CHAPTER ONE
INTRODUCTION
1.1 Background of the Study
The main focus of this study is to seek to understand how debt financing is impacting the performance of Small and Medium Enterprises (SMEs) in the county of Nairobi, Kenya. The first step will be in defining our variables for the purpose of this research study. Our independent variable will be debt financing, and our independent variable is the performance of SMEs.
Debt financing is a financial instrument used to raise working capital for business enterprises. It achieves this by selling debt instruments to the public either as individuals or as institutional investors. The debt instruments come in fixed-income products; examples include bonds, notes, or bills. When the public purchases these debt instruments, they essentially become creditors and thus promise to be paid both the principal and accrued interest. The principal refers to the amount of investment put in as a loan, and interest is the additional amount to be paid spread over an agreed time.
Debt financing can be considered the opposite of equity financing, where businesses sell shares to raise working capital. Equity financing gives an ownership stake in the enterprise, which is essential to consider in the case of SMEs. Another vital consideration is that the creditors are first in line to be paid back in case the business files for bankruptcy. At the same time, the parties with equity are given last consideration. Shareholders do, however, earn dividends annually that could vary in amount depending on the performance of the business. Bondholders, on the other hand, always make a fixed amount defined by the agreed interest payments.
After defining these two methods of capital financing, we can then clearly describe a firm’s capital structure. This structure is made up of two elements equity and debt. The cost of equity to the firms is the dividend payouts annually to shareholders, and on the other hand, the cost of debt is the interest payouts to bondholders. It is essential to recognize this cost of debt to the firm when attempting to understand the effect on its performance. It is not often that a business relies on only one form of capital financing, and thus it is necessary to recognize both methods.
The combined cost of equity and cost of debt is referred to as the cost of capital. This cost of capital represents the least amount of profit the business is required to generate to satisfy all its backers, including stakeholders and creditors. It then means that when the company is making investment decisions on new ventures, the generated returns should always be more than the cost of capital. In case the business is earning returns on its capital expenditures that are below the cost of capital, it means that it is losing money for its investors. In such a case, re-evaluation and re-balancing of the capital structure are necessary.
The return on capital expenditure concerning the cost of capital defined above is the basis of the performance factor we shall be focusing on in our study. The next point will be to determine the SMEs we shall be focusing on. An SME is a type of business defined by its maintenance of assets, revenues, and the number of permanent employees below a certain threshold. This threshold varies from country to country and thus makes the term SME very flexible. The criterion to define SMEs consistently varies depending on the economy mainly, but sometimes the industry in which the business operates is also considered.
SMEs play a vital role in any economy since they are the most abundant business, outnumbering large firms significantly. They are usually the most prominent employers among companies in any population despite their small individual size. They thus play a crucial role in reducing unemployment rates which boosts the economy significantly. Most SMEs are also entrepreneurial and therefore are a source of a lot of innovation in the economy.
The types of SMEs are usually very diverse and cover almost all existing industries. They play a crucial role in providing services to people in areas such as health, beauty, and leisure. They also offer distribution outlets for larger firms’ goods and supply them with raw materials. The goal of any SME is to perform well enough to grow into a large firm.
1.1.1 Debt Financing in Kenya
Debt financing, as we have already touched upon lightly, comes in many forms. In this section, we shall further elaborate on the different kinds of debt financing that exist. We shall also look into the types of debt financing that are available to SMEs in Nairobi County, Kenya.
Debt financing is broadly divided into two categories according to the time specified for repayment. These include funding long-term and short-term funding. The needs of the business usually determine the kind of debt financing it undertakes. Short-term debt financing is suitable to fund the enterprise’s daily operations, including paying employee wages, purchasing inventory, and paying utilities. The repayment period of such short-term loans is usually under a year but can go up to two years.
Long-term financing is usually used to fund the purchase of assets, including buildings, machinery, equipment, and land. These loans are generally structured for repayment of between three to ten years. They include a fixed interest rate broken down into monthly payments.
These monthly payments provide a chance for SMEs to improve their credit score if paid consistently. A good credit score eases the process of seeking future financing. The interest payments also have the advantage of being tax-deductible and thus are very attractive to entrepreneurs.
In Nairobi, several types of debt financing are available to the SMEs functioning within the county. For ease of classification, we shall categorize them as private financing and public/institutional financing. Both of these categories have several sub-categories that we shall look at briefly. The first of which will be private debt financing sources.
Private Debt Financing Sources
These private sources are defined as the borrowed money sourced from single individuals who could be part of the entrepreneurs’ family or circle of friends; it could also include investors willing to fund the business. Private means are a common source for SMEs that are not fully developed and are thus of high risk. The risk appetites of institutional financiers are usually below this threshold and hence shy away from such budding SMEs. The relationship between the entrepreneur and private investor plays a massive role in facilitating the loan.
