Small and Medium Enterprises

Submitted by:

NIshant kr. Oraon

CUJ/I/2011/IMBA/18
SMALL AND MEDIUM ENTERPRISES

Small and medium enterprises are businesses whose personnel number falls below certain
limits. The abbreviation SME is used in the European Union and by international
organizations such as the World Bank, the United Nations and the World Trade Organization.
Small Enterprises outnumber large companies by a wide margin and also employ many more
people. SMEs are also said to be responsible for driving innovation and competition in many
economic sectors.
SMEs play a very decisive role in economic growth which they pave with employment
generation, enlargement of entrepreneurial skills and contribution to overall industrial
production. They have their own indigenous technology as well as modern expertise with
which they produce a vast range of items. While talking of their contribution to the larger
economy, Indian SMEs have grown at a stable pace of 4.5% in the last 5 years. According to
the latest Annual report issued by the Ministry of Micro, small and Medium Enterprises, there
are over 6000 products ranging from traditional to high-tech, which are being manufactured
by the MSME sector for domestic as well as international market.
According to the latest Economic Survey, Indian SMEs employ close to 40% of Indias
workforce. After the agriculture sector, SMEs rank second in fostering employment
opportunities. Over 3.25 lakhs jobs were generated in the SME sector during the period
between April 2011 and February 2012.

Total no of SMEs in India. (2008-13)

Source: Ministry of Micro, Small and Medium Enterprises (MSME)

Definition
Under section 7 of the Micro, Small and Medium Enterprises Development (MSMED) Act
2006, the Indian government define the size of Micro, Small and Medium Enterprises as:
a) In the case of the enterprises engaged in the manufacture or production of goods
pertaining to any industry specified to the Industries (Development and Regulation)
Act, 1951, as-
i. A micro enterprise, where the investment in plant and machinery does not
exceed twenty-five lakh rupees;
ii. A small enterprise, where the investment in plant and machinery is more than
twenty-five lakh rupees but does not exceed five crore rupees; or
iii. A medium enterprise, where the investment in plant and machinery is more
than five crore rupees but does not exceed ten crore rupees.
b) In the case of enterprises engaged in providing or rendering of services, as-
i. A micro enterprise, where the investment in equipment does not exceed ten
lakh rupees;
ii. A small enterprise, where the investment in equipment is more than ten lakh
rupees but does not exceed two crore rupees; or
iii. A medium enterprise, where the investment in equipment is more than two
crore rupees but does not exceed five crore rupees.

Businesses that are declared as MSMEs and within specific sectors and criteria can then
apply for priority sectors lending to help with business expenses; banks have annual targets
set by the Prime Ministers Task Force on MSMEs for year-on-year increases of lending to
various categories of MSMEs.
Significance of SMEs:

Provides low cost employment since the unit cost of persons employed is lower for
SMEs than for Large Scale Enterprises (LSEs).
Assists in regional and local development since SMEs accelerate rural industrialization
by linking it with more organized urban sector.
Help achieve fair and equitable distribution of wealth by regional dispersion of
economic activities.
Contribute significantly to export revenues because of the low cost labour intensive
nature of its products.
Have a positive effect on the trade balance since SMEs generally use indigenous raw
materials, reducing dependence on imported machinery, raw material or labour.
Assist in fostering self-help and entrepreneurial culture by bringing together skills and
capital through various lending and skill enhancement schemes.
Converts the raw material within the country into semi-finished items and later pass it
on the LSEs that have capital, skill and equipment to process these into finished goods.
Provide rural people an opportunity for income generation and personal growth since
they can work at home. This helps to achieve fair and equitable distribution of wealth
by creating nationwide non-discriminatory job opportunities.
History of SMEs in India:
Industries are an integral part of the Indian Economy since the Harappan Era. Until the
advent of British rule and modern industry, it had perforce, to be small scale. The
entrepreneurial spirit was stifled during the long colonial rule as also reflected in the GDP
growth rate of 0.9% during the first half of the 20th century. The Europeans were expanding
their colonial rule all over the world in search of raw material for their factories and markets
for the products of these factories. It was during this period that the Industrial Revolution was
sweeping the European continent. India missed the Industrial Revolution as the foreign rulers
did not allow the Indian Entrepreneurship to flourish. We have only to recall the Swadeshi
Movement and boycott of foreign goods in the first quarter of the last century, to realize the
place of entrepreneurs and small industry in the developing consciousness of modern and free
India.
The importance of SMEs in our country has its root from the Gandhian Model of economic
self reliance. Mahatma Gandhis vision for economic model was aimed at providing
employment to large numbers of people to address the issue of poverty.

