Project Proposal Literature on Loan Capitalization

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CHAPTER TWO

2.0 Introduction

This chapter reveals the existing literature on loan capitalization, weaknesses and effects,

small scale business profitability and where small businesses get loan capital. It also

reveals how the loan capital affect small scale businesses and factors that make it hard to

access loan capital by small scale businesses

2.1 Loan capitalization

The term capitalization is derived from the word capital. An acceptable definition of

capitalization according to N.A. Saleemi, (1993) , refers to the total value of loan capital,

ordinary shares, preference shares, debentures, and retained earnings.In most cases a firm

is either over capitalized or under capitalized.

Overcapitalizationmeans that the total capital is in excess in relation to a companys

earnings capacity. This situation exists when the amount of capital is too large in relation

to the volume of the business. Too much loan capital or excessive ploughing back of

profits is the main cause of this situation. Overcapitalization results into the lower rate of

capital employed.

Under capitalization this means that the firm's earning capacity is more in relation to its

capital employed. The main cause of under capitalization is efficiency

Wikipedia free encyclopedia define a loan as a contractual promise between two parties

where one party, the creditor, agrees to provide a sum of money to a debtor, who

promises to return the money to the creditor either in one lump sum or in parts over a

fixed period in time. This agreement may include providing additional payments of rental

charges on the funds advanced to the debtor for the time the funds are in the hands of the

debtor (interst). It also that there are three types of loans i.e secured, unsecured and

demand laons. The difference in these three comes in form of collateral pledged on

secured loan whereas the unsecred is collateral free. The demand loan is a short term loan


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which do not have fixed dates for repayment and carry a floating interest rate which

varies according to the prime rate. This loan can be "called" for repayment by the lending

institution at any time.

HSBC the worlds local bank (2009) states the sources of loans can be availed to a

business that is to say retail or traditional banks, saving banks, credit unions, consumer

finance companies, small loan companies and brokerage firms.

With all these sources one can easily conclude that funds are readily available to those

who require them. However, a strong question arises; does availabilty of bank loans

affect demand for credit by small firms? At first glance the answer to this question seems

to be an obviousyes.

In the European Central Bank survey (April 2001), found out that as to the factors

influencing credit demand, include an economic activity variable and financing costs (i.e.

interest rates or bank lending rates) as its main determinants. However, the findings

further reveal that there seems to be no clear consensus in the literature about how

economic activity affects credit demand. The research adds that some empirical findings

point to apositive relation between the two variables based on the theoretical grounds

that strong economic growth would have a positive effect on expected income and profits

and, thus, on the overall financial conditions of households and corporations.

Most empirical studies include a measure of the cost of loans as an explanatory variable.

The negative relationship between the demand for loans and their cost (i.e. bank lending

interest rates) appears to be more consensual, though some studies have pointed out that

the price of loans should be adjusted to reflect the opportunity cost of bank loans (i.e. the

cost of alternative sources of finance should be netted out as in Friedman and Kuttner,

1993). The underlying argument is that the demand for loans will depend not only on the

own price of the borrowed funds, but also on their relative price (that is relative to the

cost of funds obtained from other internal or external sources).This issue is more relevant

for non-financial corporations than for households since the latter have limited access to

financing from sources other than the banking sector.


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Whereas finance experts advocated for making the borrowing decision, this may not be

applicable to SSBs where the owner of the business is the manager, financial analyst

accountant, sales manager and a store keeper (world bank research on SMEs, 1991).

In this research Wold Bank lending for small and medium enterprises two approaches to

evaluation were employed, the first evaluating completed projects according to their

objectives as stated in staff appraisal reports, comparing actual outcomes of profits with

projected outcomes. In this way projects are evaluated in their own terms. The second

looks at project viability and sustainability and evaluates the financial and institutional

soundness of Bank assisted SME programmes. The Bank had lent money to SMEs with

objectives including strengthening finanacial position, job creation and correlation of

market imperfections that limit small enterprenuers to access credit.

The distributon resulting from this analysis showed that 18 (55%) projects achieved

atleast two of the three objectives . Four projects achieved only one of the three

objectives and eleven projects failed to reach any of the goals.

