Topic 3: Financing medium-sized businesses
Introduction
Normally, businesses are established and operated by individuals or groups of individuals with the main objective of generating profits. In particular, one of the factors to be considered before establishing a business is the way it can be financed. In this chapter, you will learn about the concept of medium-sized businesses, and sources of financing for the medium-sized businesses.
The competences developed will enable you to acquire financial support from different sources to establish and run the medium-sized businesses.
The concept of medium-sized businesses
Universally, there is no single accepted definition of medium-sized businesses. However, nations use different measures of size to define medium-sized businesses depending on their level of development.
The Tanzania Small and Medium Enterprise (SME)
Development Policy of 2003 recognises four categories of businesses namely: micro, small. medium, and large-scale enterprises. Medium-sized businesses are based on the following features:
Number of employees: Medium-sized businesses employ 50 to 99 people who are engaged in various business activities like production and marketing of products as well as business support services such as accounting and human resources management.
Capital invested: Medium-sized businesses invest capital which range from TShs. 200 million to TShs. 800 million.
Operations: Medium-sized businesses employees are divided into different sections of operations like production, marketing, finance, information technology. procurement, and human resourtes that lead them to perfonn the assigned duties or activities.
Proprietorship: Medium-sized businesses may be owned by an individual, groups of individuals, family members as well as the public who have a common interest to ensure pre-determined goals are achieved.
Generally, medium-sized businesses are businesses whose number of employees and capital invested fall under well-defined limits depending on a country’s SME policy.
Importance of medium-sized businesses
The following are the importance of the medium-sized businesses:
Creates employment: Medium-sized businesses employ a relatively large number of people to cany out various business activities. The number of people employed is usually large compared to small businesses. Forexample, in Tanzania medium enterprises employ from 50 to 99 people.
Faster decision-making: Medium-sized businesses decisions can be made by a single person or group of persons unlike large enterprises. This enables the businesses to reach conclusions on various matters timely.
Easy sharing of information: Medium- sized businesses communication process is easier compared to large businesses since management and employees are closer due to its smaller size. This enables information to flow smoothly and problems are addressed timely by people working together as a team.
Enhances growth of the economy: Medium-sized businesses contribute to the country’s economic growth through payment of different taxes which are used in the provision of public services. They also facilitate the supply of products for consumption, boost exports, and enable investment in other economic sectors.
Cost effectiveness: Medium-sized businesses are likely to have lower operational costs compared to large businesses due to theirscale of operations.
This enables them to have proper allocation of resources and efficiency in business operations and management.
Easy access to resources: Medium-sized businesses have better access to resources including finance compared to small businesses. Such access facilitates medium- sized businesses to grow and pursue more business opportunities to foster optimum business perfonnance.
Closer relationship with customers: Medium-sized businesses can provide satisfactory customerservices than larger- sized businesses due to their smaller customer base. They have the capacity to develop strong personalised relationships with customers, understand their demand and receive unique feedback from them.
Sources of financing for medium-sized businesses
Business enterprises need money for conducting different activities including buying raw materials, paying labours, or other production costs, and operational costs. Commonly, financing a business is
essential as it assists the business to reach its pre-arranged goals. Thus: without finance, the business will not be able to engage in production and realize its objectives.
Medium-sized businesses are either financed by the owner (s), other people or organisations outside the business.
There are various sources of finance for medium-sized husinesses. These sources of finance are grouped into two main categories: internal and external sources.
Internal sources of finance
The internal funding of a business is acquired within the business without any support from outside. Some internal sources of finance include retained earnings, sale of non-current assets, leasing of non- current assets, and sale and leaseback of non-current assets which are explained as follows:
Retained earnings
Retained carnings are also termed as undistributable profit. These are profits obtained in the business that are not distributed to owners as returns on their investment. Medium-sized business owners may decide to reallocate some of the undistributable profits gained from the business to enhance efficiency and effectiveness in their business operations. Retained eamings are typically contemplated as further finance for better business growth in the future. Higher retained earnings indicate that a business is financially healthier.
