1.1 Introduction
Bank loans refer to sums of money lent by financial institutions to borrowers, which must be repaid with interest over a specified period. These loans can be secured or unsecured, depending on whether collateral is required. For SMEs, bank loans are a crucial source of external financing to support operational and capital needs. Small and Medium Enterprises (SMEs) play a pivotal role in the economic development of Nigeria. They contribute significantly to employment, income generation, and poverty alleviation. However, one of the primary challenges faced by Small and Medium Enterprises in Nigeria is access to adequate financing. Bank loans are a critical source of funding for these enterprises, enabling them to invest in new technologies, expand operations, and improve productivity (CBN, 2019).
As a prelude to other parts of this study, this chapter will discuss the background upon which this study was initiated, the statement of problems that led to this study, the Aim and Objectives of the study. Others are Significance of the study, Scope of work, Research hypothesis and questions, Limitation of the study and Definition of terms.
1.2 Background of Study
In Nigeria, available data from the Registrar General Department indicates that 90% of companies registered are micro, small and medium enterprises (Mensah, 2004). This target group has been identified as the catalyst for economic growth of the country as they are a major source of income and employment to many Nigeriaians. According to Mensah (2004) Small enterprises employ between 6 and 29 employees with fixed assets of $100 Thousand with Medium enterprises employing between 30 and 99 employees with fixed assets of up to $1 Million, Hallberg (2001) put forward that SMEs account for majority of firms in an economy and a significant share of employment. Like other countries of the world, SMEs in Nigeria have the tendency to serve as sources of livelihood to the poor, create employment opportunities, generate income and contribute immensely to economic growth. Small firms are the engines for economic development of several developed countries such as the US and Japan (Hallberg, 2001).
Developing countries such as Zimbabwe have also identified the potential of small firms to turn economies with negative growth into vibrant ones. For this reason, several governments in developing countries offer funding to small firms either directly or by guaranteeing the payment of such loans as lack of funding is cited as one of the major challenges faced by small businesses. Obert and Olawale (2010) argues that due to limited resources by governments, not all small firms receive funding from the government; therefore, the other option would be to go for bank loans Obert and Olawale (2010). Despite its increasing roles, access to credit by SMEs remains one major constraint to Nigeriaian SMEs. According to Augusto et al (2008), most large companies usually start as small enterprises, so the ability of SMEs to develop and invest becomes crucial to any economy wishing to prosper.
Although countries’ definitions of what constitutes an SME for legal or statistical purposes are typically based on the number of employees, banks generally define SMEs in terms of average annual sale; an indicator that is more easily observable, a good proxy of an SME level of business activity, and, thus, more useful to banks’ business and risk management purposes (Augusto et al 2008). Augusto et al (2008) further points out that the threshold of annual sales used by banks varies by country, according to the size of the economies and structure of their corporate sector. Augusto et al (2008) hints that in Argentina, a company is considered to be an SME when its average annual sales are approximately between 300,000 and 30 million US dollars. In Chile, the range goes from around 90,000 to 24 million US dollars.
In Colombia, banks consider SMEs those firms with annual sales between 400,000 and 13 million US dollars (although for most domestic banks the range is between 100,000 and 5 million. In Serbia, SMEs are typically defined as having annual sales between 500,000 and 10 million Euros. A vast number of data on SMEs in Nigeria also suggest SMEs are more financially constrained than large firms. For example, using data from 10,000 firms in 80 countries, Beck et al (2006) showed that the probability that a firm rates financing as a major obstacle is 39% for small firms, 38% for medium-size firms, and 29% for large firms.
Mensah (2004) states that a major barrier to rapid development of the SME sector is a shortage of both debt and equity financing. However Mensah (2004) postulate that equity shortage occurs because Equity investors seek highest return consistent with the risk of the investment and since SME investments are difficult to evaluate, their investments take time to mature and among others major institutional investors such as insurance companies are not allowed to invest in private SMEs. Hence there are many who believe that the single most important factor constraining the growth of the SME sector is the lack of finance.
There are many factors that can be adduced for this lack of finance according to Mensah (2004). For instance a relatively undeveloped financial sector with low levels of intermediation; Lack of institutional and legal structures that facilitate the management of SME lending risk; High cost of borrowing and rigidities interest rates. Thus Because of the persistent financing gap, many interventions have been launched by governments and development partners to stimulate the flow of financing to SMEs over and above what is available from exiting private sector financial institutions. Karimunda and Barumwete (2006) put forward the fact that, there are several reasons why a SME need a loan such us the financing of new branches, of new projects and more. Companies do not always have the capacity for finance their own business that is why they have sometimes to turn to other financers. However, when companies need new capital, they firstly resort to their internal generated funds.
