SMES EXTERNAL FINANCING PREFERENCE AND ITS IMPACT ON GROWTH

As firms go about their operations and expand their activities, the retained earnings of the firm might prove insufficient to support its activities. Firms are forced to look for external finance and the ordeal lies with how to raise the needed funds. A financial contract design for small firms is chosen on the basis of the financial characteristics of the firm, the entrepreneur, the firm’s prospects and the associated information problems (Berger & Udell, 1998). Broadly, these factors that play a crucial role in determining the financial contract type (debt or equity) can be categorized into three. The firm characteristics which combine the financial characteristics of the firm and the firm’s prospects. The other categories are the owner characteristics representing the entrepreneur factor and lastly, the control mechanisms present to deal with the information problems. The firm characteristics include the age, size, asset structure and legal status. The preference for an external contract type is a function of the financing costs associated with the various sources of finance (Chittenden, Hall, & Hutchinson, 1996). These firm-specific features may affect the type of external finance a firm will prefer. Given the firm characteristics of SMEs, the financing costs associated with external financing may be relatively higher than their larger counterparts. For instance, the cost associated with the issue of public securities (especially equity securities) is essentially characterized by significant fixed cost. Therefore, the firm creates economies of scale by virtue of its issue size. As a result, it becomes difficult for SMEs to raise equity finance and tend to prefer debt financing.