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The Main Types of Funding for Smes

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Table of Contents

  • Introduction
  • The Role of SMEs in the British Economy
  • Types of Financing Methods for SMEs
  • Internal Finance
    External Finance
  • Conclusions

Introduction

Nowadays, with the rapid development of modern society, small and medium-sized enterprises (SMEs) are playing an more and more important role in a country’s economy. According to the English company law(Companies Act ,2006) , meeting two of the following conditions may be regarded as a SME: Firstly, the turnover should not exceed 11.2million pounds; Secondly, the total balance sheet should not exceed 5.6 million; Lastly, the employees should not more than 250 people. There are many ways for SMEs to raise capital, but each method can adapt to different situations. Therefore, this essay will discuss the advantages and disadvantages about financing types and then give some suggestions to choose the most appropriate methods.

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The Role of SMEs in the British Economy

SMEs play a significant role in the UK, at the beginning of 2017, SMEs accounted for 99 per cent of all private sector enterprises. There are 16.1 million people working for small and medium-sized enterprises, accounting for 60 per cent of all private-sector employment in the UK. In addition, SMEs account for 51 per cent of UK private sector turnover (1.9 trillion) (Jiten Champaneri ,2017).

Although the contribution of SMEs to the UK economy is significant, there are still some problems of financing.

Types of Financing Methods for SMEs

When a SME want to require finance, they are mainly divided into internal finance and external finance:

Internal Finance

Internal finance means that the business owner’s own funds, friends’ loans or operating profits in the process of opening and operating. Generally speaking, most of the small businesses use internal finance as their main source of funding(Keown et al. ,1985). In other words, small business have traditionally relied on their employer’s own money when they started out(Hutchinson & Ray, 1983).

Very flexible is that internal financing has strong autonomy, it is not easy to be affected and restricted by the outside world. Unfortunately, SMEs often do not have much of their own capital. If the company is losing money, it will be more troublesome.

External Finance

Compared with internal finance, external finance is more abundant and more likely used in medium-sized enterprises. In the study by McLaney(2009), as SMEs find it difficult and more expensive to raise external finance than do larger businesses. Even so, there are 69% of SME employers used external finance at the start of 2018 in the UK. Moreover, it appears that larger SMEs were more likely to use it than smaller ones(Sean Mattson, 2018). As the business case develops, external financing will be attracted. Such as the form of trade credit, loan from bank and overdrafts. Furthermore, when the business become more and more stronger, it appears that the other sources of finance such as grants, leasing and asset finance would be used(Hutchinson and Ray, 1983).

There are many ways to get external finance, and this essay will focus on credit cards, bank overdrafts and leasing or hire purchase. Because at the start of 2018, these three external financing methods are the most popular ways for SMEs in the UK(Sean Mattson,2018).

Firstly, the form of credit cards is a typical way to lend money. The borrower should repay the principal on some specified terms. Bates (1967) held that compared with listed companies, SMEs are more dependent on credit cards financing. Credit cards are widely used in manufacturing, retail and administrative services in SMEs, accounting for 39%, 38% and 38% respectively(Sean Mattson,2018). And the advantage of credit cards is that the debtor does not have to give the lender a certain amount of profit or commission. Nonetheless, credit cards are not flexible because Banks have strict conditions for lending to SMEs.

Secondly, overdraft is a small credit instrument that allows temporary overspending and is designed to repay short-term debt. In the research by Sean Mattson (2018), primary, retail and construction are the industries that use the form of overdraft the most. In particular, this kind of financing is really flexible, it can help SMEs to solve some urgent problems. Therefore, the limitation is that within a certain range, there is a risk of late or excessive fines.

Lastly, leasing or hire purchase is an asset financing, which is an asset held and controlled by a company or an individual for a certain period of time and pays rent or installment payments, including depreciation of assets, and interest on the cost of capital(ACCA global,2018). This financing is widely used in primary(50%), construction(30%) and manufacturing(29%). On the positive side, you may get the equipment or assets you could not afford. On the other hand, because of certain conditions in the lease contract, these assets may be more expensive than the direct purchase.

Conclusions

In general, the financing strategies of SMEs are possibly divided into internal finance and external finance. According to Keown et al. (1985), internal finance is more applicable to small enterprises, while external finance is mainly suitable to medium-sized enterprises. No matter which option you choose, make sure your research is rational and practical. Spend more time comparing and trying to communicate with experienced companies. But remember, that experience is only a reference, and every business has its own special characteristics. There is no the best way to raise money, only the right way to funding.

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