After these sources, SMEs turn to equity financing by addressing closely related investors. These sources exhibit very low costs and may be for example equity capital from the owner, family or friends. Despite these, there are others types of financing that one can use: external equity financing and external debt financing. For SMEs, possibilities for using external equity finance are limited since the majority of these companies are privately managed. Companies can also use venture capitalist as alternative means of equity financing.
However, these possibilities are difficult for SMEs since most of them do not always meet the return expectations. They thereby become less attractive for this group of investors. Other alternatives to financing are private placements and corporate bonds. Unfortunately, these types of financing are too expensive for SMEs or have limited resources. Therefore bank loans seem to be an appropriate way to finance SMEs’ capital requirements and seem to be an appropriate way. As a result, SMEs prefer most frequently debt funding by bank loans. The bank financing is tremendously attractive and seems to be realistic and a more reliable source to SMEs. Mensah (2004) states that recently, as banks and other financial institutions have sought to broaden their loan portfolio, SMEs have become an increasingly attractive customer group. Traditionally, however, financial institutions in Nigeria have been cautious with lending to SME groups because of high default rates and risks associated with the sector. Few banks have therefore developed an explicit policy for SME target groups taking the particular requirements and needs into consideration, an example is the development of customized financial products and appropriate credit management systems.
Only few banks have SME specific loan products, and many of these are donor funded. Since SMEs are scarcely finance by equity due to risk in its operation amongst others, the last resort is thus debt financing and this is usually financed by financial institutions through the granting of loans. Debt financing according to Ayadi et al (2009) continues to be the primary source of financing for SMEs in Europe, much more important than venture capital. This implies, for one thing, that an efficient functioning of credit markets is of utmost importance for SMEs − and the economy at large − to thrive. This problem seems to be particularly severe in transition economies, whose catching-up may suffer from continued wide-spread exclusion of SMEs from external bank finance. Of recent, there has been an increase in the recognition of the role played by small firms in national economies. Their contribution to job creation and poverty alleviation has been recognized by several governments of developing countries to the extent that they now include them in their development plans.
Abor (2005) proposed among the support structures include offering funding to the small firms’ sector, usually at concessionary rates. But whether the use of such debt improves the profitability, thereby enhancing sustainability, is not well known Abor (2005). However, despite the importance of the small business sector, access to finance is a frequently cited problem. Sources of capital are more limited for SMEs compared to large firms. Therefore, unlike large, particularly publicly-listed firms, SMEs do not have the option of issuing shares or debentures in the capital market. Even if they are allowed to participate in the capital market, the high transaction costs associated with publicly issued debt and equity will be too expensive for them. Owing to their inability to access the public debt and equity markets, SMEs tend to be heavily reliant on commercial banks as a source of debt financing (Berry et al., 2002). Research by Berry et al. (2002), documents the reliance of SMEs on bank debt as a source of financing. These researchers, however, point out that access to bank debt is, paradoxically, a frequently cited challenge for SMEs.
SMEs are often relatively new and lack a consistent track record of profitability that would demonstrate the capability to repay a loan. In addition, many SMEs lack assets that could be used as collateral. SMEs are also more prone to financial distress and failure. Commercial banks, because of these factors, consider lending to SMEs a high risk. Therefore, commercial banks often deny loans or offer loans to SMEs at higher rates of interest to accommodate the perceived high credit risk of SMEs according to Coleman and Cohn (2001). The inaccessibility of debt finance to SMEs can further be attributed to information asymmetry. Rwelamila et al. (2004) indicates that this arises when one party to a transaction has better information than the other.
SMEs may have more information about their future prospects than the banks. Since banks do not have the necessary information, even small firms with profitable investment opportunities are turned down when requesting credit facilities. Banks, therefore, introduce restrictive covenants and also collect collateral from small firms to mitigate this problem Bose and Cotheren (1997).The question is what the impact of this loan on these SMEs is? Traditionally, debt finance has been viewed as less expensive than equity. It furthermore has been used both to decrease the average cost of capital and enhance shareholders returns.
