Corporate Finance

Problems faced when financing a small business

The following problems may be relevant to a proprietor considering financing a small business:

1. Lack of equity finance: In most cases equity finance is restricted to that contributed by the proprietor. This would effectively include loans raised which are secured upon the proprietor’s own property. Clearly, this will be a limited source of finance, particularly since a proprietor will wish to minimize the commitment of personal assets. External equity is often rejected because of the loss of control it would entail. Even if external equity finance is considered acceptable, it may be difficult to raise, and relatively expensive considering the lack of marketability.

2. Difficulty in obtaining institutional sources of finance: Investing institutions such as insurance companies and pension funds are an important source of equity capital and long-term debt capital. However, they are more interested in large companies than in similar firms. This is because, first, the perceived risk of smaller firms is greater, and second, they are more interested in large scale investments for their funds. The cost of monitoring many small investments would be much greater than a few very large investments.

3. Reliance on short-term finance: Most of the external finance of a small firm will be short-term, bank overdrafts, factoring, for example, agreements, trade credit, leasing, rentals and hire purchaser. This reliance on short-term credit-will be risky, particularly if it is used to finance long-term investments. This situation is often illustrated by small firms having a relatively low current ratio. Even this often understates the huge amount of short-term, capital small firms depend on, since much of it may be “off balance sheet” finance.

4. Dependence upon internally-generated funds for long-term capital: This dependence can produce problems if a sudden deterioration in cash flow generation occurs. It may also present problems for a high-growth firm where the cash generated is not sufficient to match the increased requirements for capital because of rapid increases in the value of stocks and debtors.

5. Problems in obtaining short-term and medium-term debt finance: Most short-term and medium-term debt is obtained from banks. There are several problems which small firms in come up against:
• A lack of suitable security to offer for loans.
• The probable lack of a trading record which can be used as evidence of stable operations.
• A general unwillingness among banks to lend unsecured loans on the basis of cash flow forecasts.
• A lack of financial expertise on the part of a proprietor in presenting a loan proposal to a bank.