SME Financing in Canada, 2003 — Part II: Financial Structure of Canadian SMEs

1. National Overview and Regional Variations

1.1 Financial Structure of SMEs: National Overview

Characteristics of an average Canadian SME in 2000: Business Population: 1.4 million SMEs Years in Business: 75 percent of SMEs were older than five years Fixed Assets: averaged $291 000 Debt Outstanding: averaged $294 000 Profitability: averaged $54 000 net income before taxes Total Equity: averaged $210 000 Long-term Debt-To-Equity Ratio: 0.75 Demand for Financing: 23 percent of SMEs requested debt, 82 percent were approved

Formal versus Informal Types of Financing

As seen in Figure 18, SMEs used a wide range of formal and informal financial instruments in 2000. Formal types of financing are obtained from sources external to the firm, that are in the business of providing financing. With the exception of factoring and government grants, formal types of financing often appear on the business' financial statements as amounts owed by the business.

Informal types of financing are obtained from sources that are not in the business of financial lending, or are acquired through the business' activities (e.g. retained earnings) or from the owners (e.g. personal savings). Informal financing may not always appear on the business' financial statements.

Types of Financial Instruments Available Formal types of financing include the following: commercial loans and lines of credit commercial credit cards government loans or grants leasing factoring Informal types of financing include the following: retained earnings of the business trade credit from suppliers personal savings of owner(s) personal credit of owner(s) (i.e. loans, lines of credit, credit cards) loans from friends or relatives of owner(s) loans from employees loans from other individuals (i.e. angels)

Formal Types of Financing in 2000.²¹

• 49 percent of all SMEs used commercial loans and lines of credit
• 26 percent used commercial credit cards
• 16 percent used leasing
• 7 percent used government loans or grants

Informal Types of Financing in 2000

• 39 percent of all SMEs used trade credit from suppliers
• 35 percent used the personal savings of the owner(s)²²
• 33 percent used the personal credit cards of the owner(s)
• 31 percent used the business' retained earnings²³
• 21 percent used the personal lines of credit of the owner(s)
• 14 percent used the personal loans of the owner(s)

These findings are similar to those from the Canadian Federation of Independent Business (CFIB) surveys, which found that while commercial loans and lines of credit comprise the majority of small business debt, personal financing and trade credit are also common financing options.²⁴

The importance of personal debt to small business may also indicate that:

• Many chartered banks have moved small business clients from commercial to personal banking divisions
• Personal sources of financing provide a “bridge” until more permanent financing is available (term debt or other forms of commercial credit)

Figure 18
Types of Financial Instruments in Use by SMEs in 2000*

It is unclear whether the decision to use personal sources of short-term credit for business purposes is a matter of personal choice or reflects the financial community's unwillingness to advance capital to small businesses. The latter would likely constitute a market imperfection, but more detailed data are required before conclusions can be drawn in this regard.

Figure 19 shows that suppliers of informal financial products are as important to SMEs' debt structure as formal sources. Informal types financing (supplied through loans from individuals and trade credit from suppliers) accounted for nearly 40 percent of the outstanding debt owed by Canadian SMEs in 2000. This was equivalent to the amount of debt owed to formal financial providers (40 percent of outstanding SME debt), including chartered banks, credit unions, caisses populaires, government and lessors.

Figure 19
Average Distribution (%) of Debt Outstanding by SMEs in 2000, by Supplier

SME Ownership Capital in 2000

Business owners can obtain significant amounts of capital by selling equity shares in their firm. This financing strategy is often used by firms that require substantial amounts of growth or expansion capital, or by those that lack collateral.

The majority of ownership in 2000 rested in the hands of the business owner/operator (see Figure 20), with very limited use of equity financing from other sources. While this is true of SMEs in general, Part IV will discuss a class of high-growth SMEs that use equity financing to support rapid growth.²⁵

Debt-intensity among Canadian SMEs is high, since so few use equity as a financing strategy. Using the long-term debt to equity ratio as a measure of the reliance of SMEs on debt as their primary source of financing, debt accounted for 75 percent of SMEs' long-term financing structure in 2000. From the available data, it is not yet possible to determine whether this capital mix is optimal or whether it reflects the adjustments of SMEs to market imperfections. It seems that equity capital comes at too high a cost to many SME owners — percent of Canadian SME owners said that they would refuse to share ownership in their firms in return for equity capital.²⁶

Key Findings on the Ownership of SMEs: There was $299 billion in total ownership capital, or $209 818 per SME 86 percent were owned by the business owner/operator 3.7 percent were owned by friends or relatives of the owner (love money) 1.2 percent were owned by private foreign or domestic investors (angels) 0.3 percent were owned by foreign or domestic venture capital funds

Figure 20
Distribution (%) of Ownership Capital in SMEs, 2000

1.2 Financial Structure of SMEs: Regional Variations

With few exceptions, the financial structure of SMEs is fairly consistent across Canada.²⁷ Where regional variations do arise, they can usually be attributed to the economic and industrial composition of provinces (regarding the types of financing used) and/or the regional concentration of certain financial suppliers (regarding the sources of financing). This section focusses on the variation from the national averages outlined above.

