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.
Overcapitalization means that the total capital is in excess in relation to a company’s
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
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 world’s 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 obvious yes.

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 a positive 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.
In the World bank review, (1994), SSBs' demand for finance is overwhelmingly for bank
loans. Informal lenders generally cannot provide enough funds and charge too much
interest, and individual equity partners are considered undesirable.

2.2 Profitability

Samuels J.M (1991), defines profitability as ability of a firm to generate net income on a
consistent basis. It is often measured by profit to earnings ratio

Emuron F.G, (2001), asserts that in order to quantify and assess the profitability of a

business enterprise, management has to ensure that financial records are in place and are
religiously maintained. These include income statements, balance sheet, cash flow
statements, and cash analysis register

2.3 Effect of loan capital on SSBs' profitability

Balunywa W (1998) showed that there is no formula for the determination of the
proportion of loan capital in the performance of SSBs because the ideal situation varies
from one organization to another, industry to industry and time to time.

That loan capital can lead to positive or adverse effects on the results of business and
there fore the optimum amount to be borrowed into a business for optimum performance
is a fudicious decision by the finance people depending on the objective to be achieved.
Classical and neo classical schools view on the capital structure debate, loan capital give
an advantage of tax shield. However a point to consider is in what way will this
advantage be benefited by the SSBs? Emuron F.G (2001) states that since SSBs don’t
keep adequate financial statements, they may not enjoy this benefit.

Turamye (1994) in his study "the performance of rural small sacle industry in Mbarara
distrct", showed that the growth of small scale businesses is affected by a limitation of
working capital, shortage of needed requirement and possibly some spare parts. It
matches with the saying that small scale businesses operate at excess capacity. In this
case there fore extra inputs of capital could boom up small scale businesses.
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 this SSBs
pay higher interest rates for their capital.
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
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 doesn’t 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 Lore’s 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
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 for
expansion. 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
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

Murphy M (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