Here is the following definition of a SME in accordance with SME Policy 2007, which is the benchmark tool for Lahore Chambers of Commerce’s categorization of SMEs. Since the data extracted from the chamber is of 2015, and the revision of the policy came in May, 2016, SME Policy 2007 shall be used to assess the SMEs, rather than the policy revision.

• Employment – 250 Persons
• Paid Up Capital – 25 Million PKR
• Annual Sales – 250 Million PKR

Lahore Chambers of Commerce Definition of Associate Class:

According to LCCI, there are two classes; associate and corporate class, where the associate class is a list of SMEs with the annual sales turnover PKR 5 Million or less.
Economic Contribution:

SMEs’ share in the industrial employment is estimated to be 78%, in value addition approximately 28% and in export earnings at 25%.

Contribution in Employment Generation: SMEs normally tend to be labor-intensive, and thus create employment with relatively low level of investment per job created. At present, unemployment is a significant problem in Pakistan and a majority of new entrants have low marketable skills. They find few opportunities in the public sector, thus a sizeable number of these persons end up in the SME sector, and especially in the informal sector. Given this situation and the fact that Pakistan is characterized by low rate of capital formation, SMEs are the best option to address this problem.

Effective Utilization of Local Resources: SMEs tend to be more effective in utilization of local resources using simple and affordable technology. Further, development of SMEs facilitates distribution of economic activities within the economy and thus fosters equitable income distribution. SMEs technologies are easier to acquire, transfer and adopt. Also, SMEs are better positioned to satisfy limited demands brought about by small and localized markets due to their lower overheads and fixed costs.

Outsourcing Hubs of Large Corporations:  Through business linkages, partnerships and subcontracting relationships, SMEs have great potential to complement large industries requirements. A strong and productive industrial structure can only be achieved where SMEs and large enterprises not only co-exist   but also function in a symbiotic relationship.

Entrepreneurship Development: SMEs serve as a training ground for entrepreneurship and managerial development and enable motivated individuals to find new avenues for investment and expanding their operations.

Starting up Business:

There are different types of firms, amongst these three types of businesses that SMEs usually adopt are; sole proprietor, partnership and private limited company.

Sole Proprietorship:

A sole proprietorship also known as a sole trader/sole owner is a type of business entity which is owned and run by one individual and where there is no legal distinction between the owner and the business. All profits and all losses accrue to the sole owner (proprietor / trader). All assets of the business are owned by the owner (proprietor / Sole trader) and all debts of the business are his/her debts and he/she must pay them from their personal resources. This means that the owner has unlimited liability. It is a “sole” proprietorship in the sense that the owner has no partners (partnership).

This is the most straightforward structure for a business. Basically, it means the business decisions are being made by one person. Of course, it doesn’t necessarily mean that the business has only one worker. The sole trader can employ others to do any or all of the work in the business. A sole proprietor may do business with a trade name other than his or her legal name. This also allows the proprietor to open a business account with banking institutions.

Partnership:

A partnership is a type of business entity in which partners (owners) share with each other the profits or losses of the business. Partnerships are often favored over corporations for taxation purposes, as the partnership structure does not generally incur a tax on profits before it is distributed to the partners. However, depending on the partnership structure and the jurisdiction in which it operates, owners of a partnership may be exposed to greater personal liability than they would as shareholders of a company. Sometimes companies also form partnerships. Two or more companies can form a legal partnership in Pakistan to achieve common objectives through alignment of resources in pursuit of long term goals. Such partnering can be used as alternative to traditional mergers and acquisitions.

Like most countries in the world, first step for expansion for sole proprietors and sometimes the first step for businesses is the formation of a partnership in Pakistan. Partnerships may have small to medium sized business set-ups. Partnerships are normally formed where there is a desire to have some structural flexibility along with some formality of relationship between partners. A partnership may be registered with the Registrar of Firms of an area where the office of the firm is situated or proposed to be situated.

Private Limited Company
Private limited company is a voluntary association of not less than two and not more than fifty members, whose liability is limited, the transfer of whose shares is limited to its members and who is not allowed to invite the public to subscribe to its shares or debentures. It has an independent legal existence. The Companies Act contains the provisions regarding the legal formalities for setting up of a private limited company. Registrars of Companies (ROC) appointed under the Companies Act covering the various States and Union Territories are vested with the primary duty of registering companies floated in the respective states and the Union Territories.

It is relatively less cumbersome to organize and operate it as it has been exempted from many regulations and restrictions to which a public limited company is subjected to. The liability of its members is limited.  The shares allotted to its members are also not freely transferable between them. These companies are not allowed to invite public to subscribe to its shares and debentures. It enjoys continuity of existence i.e. it continues to exist even if all its members die or desert it. The minimum paid up capital at the time of incorporation of a private limited company has to be Rs. 100,000. There is no upper limit on having the authorized capital and the paid-up capital. Capital can be increased any time.

