By Prof. E. Ofori Asamoah.
CertifiedManagement Consultant and President, Regent university College of Science and Technology.
The Need for Alternative Finance for Small and Medium Enterprises while corporate firms may have the capacity and credit worthiness to access large amount of loans and other credit facilities from banks to expand their operations, same cannot be said of SMEs.
By the nature of their formation and the fact that majority of SMEs in Ghana are sole proprietorship businesses without a clear separation of management from owners, it becomes very difficult to list them on the GSE to access finance from investors who intend to have a stake in the SMEs.
This poses a major challenge to SMEs accessing funds from the public through the issuance of shares on the stock exchange.
Again, by their own characteristics and ownership structure, majority of SMEs exclude themselves from gaining entry into the capital market to access finance.
Hence, they are left with limited access to finance in the financial sectors amid the intense competition from larger corporate firms who are deemed by banks to be of low risk and more credit worthy as compared to SMEs.
The major sources of finance for SMEs in Ghana are depicted in figure 1.
Sources of SME Financing in Ghana
Venture capital, though an important source for financing SMEs represents a very small part of finance in Ghana and is mostly the least considered by most entrepreneurs.
Alternative Financing Options
In its 2018 ministerial conference on strengthening SMEs and entrepreneurship for productivity and inclusive growth, the OECD (2018) indicated that despite the challenges encountered by SMEs in accessing bank credit, there are opportunities for SMEs to tap into a wide range of alternative financing instruments as an innovative means of meeting their financial needs.
The alternative financial instruments for SMEs could be categorized into four major groups based on their risk/return relationship as follows:
Asset-based finance may be defined as a financial arrangement whereby a business uses its non-current assets other than cash as collateral to obtain short-term credit without much emphasis on its credit history.
Examples of asset-based financing instruments include asset-based lending, factoring, hire purchase, invoice discounting, and leasing.
This form of alternative finance is widely used by SMEs in developed countries to meet their short-term cash flow needs and in recent times has gained considerable attention in some emerging economies as an effective financial instrument for meeting the working capital needs of SMEs (OECD, 2018).
It must be emphasized that an SME’s qualification for asset-based finance depends on the liquidation value of its underlying asset, rather than on its credit history.
The major examples of asset-based financing instruments have been discussed below to give an overview of the instruments and how SMEs can explore them in meeting their financing needs:
Asset-based lending is an alternative financial arrangement where a finance company grants a short-term loan to a business using the value of assets pledged as collateral occurs when a loan is granted to a firm solely on the value of assets pledged as collateral (Abor & Quartey, 2010).
It must be emphasized that the terms and conditions of asset-based lending depend on the type and value of assets offered as collateral for the loan with lenders preferring highly liquid securities that can readily be converted to cash in situations where the borrower defaults on its payments (OECD, 2015).
This implies that the higher the liquidity of the asset, the higher the loan-to-value ratio.
However, it is worthy to note that the amount granted under asset-based lending is not equal to the full book value of the assets pledged.
Factoring is a financial arrangement whereby a business entity sells its account receivables (invoices) to a third-party called a “factor” at a discount to meet its present cash needs.
Factoring has become a more widely used and accepted alternative to liquidity-strapped SMEs in many countries, with volumes expanding significantly over the last decade, especially in emerging economies (OECD, 2018). In a typical factoring arrangement, the business makes a sale, delivers the product or service, and generates an invoice. The factor then buys the account receivables of the firm to gain the right to collect the amount on the invoice by agreeing to pay the firm the invoice’s face value less a discount normally in the region of 2 to 6 percent. With this type of arrangement, the factor takes full control of managing the sales ledger and credit control with the right to pursue the customers for settlement of their invoices.
The factoring process
There are three main parties to the factoring agreement. The client business will sell goods or services on credit and the factor will take responsibility for invoicing the customer and collecting the amount owing. The factor will then pay the client business the invoice amount, less fees and interest, in two stages.
The first stage typically represents 80 per cent of the invoice value and will be paid immediately after the goods or services have been delivered to the customer.
The second stage will represent the balance outstanding and will usually be paid when the customer has paid the factor the amount owing.
The underlying reason why firms adopt factoring as a short-term financing option is to reduce their debtors’ collection period by turning their account receivables into cash to build up their cash flow. Milenkovic-Kerkovic and Dencic-Mihajlov (2012) assert that a firm qualifies for factoring arrangement not based on its creditworthiness but rather on the ability of its customers to pay their debts with the stipulated debtors’ collection period. This implies that a firm with creditworthy customers may be able to factor even if it lacks the collateral and credit history to qualify for a loan.