2) Literature review
2.1) Theoretical background
Boom et al. (1983) and Longenecker et al. (1994), describe two basic types of financing
available for SMEs, namely debt and equity. And they describe debt as funds borrowed to be
paid at future date and a fee, referred to as interest to be paid an at agreed time schedule. The
payments of interest are supposed to be done regardless of whether the firm makes profit or loss.
Equity, on the other hand, is defined as funds contributed by entrepreneurs or investors who
become owners or part owners of the firm and whose returns are primarily based on the profits.
This implies that if a firm fails to make profits its owners do not get any returns.
Debt financing is any type of business loan that a company uses to fund working capital, the
purchase of specific assets, or other operations. Based on the type of loan you are seeking, debt
financing can be either long term or short term. With all debt financing the borrower must pay
back principal and interest on the debt. If the borrower defaults on the loan, they typically have
to forfeit some form of collateral to repay the debt. This is in contrast to equity financing, where
business owners sell equity in their business in exchange for capital. (Meredith wood, 2019)
2.2) what is debt?
Debt Financing is the practice of borrowing funds from outside an organization from such
institutions as commercial banks, money lenders, or micro finance institutions. It includes longterm debt (loans repayable in more than a year) and short-term loans (loans repayable within a
year) (Frasch, 2013)
According to De la Torre (2009), debt financing is a system of funding in which a company takes
delivery of credit [which includes long-term debt and short-term loans and gives its promise to
repay the credit. Small businesses have been recognized as being great contributors to national
economies offering both employment and platform for innovative ideas. They form a larger
percentage of the businesses that operate in especially developing countries. They are however
faced by many constraints that hinder their profitability and, consequently, their growth. One of
the main constraints that have been highlighted over the years is the financial constraint. The
need for finance is of paramount importance for the success of any firm, be it big or small (IMF,
2007 and 2008).
Abdulsaleh (2013) determined that access to debt finance was particularly more important for
establishing smaller businesses such as retail businesses, and for the expansion of small
businesses into medium-sized enterprises. Abdulsaleh postulated that the growth and
development of existing businesses would consequently boost the national economic growth of
any country
2.1) Impact of debt on the profitability of small firms?
Financing is an essential element for profitability of a business enterprise irrespective of its size
or where it operates (Stierwald, 2009).
Financing with debt facilitates the primary economic functions of production and distribution;
Financing ensures that a firm is liquid enough to meet working capital needs. With availability of
financial resources, industrial development is initiated since it is possible to take advantage of
new investment opportunities as they arise (Karlan & Morduch, 2009).
Modigliani and Miller (1963) affirmed that since interests on debt are tax-deductible, thereby
creating tax savings for the borrower, it becomes possible for firms to minimize their costs of
capital and maximize shareholders’ wealth by using debt. This implies that the value of a levered
firm becomes higher than that of an unlevered firm. The use of debt is expected to enhance a
firm’s return on equity which is the ultimate measure of profitability.
Correia et al. (2003) point out that the impact of the use of debt on a firm’s profitability can be
positive or negative. Leverage (debt) is positive when it is used to generate a return on assets that
is higher than the before-tax cost of debt, thereby enhancing the return on equity. This results in
profitability and wealth maximization. Positive leverage usually occurs when a firm operates
under favorable conditions, when sales and profit margins are high and when the company is
able to generate a good return on assets. However, leverage is negative when it is used to
generate a return on assets lower than the before-tax cost of debt.
Access to finance is seen as necessary condition for small firms success in their drive to build
productive capacity, to compete and to contribute to poverty alleviation in developing countries.
Without finance, SMEs can neither absorb new technologies nor can they expand to compete in
global markets or even strike business linkages with larger firms (Idowu, 2010).
Credit financing improves firm performance mostly in the first few years after start-up and
financial leverage has a positive effect on the firm's return on equity provided that the earning
powers of the firm’s assets exceeds the average interest cost of debt to the firm(Franck and
Huyghebaert, 2009).
Michaelas et al (1999) reveal that the minimization of the cost of capital and maximization of
profitability through the use of debt finance might not hold for SMEs. The researcherr conclude
that SMEs find it difficult to borrow from commercial banks for a variety of reasons. When they
are able to borrow from banks, the costs of debt financing for SMEs are usually higher than those
of large firms due to their higher credit risk, and he generalize that profitability through the use
of debt finance might not valid for SMEs.
2.2) Constraints Faced by SMEs in Accessing Credit
Cuevas et al. (1993) indicates that access to bank credit by SMEs has been an issue repeatedly
raised by numerous studies as a major constraint to industrial growth. A common explanation for
the alleged lack of access to bank loan by SMEs is their inability to pledge acceptable collateral,
which provides an incentive to repay and offset losses in case of default.