However, there is a negative side to debt, since interest payments must be made regardless of market conditions. This vulnerability is an important factor that firms must consider when making capital structure decisions. In addition Glen (2004) states, there is a very strong economic and statistical link between macroeconomic variables and a firm’s ability to meet debt obligations. The macro-economic environment implies the level of aggregate demand, the level of interest rates, and the level of inflation. A positive macro-economic environment results in a rise in aggregate demand and positively impacts on the ability of a firm to meet debt obligations.
The ability to service debt becomes problematic when the macro-economic environment deteriorates; resulting in the insolvency of firms (Glen, 2004). Rwelamila et al. (2004) affirm that, during the early stages of starting a firm, many owners commit themselves to the use of debt, which might be one of the sources of finance available to them. The use of debt can be disastrous, as high interest rates and unfavorable repayment schedules are often overlooked due to the pressure of financing the firm.
Against this background, the study investigates whether SMEs in developing countries can use debt and still remain solvent in this era of high interest rates. Furthermore, SMEs often pay interest premiums and a host of non-interest fees such as application and other transaction fees when borrowing from commercial banks. The cause of this is that SMEs are considered a high credit risk compared to large firms. This high cost of funds because of increased risk increases the costs of debt for small firms.
1.3 Statement of Problems
Investigation revealed that despite the recognized importance of Small and Medium Enterprises (SMEs) in fostering economic growth and development in Nigeria, these enterprises face significant challenges in accessing the necessary financing to sustain and expand their operations. The inability to secure adequate funding remains one of the most critical constraints, impeding the growth and survival of SMEs in the country.
One of the primary issues is the high interest rates associated with bank loans, which make borrowing prohibitively expensive for many SMEs. According to the Central Bank of Nigeria (CBN), interest rates on commercial loans in Nigeria often exceed 20%, a rate that is unsustainable for most small businesses (CBN, 2019). This high cost of borrowing discourages SMEs from seeking bank loans, limiting their capacity to invest in new technologies, infrastructure, and market expansion.
In addition to high interest rates, stringent collateral requirements pose another significant barrier for SMEs. Many small businesses lack the substantial assets required by banks as collateral, making it difficult for them to qualify for loans. The Nigerian Bureau of Statistics (NBS) reports that over 60% of SMEs cite collateral requirements as a major obstacle to obtaining bank financing (NBS, 2021). This challenge is particularly acute for new and informal businesses, which often operate without formalized assets that can be used as security for loans.
The combination of these challenges high interest rates, stringent collateral requirements, complex loan processes, and mismatched financial products—creates a significant barrier to the growth and sustainability of SMEs in Nigeria. Addressing these issues is crucial to unlocking the potential of SMEs to contribute more effectively to economic development, job creation, and poverty alleviation in the country. This study seeks to investigate these problems in detail, providing insights and recommendations for improving the accessibility and impact of bank loans on SMEs in Nigeria.
1.4 Aim and Objectives of Study
The aim of the study is to investigate the impact of bank loans on small and medium enterprises (SMEs) in Nigeria. In achieving this aim, the following specific objectives were laid out as follows:
- To explore the alignment between the financial products offered by banks and the specific needs of small and medium enterprises;
- To identify the main challenges faced by small and medium enterprises in accessing bank loans, including high interest rates, collateral requirements, and bureaucratic loan application processes;
- To analyze the extent to which SMEs in Nigeria depend on bank loans for their capital and operational needs;
- To assess the impact of bank loans on the performance and growth of small and medium enterprises; and
- To provide recommendations for policymakers and financial institutions on how to improve the accessibility and impact of bank loans for SMEs, fostering a more conducive financial environment for their growth and sustainability.
1.5 Research Questions
The study came up with research questions so as to be able to ascertain the above stated objectives. The specific research questions for the study are stated below as follows:
- What is the alignment between the financial products offered by banks and the specific needs of small and medium enterprises?
- What are the primary challenges faced by SMEs in accessing bank loans in Nigeria?
- To what extent do SMEs in Nigeria rely on bank loans for their capital and operational needs?
- What is the overall impact of bank loans on the performance and growth of small and medium enterprises in Nigeria?
- What strategies can be recommended to enhance the accessibility and impact of bank loans for SMEs, thereby supporting their growth and sustainability?
1.6 Research Hypothesis
In order to pursue the objective of this study, the following generalized statements have been designed to guide and aids in obtaining the result for the experiment to be conducted. For this work, the null hypothesis will be represented with H0 while the alternative hypothesis will be represented with hypothesis H1.
