Access to finance is a major concern for small and medium enterprises. They find it difficult to obtain bank loans like large firms do. They mainly have to count on internal funds in order to launch and run their enterprises. SMEs that look forward to improving their capital structure or de-leverage, often face economic crises. This calls for the need to ensure that the capital structures of SMEs are improved and strengthened, and that their dependence on informal borrowing is reduced.
Although banking finance is an important source of financing in the SME sector, credit constraint is likely to become a constraint in the near future. Therefore, it is important to make more financial instruments available in the money market for SMEs so that they do not have to face financial constraints. Read on to learn more about the scope of investment banking in small and medium enterprises.
Traditional Lending to the SMEs
The most common source of funding for SMEs is the traditional methods of lending such as overdrafts, bank loans, credit lines, credit cards, and so on. In this kind of lending, the borrower's creditworthiness is assessed and he is entitled to pay a certain interest amount to the creditor at a specific interval, disregarding the financial condition of the organisation or the return on investment it is earning. In this case, the interest rate may either be fixed or changeable.
However, traditional bank lending to SMEs can be risky. Monitoring and assessment become a problem since SMEs do not produce any audited financial statement that can provide information on the financial status of the enterprise. In the case of small enterprises, the line between the finances of the business and those of the owner’s personal use is often blurred. It may also happen that the entrepreneur uses the money for some other purpose.
However, to mitigate the problem, it is ideal to incorporate the use of risk management strategies like mandating the requirement of collateral.
Alternate Sources of Finance for the SMEs
Alongside the traditional way of deriving funding through banks, SMEs can also count on some alternate and more innovative sources of finance. Some of these instruments include covered bonds, securitised debts, corporate bonds, etc. Through these instruments, SMEs receive funding not through banks, but through the investors in the capital market or derivative market.
Securitisation and covered bonds are also forms of indirect financing tools that can help SMEs with their funding. Through the securitisation of SME debt, banks can easily transfer their credit risk to the money market. In this process, the SME loans are sold to some specialised companies. This helps to create new security that is backed by the SMEs’ payments.
These debts make sure that SMEs are not directly exposed to the capital markets. The SMEs receive the loan from the bank, and the extension is backed by the activities that the bank carries out in the capital market.
SMEs can also opt for asset-based finance like asset-based leasing and lending, in which an enterprise obtains funding based on the value that is generated by a particular asset during the course of its business. SMEs can also opt for trade credit instead of short-term bank lending.
SMEs can also receive funding through equity finance, where an investor provides financial resources to an enterprise in exchange for some ownership interest. The investor is also entitled to entrepreneurial risks, and the return on investment depends on the enterprise’s success. An investor may also choose to sell his share in the firm, or he may also receive his share in case the enterprise is sold.
You can learn about more financial instruments if you opt for an investment banking course.
Is Investing in the SME Sector a Good Option?
SMEs are a profitable sector and are slowly emerging as the backbone of economic activities. SMEs are also generating employment in many countries. This creates an opportunity for the banks to serve them better. Banks can also extend their digital solutions to the SME sectors.
The focus is improving the access of SMEs to finance and finding innovative solutions to combat the financial crisis, and banks are trying to bring about a holistic approach in the money market to make sure that SMEs can effectively contribute to the economy.
However, although SMEs can be a profitable option to invest in because of the high returns it is capable of generating, the risk factor is also when investing in small and medium-sized companies. If you have not done thorough research, there might be chances of an investor incurring heavy losses. Not only this, but you may also not be able to find a matching seller/buyer almost immediately. Therefore, liquidity is low in the case of SME exchanges.
SMEs can be extended support in a number of ways so that they can access financial services better. For instance, the financial sector can be assessed thoroughly so as to identify the areas of improvement and allow SMEs better access to finance. Improving the credit infrastructure can also be beneficial. SME finance can also undergo a lot of innovation in the form of e-lending platforms, e-invoicing, supply chain financing, etc. They should also be adequately informed of the best practices and the most successful models.
SMEs are important for the economic growth of a nation. They also provide employment opportunities. Therefore, it is important to make sure that they receive adequate financial support.
If you are looking forward to learning more about how investment banking can aid in the growth of SMEs, you can pursue an online investment banking certification course offered by Imarticus Learning. The course is ideally suited for finance graduates who have 0-3 years of working experience.