Schiffer and Weder (1991) found that lending to small businesses and entrepreneurs remain
limited because financial intermediaries are apprehensive about supplying credit to businesses
due to their high risk, high transaction cost, and inadequate business portfolios, A business
portfolio analysis is useful for creditors for looking at a company's products and services and
categorizing them based on how well they're performing and their competitiveness, the
categorizing helps them in indicating which firm is more efficient and profitable, with capacity
of returning the debt.
According to Villalonga (2004) the age of the firm has implications on financial access and as
such the link between age of the firm and growth or profitability has been given attention in the
industrial organization literature.
Owing to lack of business experience of many small owner-managers in the early years of the
business, business risk may be more significant than for large firms. Small firms generally have
smaller financial reserves to draw on in times of crisis and are also relatively highly geared
compared to larger firms due to the difficulty and expense of attracting new equity finance. Thus,
such firms are characterized not only by higher business risk but also higher financial distress
risk. Banks tend to respond to this risk by adopting a (capital-gearing) rather than an (income
gearing) approach to lending. Thus, rather than focusing their attention on evaluating the income
streams flowing from an investment project, they may focus more on the value of collateral
available in the event of financial distress. This creates a problem for small firms in that they
often do not have significant fixed assets to secure on their early years of establishment (World
Bank, 2011).
2.3) what can increase debt usage of SMEs?
Zecchini and Ventura (2009) argue that currently, there’s widespread agreement that for various
financial institutions to operate profitably and sustainably, there’s need for them to keep their
costs as low as possible by levying proportionate interest rates and fees that is enough to cover
those costs.
Kamweru (2011) argues that firms that are younger have no reputation and no established credit
history that providers of external finance can use to evaluate their creditworthiness; as such they
are more constrained in the use of external financing. On the other hand, he contends that older
firms have a well-established credit history and have built a good reputation with providers of
external finance; as such are less constrained in the use of external financ
4) Research Methodology
To evaluate factors influencing access to finance for Small and Medium enterprise (SMEs) we
will use mixed research approach applied. The reason for combining both quantitative and
qualitative data is to better understand the research problem by combining both numeric values
from quantitative research and the non numeric ideas from qualitative research. It is often the
most efficient and cost- effective research method
4.1) Data Collection techniques
The data for this study will be gathered through the use of primary and secondary data sources.
The primary data source for this study involved the use of questionnaire that will be distributed
to SME operators or owners towards answering the research questions and personal interview
from creditors specifically from banks,
Questionnaires concentrated on the data of the respondent firms such as:
 Age of the firm
 Nature of the firm
 Profitability of the firm
 Number of employees of the firm
 Location of the firm
 Their preference on the term of loan
 Purpose of the debt
 Existence of firms with the same function
 What industry sector do you operate in?
 The biggest obstacle in faced in access debt?
Personal interview concentrated on the data of the respondent banks;
 The kind of loan they grant
 The interest rate they charge
 What security they prefer
 About difficulties in advance recovery
As regards secondary data, annual reports and other published material will be assessed. These
included loan manuals from banks, financial reports, of firms.
4.2) Sampling method
We use samples for our studies due to the existence of very large number of small and medium
sized firms but if we plan to collect data from that population the cost incur will be very huge.
Simple random sampling is the basic sampling technique we will follow that involves in select a
group of subjects (a sample) for study from a population). Sample of SMEs will be chosen
entirely by chance and each member of the population had an equal chance of being included in
the sample, we choose this sampling technique to eliminate sampling bias.
In selecting sample, two factors determine the size of an adequate sample includes: nature of
population and the researcher capacity to access to the participants, using a sample that is too
large is a waste of time and energy while using a sample that is too small may lead to invalid
results.
4.3) Data Analysis
Data will performed on both quantitative and qualitative data analysis which involve drawing
inductive inferences from data
4.4) Qualitative data Analysis
Data from key informants will be analyzed carefully and this involved condensing individual
responses into similar themes and integrating them for easy analysis. The use of the qualitative
design was aimed at giving deeper insights of the issues that were uncovered by the quantitative
data collection.
4.5) Quantitative data analysis
The quantitative data analysis focused on the examination of numerical values aggregated from
the study about which descriptions such as the mean and standard deviations. Data collected was
checked to ensure accuracy. Also programs that can help in data analysis will be used for
example SPSS program analysis and Microsoft excel.
4.6) Data processing
Data from the above sources will be sorted, coded and organized in tables. Frequencies and
percentages will also presented at this stage.