Hypothesis One
- H0: There is no significant positive relationship between access to bank loans and the growth of SMEs in Nigeria
- H1: There is a significant positive relationship between access to bank loans and the growth of SMEs in Nigeria
Hypothesis Two
- H0: High interest rates do not significantly reduce the likelihood of SMEs obtaining bank loans in Nigeria
- H1: High interest rates significantly reduce the likelihood of SMEs obtaining bank loans in Nigeria
Hypothesis Three
- H0: Stringent collateral requirements do not significantly hinder SMEs' ability to access bank loans in Nigeria
- H1: Stringent collateral requirements significantly hinder SMEs' ability to access bank loans in Nigeria
1.7 Significance of Study
The significance of this study extends across various stakeholders, highlighting its multifaceted impact:
- For SME owners and entrepreneurs, this study provides critical insights into the challenges and opportunities associated with accessing bank loans. Understanding these factors can help them navigate the financial landscape more effectively, enabling them to secure the necessary capital for growth and expansion.
- For financial institutions and banks, the research offers valuable information on the barriers SMEs face when seeking loans. By addressing these issues, banks can tailor their financial products and services to better meet the needs of SMEs, potentially expanding their customer base and fostering stronger relationships with small business clients.
- For policymakers and government agencies, the findings can inform the development of policies and programs designed to enhance the accessibility of bank loans for SMEs. This can lead to more effective support frameworks that drive economic growth, job creation, and poverty alleviation.
- For academics and researchers, this study contributes to the body of knowledge on SME financing and economic development. It provides a foundation for further research into the dynamics of bank lending and its impact on small businesses, offering a basis for comparative studies and theoretical advancements.
- For the wider economy and society, the successful growth and development of SMEs have far-reaching implications. Improved access to bank loans can lead to increased business activities, higher employment rates, and overall economic prosperity, benefiting communities and enhancing the quality of life for individuals across Nigeria.
1.8 Scope of Study
The scope of this research is focused on the Impact of Bank Loans on Small and Medium Enterprises (SMEs) in Nigeria.
1.9 Limitations of the Study
During the course of this study, many things militated against its completion, some of which are:
- Time Constraint: The time frame given to accomplish this project was very short due to school academic calendar and it was carried out under pressure which made the researcher not to implement some necessary features.
- Financial Constraint: Insufficient fund tends to impede the efficiency of the researcher in sourcing for the relevant materials, literature or information and in the process of data collection (internet, questionnaire and interview).
1.10 Definition of Terms
Small and Medium Enterprises (SMEs):
SMEs are businesses with a limited number of employees and a moderate level of revenue. In Nigeria, the classification of SMEs varies, but according to the Small and Medium Enterprises Development Agency of Nigeria (SMEDAN), SMEs typically have fewer than 200 employees and an asset base (excluding land and buildings) of less than ₦500 million (SMEDAN, 2020).
Bank Loans:
Bank loans refer to sums of money lent by financial institutions to borrowers, which must be repaid with interest over a specified period. These loans can be secured or unsecured, depending on whether collateral is required. For SMEs, bank loans are a crucial source of external financing to support operational and capital needs (CBN, 2019).
Interest Rates:
Interest rates are the proportion of a loan charged as interest to the borrower, typically expressed as an annual percentage of the loan amount. High interest rates can significantly increase the cost of borrowing and are a major factor influencing the accessibility of bank loans for SMEs (CBN, 2019).
Collateral Requirements:
Collateral requirements refer to the assets that borrowers must pledge to secure a loan. These assets act as security for the lender in case the borrower defaults on the loan. For many SMEs, stringent collateral requirements are a significant barrier to accessing bank loans (NBS, 2021).
Loan Application Processes:
The loan application process encompasses the steps and procedures that borrowers must follow to apply for and obtain a loan from a financial institution. This includes submitting necessary documentation, undergoing credit assessments, and meeting specific eligibility criteria. Complex and bureaucratic processes can deter SMEs from pursuing bank loans (Ogujuiba et al., 2004).
Financial Products:
Financial products refer to the various types of loans and credit facilities offered by banks and financial institutions. These can include term loans, overdrafts, lines of credit, and equity investments. The alignment of these products with the needs of SMEs is crucial for effective financing (CBN, 2019).
Economic Growth:
Economic growth is the increase in the production of goods and services in an economy over a period of time. It is often measured by the rise in Gross Domestic Product (GDP). SMEs play a vital role in driving economic growth through job creation, innovation, and contributions to GDP (SMEDAN, 2020).
