Chapter Two: Financing Small-Sized Businesses - Business Studies Form Two

Chapter Two: Financing Small-Sized Businesses – Business Studies Form Two

Introduction

Funds enable small businesses to start, grow operations, enter new markets, and innovate their products or services. Sources of funds are essential for the progress and success of small businesses. In this chapter, you will learn about the concept of small-sized businesses, sources of funds for small businesses and the roles of microfinancing and cooperatives in facilitating business formation and operations. The competences developed will enable you to finance your small business from different sources.

Think

Operating a business without funds.

Activity 1

Visit at least three small businesses in your community or search various sources, including online, to learn how the owners get funds for starting and growing their businesses. Write down a small report on your findings.

The concept of small-sized businesses

Globally, there is no single accepted definition of small-sized businesses. However, nations use measures of different sizes to define small businesses depending on their level of development. The Tanzania Small and Medium Enterprise (SME) Development Policy of 2003 recognises small businesses as both micro and small. Hence, the context of small business refers to micro and small businesses.

A micro business is a business that employs 1-4 people and/or has a capital investment of up to TShs 5 million.

A small business has 5-49 employees and/or a capital investment of above TShs 5 million to 200 million.

Note: If a business falls under more than one category, the level of capital invested into a business will be the deciding factor. Small-sized businesses may be owned by individuals, groups of individuals, family members, or the public with a common interest in ensuring that pre-determined goals are achieved. Throughout this textbook, small-sized businesses are termed micro and small businesses.

Importance of small-sized businesses

Small-sized businesses have the following importance:

Contribution to the economy: Small businesses contribute to the country’s economic growth by paying taxes and fees, which can be used to provide public goods.
Creates employment: Small businesses play a crucial role in job creation by providing employment opportunities to business owners and others. As such, they serve as a solution to reducing unemployment rates in the country.
Foster equitable income distribution: Most small businesses use locally available resources and simple and affordable technology, thus facilitating the distribution of economic activities within the economy and fostering equitable income distribution.
Supplier to large businesses: Most small businesses supply materials to large businesses, thus making it easier and cheaper to operate and fulfil their objectives.
Community development: Small businesses support community development by keeping wealth within local areas and providing services tailored to local needs.
Product availability in remote areas: Small businesses can supply goods and services not supplied directly by large businesses in remote areas.

The sources of funds for small businesses

Small businesses can access funds from different sources depending on their needs, financial position, or existing status. Several sources of funds for small businesses include loans from lenders, personal savings, deferred payments, and funds from family and friends.

1. Loan

A loan is money borrowed from a lender/ bank with the agreement to repay it, usually with interest over an agreed time. Interest refers to the monetary cost of borrowed money, mainly expressed as an annual percentage rate of the borrowed amount. Entrepreneurs can use loans as sources of funds to start up their small businesses.

Advantages of loans

There are different advantages to taking a loan. Among those advantages are as follows:

Availability of funds: Loans allow business owners to access a lump sum of money to start or expand a business.
Flexibility: Different types of loans offer different conditions and repayment options, allowing borrowers to choose the loan that best suits their needs and financial situation.
Credit building: Responsible borrowing and timely repayment of loans can help business owners build their credit scores, which can be significant for future financial opportunities.
Investment opportunities: Loans provide funds required to invest in different opportunities with the potential for high returns.
Financial leverage: Borrowing money allows business owners to make more significant investments than they can afford through cash.

Disadvantages of loans

Loans come with responsibilities and potential risks like interest payments and possible negative effects on credit if repayments are delayed or not honoured completely. Thus, business owners must consider their financial situation before taking on any loan.

Some of the disadvantages of loans are explained as follows:

High interest rates: Lenders tend to change high interest rates, which may hinder the business owner’s access to loans.
Needs eligibility: This means the borrower must meet all the given conditions and requirements, including collateral, to qualify for the loan, whereas others miss some qualifications and fail to access loans.
Fees and penalties can be challenging: Some borrowers fail to repay loans because of exceeded fees and penalties resulting from the aggressive repayment schedule, which may be difficult for business owners to comply with on time or other factors related to business operations.
Limited flexibility: The obligation to meet regular repayments can limit a business’s ability to invest in growth opportunities or adapt to changing market conditions.