Factors Affecting Regional Demand

As seen in Part I, different types of firms have different priorities and requirements. Manufacturing concerns (which are concentrated in Central Canada) have different financing needs than agricultural firms (which are concentrated in Western Canada). These sectoral factors strongly influence the financial structure of SMEs, and must be taken into account to avoid mistaking regional variations for financial market gaps.

Factors Influencing Regional Supply

Chartered banks are the single largest suppliers of SME financing in Canada. However, other suppliers also exert a strong regional presence across the country. For example, credit cooperative movements are heavily concentrated in Quebec (caisses populaires) and in the Prairies (credit unions).²⁸ Financing available through government programs is also regionally concentrated, a tendency that is illustrated by the importance of the Atlantic Canada Opportunities Agency to the Atlantic region and Farm Credit Canada and Western Economic Diversification Canada to Western Canada. The regional concentrations of suppliers must be taken into account to avoid confusing regional variations in SME funding with the realities of the financial services sector.

1.2.1 Atlantic Provinces

Formal versus Informal Types of Financing

Formal Types of Financing in 2000

• 54 percent of SMEs in Atlantic Canada used commercial loans or lines of credit (second highest of all regions, compared with the 49-percent national average)
• 8 percent used government loans or grants (third highest in Canada)

Informal Types of Financing in 2000

• 46 percent of SMEs in Atlantic Canada used trade credit from suppliers (highest of all regions, compared with the 39-percent national average)
• 25 percent used the personal lines of credit of the owner(s) (compared with 21 percent for SMEs overall)
• 35 percent used the personal savings of business owner(s)

The higher use of both formal and informal types of debt in the Atlantic provinces is supported by the findings discussed in Part I — Atlantic SMEs had among the highest debt request rates in 2000 and 2001 (see Table 3, Part I). Atlantic Canadian SMEs owed 27 percent of their debt to chartered banks in 2000 (in line with the 29-percent national average). Government suppliers of financing held 12 percent of the Atlantic SME debt, much higher than the 4-percent national average.

Atlantic SMEs owed much less debt to credit unions/caisses populaires than SMEs across the country (accounting for 2 percent of Atlantic SMEs' debt versus 5 percent nationally). These financing trends reflect the structure of the financial marketplace in Atlantic Canada.²⁹

1.2.2 Quebec

Formal versus Informal Types of Financing

Formal Types of Financing in 2000

• 51 percent of SMEs in Quebec used commercial loans and lines of credit (third highest in Canada; compared with the national average of 49 percent)
• 11 percent used leasing (lowest of all regions; compared with the 16-percent national average)

Informal Types of Financing in 2000

• 37 percent of SMEs in Quebec used trade credit from suppliers (second lowest of all regions, compared with the national average of 39 percent)
• 27 percent used the personal credit card of the business owner(s) (lowest of all regions, compared with 33 percent nationally)
• 12 percent used the personal lines of credit of the owner(s) (lowest of all regions, compared with the 21-percent national average)
• 22 percent used the business' retained earnings (lowest of all regions, compared with the 31-percent national average)

Despite the lower than average use of trade credit of SMEs in Quebec, this source of informal financing accounted for a larger than average share of Quebec SMEs' debt than was the case for SMEs in the rest of Canada. In fact, in 2000, trade credit from suppliers represented 28 percent of Quebec firms' debt, compared with 21 percent nationally. While fewer SMEs in Quebec used this instrument, those that did tended to use it for higher amounts. As discussed below, trade credit is associated with manufacturing, wholesale and retail, and professional services. In Quebec, the highest proportion of SMEs are in the manufacturing sector, followed by the wholesale and retail sector. More data will need to be gathered to build a more complete understanding of SME financing trends in Quebec.

1.2.3 Ontario

As discussed earlier in SME Marketplace, Ontario is home to the highest percentage of Canada's SMEs, which accounts for the lack of variation between the findings for Ontario and those for Canada as a whole.

