A key stimulator of economic development in India, small and medium enterprises (SMEs) face much difficulty in accessing finance. Though fund flows to the sector have improved of late, the gap between demand and supply for funds remains wide. Several factors contribute to this stifling business environment.
The prime reason is the reluctance of financial institutions or investors to lend to SMEs, given the high risks associated with their businesses. The inherent problems of small enterprises, like the lack of transparency and non-adherence to accounting norms, act as deterrents in financing them.
Banks have been a major source of finance for SMEs. But bank lending to the sector is far below the demand. That?s because banks perceive SMEs are as high-risk enterprises, since these enterprises operate in a highly uncertain and competitive environment and tend to have more variable rates of return compared to large companies. Moreover, the lack of competitiveness?owing to old technologies and unskilled resources?and historically high failure rates of some segments have inculcated a sense of risk-aversion in lenders. The risk of default tends to be higher, given that in many instances the property or the business of an SME is not properly registered and its accounting system is mostly poor. Because of such issues, even enterprises with good growth potential are denied funds from the formal sources.
A major impediment faced by financial institutions in lending to SMEs is inadequate information about the business of an enterprise. Informational asymmetries dampen lender/investor confidence as it is difficult for him to gauge the risks associated with a project and price the loan accordingly. In many instances there is no transparency in fund utilisation once the loan is disbursed. This makes the portfolio of the lender riskier.
SMEs incur high transaction costs for activities like appraising a loan application or conducting a due diligence or credit rating exercise, given their high risk profile. These activities are independent of the size of financing and involve huge administrative and related charges. Moreover, if financing is done through equities or debt, an additional burden of high marketing expense has to be borne by the enterprise. The lack of effective management information systems in financial institutions, undeveloped state of the economic information industry and poor state of public services like registration of property titles add to the transaction costs of financing.
This is not all. SMEs? poor knowledge about managing the business, opportunities, government policies is a barrier to their growth. Even in well-established businesses, there are indications that their knowledge of financial instruments is limited. SMEs tend to use the traditional modes of financing and are reluctant to try out new avenues of fund-raising. Apart from banks, SMEs source finance from venture capitalists, NBFCs and bonds. Venture capital funds? investment in SMEs has seen some improvement in the last few years. However, because of non-transparency, SMEs have not been able to fully use this mode of financing. SMEs are also increasingly being financed by NBFCs. However, informal finance, which has significantly high borrowing cost, makes up a large part of SME financing.
Funding constraints impair the functioning of SMEs and hamper their competitiveness in domestic and international markets. That begs for a business-friendly environment that synchronises the needs of both the demand and supply sides.
The author is senior economist at Dun & Bradstreet India