Activity 2

Visit any financial institution around your community, which offers loans to small businesses, or search from various sources, including online. Ask the loan officer or any other person responsible for loans about the conditions necessary for any small business to obtain a loan and the actions that could be taken if the business fails to repay the loan. Write a brief report on your findings.

2. Personal savings

Personal savings refers to setting aside part of an individual’s income or earnings for future usage instead of spending all of it. Developing a saving habit is highly encouraged, as the little money saved later becomes huge and can be used to set up a small business. There are several ways through which an individual can save money. Saving can include money from a savings account, retirement account, or other investments.

Advantages of personal savings

Personal savings is essential for building wealth and securing a financial future. Personal saving protects an individual from the uncertainties of life and provides an opportunity to enjoy a promising future. Saving money systematically helps to prevent many financial challenges.

Saving support in a time of need that guarantees the family to have security in case of financial challenges. More importantly, savings can be used as a fund or capital for starting or improving a small business.

Here are some of the advantages of savings:

Long-term security: Saving offers significant long-term security for small businesses. Life’s unpredictability means financial emergencies can arise unexpectedly. A business owner creates a financial safety net for future expenses and unforeseen needs by saving. This ensures readiness for potential challenges and contributes to peace of mind and more stable and comfortable business operations.
Immediate access: Utilising personal savings allows entrepreneurs to quickly access capital without requiring lengthy approval processes (approval time) or complex paperwork associated with traditional loans or investor funding.
No debt: By funding their business with personal savings, owners avoid taking on loans, which can be crucial for minimising financial obligations.
Flexibility: Personal savings provide flexibility in how funds are used, enabling business owners to allocate resources according to their specific needs and priorities without external influence.
Lower financial risk: Personal savings reduce reliance on external financing sources, decreasing the risk of financial strain or default associated with borrowed capital.

Disadvantages of personal savings

Provided that saving is mainly considered a sensible financial practice, there are also possible disadvantages to look at as follows:

Low returns: Interest rates on savings accounts and other passive investments are often very low. This means that savings income may not keep pace with inflation, leading to a decline in purchasing power over time.
Opportunity cost: Money saved and held in accounts with low returns may fail to benefit from higher returns in other investment opportunities, such as stocks, bonds, or real estate.
Risk to personal finances: Using personal savings for business funding puts personal financial stability at risk. Entrepreneurs’ assets and savings could be jeopardised if the business fails or encounters financial difficulties.
Behavioural biases: Some individuals may struggle with spending temptations if they see their savings as an available pool for discretionary purchases rather than long-term financial goals.
Emergency fund limitations: An emergency fund is essential. However, keeping too much money in a low-interest savings account could prevent you from using those funds effectively to generate more income.

Activity 3

From today (the day you read this part), start saving part of any money you get for personal spending. It might be money from your parents, guardians, and relatives for different purposes, such as a transport allowance, meal allowance, or other pocket money. After three months, sum up the amount you saved. Use your saved money to start a small business of your own. After two months, write a report from the time you started saving.

3. Deferred payment

Deferred payment is an agreement between buyer and seller in which the buyer can pay for goods and services later. Business owners can use this approach to obtain materials for starting or expanding their businesses.

Deferred payment plans are often used in various businesses, such as retail, where customers can purchase products (useful materials for their business) and then pay for them at a future date.

For example, if the business is a bread production, the owner can apply this approach to access all the materials required to make the bread and then pay for all the supplies after selling bread to the customer.

Advantages of deferred payment

Deferred payment arrangements can offer several advantages for both buyers and sellers:

For buyers

Cash flow management: Deferred payments allow buyers to manage their cash flow by delaying payment for goods or services until later. This can benefit flexible individuals or businesses with fluctuating incomes.
Financial flexibility: By deferring payment, buyers may use the money they receive after the sale for other immediate needs or investment opportunities before paying for the purchased goods.
Budget: Deferred payments allow buyers to budget and spend more effectively, as they can cover costs over time instead of paying a large lump sum.

