SME Financing Problems and Remedies

Small and medium-sized businesses are the backbone of the Nigerian economy: the Securities and Exchange Commission has estimated some 37 million micro, small and medium enterprises, nearly all of them micro, and together they provide most of the jobs and a large share of output. Yet they find it harder than large companies to raise money.

A large company can issue shares, bonds or commercial paper and borrow from banks at rates based on its rating; the owner of a small business usually has the family’s savings, a few suppliers and a bank manager who wants a mortgage on the family home. This is the financing problem of the small business.

The constraint is not only the supply of money but the difficulty of showing lenders that the business is a good risk.

This topic explains the characteristics and definition of small and medium-sized enterprises (SMEs), why they matter, why their equity and debt finance are limited (control, risk, information, security, the maturity gap, the cost of risk), the debt service cover that decides how much a bank will lend, and the practical remedies: leasing, factoring and invoice discounting, supply chain finance, guarantees, better information and retained profit.

The next topic covers the specialist sources of equity and other finance for growing businesses.

The syllabus asks for the problems of financing small and medium-sized enterprises, and the main sources. Read pecking order theory and choosing the financing method first.

What an SME is, and why it matters

There is no universal definition. SMEs are typically private companies owned by a few individuals, often a family group, and the definition varies with the industry.

In Nigeria the Small and Medium Enterprises Development Agency (SMEDAN) and the Bank of Industry classify enterprises by the number of employees and by asset value excluding land and buildings (and, increasingly, by turnover): in the national policy a micro enterprise has fewer than 10 employees, a small enterprise 10 to 49 and a medium enterprise 50 to 199, with asset limits that have been raised over time (for example ₦10m, ₦100m and ₦1bn in recent descriptions of the policy; earlier figures were ₦5m, ₦50m and ₦500m, and the Central Bank of Nigeria has used other definitions).

A question will give the definition to use. SMEs make up most of the number of businesses and a large part of employment, so a country that wants growth needs SMEs to be able to grow, and to grow they need long-term capital, which is where the difficulty lies.

The equity problem

• Owners do not want to dilute control. A new outside shareholder takes part of the ownership and the say.
  If an owner needs ₦30m and the business is worth ₦70m before the money goes in, the new investor must have 30 ÷ (70 + 30) = 30% of the company, and the owner falls from 100% to 70%.
• Outside investors see high risk. The shares of a private company are hard to value and hard to sell, so investors want a large return or stay away.
• Owners’ own wealth is limited, so they cannot supply much more, even if they are willing.
• Retained profit is slow. Even in a profitable small company it takes a long time to build up capital, and the opportunities may be lost before the money is saved.

A private company cannot offer shares to the public (the Companies and Allied Matters Act 2020, section 22(5)(a)), so a public share issue is not open to it unless it first converts to a public company.

The debt problem

The main source of external finance for an SME is the bank. The difficulties:

• Limited information. Small companies may not have to publish accounts or be audited; they must convince the bank with a business plan and financial information that is credible. The bank has less information than the owner, so it asks for more security and a higher rate (this is the problem of information asymmetry).
• Management. Lack of experienced management, and forecasts the bank suspects are too optimistic.
• Security. Few assets to offer. Long-term loans are easier to obtain because they can be secured on land and buildings. The problem is short and medium-term loans, for which adequate security does not exist, called the maturity gap. Banks often ask for a personal guarantee, perhaps a mortgage on the family home.
• Risk premium. High-risk projects and a short track record mean a higher interest rate. For example, a larger company might borrow ₦20m at 18% (₦3.6m interest) and a small one at 24% (₦4.8m): the extra ₦1.2m is the price of the risk and of the lack of information.
• Trade credit and overdrafts may be hard to obtain without a track record. Heavy reliance on short-term finance increases the risk of overtrading (growing sales faster than the finance available for working capital).

How much a bank will lend: debt service cover

Banks lend what the cash flow can bear. The debt service cover ratio is the cash flow available for debt service ÷ (interest + principal repayments due in the year), and banks look for 1.3 to 1.5 or more. An SME has earnings before interest, tax, depreciation and amortisation of ₦12m and pays ₦1m in tax, leaving ₦11m. It wants a ₦20m four-year loan at 24%, repaid in equal annual instalments of principal (₦5m).