Formal versus Informal Types of Financing

Formal Types of Financing in 2000

• 44 percent of SMEs in Ontario used commercial loans and lines of credit (lowest of all regions, compared with 49 percent nationally)
• 4 percent used government loans or grants (lowest of all regions, compared with the 7-percent national average)

Informal Types of Financing in 2000

• 37 percent of SMEs in Ontario used trade credit from suppliers (compared with 39 percent nationally)
• 36 percent used the personal savings of the owner(s) (compared with 35 percent nationally)
• 33 percent used the business' retained earnings (compared with 31 percent nationally)
• 4 percent used loans from other individuals (second highest of all regions)

Excluding loans from other individuals (mostly "angel" investments), Ontario SMEs' use of informal types of financing showed little variation from the national averages. Formal types of financing, however, were used proportionally less by Ontario SMEs, which may be a function of the diversity of the financial marketplace in Ontario. Alternative financing methods such as leasing, and a far more developed risk capital market (as discussed in Part IV) are available to Ontario SMEs.

Chartered banks are the leading suppliers of formal financing in Ontario, holding nearly a third of Ontario's SME debt in 2000 (31 percent, slightly higher than the 29-percent national average). Given chartered banks' market presence in Ontario (86 percent of the points of service available), it is not surprising that they are the leading supplier of formal debt. Credit unions and/or caisses populaires were owed only 3 percent of Ontario's SME debt (compared with 5 percent nationally), although this proportion appears to be in line with their market presence in Ontario. Currently, there are 581 credit unions or caisses populaires operating in Ontario, which accounts for approximately 14 percent of the points of service available from chartered banks and credit unions/caisses populaires.³¹

1.2.4 Manitoba/Saskatchewan/Nunavut

Formal versus Informal Types of Financing

Formal Types of Financing in 2000

• 61 percent of SMEs in Manitoba/Saskatchewan/Nunavut used commercial loans and lines of credit (highest of all regions, compared with 49 percent nationally)
• 20 percent used leasing (highest of all regions, compared with 16 percent nationally)
• 14 percent used government loans or grants (highest in Canada; compared with the national average of 7 percent)

Informal Types of Financing in 2000

• 28 percent of SMEs in Manitoba/ Saskatchewan/ Nunavut used the owner(s)'s personal lines of credit (highest in Canada, compared with the 21-percent national average)
• 19 percent used the personal loans of the owner(s) (highest in Canada; compared with 14 percent nationally)

Table 9 — Manitoba/Saskatchewan/Nunavut: Sectoral Distribution of SMEs, 2000

Agriculture	44.8%
Knowledge–based industries	1.9%
Manufacturing	3.0%
Primary	1.2%
Professional services	4.3%
Wholesale and retail	8.2%
All other	32.7%

Source: Statistics Canada, Survey on Financing of
Small and Medium-sized Enterprises, 2000.

As discussed in SME Marketplace, the agricultural sector dominates much of this region's economic activity; Table 9 shows that agricultural firms accounted for nearly half of the SME market in Manitoba, Saskatchewan, and Nunavut — nearly four times the proportion of agricultural firms in other regions.³² As discussed later in this part, the pattern of instrument usage (i.e. higher than average use of formal instruments and personal resources of the owner) is a reflection of agricultural SMEs' use of formal sources of debt. Much of the debt owed by SMEs in this region is to formal suppliers, including chartered banks (37 percent of SME debt, compared with 29 percent nationally), and credit unions/caisses populaires (12 percent of SME debt, compared with 5 percent nationally). In fact, in this region, debt owed to credit unions represents the highest proportion of SME debt of any region in Canada. This reflects the strong market presence of this supplier in Manitoba and Saskatchewan: 181 credit unions are currently operating in 515 locations in the region.³³

1.2.5 Alberta/Northwest Territories

Formal versus Informal Types of Financing

Formal Types of Financing in 2000

• 28 percent of SMEs in Alberta/Northwest Territories used commercial credit cards (highest in Canada; compared with 26 percent nationally)
• 9 percent used government loans or grants (second highest in Canada, compared with the 7-percent national average)

Informal Types of Financing in 2000

• 43 percent of SMEs in Alberta/Northwest Territories used trade credit from suppliers (third highest region, compared with the 39-percent national average)
• 41 percent used the personal credit cards of the owner(s) (highest of all regions, compared with 33 percent nationally)
• 37 percent used the business' retained earnings (highest in Canada, compared with the 31-percent national average)

In Alberta, the strong market presence of the ATB Financial (formerly Alberta Treasury Branches) has influenced trends in the sources of financing, and explains the proportionally high use of government financing programs in this region. ATB Financial is a government-owned financial institution that has provided financing to over 20 000 business customers (roughly 14 percent of Alberta's SMEs). In 2000, government sources were owed 8 percent of the SME debt in this region (compared with 4 percent nationally). The presence of the ATB Financial also likely lowered the region's reliance on chartered banks, which accounted for 24 percent of the debt of SMEs (compared with 29 percent nationally).