For sellers

Increased sales: Offering deferred payment options can attract many customers who do not have immediate cash to purchase products for sale but are willing and able to pay over time, thereby increasing sales volume.
Customer retention: Offering deferred payment terms can help sellers gain loyal customers who can buy more products and make payments on time after they sell the products, they picked up without paying for them.
Competitive advantage: In a competitive market, offering deferred payment options can differentiate a seller from other sellers and attract more customers looking for such convenient payment terms.

Disadvantages of deferred payment

Given that deferred payment offers several advantages, it also has some disadvantages to understand for both buyers and sellers:

For buyers

Interest: Deferred payment can incur added interest, increasing the purchased products’ overall cost over time.
Impulse purchasing: Delaying payment may lead buyers to purchase goods or services without planning and considering their long-term financial needs.
Debt accumulation: Depending on deferred payments for various purchases may lead to debt accumulation, which may become awkward if it cannot be managed effectively.

For sellers

Cash flow concerns: Agreeing deferred payment options can affect seller’s cash flow, as they have to wait a long time to receive full payment for the products sold.
Risk of non-payment: Sellers face non-payment risk when allowing buyers to defer payments, which could potentially lead to financial loss and an administrative burden in pursuing collections.
Administrative burden: Managing and tracking deferred payment agreements can increase administrative workload for sellers, especially if multiple customers are on varying payment schedules.

Activity 4

Extend Activity 2.3 by visiting the supplier of your business items (items you are selling) and asking for deferred payments on some items. Expect to be agreed upon or not agreed upon. If the supplier agrees with your proposal, take the items and ask questions like is it the normal thing he or she does? What are the strategies she or he uses to be paid back? What are the challenges of the method, and how does she or he overcome the challenges? If the supplier disagrees with your proposal, ask why and try to convince her or him to give you deferred payment on some items. Write a short report on your observation.

4. Funds from family and friends

Funds from family and friends are financial contributions from people close to the business owner in the form of equity investments or loans, sometimes without interest, to help start or run a small business. This form of financing is the most common source for small businesses.

Advantages of funds from family and friends

Advantages of using funds from family and friends as a source of funds for small businesses include:

Accessibility: Family and friends are sometimes willing to provide funds at a time when official lenders hesitate, which makes these funds easier for small business owners to access.
Flexibility: Friends and family members may offer more favourable conditions, such as lower interest rates and extended repayment schedules, than formal lenders.
Non-financial support: In addition to financial assistance, loved ones can provide valuable non-financial support in the form of mentorship, guidance, and emotional encouragement.

Disadvantages of funds from family and friends

Given all the advantages of using funds from family and friends for small businesses, there are also potential disadvantages as follows:

Personal conflicts: Receiving money from family and friends may result in personal conflicts, especially when the business is underperforming and one fails to repay the money. Furthermore, the lack of formal agreements like the ones in financial institutions and the variation of the repayment schedule may create conflicts among family members and friends.
Emotional pressure: The business owners may need to work under pressure and tension because they may not want to disappoint loved ones. Working under pressure and stress may result in poor decision-making.
Limited access to capital: Relying solely on family and friends for funding might restrict access to larger amounts of capital necessary for significant growth opportunities.

Activity 5

Extend Activity 2.3 by telling your friends, parents, and guardians what you are doing from the savings you made and the deferred payment items the supplier gave you or if you were not given. Ask them to provide you with some money to extend your business. Write a short report on what you have experienced from this activity.

Exercise 1

Assume you are doing a business selling groundnuts in your locality. You have reached a point where you have many more customers than what you sell. Describe ways you may use to finance your business.
Describe the benefits and disadvantages of saving part of personal earnings rather than spending all of it.
Assume you need to start up your preferred business, but currently, you do not have access to funding. However, you shared your business idea with your parents, and they have decided to provide funds to help you start your business. With this information, what kind of funding sources is this? Explain its benefits and disadvantages.

Microfinancing and cooperatives in facilitating business formation and operations

Microfinancing and cooperatives are essential in facilitating the establishment and operation of small businesses, especially for those who lack access to financing.

