BANKS’ VITAL ROLE IN PROVIDING FINANCE FOR SMALL BUSINESSES IN THE UK

In ‘normal’ times, most small firms, most of the time, get what they seek in terms of outside finance. That is the central finding of a study of the financing of over 2,500 small and medium-sized enterprises in the UK.

But the research by Andy Cosh, Douglas Cumming and Alan Hughes, published in the October 2009 issue of the Economic Journal, also finds that banks are by far the largest providers of finance to this sector of the economy. They conclude that:

‘In the current recession, circumstances for both the demand for and supply of finance are constrained. But as demand conditions improve and the demand for finance rises, the role to be played by banks will be critically important.

‘It is essential that policy measures are in place to ensure they have the asset base and structure to ensure that they can play that role.’

The researchers note that there is a ‘Catch 22’ facing small business owners – when you don’t need finance since business is going well, it’s easy to obtain it; but when profits are low and you need external finance, no one returns your call.

This is particularly true for young, innovative firms without an established track record. Banks tend to steer clear of these riskier businesses and they are too small to be of interest to the venture capitalists.

This research, which took place before the recession, addresses three questions that have great relevance to understanding the ways in which the capital market will need to work if the small business sector is to be funded effectively in the recovery:

• What causes small companies to need external finance?
• How much do they seek and from whom?
• How successful are they in obtaining the finance and what determines this?

The research draws on unique data on the financing of over 2,500 UK small businesses, looking from the small firm’s point of view rather than those of the finance providers and identifying the full range of sources of capital that they use.

The accepted way of understanding firms’ choice of sources of finance is called the ‘pecking order hypothesis’. This recognises that finance providers face risk and uncertainty about the small firms applying to them for finance and this is priced into the terms on which they are prepared to lend or invest.

As a consequence, small firms will prefer to use internally generated funds before turning to external finance. Since equity finance is more risky than debt finance (no regular return and paid out last in the event of business failure), its cost is higher and so the pecking order hypothesis is that debt finance will be used before resorting to equity. The pecking order of first internal finance, then debt and then equity is reinforced by the desire of small business owners to keep control of their businesses.

Overall, the research supports this idea. Firms seek external funds when their profits cannot support their business needs. And they seek to borrow the funds (banks, leasing, invoice discounting) rather than seeking equity finance (venture capital, business angels, owners).

Around 38% of firms in the survey sought finance. The firms most likely to seek finance were those with high growth ambitions and with high capital expenditures relative to their profits.

The amount sought by these companies was about £100,000 though some sought substantially more. The same factors determining the decision to seek external finance, plus the ratio of a firm’s debt to its assets, also influenced the amount sought.

At first, a higher debt ratio increased the amount sought but at higher levels of the ratio, the amount sought decreased. This suggests that firms recognise the limitations to the amount they can borrow relative to their assets.

Of those seeking finance: 81% approached banks; 50% hire purchase/leasing; 16% factoring/invoice discounting; 14% approached the owners of the business; 9% went to venture capitalists; and 9% to business angels. Banks were by far the largest providers of finance to the businesses; this emphasises the key importance of bank lending.

Overall, the firms were successful in obtaining the finance they sought and 81% of the amount they sought was obtained. But while firms often get the capital that they seek, firms do not always obtain capital in the form that they would like.

Rejection rates were low for larger businesses, but higher for small, young, innovative firms. The highest rejection rates were from venture capitalists (46%). Bank rejection rates were 17% and the lowest rates were for asset-based lending such as leasing (5%).

Banks favoured larger firms operating in less risky areas. Leasing firms, trade customers and suppliers, invoice discounting and owners were more likely to provide finance for more profitable businesses. Venture capitalists and business angels financed larger, more innovative, growth-oriented businesses.

ENDS

Notes for editors: ‘Outside Entrepreneurial Capital’ by Andy Cosh, Douglas Cumming and Alan Hughes is published in the October 2009 issue of the Economic Journal.

Andy Cosh and Alan Hughes are at the Centre for Business Research, Cambridge University. Douglas Cumming is at the Schulich School of Business, York University in Canada.

For further information: contact Andy Cosh on 01223-335551 (email: adc1@cam.ac.uk); or Romesh Vaitilingam on 07768-661095 (email: romesh@vaitilingam.com).