Answer to Question #96858 in Finance for ABU

Question

What are the practical difficulties of a small scale enterprise wishing to obtain credit to expand production?

Distinguish between internal and external sources of finance for a limited liability company.

Answer 1

The main factors, that determine the chances of small businesses to get a credit, are

Uncertainty. A small business is seriously handicapped by lack of past record that potential lenders can analyse to determine whether or not to furnish the small business with the required fund needed for expansion.

Lack of credit scoring. Banks always insist that their small business clients must provide an acceptable credit scoring and base their decision on this system so as to control exposure.

Lack of adequate press coverage. 

Entangled position. Entangled position is used to describe a situation where banks are unwilling o increase credit facility without a corresponding increment in security from the part of the small business that in turn may be unwilling or unable to make such increment. Some banks even require that the owners’ equity in the business be increased before further credit line be given. 

Maturity gap. It is particularly difficult for small companies to obtain medium term loans due to a mismatching of the maturity of assets and liabilities. Longer term loans are easier to obtain than the medium and short term loans. The reason is because longer term loans are secured with mortgages against property.

Interest rate discrimination. Banks and other financial institutions tend to ask for personal guarantees from owners of small businesses and will set interest rates at higher levels than those charged to big and established companies.

Internal sources of finance are sources inside the business (profits, retained earnings). External sources of finance, on the other hand, are sources outside the business (debts, etc.) Main differences between them are:

1)Meaning. Internal sources of finance alludes to the sources of business finance that are generated within the business, from the existing assets or activities.External sources of finance implies the arrangement of capital or funds from sources outside the business.

2)Includes. Internal sources include sale of stock, sale of fixed assets, retained earnings and debt collection. External sources include financial institutions, loan from banks, preference shares, debenture, public deposits, lease financing, commercial paper, trade credit, factoring.

3)Cost

4)Collateral

5)Amount raised