Controlled policy:
Post independence, India adopted the Industrial Policy Resolution of 1948 that defined the
dual role of Government that of the entrepreneur and the regulatory authority. Centralized
planning was a strong feature of the first few decades and several controls were kept on
private trade, investment, land ownership and foreign exchange. Independent Indias
economic planning gave a place of pride to the small scale sector, especially, with the
objective of fostering entrepreneurship and promoting employment. The small scale sector
flourished notably as ancillary to large industries, as a robust export sector and under the
policy of reservation of some products for small scale.
Stages of SME financing
1. Stages of self-financing:
SMEs may be established with funds provide by the founders and their
relatives or friends. This is noticed in the initial stages of development since by
this time institution sources are not developed. Self-financing has several
advantages including that it avoid the hassles of complying with the terms and
condition of the financial institution. People are more judicious in using their
own money.
2. Stages of debt financing:
When SMEs expand or undertake major changes, they need to obtain funds for
investment for external sources. Credit institutions are traditionally the primary
source of SME growth. Among such institution, commercial banks and state
level financial institution play an important role.
3. Stage of lease financing:
Non banking financial institution often serves as an important vehicle of SME
financing. A typical example is leasing companies. Through leasing contracts
leasing companies accommodate financial need of SMEs for real-estate of
certain movable properties.
4. Stage leading to emergencies of equity financing:
Traditionally, SME have seldom had direct access to capital market for equity
financing. However recent advancement in technology coupled with financial
market growth is rapidly changing scene.
5. Stage of venture capital financing:
While credit is usually primary financial resources for SEM to operate and
invest equity capital is indispensable element in SEMs financing. Venture
capital industry has developed a source of equity capital for SEMs. Venture
capital industry.
SICK UNITS:
After nationalization of banks in 1969, the banking sector became a key source of support for
small and medium industry. Technical consultancy support and various financial institutions
formed a framework for supporting SMEs. Within this framework, in 1987 and in 1989,
Reserve Bank of India announced schemes for rehabilitation of small and medium industries.
These schemes entailed restructuring of debt of sick companies with relief and concessions.
The rehabilitation schemes worked selectively and were effective where markets were
available for the units products and where entrepreneurs were skilled and serious. This was a
period of economic growth ranging between 3% & 5%.
Growth of internal & international competition and technological changes continued to erode
the financial strength and viability of SMEs, putting them in need of rehabilitation measures.
The protection available to the industry has been gradually coming down since 1991 with
integration of Indian economy with global economy. IRAC norms were introduced in 1992,
making the banks hesitant to lend to small enterprises as it is perceived as risky lending.

Growth of MSME Sector:

The high rate of NPAs in small enterprises sector has created risk aversion among lenders,
which has hindered increase in flow of credit to the sector. The non credit related factors
responsible for slow growth rate of small enterprises sector are non-availability of power and
other infrastructural facilities, delay in getting clearance from different agencies, prevailing
condition of the economy, lack of entrepreneurship development infrastructure and
historical/social factors etc. Still, states that give due importance to this sector and have
provided adequate infrastructure and enabling environment have seen good growth in small
enterprises sector. However, there is tremendous potential for growth of MSME due to its
inherent strength to contribute to the economy of the nation.
It is observed that the banks consider marketing problems, inadequate infrastructure, and
technology related issues as major hindrances to growth. Besides these reasons, RRBs
consider lack of managerial competence as another important factor for poor growth.
MSME Associations have stated that delayed availability / shortage of funds, non
responsiveness of the government departments, and high cost of funds, inadequate
infrastructure and marketing problems are the major reasons for poor growth of MSMEs.
Credit related issues:
There is lack of transparency in accounts of small enterprises and their accounts are not based
on accounting standards and generally accepted accounting principles. Non maintenance of
proper records by MSMEs is also a problem indicated by the banks during interactions. It is
indeed difficult for the banks to assess the capacity of the enterprise to repay.
A bankers risk perception towards SMEs is heightened by the poor historical performance of
SME loan portfolios, particularly loans extended by the public sector banks, which account
for more than 90 per cent of all lending to SMEs.

FOREIGN DIRECT INVESTMENT IN SME:

Diaspora contribution to their state of origin has been made in various ways, through
remittances, foreign direct investment, transfer of knowledge and entrepreneurial networks.
India has the worlds second largest Diaspora next to China with a substantive presence in all
the six continents.

While the contribution of the Indian Diaspora to Indias economy and society is a matter of
great pride and achievement for Indians the world over, however the Indian Diaspora has not
come forward as investors for the Indian SME sector, in the scale that was expected post-
liberalization in the early 1990s.