Microfinancing

Microfinancing refers to financial services offered to low-income individuals, groups or small businesses that may not have access to conventional banking services. Microfinance provides small loans, mostly to unemployed or low-income individuals, including small business owners, without access to regular banking services. The loans can be used to start or expand a business, purchase equipment and materials, or meet other financial needs. By providing these financial supports, microfinancing enables business owners to establish and grow their businesses.

Cooperatives

Cooperatives are organisations owned and operated by people with common interests or needs. They provide various benefits for business formation and operation, allowing members to pool resources when purchasing equipment or marketing products. In addition, cooperatives offer training opportunities and support services that help business owners develop their skills and knowledge in running their businesses.

Moreover, cooperatives provide access to markets that business owners might struggle to reach independently. Working together, small business owners benefit from shared marketing efforts and distribution channels.

In general, microfinance and cooperatives contribute significantly to the development of entrepreneurs by providing appropriate financial assistance, valuable resources, training, and a market for small business products.

Activity 6

Visit at least one microfinance institution and one cooperative operating in your locality (if any) or search from various sources, including online, to understand what they do for small business development. Compare the responses of each one and write a short report to show the differences or similarities between the two.

Exercise 2

How does microfinance support small business start-ups, and what benefits does it offer entrepreneurs in pre-financing and starting their small businesses?
Given TShs 300,000 as a loan, develop a plan for utilising the funds to start a small business of your choice. Then, state how you will use the given fund and how you plan to repay it.
What benefits can cooperatives provide to entrepreneurs in terms of facilitating small business activities, pooling resources, and accessing markets?

Skills lab activity

Based on the knowledge you have acquired about the sources of funds for small businesses, what source do you think is most common and why?

Project activity

Develop a fundraising plan for your chosen small business at your school business club. The plan should include specific fundraising strategies and goals within your community.

Chapter summary

A loan is money borrowed from a lender or bank with the agreement to repay it with interest over an agreed time.
Saving refers to setting aside part of an individual’s income for future usage instead of spending the whole of it.
Deferred payment is an agreement between buyer and seller in which the buyer can pay for goods and services later.
Funds from family and friends refer to funds that an entrepreneur is given by his or her family or friends to establish or develop his or her small business, as they can be a normal source of funding for small business development.
Microfinancing refers to the financial services offered to individuals or small businesses that do not have access to traditional banking services.
Cooperatives are organisations owned and operated by individuals with similar interests or needs.

Revision exercise

In each of the following questions 1 to 5, choose the correct answer and write its letter in your exercise book.

1. Organisations owned and operated by people with similar needs are called……….

(a) microfinance.

(b) corporation.

(d) cooperatives.

2. Interest means……….

(a) profit.

(b) buying and selling.

(d) saving.

3. Keeping aside part of personal earnings for future use refers to……….

(a) debt.

(b) saving.

(d) loan.

4. Borrowing funds from financial institutions with the agreement of repaying them with interest over a specific time refers to……….

(a) financial business.

(b) raising fund.

(d) deferred payment.

5. The process of making payment for the purchased products at a later date refers to………

(a) purchases.

(b) borrowing.

(d) cash payment.

6. Match the items from Group A with those in Group B by writing the letter of a correct option in Group B that corresponds to an item in Group A

Group A	Group B
(i) Borrowing money allows business owners to leverage their existing funds for more significant investments than they could afford through their cash	A. Financial flexibility
(ii) It increases the debt load	B. Advantage of saving
(iii) It includes money from savings accounts.	C. Opportunity cost
(iv) Leads to financial independence	D. Behavioural biases
(v) Keeping too much money in a low-interest savings account causes missing opportunities to put those funds to work effectively somewhere else.	E. Disadvantage of saving
	F. Saving
	G. Advantage of loan
	H. Loan

7. George has a friend who made much money from his small business. His friend gave him TShs1,000,000 as a gift to expand his small business. What type of funding for small businesses is this? What are the advantages and disadvantages of this funding type?

8. Veronica borrowed money to start a business selling water. After getting a loan, she changed her mind and bought a mattress she did not have. Explain the impacts that her decision to change the purpose of the money borrowed will have on her.