How capital markets can ease SMEs’ capital burden

A barista prepares coffee.SMEs rely on bank loans as a source of capital. PHOTO BY RACHEL MABALA

What you need to know:

In East Africa, the question is: What does it take to encourage investors, grow our economies and create jobs? Small and Medium Enterprises (SMEs) form a vital sector of our economy. But they suffer high costs of financing. SMEs need capital to start up or run their businesses but borrowing or using investors’ funds is not free. The cost of capital is the return required as compensation for contributing capital

Primary capital markets are markets in which companies and governments raise capital. Companies raise funds by borrowing money or issuing equity; governments by borrowing. These securities can later be traded in the secondary market.

In a liquid market, transaction costs are low, shareholders and lenders can easily value their securities and sell when they need to, so they are more willing to fund potential investments.

A market is considered deep when large trades can be made without causing large price movements and the costs of trading large amounts is relatively small.

The capital markets need to channel savings to the most productive use. Economies grow when resources are used productively, and remain poor when they are not. The regulators – the Capital Market Authorities, ensure there is a system that protects investors from fraud. They vet companies seeking funding and regulate the companies who receive the funding. The market encourages investments by offering attractive returns for savings and gives an alternative to borrowing as a source of capital.

In East Africa, the question is: What does it take to encourage investors, grow our economies and create jobs? Small and Medium Enterprises (SMEs) form a vital sector of our economy. But they suffer high costs of financing. SMEs need capital to start up or run their businesses but borrowing or using investors’ funds is not free. The cost of capital is the return required as compensation for contributing capital.

To justify contributing capital, returns need to be equal or higher than returns of other investment opportunities with similar risk. The riskier the investment, the greater the cost of capital. SMEs that generate returns greater than the cost of capital are able to keep going, add value to the economy, create jobs, and attract investors.

Alternative sources
The capital markets provide an option for a source of capital for SMEs. The Exchanges in East Africa are the Uganda Securities Exchange (USE), Nairobi Stock Exchange (NSE), Rwanda Stock Exchange (RSE) and the Dar es Salaam Stock Exchange (DSE). These markets are shallow, meaning large trades cause drastic movements in price and the costs of large trades is high.

Deeper capital markets will attract both local and foreign investors who have stayed away because of the illiquidity, small size, limited options available and lack of depth of our markets. Investors would pay more for securities that they can easily sell, bringing down the cost of capital.

If SMEs seek funding from the capital markets, regulations will require them to have good corporate governance and transparency, which will reduce their cost of capital and improve their earnings.

The CFA Society East Africa Investment Conference to be held in Kampala at the Serena Hotel towards the end of the month (29th August) have assembled regional and global speakers, financiers, regulators, policy makers and investment practitioners.

SMEs risk
SMEs keep the cost of capital high, making it hard to generate returns higher than this cost.

Most SMEs rely on personal savings or bank loans as a source of capital. Savings are normally inadequate so they use excessive financial leverage, increasing their risk of failure.