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

3. Industry Sector

Industry sector influences SMEs' financial structure. The sector of operation has long been one of the "Five Cs" used by financial institutions to assess a firm's creditworthiness.³⁹ More recently, industry sector has become a primary consideration in financial institutions' credit scoring models. These models account for the fact that different sectors typically have different asset structures, profitability levels, risk of default or failure rates.⁴⁰ That different sectors use different kinds of financing is not, in itself, evidence of a financial market imperfection or gap. Many factors may determine these patterns, but from one set of observations it is not possible to identify the direction of causality.

Sectoral differences in the use of formal and informal types of financing

The sectoral differences in financial structure are most apparent in comparisons between resource-based sectors (e.g. agriculture) and service sectors (e.g. knowledge-based industries). For instance, agricultural firms typically have more fixed asset collateral, which enables them to support higher levels of formal sources of debt. Since SMEs in service industries do not typically have as high an asset base, they tend to use informal sources of debt. The discussion that follows is derived from Tables 11 and 12.

Key Findings for Industry Sector Resource-based and goods-producing sectors' higher use of formal types of financing: 71 percent of agricultural firms used commercial loans and lines of credit 28 percent of agricultural firms used government loans or grants — highest of all sectors 58 percent of manufacturing firms used trade credit from suppliers 25 percent of manufacturing firms used leasing — highest of all sectors Service sectors' higher use of informal types of financing: 37 percent of KBI firms used retained earnings — highest of all sectors. 21 percent of KBI firms used commercial loans and lines of credit — lowest of all sectors 35 percent of wholesale/retail firms used the owner's personal savings — among the highest of all sectors

3.1 Resource-Based and Goods-Producing Sectors

Figure 22 shows the distribution of financing instruments in the resource-based and goods-producing sectors in 2000. With few exceptions, the resource-intensive agricultural and primary sectors and the goods-producing manufacturing industry finance their operations through formal types of debt, the owner's personal savings or the business' retained earnings. To illustrate the debt intensity among the resource and goods-producing sectors, agriculture and manufacturing trends are examined more closely below.

Figure 22
Types of Financial Instruments in Use by Resource-Based or Goods- Producing SMEs in 2000*

3.1.1 Agricultural Sector

Characteristics of an average agricultural SME in 2000: Share of Business Population: 13 percent of the 1.4 million SMEs Years in Business: 85 percent of agricultural SMEs were older than five years Fixed Assets: averaged $581 000 Debt Outstanding: averaged $309 000 Profitability: averaged $28 000 net income before taxes Total Equity: averaged $470 500 Long-Term Debt-To-Equity Ratio: 0.48 Demand for Financing: 39 percent of SMEs requested debt, 93 percent were approved

Formal versus Informal Types of Financing

Formal Types of Financing in 2000

• 71 percent of agricultural SMEs used commercial loans and lines of credit (highest of all sectors, compared with the 49-percent national average)
• 28 percent used government loans or grants (nearly four times the national average)⁴¹

Informal Types of Financing in 2000

• 42 percent of agricultural SMEs used the personal savings of owner(s) (highest of all sectors, compared with the 35-percent national average)
• 29 percent used the business' retained earnings (lowest of all sectors, compared with the 31-percent national average)
• 28 percent used the personal lines of credit of the owner(s) (highest of all sectors, compared with the 21-percent national average)
• 16 percent used loans from friends or relatives of the owner(s) (highest of all sectors, 60 percent higher than the national average)

Agricultural SMEs' high use of formal types of debt is likely related to:

• The availability of fixed assets to pledge as debt security: Agricultural firms had the highest fixed asset holdings of all industries (averaging $581 000 in fixed assets per SME, compared with $291 000 for SMEs overall, in 2000) and therefore had more collateral to secure their debt
• Their more established credit history with their financial institution: Many firms in this sector have reported longer relationships with their financial providers
  • 83 percent claimed to have dealt with the same financial institution for more than seven years, compared with 60 percent of SMEs overall
  • CFIB⁴² reports that longer track records and longer-term relationships with account managers and financial institutions improves access to financing
  • Since the majority of agricultural SMEs are more mature firms, they tend to have well-established credit histories, and as a result, they enjoy better access to financing