The terms of the loan are usually determined by this relationship, which can sometimes be detrimental to the business. People close to the entrepreneur tend to offer more flexible terms of payment and take up more risk. On the downside, it is the same people who will be keener to be involved in the management of the business. For this reason, it is prudent for terms to be agreed upon in formal writing before any money changes hands. There are also institutions, primarily banks in the county, that could act as private financers. When they do, they tend to have high interest rates and more strict payment regiments. They have such high interests in an attempt to offset the high-risk nature of the SMEs being financed.
Public Debt Financing Sources
The public Sources are financing options that are sourced from government programs at both the state and county level. These sources usually have friendly terms that are aimed at benefiting entrepreneurs. They also, more often than not, target an underserviced selection of business owners. The underserviced include marginalized groups such as the youth, women, and people with disabilities. Such incentives include the Youth Enterprise Development Fund that was gazetted in 2006 and made into an official state corporation in the following year.
As was stated earlier, SMEs in an economy are vital to the economy’s overall health. For that reason, the government is greatly incentivized to provide suitable conditions for them to thrive. One of the ways it does that is to provide tailor-made debt financing options. The introduction of the county system of governance further improved this function, with localized efforts being made countrywide. Nairobi County has one of the most significant annual budgets in the county, meaning it has access to a lot of funds to finance SMEs.
SMEs in Nairobi, Kenya
In Kenya, there is a unique definition of SMEs from the rest of the world. The SMEs in the country have come to be known as Micro, Small, and Medium-sized Enterprises (MSMEs). This change was made to include the micro-sized businesses since they are ubiquitous in the country and deserve the same attention given to the small and medium-sized enterprises.
The threshold to define the MSMEs has therefore been outlined in terms of employees as up to 10 employees for micro-enterprises, between 10 and 50 employees for small enterprises, and between 50 and 100 employees for medium-sized enterprises. A study done by Viffa Consult using survey data from the Central Bank Of Kenya on the state of financing for SMEs in Kenya had the following findings. SMEs contributed 3% to the 6.4% growth in the GDP in 2017. The SMEs also constitute 98% of all businesses in the country and provide 30% of the jobs annually.
The SMEs in Nairobi County and the rest of the country are based in the informal sector, known as the Jua Kali sector. This is a sector that provides 80% of the jobs created annually. The study also found that the most significant problem faced by SMEs in accessing financing followed closely by access to markets.
Nairobi County, in particular, has a fast-growing Jua Kali sector that supports the many industries found in the county. The informal sector has shown good growth statistics over the years, only being interrupted by the Covid-19pandemic in 2020. The government, however, is making targeted efforts to aid in the recovery of the sector.
1.1.3 Determining Financial Performance
A significant point of this study is to determine the financial performance of SMEs. This will be achieved using a few key metrics, the first of which is the interest rate. SMEs tend to be charged a high-interest rate and obligated to meet very restrictive requirements when they obtain institutional credit. The situation contrasts with the lower interest rate and looser requirements imposed on large-scale enterprises(Berger, 2004).
The next is the inflation rate that is directly affected by the interest rates. Low interest rates can stimulate growth in the economy and, at the same time, lead to inflation. The government has been putting in place regulations to control such interest-caused inflation.
Another factor is access to tangible assets, which affects the ability of SMEs to gain financing in terms of the collateral they can put up as security. The more the number of assets the enterprises have, the greater the level of funding they can receive.
1.2 Statement of the problem
The challenges faced by SMEs in Nairobi county are numerous, but the main one is access to financing. For this reason, this study focuses on debt financing and seeks to provide an understanding of how it can be applied to provide better financial performance in SMEs.
The first step is in understanding why SMEs have limited access to credit services in the region. The limitation arises mainly due to the underdeveloped capital market that pushes SMEs to turn to self-financing and borrowing from family and friends. The availability of long-term credit for SMEs is also limited, forcing them into multiple short-term financing contracts that are expensive in the long run. These challenges arise from the prevailing stereotype among formal lending institutions that SMEs are all equally risky and un-credit worthy. The situation is not helped by the emergence of the less traditional credit institutions such as MFIs and SACCOs. Their minuscule funding limits these micro-credit institutions in comparison to the demand. They tend to have short-term financing, meaning they find it difficult to turn the savings they collect into long-term loans. The more prominent financial regulations are also against them since they do not receive refinancing from the central bank that the formal banking sector access (Wanjohi 2009).
The other major problem is a lack of understanding of the market space in which most SMEs experience growth. The financial institutions that the enterprises are dependent on have very little knowledge of the nature of the Jua Kali sector. The informal sector is an industry that lags in technology adaptation, and therefore data on the day-to-day performance of the sector is scarce. The industry thrives on manual records if any are kept, and the use of computers is deemed expensive.