A mere 55% doesnot create a good result and also show that there is still a big problem

related to loan finacing in small scale businesses.

In general, variety of studies in this area point to the effect that loan capital plays as part

in enhancing performance of SSBs, this is contrary to what is happening to the ground

where most of the businesses that have got loan capital have had tendency of nearly

collapsing. This has been explained by some researchers in the following way.

Michael Murphy (1996) in his work Small Business Management states that the source

from which to repay the loans would appear to be profits and in fact the only source for

SSBs. the business must therefore generate cash almost at once and it is well to remember

that profit may not always be equal to cash. With this the structure of borrowing would

obviously affect the period and nature of repayment to the bank. In addition to thisSSBs

pay higher interest rates for their capital.


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In a world bank report (1980) a survey carried out on small scale interprises in Korea and

Taiwan it was found out that small and large enterprises pay significantly different prices

for their capital. In Korea and Taiwan, the interest on institutional loans is low and

usually subsidized and that enterprises able to get these loans are generally large.

Enterprises not able to obtain these loans are SSBs and they borrow from informal credit

market characterized by higher interest rates. The evidence available was that in 1970's

private lenders in Korea charged interest of 3-4% per month making it 36-48% per year

In her research about Lending terms and Performance of Small scale enterprises

Financed by selected microfinance institutions in Uganda Nassuna A.N,(2003), indicates

that lenders especially MFIs allow SSBs access the loan capital with high interest rates.

More to this, most SSBs that have accessed loans with MFIs have to pay back quite often

on weekly or monthly basis. This cost of transporting the money to the MFIs affect

business and the regular installments from the business do not allow regular growth of

business and profit accumulation.

Rutherford (1997) observed that for the SSBs, opportunities for productive use of loans

are often limited. Weekly meetings are time consuming and also the risks of not repaying

loans on a weekly basis are too high. He adds that paying in small installments weekly is

costly as spending the time on journeys that would otherwise be utilized in other

productive ventures.

From all the above researchers its indicated that trully loan capital has got a negative

effect on profitability of small scale businesses and may be it explains why some SSBs

die in their infantry or fail to achieve the expected growth. Talking about growth of SSBs

researchers like Enoch Byabarema (small scale businesses and commercial banks in

uganda, 1998), reject the opinion that cost of loan funds is a major problem to SSBs

With his experience as an employee of Uganda commercial bank for 27 years ascerts that

the reasons why SSBs fail can be attributed to lack of business and mangement

knowledge, mismanagement of financial resources, inihibitive management styles and

inihibitive situations. He adds that the needs of SSBs today and future may stretch


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beyond the techinical know how, experience and financial resources of a single day and

therefore ugandans should form limited liability companies to take advantage of

economies of large scale otherwise they run thwe risk of a rude awakening!

2.4 Limitation of small scale businesses to obtain loans

Emuron F.G (2001), indicates that small scale businesses have had a g reat need to have

capital leaving aside the cost. Howver, their desire has always been overturned by various

factors. In his study Factors hindering access to Commercial bank Credit stated that lack

of financial statements doesnt favor them in obtaining bank loan. The researcher took a

sample on SSBs in Jinja and found out that 20% of SSBs prepare and keep all the sets of

documents, while 14% prepare only one document. Others did not indicate the type of

document kept. It should be noted that these statements are vital ingredient for a lender to

determine whether it is worthy extending financial support to the business.

In an article written on www.smsmallbiz.com (small firms get loans, November 10th

2008), explains how banks resiliently fail to offer loans to small businesses no matter

how hard they try. When applying for loans, Ms. Loera says she highlighted the fact that

her restaurants are based in so-called bedroom communities like Rancho Cucamonga,

Calif. where people commute some distance to work, is strapped for time, and look for

a place where they can eat an affordable family meal at the end of the day. She presented

a three-inch-thick binder filled with financial statements showing the historical results of

existing restaurants as well as the fact that they were debt-free. The Lores had credit

ratings in the 750 range, she says. She also gave a projection of how much money the

new restaurant would bring in over the first 12 months, and a business plan that included

details such as the number of employees the new location would have and the intended

menu. Ms. Loera says all that data didn't affect the decision of the banks. this matches

with the survey taken in Ghana, World bank (1994) where at the market interest rate of

30%, 53% of rising profit firms indicated that they would be very interested in a loan for

few investment, as against only 24% of falling profit firms. Nevertheless, a larger

proportion of the forms with rising profits had their applications rejected by banks and


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successful ones received small loan amounts than the less profitable firms.