The financial structure of agricultural SMEs suggests that control of the firm's financial assets is an important consideration. This tendency is evident in agricultural SMEs' high use of debt instruments of all kinds (both formal and informal), and their low reliance on retained earnings. However, the debt intensity in agricultural firms' capital mix is not reflected in their long-term debt to equity ratio. On average, in 2000, debt comprised 48 percent of agricultural SMEs' long-term financing structure. The reason for this comparatively low ratio is not that SMEs in this sector do not rely on debt, but rather that they have more equity in their businesses than other sectors, and also tend to use shorter-term instruments.

This debt intensive financial structure is also evident in agricultural SMEs' higher than average debt owed to chartered banks (34 percent of debt owed, compared with the 29-percent national average) and credit unions/caisses populaires (11 percent of debt owed, compared with 5 percent nationally).

Figure 23
Percentage Ownership Capital Owned by the Business Owner/Operator in 2000, by Sector

SME Ownership Capital in 2000

In 2000, there was $361 000 in average owner's equity in agricultural SMEs. Of this equity, 94 percent was owned by the business owner/operator (highest of all sectors, compared with the 86-percent national average).

3.1.2 Manufacturing Sector

Characteristics of an average manufacturing SME in 2000: Share of Business Population: 5 percent of the 1.4 million SMEs Years in Business: 72 percent of manufacturing SMEs were older than five years Fixed Assets: averaged $372 000 Debt Outstanding: averaged $531 500 Profitability: averaged $91 000 net income before taxes Total Equity: averaged $332 000 Long-Term Debt-To-Equity Ratio: 0.62 Demand for Financing: 27 percent of SMEs requested debt, 77 percent were approved

Formal versus informal types of financing

Formal Types of Financing in 2000

• 51 percent of manufacturing SMEs used commercial loans and lines of credit (third among sectors: close to the overall SME average of 48 percent)
• 33 percent used commercial credit cards (highest of all sectors, compared with the 26-percent national average)
• 25 percent used leasing (highest of all sectors; compared with the national average of 16 percent)

Informal Types of Financing in 2000

• 58 percent of manufacturing SMEs used trade credit from suppliers (highest of all sectors, compared with the national average of 39 percent)
• 34 percent used the business' retained earnings (second highest of all sectors, compared with the 31-percent national average)
• 35 percent used the personal credit cards of the owner(s) (second highest among sectors, compared with the average of 33 percent)

The types of financing instruments used by manufacturing SMEs in 2000 (trade credit from suppliers, leasing, commercial, or personal credit cards and lines of credit) indicate a preference for flexible financing arrangements. These instruments allow firms to react to changing supply and demand conditions, to control costs, and to exploit opportunities.

The debt structure of manufacturing SMEs reflects their mix of financial instruments. Trade credit from suppliers accounted for a higher percentage of manufacturing firms' debt in 2000 (representing 30 percent of debt owed by manufacturing SMEs, compared with 21 for all sectors). Trade credit debt owed by the manufacturing sector even exceeded debt owed to chartered banks, 27 percent in 2000 (slightly less than the 29-percent average among all sectors).

SME Ownership Capital in 2000

In 2000:

• 71 percent of manufacturing SMEs' ownership capital was owned by the business owner/operator (third lowest of all sectors, compared with the 86-percent national average)
• 8 percent was owned by the parent company
• 5 percent was owned by friends or relatives of the owner(s) (highest of all sectors; compared with the 4-percent national average)
• 4 percent was owned by private foreign and domestic (angel) investors

As will be discussed in Section 7, the manufacturing sector produced the highest percentage of high-growth firms (17 percent of manufacturing SMEs reported cumulative sales growth in excess of 50 percent over a three-year period ending in 2000). Financing cumulative rounds of growth requires substantial capital, and often requires firms to seek sources of equity financing. The comparatively high level of external equity ownership in manufacturing firms is a reflection of this growth phenomenon.