Diasporic FDI, especially in comparison with China, has been very modest in India. Only 4%
of Indias FDI comes from the Diaspora. This is due to the certain policies and procedures
that restrict FDI in the SME sector. According to the present status an industrial undertaking,
i.e., a company with interests in industry can invest upto 24% equity in a SSI unit, however,
if the equity goes beyond 24%, the industrial unit loses its SSI status. Consequently,
manufacture of items reserved for SSI would require an Industrial License and export
obligation of 50%. This applies to an industrial undertaking with foreign (including NRI)
investment.
Financing the SMEs:
The SMEs market in India, though growing at a fast pace is highly fragmented. Despite the
fact that the sector contributes around 7 percent to the GDP of the economy, it remains a
largely neglected and under serviced sector from the banking and formal funding point of
view.

The credit challenge

Most SMEs in India are promoted by enterprising technocrats. They are ingenious in seizing
new opportunities and adapting to environmental changes, provided that the growth
opportunities are supported by good infrastructure and financing requirements are being met.
However, like anywhere else in the world, India SMEs too face challenges in assessing
adequate funds on time from banks and financial institutions. Only 17% of the SME units are
able to assess institutional finance and most of them depend more on internally generated
funds and /or informal financing channels for their expansion and modernization
requirements and are deprived of cheaper institutional credit. SMEs with access to
institutional credit at competitive rates are more likely to significantly increase their
contribution to the GDP and would be in a better position to take on global competitive
pressure. The issue also needs to be assesses from macro prospective.

Inherent issues in SME lending:

Banks find it difficult to provide SME adequate and timely credit due to these reasons:
Highly fragmented nature of SMEs
Information asymmetry
Multiple segments, multiple needs
Lack of transparency and limited financial disclosures in financial statements of SME
NPA and their legacy effects
Information asymmetry:
A proper assessment of the SMEs credit needs and of SMEs analysis of their balance sheets
and inter firm and inter size comparisons is not possible in a cost effective manner in the
absence of information. The multiple segments and multiple needs nature of SMEs and the
fine granularities arising due to the various types of ownerships, regions, industries, products
and processes, etc. further pose limitations on the lending banks.
Often, the low ticket size of an individual deal does not justify a detailed assessment on the
part of lender. Assessments take up a substantial part of the time of a banker. Bankers have a
tendency to concentrate on the larger ticket size. SMEs are hit both ways by information
asymmetry. While on one hand the lenders have little knowledge about them, on the other
hand SMEs are themselves not abreast with the latest happenings in the finance world.
The government has made many efforts to provide finance to SME through the traditional
modes. But the following case study highlights the role of government as a facilitator for
meeting the needs of SMEs in their countries.
Performance of Small Cap and Mid Cap Indices
To understand the small and medium capitalised companies in the financial market in India,
small cap and medium cap indices at the both BSE (Bombay Stock Exchange) and NSE
(National Stock Exchange) are analysed to look at their performance. Both the BSE and the
NSE innovated with mid cap and small cap indices to mirror the behaviour and performance
of medium and small segments. For small capitalised companies the BSE has mandated
minimum criteria like minimum post issue paid up capital of the company should be $0.6
million, the minimum number of investors should be 1000, the turnover of the company
should be $0.6 million in each of the preceding 3 of the 12-months period. While the NSE
has laid out the requirement criteria like 3 years track record of positive net worth,
companies should demonstrate a trading frequency of at least 90 percent in the last six
months and should not constitute individually more than 5 percent free float market
capitalisation of the universe.
The eligibility criteria set for small capitalised companies at the BSE can be comparable to
the criteria set for SME exchange, with some relaxations to the SMEs. Hence, performance of
small and medium capitalised companies can be indicative if not exhaustive to make
conjecture about SMEs.

Growth of CNX Midcap Indices

Source: Indian index service & product ltd.

Growth of CNX Small cap Indices

Source: Indian index service & product ltd.

Growth of BSE Midcap Indices

Source: Bombay Stock Exchange, India

Growth of Small cap Indices

Source: Bombay Stock Exchange, India

From the above charts we can say that both the indices of medium cap and small cap are
growing. At the BSE the small cap index is growing above the mid cap index. It is found that
the performance of small cap index at both the BSE and the NSE are poorer than sensex and
nifty. Small and mid cap companies also suffer from greater amount of loss during any crisis.
However, the risk component of small cap companies is very much comparable with sensex
and nifty. It is also true that unlike sensex and nifty the small cap and mid cap indices are not
very old, so they need more time to mature. Sensex and nifty comprises of large companies
with high market capitalisation while small cap and mid cap companies are with much lesser
market capitalisation, yet they provide positive and relatively good returns when compared to
sensex and nifty. It indicates that small and mid cap companies are able to attract investors.