In explaining why SSBs are limited to access loan finance, Marguerita S. Robinson

(2001) asserts that a number of features generally associated in aggregate with informal

enterprises (SSBs) tend to be absent from the formal enterprises. Theses include family

ownership, small scale operations, non legal status, lack of security of business location,

operation in unregulated markets, relatively easy entry into markets, labor intensive

production modes, non formal education and low skill levels, irregular work hours, small

inventories, use of indigenous resources and domestic sales of products often to end

users. By this there the financial sector has generally been self deterred from financing

informal enterprises by characteristics typical associated with such businesses.

She adds that huge informal sector in many countries remained essentially invincible in

government plans, in economists models, in bankers portfolios and in national policies. in

fact the most visible government policies on the informal sector tend to aim at repressing

or eliminating the sector by removing micro entrepreneurs from streets, by sending urban

informal laborer back to villages which they left because of unemployment

In a world bank survey report (small scale enterprises in Korea and Taiwan, 1980),

financial institutions apparently play a some what minor role in supply of funds to small

scale enterprises for use as working capital or to help finance additional fixed

investments. A medium small scale industry bank survey reported that of the investments

in fixed capital made by manufacturing enterprises with 5-49workers in1975, 32%were

financed by financial institutions, 3% by private lenders, and 65%self financed. However

the very small enterprises still had to depend almost extremely on their own resources forexpansion. also according to the 1973 survey of small and petty businesses,

approximately three quarters of the required working capital of small manufacturing

enterprises was self provided. in trying to understand why small enterprises have received

so little institution credit, loans are more costly to process and default risks are perceived

to be substantial higher for SSBs


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In another survey taken in Ghana, World bank (1994), 65 %of the SSBs had to use their

savings as primary source of start up capital.

John Lambden and David zargett (Michael Murphy 1996) in their instructive and

admirable survey "small business finance" (pitman 1990) Point out that vast majority of

small businesses owners enrolling for a financing program actively disliked their bank

mangers and avoided them whenever possible. To them bank managers are taken to be

highly profile people who could care less to their problems

In Uganda, World Bank (1991), small and medium scale enterprises were characterized

by lack of well established management and organizational structures attributed to low

education. The republic of Uganda (1992) supported these findings recognizing that the

level of management and technical skills in SSBs was very low and that partly as a result,

they operated outside the formal banking sector.

References

Balunywa W (1998), Business Administration, Kampala

European Central bank, 2001, Modeling the Demand for Loans to the Private Sector in

the Euro area- A Calza, C. Garther and J. Sousa

Nassuna A.N,(2003),Lending terms and Performance of Small scale enterprises

Financed by selected microfinance institutions in Uganda, Kampala Makerere Universit

Perry CA (1963), Management Accounting for Small businesses, London ACCA


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MurphyM (1996), Small Business Management, London; financial times (pitman)

Samuels J.M (1991), Management of Company Finance, London: New York;

Chapman hall

World Bank, 1(994), supply and demand for finance of small enterprises in Ghana,

Washington D.C

World Bank, (1984), Small scale Enterprises in Korea and Taiwan, Washington D.C

Surdej Aleksander, Small and Medium sized Development in Poland after 1990,

Helsinki UNU World institute for development economics research

Webster Leila, (1991), World Bank Lending to Small and medium sized Enterprises:

fifteen years of experience, Washington D.C

Biryabarema E, (1998), Small Scale Businesses and Commercial Banks in Uganda,

Kampala Makerere University Press

Documents

Project Proposal Literature on Loan Capitalization