The small and medium enterprises

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The small and medium enterprises are playing a key role in diversification of economic activity and in the creation of better employment opportunities. According to recent census of establishment conducted by Federal Bureau of Statistics, the small and medium sized enterprise contributes over 30% to GDP, 25% in export earning besides sharing 35% in manufacturing value addition, which has made them a potential source of sustainable growth and development. But according to research published by Muhammad Mohsin (1995) one of constraint to development of SME's is controls and interest rate ceilings which encourage commercial banks to favor large firms even more than their natural disposition to do so. According to him the market rule is "Other things being equal, the higher the risk, the higher shall be the rate of interest (cost of capital)". Thus smaller the borrower, the more risky it is to lend to him. In order to minimize risks, lenders exact physical collateral guarantees which small enterprises cannot provide. The SME's is therefore, ranked as a `high risk' and `high cost' borrower. In this process the small entrepreneur is often eliminated from the market, if sufficient collateral is not provided.

Though now-a-day's government in many developing countries with a view to overcoming these problems has established specialized institutions to give loans on soft terms and at subsidized rates to the SME's. But these institutions continue to rely on collateral' which does not serve the interests of SME's as the most crucial need of the small scale business is the provision of equity capital and the Islamic modes of finance based on risk bearing and profit sharing fully ensures this.

A great extent of knowledge exists regarding the Islamic banking system and uses of Islamic instruments for SME's financing. Here we identify the types of industries which fall into the category of SME's. A discussion paper (2005) on SME's and its social responsibility tells that the SME's and micro-enterprise sector encompasses a very broad range of firms from established traditional family businesses employing over a hundred people to 'survivalist' self-employed people working in informal micro-enterprises. Similarly Prof. V. K. Sapovadia, while discussing about micro enterprise clients tell that the typical micro finance clients are low-income persons that do not have access to formal financial institutions. Micro finance clients are typically self-employed, often household-based entrepreneurs. In rural areas, they are usually small farmers and others who are engaged in small income generating activities such as food processing and petty trade. In urban areas, SME's are more diverse and include shopkeepers, service providers, artisans, street vendors, construction, transportation companies, auto part manufacturers, consumer goods dealers etc.

Sapovadia while discussing about the needs of SME's for its growth and development describes that SME's requires both financial services and non-financial i.e. business development services, such as market information, management and vocational skills training and business advice

According to Research Paper by Muhammad Mohsin (1995) two of the most important needs of SME's for their growth are financing fixed asset formation and financing business operations which can be fulfilled through Islamic instruments. The debt-based modes of fixed assets financing are Bay'al Salam and Murabahah. Under these terms the owner of a small business is obliged to pay back the entire amount at agreed terms. The debt-form may be without any charge (Qard-Hasan) or it may carry some nominal administrative charges known as `service charges'. Murabahah based transactions may include cost plus or they may be a markup-based. The non-debt modes of financing are Mudarabah and Musharakah. The debt-creating modes impose a burden on the borrower irrespective of the profitability of the Enterprise and in equity financing (Mudarabah and Musharakah); the payment is based upon the earnings. Various features of financial instruments and types of finance can be used to suit the circumstances of SME's as borrower. One of feature of Islamic instrument is level of participation in management of SME's by Islamic bank. This level of management varies in each instrument so SME's depending upon its need can utilize any one of instrument. Both in Mudarabah and Bay'al Salam, once the funds have been handed over, the SSB enterprise is free to use them according to its discretion. The Islamic bank has no participation in the management. Musharakah provides an opportunity under which the Islamic bank has a role in the management of funds.