In year 1 the debt service is 4.8 + 5.0 = ₦9.8m, so the cover is 11 ÷ 9.8 = 1.12, below a requirement of 1.3. The most the bank would lend is found from 11 ÷ 1.3 = ₦8.46m a year of debt service allowed; in year 1 debt service is 24% × L + L ÷ 4 = 0.49L, so L = 8.46 ÷ 0.49 = about ₦17.3m. The business is ₦2.7m short of what it wanted.

If the bank also requires security of 150% of the loan, a ₦20m loan needs ₦30m of security; if the business has only ₦18m of acceptable assets, there is a ₦12m gap, which a personal guarantee may be asked to fill.

Remedies

• Leasing. SMEs make extensive use of operating and finance leases, because the lessor remains the owner and can take back the asset if the lessee cannot pay, which is a form of security. A lessor may therefore agree to a deal that a bank would refuse as a loan.
• Factoring and invoice discounting convert receivables into cash quickly (up to 70% to 80% of the invoices), reducing the working capital needed and the need for an overdraft.
• Supply chain finance lets a small supplier sell invoices that a large buyer has approved to a bank at a discount based on the buyer’s better credit risk: the supplier gets cash sooner and cheaper than through factoring.
• Credit guarantee schemes in which a government agency guarantees part of a bank loan reduce the bank’s risk and so its need for security.
• Better information and planning: audited accounts, a credible business plan with cash flow forecasts, regular reporting and a track record with the bank reduce the information problem and the risk premium.
• Negotiated trade credit and careful working capital management reduce the need for outside finance.
• Retained profit and owners’ funds, including patient family finance, which is consistent with the pecking order theory.
• Specialist equity (venture capital, business angels, crowdfunding) and government and development finance, covered in the next topic.

The ideas in more depth

Why banks ask for security even when the project is good

A bank cannot easily tell a good small borrower from a bad one, and it cannot afford to study each in depth. Security and guarantees make the borrower share the risk and give the bank something to fall back on; they also act as a signal that the owner believes in the business.

The cost is that sound businesses with no assets are turned away, which is the heart of the SME finance gap.

Why supply chain finance works

A bank lending against an invoice approved by a large, creditworthy buyer is, in effect, lending to the buyer.

So it prices the discount on the buyer’s credit, not the small supplier’s. If the supplier’s own credit would cost 28% a year but the buyer’s costs 18%, then on a ₦50m invoice due in 90 days the supplier receives ₦47.8m at 18% against ₦46.5m at 28%, an extra ₦1.2m of cash. The buyer meanwhile pays at the normal due date or later.

Sources and references

• The definition of micro, small and medium enterprises is that of the National Policy on Micro, Small and Medium Enterprises and of the Small and Medium Enterprises Development Agency of Nigeria and the Bank of Industry. Thresholds have been revised, so use the definition in a question. The restriction on private companies is in the Companies and Allied Matters Act 2020.

These points are stated as at 5 November 2026.

Worked examples

1. Value after.
   70 + 30 = ₦100m.
2. Share.
   30 ÷ 100 = 30%; the owner keeps 70%.

1. Debt service.
   4.8 + 5.0 = ₦9.8m.
2. Cover.
   11 ÷ 9.8 = 1.12.

1. Interest. 4.8 against 3.6.
2. Extra.
   4.8 − 3.6 = ₦1.2m.

How to answer in the exam

• Separate equity and debt problems and explain each in terms of the owner, the investor and the lender.
• Use the case facts: age, assets, information, management, sector and the amount needed.
• Suggest remedies that fit, with the cost and the risk of each.
• Mention overtrading where the case shows heavy short-term finance.

Common mistakes in the exam

• Saying that SMEs cannot borrow at all, instead of explaining why it is costly and limited.
• Confusing the maturity gap with a mismatch of currencies.
• Recommending a share issue to the public for a private company.
• Ignoring the owner’s wish to keep control.
• Listing sources without saying how they overcome the specific problem.
• Forgetting debt service cover when advising on borrowing capacity.

Quick revision

• Equity: control, risk, owners’ wealth, slow retained profit.
• Debt: information, management, security, maturity gap, risk premium.
• Debt service cover = cash flow ÷ (interest + principal).
• Remedies: leasing, factoring, supply chain finance, guarantees, information.

Practice questions

These are original questions written in the style of the Institute’s exams. Try each one before you open the answer. Section A is a recall check, because the paper itself is written.

Recall check: multiple choice

Section B style: written questions

A further written question

Model answers

Spotted a mistake? Tell us and we will check it.