In Britain, Small and medium sized firms (SME’s) are the companies whose turnover is not more than £22.8 million and the average number of employees is 250 or fewer. Despite small and medium sized firms having a major role to play in the growth of economy and generation of employment in UK, they have to face higher barriers to external financing than large firms which eventually limit their growth and development (Ardic et al., 2011). The difficulty in generating finance from external sources is mainly due to a number of reasons, which include small cash flows, inadequate credit history, lack of collateral, difficulties in proving credit worthiness, high risk premiums, under-developed bank-borrower relationships and high transaction costs (IFC, 2009).
There has been a decline in allotting loans to small and medium sized firms (SME’s) by banks after 2008 as the market now has become more cautious in assessing risk. It is seen that the bank lending in November 2011 has been 6.1per cent lower than that in 2010 (Department for Business Innovation and Skills, 2012). Financing of SME’s is mainly determined by “firm characteristics”, “owner characteristics” or both together. Firm characteristics include firm size, firm age, profitability, asset structure, growth and operating risk. Owner characteristics are generally determined by two approaches, one of them being firm owner’s personal characteristics (age, gender, race, education and previous business experience), and the second one being firm owner’s preferences, business goals and motivations (Ciaran Mac an Bhaird, 2010).
This report gives an overview on the challenges that are faced by them in generating finance for their sustenance, capital structure, financing decisions in SME’s and prospects that are ahead of them. It also covers various topics of finance and key theories that the article relates to. A study on the model of SME’s in other countries is also carried out to analyze the benefits and shortcomings for the model followed in UK.
2.0 FINANCE TOPIC
The finance topic under which the article falls is the “Sources of Finance/Capital structure”. Capital structure refers to a mix of company’s long-term debt, specific short-term debt, common equity and preferred equity. The capital structure is how a firm finances its overall operations and growth by using different sources of funds.
Fig. 1: Share of business in UK Private Sector
3.0 KEY THEORIES TO BE APPLIED
There are numerous theories relating to the area of Capital structure. However the theories to be focused here are as follows:- * Trade-Off Theory
* Pecking Order Theory
* Asymmetric Information Theory
4.1 TRADE-OFF THEORY
The trade-off theory of capital structure refers to the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. According to Modigliani and Miller firm value is determined by the profitability and the riskiness of its real assets, and not by its capital structure. But, there is a trade-off between tax benefits of debt and potential costs of financial distress. However, as per the trade-off theory the debt-tax shield may not be as important for SME’s as it is for publicly quoted firms (Heyman et al., 2008).
Risk of financial distress is the second component of the trade-off theory. Bankruptcy is the ultimate consequence of financial distress and it is seen that young firms are more prone than the old ones (Cressy, 2006). Younger firms face higher business risks, which are due to the following factors – their over-dependency on small number of customers, under-capitalization, adverse macroeconomic conditions and economic shocks (Cambridge Small Business Research Centre, 1992). Smaller firms also face heightened risk of personal loss, as most of the owners’ personal finances are involved for financing the firm (Avery et al., 1998)....
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