Similarly, in Murabahah (markup-based) financing and Ijarah (leased-based) financing, the Islamic bank has full control over the use of funds. So if the SME entrepreneur feels that for proper growth and development of his business he needs some of guidance and managerial assistance he can utilize Musharakah, Murabaha etc. Islamic instruments also help in financing SME's business operations. These operational issues can be day-to-day problems which have to be carefully managed. Many conventional small-scale enterprises fail due to the improper management of inventory. Overinvestment causes a considerable erosion of profits and capital. Generally, firms build up stocks of raw material in order to ensure the continuity of production and the availability of quantity discounts. On the other hand if SME's consult Islamic banks for use of Islamic instruments then Islamic bank will buy raw material from supplier on the basis of Murabaha or Musharaka and then sell raw material to the users (SME's on the basis of "Bay Muajjal" or "Bay Bithaman" (deferred sale). Under the system of transaction, the raw material will be delivered to the SME's immediately, while payment for the raw material will be postponed to a later date. Similarly, if SME's employ Islamic instruments for sale of their finished goods then banks would buy finished goods from the SME's sell them in the market which will relieve producers from marketing problems and will allow flexibility in production scheduling.

As this research paper has identified that one of most important Micro enterprise is Agriculture so now role of Islamic instrument in growth of this Micro enterprise will be discussed through available literature on it. According to Research paper by Dr. Mahmoud A. Gulaid, major activities in agriculture include Post-Harvest Activities, Harvesting, and Pre-harvest Management. Land preparation, Prep. of Irrigation and Drainage Systems and Cultivation & Planting activities and these activities require following inputs such as chemical-biological-mechanical inputs, human capital component which is embodied in the skill and expertise of the entrepreneur, Working capital which is required to finance day-to- day requisites of the operation, and information-marketing and services-related capital. Acquisition of these inputs requires financing but as this sector is prone to many natural risks. Incidence of drought, floods, hail, earthquakes, mud slides and a multitude of other mishaps often need to be taken into the decision-making process. Financiers have been discouraged from investing in this sector because of presence of these risks. For the growth and development of this sector Islamic instruments can be widely used e.g. Musharaka financing, including all its variants, can be extensively used in agriculture in order to provide farmers with the essential factors of production. In particular, agricultural machinery and equipment can be financed through Diminishing Musharaka. Muzara'a, Musaqah can be used to finance labor, expertise and management components of the production cycle. The working capital and other inputs such as fertilizers, seeds, etc. can be provided by the financier through comprehensive Musharaka arrangements. Some Islamic banks own a pool of machinery, equipment and expertise in extension services. These banks lease water drilling rigs, tractors, and combine harvesters on the basis of hourly rentals. These can be implemented through Ijara contracts. Ijara can also be used by Islamic banks to finance acquisition of real assets in agriculture. Murabaha, especially Bai' Al Murabaha lil Amir Bi Al Shira, can be very useful in financing the chemical, biological and mechanical inputs that are essential for modern agriculture. Bai' al Salam, from the farmer's perspective, can be used to finance sale of crops in agriculture. Istisna' is unique in that it is predisposed to cater for the technology-intensive input needs of the farm enterprise.

According to Research paper by Badr-El-Din A. Ibrahim (March 2003) the conventional bank usually gets back the amount it has lent along with the interest payments. It does not matter whether the entrepreneur made a profit or incurred a loss. Thus the Islamic financing modes are better suited for meeting the needs of SME's. In most cases financing is granted without an obligation on the part of the partner to pay back whether he or she gains or loses. As Islamic investment arrangements put great emphasis on the transaction itself, rather than the creditworthiness of the partner, no strict security should be demanded. . If the operation ends in a loss the partner does not bear this loss alone. If he or she is unable to settle his or her bills, a grace period is given without any additional fees. Most of Islamic instruments are suited to fulfill the needs of SME and to lead them towards growth and development e.g. Musharaka caters for both production and management, thus leading to increase incomes for income groups who do not own capital. It is a suitable mode of financing for both working and fixed capital. In Musharaka the bank may take an active role in marketing the product, thus reducing the marketing burden on small entrepreneurs. Musharaka also avoids repayments from small entrepreneurs who have already lost their livelihood in the case of a total failure. Besides providing finance to the already established SME's, partnership modes of finance are likely to create new economically and technically feasible small-sized investments, through the concentration of feasibility studies rather than the creditworthiness of small entrepreneurs. Similarly Murabaha contract is beneficial to SME's. Instead of a small entrepreneur having a loan (which he may use in a different purpose), the Murabaha contract will buy the asset or raw material for him at a profit. Thus Musharakah, Murabaha and other Islamic instruments can be used by SME's in order to fulfill their financing needs which would help in growth of SME's.

