Finance is essential to the success of SMMEs as it forms the foundation of the business (Boateng 2004). Without enough money to develop products, hire employees, establish markets and attract customers, no firm can survive and grow. Once the market opportunity and the strategy for seizing the opportunity
3. Financial structure and sources of finance for SMMEs 73
have been well defined, a firm may begin to examine the financial requirements in terms of asset needs and operating needs (Winton and Yerramilli 2008).
3.2.1
Non-current assets
Non-current assets involve expenditure on buildings, machinery, fixtures, fittings and vehicles. These are long-term tangible assets held for business use and not expected to be converted into cash in a short term period. SMMEs need non- current assets to survive, innovate and grow. While it may be possible for the owners of SMMEs to fund its initial activities, it becomes increasingly difficult for them to do so when it comes to non-current assets (Leroy 2012). Berger and Udell (2006) note that one advantage SMME can obtain from having fixed assets is that it can be used as collateral. Furthermore, the value of non-current assets is relatively more stable compared to current assets such as inventories and accounts receivable. Therefore, lenders prefer to take non-current assets rather than current assets as collateral.
Non-current assets are essential for SMMEs. However, investment in non-current assets by SMMEs is low in South Africa. SMMEs in South Africa have a low propensity to invest in non-current assets. According to Falkena, Abedian, von Blottnitz, Coovadia, Davel, Madungandaba, Masilela and Rees (2002), the rea- son for this may be attributed to the huge financial expenditure that is required for investment in these assets. In addition, SMMEs are also faced with lack of access to finance which further inhibits their ability to invest in non-current asset acquisition.
3.2.2
Working capital and cash flow
The cash flow is essential to maintain and grow a business. Padachi, Narasimhan, Durbarry and Howorth (2008) point out that if the working capital of a firm becomes weak, the firm can hardly survive. Working capital refers to a firm’s short-term/current assets and liabilities. Current assets include cash, inventory, account receivable and prepayments, while current liabilities include overdrafts, accounts payable and accruals. The difference between current assets and cur- rent liabilities called net working capital. Positive working capital means the firm current assets is more than current liabilities. While negative working cap- ital means that a firm currently is unable to meet its current liabilities with its
current assets (Firer, Ross, Westerfield and Jordan 2004).
Therefore, the failure to plan for increasing working capital needs can lead to difficulties in cash flow. Firer et al.(2004) suggest that working capital is needed to pay wages, suppliers and other expenses before sales revenue received from sales. Mart´ınez-Solano and Garc´ıa-Teruel (2006) found that the negative work- ing capital is a major constraint to the survival and growth of SMMEs. SMMEs that have limited working capital are more likely to fail than those SMMEs that have positive working capital. Thus the success of an SMME depends also on its ability to generate cash receipts in excess of the financial obligations and expenses. Therefore, even if a business is enjoying success in other areas, a short- age of cash can result in technical insolvency, which will lead to bankruptcy and possible liquidation (Gimede 2004).
However, on the other hand, working capital is often unacceptable as collateral. This could affect the availability of external finance to SMMEs (Nguyen and Ramachandran 2006). Thus asset and capital structure is an important deter- minant of a firm’s ability to obtain external finance. Firms that have relatively higher levels of non-current assets compared to current assets in their asset struc- tures are better able to get access to finance (Nguyen and Ramachandran 2006). This also suggests that SMMEs will have lack of access to finance because of their weak capitalisation.
3.2.3
Product development and initial loses
SMMEs need to raise funds to pay for the upfront costs of extended product de- velopment cycles. Product development often takes years and requires adequate funding to bring it to fruition (Leroy 2012). According to Leroy (2012),prod- uct development is defined as the process of acquiring knowledge to create a new product to serve the needs and wants of customers who are already buying the firm’s products. Product development also refers to improving an existing product. Thus, product development has become a key determinant in gaining competitive advantage. However, not all SMMEs develop new products.
Baron and Shane (2007) argue that while some SMMEs show profitability dur- ing the start-up phase, it is more common to have income statement losses until the venture generates adequate revenues to cover expenses. This implies that
3. Financial structure and sources of finance for SMMEs 75
most SMMEs have initial losses and negative cash flow in the early phases of the business and this may result in failure if additional cash flow is not available.
3.2.4
Other reasons
According to Wennberg, Wiklund, DeTienne and Cardon (2010), SMMEs also require financing in order to develop their human capital. Human capital refers to the employees of the firm. Employees contribute positively to the growth of SMMEs by helping entrepreneurs execute their objectives. An SMME may require more specific expertise and highly skilled workers than a mature firm. As the SMME enters into the expansion stage, it may be able to use less skilled workers to meet production demands. In addition, while the founders are able to assume some of the responsibilities of managing the business, other activities will have to be managed by hiring some key and non-founder employees who have the knowledge and skills to help the firm grow.