The key problems facing the SMEs are those of survival and growth
By Louis Kasekende (PhD)
The key problems facing the SMEs are those of survival and growth. Although comprehensive, up to date and reliable data are lacking, it is evident that only a minority of SMEs survive in operation for more than a few years and that very few achieve sustainable growth. In fact, even the transition to medium scale is uncommon, most SMEs remain small scale. In this address, I want to ask how we can improve the performance of SMEs, so that more of them survive and expand the scale of their operations, and how the financial sector can contribute to this.
Why do most SMEs struggle to survive and grow? Most business failures of SMEs must, in the final analysis, reflect a lack of profitability. Obviously the SME sector is heterogeneous and there must be many different causes of enterprise failures, so we should be wary about making generalisations. There are both external and internal causes of business failure.
External causes include the difficult business environment facing SMEs. Competition is fierce in many market segments, especially those which do not require much capital, to enter. The costs of doing business are high, in particular costs of power and transport. Neither is the quality and reliability of labour certain; nor is labour particularly cheap in comparison to other low income countries worldwide. Businesses and legal disputes, for example over the ownership of land and property, or the terms of contracts, are both common and costly to resolve. In general, a lack of trust within society raises the transactions costs of doing business.
With respect to internal causes, academic research suggests that the most common reasons for enterprise failures are those pertaining to management. Many owners lack business management and entrepreneurship skills, there is sometimes poor supervision of the business by the owner, who may have a full time job outside of the business. Many small scale enterprises do not maintain proper financial records and hence their owners may not even know whether profits, properly calculated, are being made. There is often a lack of separation between the finances of the business and the personal finances of the owner which, combined with a poor savings culture, means that revenues which should be used to support the business are diverted to fund personal expenses.
Even those SMEs which survive and can generate profits often fail to grow beyond a relatively small scale. Again the reasons for this are varied, but three are worthy of mention. The first pertains to control by the owner. The larger a business becomes, the greater is the need for professional management dedicated full time to the business, but many owners are very reluctant to cede control over the day to day running of their business to professional managers.
Second, the main source of funds for business expansion should be the retained profits of the enterprise, but profits are often taken out of the enterprise by the owner to fund personal and family expenses. Third, where profits are retained, they are sometimes re-invested in new start up enterprises rather than in the original enterprise in which they were earned. This may be because enterprise owners want to diversify their business assets to mitigate risks, which is understandable, but it prevents small scale enterprises from attaining economies of scale which would enable them to become more efficient and thereby improve their prospects of a viable future.
What does this mean for public policy to support SMEs? There are two areas where policy measures could yield dividends. The first is to improve the business environment, in particular by reducing the costs of doing business and by making regulations more transparent and ensuring that they are not implemented in an unfair or arbitrary manner. Strengthening the commercial justice system so that legal disputes can be resolved more quickly and at lower costs to litigants would also be very useful for SMEs.
Second, the owners and managers of many SMEs could benefit from practical help and training to strengthen their business and management skills. A number of organisations are currently providing technical assistance to SMEs in Uganda, such as the Uganda Industrial Research Institute and the Uganda Investment Authority which runs the Entrepreneurship Training Program. Training programs such as these will need to be scaled up if they are to make a significant contribution to the economy, given the huge number of SMEs in the country.
How can the financial sector best support SMEs in Uganda? The issue of financing SMEs poses many difficult challenges. Any new business requires start-up capital for its initial investment expenses. Given that all start-up businesses involve substantial risks, the most appropriate form of capital for start-ups is equity capital rather than loan capital, mainly because loans have to be serviced irrespective of whether or not a business makes a profit. To fund a start-up business mainly with loans is a recipe for trouble, as the business is likely to struggle to generate sufficient revenue in the early years of its operations to service its loans.
Therefore, most of the finance for start-up businesses must take the form of equity finance. Start-up businesses by definition have no track record of profitability and the risks of failure are high, hence it is very difficult for them to mobilise outside sources of finance, for example by issuing equity on the securities exchange. Consequently, the bulk of the equity finance needed by start-ups must be mobilised by the owners themselves, from their own savings or those of their families. This might appear unrealistic, but the capital requirements of most SMEs should be relatively modest, given that they are not, for the most part, capital intensive businesses. Once SMEs begin to generate profits, these profits will become an additional source of internal saving to fund capital investment.
The key contribution which banks can make to the SME sector is to provide working capital. To facilitate this, it is crucial for SMEs to keep proper financial records and to have realistic business plans, showing how they will generate the revenue needed to service their loans. Banks can help SMEs by undertaking financial literacy programs and giving SMEs impartial advice on the adequacy and realism of their business plans.
Banks should also look for innovative ways to reduce the transactions costs of lending to SMEs, for example by utilising digital technology, in order to lower the cost of borrowing. However we must also recognise that the risks involved in bank lending are highest when SMEs are thinly capitalised. Therefore, the more that the owners of SMEs can mobilise capital internally to fund their businesses, the more accessible will bank finance become for these businesses. Bank finance for SMEs should complement the capital resources mobilised by their owners, it cannot be a substitute for the latter.
To conclude I would like to commend Stanbic for organising this conference. Finding solutions to the problems facing SMEs is crucial for the future development of our economy and I am confident that the conference will contribute to this.
Louis Kasekende (PhD) is the Deputy Governor, Bank of Uganda