3.2 Service Sectors

Figure 24 provides the distribution of financing instruments used by SMEs in Canada's service sectors in 2000. Unlike the resource-based and goods-producing sectors, there are fewer discernable similarities among the financing sources employed by the service industries. Rather, service sectors have diversified financial structures and tend to use more informal types of financing. This pattern was also apparent in the regional analysis of financing structures in Alberta and British Columbia, where service industries dominate. The following section examines two of the sectors that have the widest variations — knowledge-based industries and firms in the wholesale/retail sector.

Figure 24
Types of Financial Instruments Used by Service Sector SMEs in 2000*

3.2.1 Knowledge-Based Industries (KBIs)

Characteristics of an average KBI SME in 2000: Share of Business Population: 5 percent of the 1.4 million SMEs Years in Business: 55 percent of KBI SMEs were older than five years Fixed Assets: averaged $127 000 Debt Outstanding: averaged $186 500 Profitability: averaged $33 000 net income before taxes Total Equity: averaged $205 000 Long-Term Debt-To-Equity Ratio: 0.36 Demand for Financing: 16 percent of SMEs requested debt, 70 percent were approved

Formal versus informal types of financing

Formal Types of Financing in 2000

• 20 percent of KBI SMEs used commercial loans and lines of credit (lowest of all sectors: far below the 49-percent national average).
• 20 percent used commercial credit cards (lowest of all sectors: compared with the 26-percent national average).

Informal Types of Financing in 2000

• 37 percent of KBI SMEs used the business' retained earnings (highest of all sectors, compared with the 31-percent national average).
• 34 percent used the personal credit cards of the owner(s) (compared with 33 percent nationally).
• 30 percent used the personal savings of the owner(s) (lowest of all sectors, compared with the 35-percent national average).

KBI financing trends show that not all forms of financing are appropriate to all firms — formal and informal sources of debt (the major form of financing for most SMEs) are often inappropriate for KBI firms. The risks associated with market volatility and developing new technologies, products and processes, are often beyond the risk appetites of formal financial providers. In fact, the Business Development Bank of Canada (2000) reported that knowledge-based SMEs face the most difficulty in accessing debt financing.⁴³ The perception is that financial institutions may be reluctant to lend to these SMEs; many of their assets are intangible (e.g. knowledge, expertise, intellectual property, products or services) and cannot be easily liquidated to cover outstanding debt, and their equipment can rapidly become obsolete.

Figure 24 shows KBI SMEs' reaction to these difficulties. These firms have the most diversified use of financial instruments of all sectors. Unlike other industries, in which formal and informal sources of external debt are the primary source of financing, KBI firms tend to have less debt-intensive financial structures. In 2000, only 36 percent of KBI firms' long-term financing structure was comprised of debt (long-term debt-to-equity ratio of 0.36). A similar tendency was seen in the debt owed by KBI firms to suppliers of formal sources of debt. On average, only 14 percent of KBI debt was owed to chartered banks (compared with the 29-percent national average) and only 1.7 percent was owed to credit unions/caisses populaires (compared with the 5-percent national average).

SME Ownership Capital in 2000

In 2000:

• $193 500 in average owner's equity in KBI SMEs.
• 56 percent was owned by the business owner/operator (lowest of all sectors, compared with the 86-percent national average).
• 5 percent was owned by foreign and domestic venture capitalist.
• 4 percent was owned by friends or relatives of the owner(s).
• 4 percent was owned by foreign and domestic private investors (angels) (highest of all sectors, compared with 1 percent for the national average).

KBI SMEs are among the highest users of risk capital in Canada. Shown in Figure 25, only 56 percent of the ownership in KBI firms was held by the business owner/operator in 2000. Consistent with this sector's risk profile and particular financing needs, KBI SMEs were the lowest users of formal and informal debt. Instead, these firms relied on the internal resources of the firm: in 2000, 37 percent of KBI SMEs used the business' retained earnings. Figure 24 showed that KBI firms use more venture capital funds or private investors than SMEs in other sectors. Whether this represents a market imperfection in access to formal debt needs to be monitored over the longer term to ensure that such gaps do not impede the sector's growth.