According to Trade Finance press abstract (2005) Islamic instruments can be very helpful to SME as in Islamic banking; loans are replaced by a contract of sale and profit-sharing. The bank shares with its customer the cost of producing goods and services and shares in the profit or mark-up. Two of the best known instruments of Islamic banking are Musharakah and Mudharabah: forms of equity investments with profit-sharing for the financing of projects in which provisions may be made for the repurchase of the equity by the enterprise or a third-party investor at a pre-agreed date or on pre-agreed terms. Leasing (ijarah) is also provided for on much the same lines as traditional leasing, and straightforward interest-free loans (qardhul hassan) are granted as accompanying measures to other instruments or with a provision that allows the lender to share in the borrower's trading profits. In this form of banking, the banker acts a true partner to its customer, sharing the risks and hence the benefits. The close involvement of the bank in the prospects and fortunes of the enterprise confers upon the bank quite a distinctive role that appears more proactive. He also discuss that Malaysia Islamic banks have successfully utilized Islamic instruments to finance agriculture sector. I.e. Malaysia Islamic bank (Bank Pertanian) finances small projects of farmers by using Mudarba and Musharika. It also offers supervision and consulting services to small farmers. This bank also use Mudaraba and Musharika to finance working capital requirements of entrepreneurs in agriculture sector and other small and medium sized.

A study by Fazal-ur-Rehman (May, 2002) provides that the essence of interest-free micro credit system is to provide the maximum share of profit to the partners (SME's) for their sustainability and betterment. The promotion of business and moral ethics, along with risk management and a close monitoring system are the key aspects of Islamic instruments which helps in growth of SME's.

A study on elimination of poverty indicate that the importance of Islamic arrangements for poverty alleviation lies in the fact that the poor cannot afford loans at 20-25% interest rate, which either make them defaulters or the staff of concerned organizations get involved in corruption by showing funds reserved for other purposes as recovery of the micro-credit. Instead of purely relying on interest-based loans, there is a need to look into the Islamic ways, like Mudariba, Musharika, Khumus, etc for supporting the needy (Abid Ullah, April, 2002).

A research conducted by Tajammal Hussain indicates that though success is entirely dependant upon strict adherence to the norms of morality and ethics, musharika as a mode of financing has a number of advantages for SME's over other approved modes of financing which includes equitable distribution of wealth, profits in musharika accrue at a lower level ( i.e. profits to partners will begin to flow in as soon as income is higher than zero unlike under markup where profits begin to accrue after payment of mark-up), maintenance of employment rate, reduction of the unethical practices and creation of welfare state based on Islam.

A.L.M. Abdul Gafoor (October, 2001) while discussing Mudaraba-based investment and financing suggests that the implementation of this system requires the cultivation of new attitudes on the part of all the participants. It requires more from each participant, but it also offers more both to the individual and to the society as a whole. The mudaraba principle is applicable to a range of situations, from a simple local two-person partnership to a multiparty international corporation.. However, the scheme is ideally suited to medium scale new enterprises.

Similarly Murabaha as an Islamic instrument will be helpful for micro and medium enterprise clients for getting short/medium and long term finance for; raw material, inventory, equipment, asset financing, import financing, export financing (Pre-shipment), Consumer goods financing, house financing, vehicle financing, and financing , shop financing , PC financing .

Istisna, would be assist Micro and Medium sized enterprise for getting;

  • Financing of plant / factory / building.
  • House financing
  • Construction of buildings and plants.

Also Ijarah can be used by Micro and medium enterprise clients as an alternative to leasing done by commercial banks now days.

Though Islamic instruments are highly beneficial to SME's but in order to increase their use by SME's some steps needs to be taken. The implementation of this system requires the cultivation of new attitudes on the part of all the participants. It requires more from each participant, but it also offers more both to the individual and to the society as a whole.