Despite having the second highest regional concentration in agriculture in 2000, the financial structure of SMEs in Alberta and the Northwest Territories was not strongly influenced by the particular financing needs of agricultural firms. The relatively balanced sectoral distribution in this region reconciles their use of formal and informal instruments with the overall national averages. It is worth noting that as with businesses in British Columbia, SMEs in Alberta and the Northwest Territories tend to finance operations through the business' own retained earnings. In contrast to other regions, SMEs in Alberta and the Northwest Territories tend to rely much less on external formal types of financing.

From one observation, however, it is not possible to determine whether this is a result of cyclical economic factors, sectoral factors, lack of access to formal sources of financing or whether it reflects SME owners' preferences.

1.2.6 British Columbia / Yukon

Formal versus Informal Types of Financing

Formal Types of Financing in 2000

• 46 percent of SMEs in British Columbia/Yukon used commercial loans and lines of credit (second lowest region after Ontario, compared with 49 percent nationally)
• 22 percent used commercial credit cards (lowest of all regions, compared with the 26-percent national average)

Informal Types of Financing in 2000

• 36 percent of SMEs in British Columbia / Yukon used trade credit from suppliers (lowest of all regions, compared with the 39-percent national average)
• 39 percent used the personal savings of the owner(s) (highest in Canada, compared with the 35-percent national average)
• 34 percent used the business' retained earnings (second highest region after Alberta)
• 5 percent used loans from other individuals (highest in Canada)

The pattern of financing in British Columbia / Yukon is similar to that in Alberta/Northwest Territories. Business owners tend to depend on their firms' financial self-reliance rather than on external sources of formal financing. This may be a function of this region's relatively balanced sectoral spread. In this region, "other" sectors, which includes a diverse array of industry groupings,³⁴ constitute the highest percentage of SMEs of any region. Given the diversity of firms in this grouping, this region does not appear to have a dominant financing pattern. As with the situation in Alberta, it is not possible to identify causality on the basis of one observation. More data and detailed analysis will be needed to determine what factors contribute to financing patterns in this region.

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21. These figures on instrument use reflect the percentage of SMEs that used a particular type of financing in 2000, regardless of whether is was authorized or obtained in a previous year. For example, a business may have received a commercial line of credit from a financial institution in 1990, but as long as the business was still using that instrument in 2000, it is reported here as part of their capital mix in 2000.

22. This may include, among other things, capital obtained from liquidating pension funds, RRSPs and life insurance, or remortgaging assets.

23. The Statistics Canada Survey on Financing of Small and Medium-sized Enterprises, 2000 found that SMEs on average had just over $83 000 in retained earnings in 2000.

24. Canadian Federation of Independent Business (2001) Banking on Entrepreneurship: Results of the CFIB Banking Survey.

25. More discussion on informal investors is available in Part IV of this report.

26. The Research Institute for SMEs, Université du Québec à Trois-Rivières (2002) Financing SMEs: Satisfaction, Access, Knowledge and Needs, 2001, a report prepared for Industry Canada.

27. A complete listing of financial structures and instrument usage by region is available in tables 11, 12, 13 and 14. The sampling for the Survey on Financing of Small and Medium-sized Enterprises, 2000, in some cases, limits data reporting to regional, not provincial, findings.

28. An in-depth discussion on the regional supply of financing and access points is available in Part III.

29. The Credit Union Central of Canada reports a combined total of 73 credit unions throughout the Atlantic region, which operate 145 locations (www.cucentral.ca).

30. This figure is based on the combined locations of the 204 credit unions and 13 caisses populaires currently operating in Ontario. (Credit Union Central of Canada, (www.cucentral.ca)).

31. Of Canada's 52 chartered banks, 3 644 branches are located throughout Ontario. (Ontario Economic Development, (www.2ontario.com).

32. Industry Canada, Small and Medium-sized Enterprise (SME) Financing in Canada, 2002.

33. Credit Union Central of Canada (www.cucentral.ca).

34. "Other" sectors include, for example, construction, transportation, warehousing, information and publishing, real estate and rental, administration, arts and entertainment, recreation, accommodation and food services, etc.