 

Demand-Side Issues:

Lack of Collaterals to Meet Banks’ Requirements: Lack of collateral is a widely-cited obstacle encountered by SMEs in accessing finance. Lenders typically request collaterals to alleviate the associated credit risks. Lack of collaterals is not limited to start-ups as well-established SMEs are also collateral deficient due to low capital base and labor intensive nature. In developing countries, the issue of collateral is much more severe.

Informal Organizational Structures: SMEs generally lack segregation of responsibilities and proper organizational structures/divisions based on area specific expertise. Lack of organizational hierarchy and proper internal control policies and procedures render most SMEs as one-man-show and highly dependent on skills, knowledge base and experiences of their owners/sponsors. These characteristics increase the risk perception of banks resulting in less availability of credit to the SMEs.

Lack of Business Planning and Strategic Vision: SMEs do not have formal procedures or disciplines for carrying out the business tasks. They are mostly run conventionally by family members, who may not be professionally literate to support the position. This informal management obstructs access to finance.

Informal Accounts and Management Systems: Financial institutions are generally attuned to evaluating repayment capacity of their borrowers through proper financial statements. Due to low levels of literacy and high costs associated with preparation and maintenance of accounting records, SMEs generally keep track of their performance through cash based single entry journal/ register, hand-written vouchers/receipts and utility bills etc. Recent experiences where some SMEs in their desperate efforts to get financing facilities actually colluded with un-ethical / morally deranged chartered accountants to spin wrong/baseless financial statements also cautioned banks. In this scenario, proper evaluation of an SME turns into a difficult task and so banks generally shy away.

Lack of credit and collateral history: Though the Credit Information Bureau has been expanded in recent years to include all loans (irrespective of their size), banks additionally require records of collaterals prior to extension of lending facilities. Currently, the Collateral Registry is available for maintaining record of limited companies only under SECP. Limited applicability of available collateral registry and absence of collateral registries of immovable assets created informational asymmetries between enterprises and lenders and victims of this situation are edge customers particularly SMEs.

Low level Financial Literacy: Low level of financial literacy is in fact a multi faceted problem for SMEs. First, SMEs do not have proper awareness of different financing options offered by financial institutions, and secondly, they lack the capability to present their project proposals and borrowing requirements. This has restricted SMEs’ ability to access formal sources of finance, thus forcing them to meet their financing needs from the informal market at exorbitant mark-up rates.

Reluctance on part of SMEs: SMEs especially Small Enterprises show high reluctance while accessing the formal credit due to many factors such as Inadequate and delayed credit, Cumbersome lending procedures and Insistence on collaterals and guarantees

External Shocks: Owning to their peculiar nature, SMEs generally operate in low margin and labor intensive sectors with small markets and high elasticity of their products. These conditions along-with limited availability of capital make SMEs more vulnerable to external shocks. In the recent past, the impact of rising energy prices, law and order situation and other factors have adversely impacted the financing to SMEs. Recent Floods wiped out fixed investment/earning assets of many SMEs particularly SEs and have negatively affected their prospects of sustainability without external support.
Supply-Side Issues:

Shortage of Marketing Skills/efforts on part of banks:  Though some financial institutions market their products, most do not aggressively target their low-end borrowers. The marketing aspect also entails providing facilitation to their borrowers in preparing basic financial record which is considered a hall mark of financial institutions in developed world. Banks generally deal with borrowers who have previous track records and this result in financial exclusion of many potentially good borrowers.

SMEs perceived as high risk borrowers: Lending to SMEs is perceived by banks to be a risky business venture. The uncertainties facing small industries, vulnerability to market and economic changes, and lack of collaterals make banks reluctant to deal with them. SMEs are also perceived to be least equipped in term of both human and capital resources to withstand economic adversities.

Corporate Finance Mindset: Most Credit Officers are inclined to balance sheet based and collateral based lending owing to their extensive experience in corporate lending. Due to this mindset, they are unable to assess cash flows from informal records, financial health from family lifestyles of SME sponsors and other non-financial aspects etc. Due to this mindset, commercial banks have not developed appropriate baking products and procedures for SMEs. Resultantly, they lack in appropriate structures and skills for SME credit evaluation, product design and marketing of SME credit tools etc.

Lack of Infrastructure for SME Business: Some banks have not developed the necessary infrastructure in terms of IT and human resource to handle large number of small loans, such as Credit Scoring, Cash flow based Lending, Program Based Lending etc. Credit scoring techniques provides sophisticated statistical tools for identification of variables that are powerful predictors of risks of default and enable banks to devise product programs for different segments of SMEs.

High Lending Costs: The costs of lending to SMEs are high and cut deep into the profitability of SMEs. Due to the feasibility issue arising from maintaining a large number of small ticket borrowers, banks remain contented and focused normally on corporate clients.

Absence of SME R&D Centers in Banks: Most financial institutions don’t have research and development centers, as a result, they lack new and innovative business ideas. Lack of assessment of the sectoral credit market size, viability of SMEs operating in different sectors of the economy, credit requirements etc, results in lack of new business ideas and development of customized and structured asset and liabilities products for SMEs.

Sources:

State Bank of Pakistan

SMEDA