Figure 25
Distribution (%) of an Average KBI SME's Ownership Capital, 2000

3.2.2 Wholesale and Retail

Characteristics of an average wholesale/retail SME in 2000: Share of Business Population: 16 percent of the 1.4 million SMEs Years in Business: 73 percent of wholesale/retail SMEs were older than five years Fixed Assets: averaged $151 500 Debt Outstanding: averaged $330 000 Profitability: averaged $43 000 net income before taxes Total Equity: averaged $169 000 Long-term Debt-To-Equity Ratio: 0.64 Demand for Financing: 23 percent of SMEs requested debt, 74 percent were approved

Formal versus informal types of financing

Formal Types of Financing in 2000

• 51 percent of wholesale/retail SMEs used commercial loans and lines of credit (second highest of all sectors, compared with the 49-percent national average)
• 29 percent used commercial credit cards (second highest following manufacturing, compared with the 26-percent national average)
• 18 percent used leasing (second highest following manufacturing, compared with the 16-percent national average)

Informal Types of Financing in 2000

• 52 percent of wholesale/retail SMEs used trade credit from suppliers (second highest following manufacturing, compared with 39 percent for the national average)
• 35 percent used the personal savings of the owner(s) (second only to the agriculture sector)
• 13 percent used loans from friends or relatives of the owner(s) (second highest sector, following agriculture)
• 5 percent used loans and investments from other individuals (i.e. angels) (highest of all sectors, compared with the 4-percent national average)

Wholesale and retail SMEs and manufacturing firms followed similar patterns in their use of formal types of debt, leasing and trade credit from suppliers in 2000. As with manufacturing SMEs, wholesale/retail firms owed most of their debt to trade suppliers — 38 percent of their total outstanding debt. Chartered banks only held 21 percent of the debt owed by wholesale and retail SMEs.

It is too early to confirm whether the higher than average use of informal financing (e.g. owner's personal savings, loans from friends and relatives; financing patterns which closely match those of the agricultural sector) indicates a sectoral financing gap. As discussed in Part I, SMEs in this sector had the second lowest approval rate for commercial debt in 2000 (74 percent approval compared with 82 percent overall). As shown above (see insert), wholesale/retail SMEs had among the highest long-term debt-to-equity ratios (0.64) of all sectors, which may contribute to the lower approval rates, and may encourage the use of informal financing.

SME Ownership Capital in 2000

• 92 percent of ownership capital in wholesale/retail SMEs was owned by the business owner/operator (second highest following agriculture, compared with the 86-percent national average)
• 4 percent was owned by friends or relatives of the owner(s)

Most of the ownership in wholesale/retail firms was held by the business owner/operator (92 percent) — second only to 94 percent for the agricultural sector (see Figure 23). This suggests that raising capital by selling equity shares is not a common method of financing in the wholesale/retail sector.

Nevertheless, love money from friends and relatives was obtained by 13 percent of firms in this sector, and friends and relatives held 4 percent of wholesale/retail firms' ownership.

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39. The Five Cs in the Credit Decision: Capacity is the extent to which a firm is able to meet its repayment obligations; capital is the amount of equity built up within a business; collateral is the value of assets available to pledge as security against loans; character is the track record of the business and its owners; conditions refers to the nature and size of the market and industrial climate. (Allan Riding, Financing Entrepreneurial Firms: Legal and Regulatory Issues (1998). Research Paper prepared for the Task Force on the Future of the Canadian Financial Services Sector).

40. Allan Riding, Financing Entrepreneurial Firms: Legal and Regulatory Issues (1998). Research Paper prepared for the Task Force on the Future of the Canadian Financial Services Sector.

41. The regional importance of ATB Financial and the impact of the Farm Credit Corporation (FCC) are the main factors underlying the higher than average usage of government programs by the agricultural industry.

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

43. Business Development Bank of Canada (2000) Financing Services to Canadian Small and Medium-sized Enterprises: Report on Focus Group Research. A report prepared by the Angus Reid Group.