disadvantages and advantages of accessing loans.
2. To find out how loans provided by financial institutions are utilized by the SMEs.
3. To investigate whether loans to SMEs actually lead to increase in stated performance or otherwise.

1.4. Research questions

1. What are the disadvantages and advantages of taking a Bank Facility?
2. How do SMEs utilize loans?
3. Do SME loans affect performance ?

1.5 Relevance of the study

A research of this sort is necessary with respect to the fact that;

1. Worldwide, the SMEs have been accepted as the engine of economic growth and for promoting equitable development. Thus its leverage should be of great concern.
2. Accessing finance has been identified as a key element for SMEs to succeed in their drive to build productive capacity, to compete, to create jobs and to contribute to poverty alleviation in developing countries.
3. Small business especially in Africa can rarely meet the conditions set by financial institutions, which see SMEs as a risk because of poor guarantees and lack of information about their ability to repay loans. Without finance, SMEs cannot acquire or absorb new technologies nor can they expand to compete in global markets or even strike business linkages with larger firms (UNCTAD, 2002).

1.6 Research Methodology

1.6.1 Type of research

The research will be descriptive in nature and employs the survey method in assessing the impact of loans on SMEs development Nigeria. In order to effectively conduct a valid analysis in the presentation and analysis of the data collected on the research field, the researcher will use descriptive statistics such as tables and charts to depict the relevant data. The study will utilize primary sources of data in which structured questionnaire are extensively used.

The purpose is to generate data about the opinion and perceptions of SMEs owners in relation to the effectiveness of loans to the performance of their companies. Thus, in addition provide means of analyzing the likely impact of loans on SMEs.

1.7 Scope of study

The research covered the whole SME industry in Nigeria since one SME was picked randomly from each sector .namely primary, secondary and tertiary. Thus making it more representative of the overall Nigeriaian industrial sector.

1.8 Limitations

Although the data collected concentrated on one SME each from each industry, it might not have reflected a true representation of realistic issues, but at least it showed a bit of what happens in each Segment. Another limitation may the fact that a single researcher collected and analyze the data. Because of this, some explanations may be skewed toward personal interpretations to distort the meaning of the results. The research is also constraint with time since the time frame for the thesis is limited.

1.9 Organization of the Study

The study is divided into five main chapters and each chapter is divided into various sub sections.

Chapter one is the general introduction. It elaborates on the setup of small and medium enterprises (SMEs) and its financing options among others reviews also focuses on the impact of loans on SMEs and presents problems identified. It also presents the research objectives, rational, methodology and scope of the study.

Chapter two reviews literature related to the problem under study. It mainly reviews literature on Small and medium enterprises and access to finance, Alternative sources of financing SMEs.

Chapter three chronicles the methodology and approach for the study.

Chapter four focuses on the presentation of data and analysis of the data collected. It starts with the test Accessibility to loans and moves on to establish loans Contributions toward SMEs Sales and Marketing Activities and overall performance. Chapter five which is the final chapter is the presentation of the major findings, conclusions and recommendations.