The situation is slowly changing with the coming generation being more willing to adapt to new technologies. Their emergence will enable the generation of raw data that can be analyzed by the financial institutions and the establishment of performance data as well as future projections. This will make the risk assessment of SMEs more favorable as the data will back up the positive investment indicators.
Another problem is the lack of understanding of the effect taking up debt has on the capital structure of SMEs. This study will educate the entrepreneurs working out of the county of Nairobi on the effects taking up debt financing has. The areas mainly affected include the credit scoring of the business as well as the tax deductibles.
Understanding all these effects is critical in determining the excellent performance of SMEs. Strategic debt financing will ensure the steady growth of the enterprise, and this is what this study seeks to establish.
1.4 Significance of the study
This study is necessary to help in solving some of the problems facing SMEs in Nairobi County. SMEs, as it has already been established, are vital to the health of the economy. They provide a rich source of income for many of the citizens dwelling in the capital. The study addresses one of the significant problems facing SMEs and is therefore quite beneficial.
This study should be taken as educational material for those entrepreneurs keen on understanding the capital structure of their businesses. The study will be beneficial to those considering raising capital through debt financing. The study will guide them on the type 0f financing they should pursue and the amount they can effectively manage depending on their business.
The study also has tips on the benefits they can gain from debt financing and their considerations before taking up the funding. The study is not limited to being use full to entrepreneurs only. The creditors willing to finance SMEs can also gain from the research done here. The private financers can gain insight into how the money they give out as loans can impact the businesses they invest in. This will encourage them to be more savvy investors. The study also promotes a deeper understanding of SMEs in the region and encourages more investment to come into this space.
1.5 Scope and Limitations
The study will cover the effect debt financing has on the SMEs themselves as well as their consumers. This area is not well researched upon, especially in the sub-Saharan regions of Africa where Nairobi is situated. The study will look at this effect in the frame of the financial performance of SMEs. This is the most significant aspect with respect to the economy that SMEs have.
The study will also cover the effect in terms of the tax obligations SMEs have to the government. Debt financing is given special consideration when it comes to filing tax returns every financial year. Understanding the local considerations made for SMEs in the Nairobi region is of great significance. Debt financing is also impactful in terms of a business credit score.
This is a key metric used to evaluate the creditworthiness of a business. Understanding how debt financing affects this metric goes a long way in ensuring it is financially stable. The future avenues of financing growth are affected by the credit score. The study will also cover the advantages and disadvantages of debt financing.
This will help entrepreneurs when they are considering means of raising working capital. The pro and cons of different debt financing methods are also be covered so that prudent decision-making is available to the entrepreneurs. Understanding this framework concerning the Nairobi county region is very helpful.
This study was limited to the county of Nairobi to reduce the number of considerations needed to conclude. The results of the study could also serve as a guide to do other county-based tasks. In the end, the study will significantly benefit the county’s economic growth and encourage the financial independence of individuals.
1.6 Limitations of the study
The study faced some challenges in execution that limited its potential exhaustiveness of the topic. The first is in the conciseness and accuracy of the study. The definition of an SME is broad, as has already been discussed; thus, narrowing down on businesses to include could be challenging. The variety of existing industries could contribute to this problem as well. A blanket conclusion might not apply to this study. To remedy this, a rigid study framework is outlined.
The study was also greatly affected by the Covid-19 pandemic, which affected some of the methodologies. Face-to-face interviews were harder to conduct due to the high infection rate. The available time and movement necessary to complete the study were also limited by the curfew and lockdown mandates issued because of the pandemic. More intense planning was essential to account for the restrictions.
The final limitation was in the available data that is specific to Nairobi County. The study was dependent on generalized data for the whole of Kenya. The study required the interpolation of most of the research data to fit the context of Nairobi County.
Chen, J. (2021, May 30). Debt financing. Retrieved June 05, 2021, from https://www.investopedia.com/terms/d/debtfinancing.asp
Githaiga, P. N. (2015). Debt financing and financial performance of small and medium-size enterprises: Evidence from Kenya. Pressacademia, 2(3), 473-473. doi:10.17261/pressacademia.2015312967
Munguti, M. J., & Wamugo, L. (2020). Microfinance credit accessibility and financial performance of small and medium enterprises in Machakos COUNTY, KENYA. Integrated Journal of Business and Economics, 4(1), 71. doi:10.33019/ijbe.v4i1.250
Mutunga, A., Editor, & Admin_nlb. (2020, June 09). SMEs dilemma in Kenya. Retrieved June 1, 2021, from https://www.nairobibusinessmonthly.com/smes-dilemma-in-kenya/
Stephen Thompson & 4 others, Brigitte Rohwerder & 4 others, & Mary Wickenden & 4 others. (2019, March 11). The SME finance gap in Kenya: How are investors missing the ‘missing MIDDLE’? Retrieved June 02, 2021, from https://www.ids.ac.uk/opinions/the-sme-finance-gap-in-kenya-how-are-investors-missing-the-missing-middle/
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