Medium-sized enterprises benefit from retained earnings as they are free cashflow that is not repaid. As opposed to loans, retained carnings have no issuc costs and no interest rate to be repaid by the business as they are profit reserves generated in the business operations.
Retained earnings also provide flexibility to business owners in reallocating resources to dilferent operations. However, some of the challenges of this source of funds in supporting medium-sized businesses
include its inadequacy to support operations and future expansions if the medium- sized business entirely depends on it.
This in turn may lead to poor business performance, which is unlikely to attract external investors hence the inability to raise additional capital.
Sale of non-current assets
Non-current assets are the assets whose economic benefits are expected to be hamessed for a long time to support business operations. Some of the non-current assets include land. plant. equipment. vehicles, and other properties. Sale of non-current assets is another source of financing formedium-sized businesses whereby business owners dispose some of their idle assets.
Sale of idle assets is a way of changing unproductive tangible assets into cash. The medium-sized business may sell idle or unproductive assets to raise finance that may be used for various productive business activities or opportunities. However, the business should evaluate the outcomes before making a decision to sell some of its non-current assets. Income gencrated by the business from the disposal of idle non-current assets can be reinvested back into the business.
From sale of non-current assets, the business acquires funds without incurring debt, and no interest is charged. It also saves some costs to business enterprises that may be used for repairing and maintaining redundant assets. However, the sale of non- current assets decreases the assets which could be used by the business in the future.
It also takes time to find the right buyer, something which leads to delaying the availability of funds needed to conduct the business operations.
Leasing of non-current assets
This refers to an agreement in which one party allows another party to use the non- current assets and return them after the specified time period. The asset owner is known as ”lessor” meanwhile the person that uses the leased assets is called “lessee”.
In leasing, the terms and conditions that regulate agreements are outlined in a contract between the parties involved. There must be periodic payment by the lessee to the owner for the use of the assets.
For this case, the medium-sized businesses will be obtaining cash after leasing their assets to other parties that will increase business finance.
Leasing of non-current assets does not add the business debts: instead, it creates more access of finance needed for business operation and expansion. In addition. lease of non-current assets enables the
lessor to repossess the asset (s) that may be productive to the business when the lessee returns them after the agreed time.
However, leasing non-current assets is not convenient to newly established businesses as they might not have redundant assets to lease. Another challenge is that the lessor temporarily loses the ownership and will have no control over the property until the agreed period between the two parties comes to an end. Again, leasing of non- current assets in business leads to wear and tear which causes a shorter life span of those assets.
Sale and leaseback of non-current assets
Sale and leaseback of non-current assets refers to the process whereby the asset owner sells some of their assets to another party then the assets are promptly leased back from the buyer. Periodic payments (rental expenses) are made by the business entity to the owner for the use of an asset for an agreed time. Bearing of repair and maintenance expenses depends on the agreement between two parties involved. Sale and leaseback benefit to the medium-sized enterprises by enabling the business venture to acquire both cash and assets that are used for various business operations.
In this case, the business will continue to use the assets cither for production or other business activities. However, this source of funding has some weaknesses like loss of ownership and control over the assets.
Exercise
1. Kichochi decided to leave his job as a sales manager of TX company to start his own medium-sized business. Explain the reasons why Kichochi might resort to seeking finance to set up his new business enterprise.
2. Suppose you own a business selling and distributing second-hand motor Nchicles within Dar es Salaam. Due to the good performance of your business, you made a plan to expand it by opening new branches outside the region, however. you do not have enough capital to support your initiative. Which sources of finance would you use and why?
3. The TIE catering business has been operating for almost six years in Tanzania Institute of Education. The business owner intends to increase capital by selling some of his assets. Explain to TIE’s catering owner or the management the benefits of using business profits as a source of finance rather than selling some of the assets.