Post on 28-Jan-2023
ISLAMIC FINANCING AS A STRATEGY FOR THE REDUCTION
OF SMEs FAILURES I N NIGERIA
NAME: NURUDEEN Y.ZBUSINESS DEPARTMENT OF BUSINESS ADMINISTRATION
FACULTY OF MANAGEMENT SCIENCES
KOGI STATE UNIVERSITY, ANYIGBA.
ABSTRACT
The roles and opportunities of Small and Medium-
scale Enterprises (SMEs) in National Growth and
Development in all Economies is well documented. In
Nigeria, these opportunities are not exploited
effectively. as a result of high rate of SME
failures. SMEs in Nigeria represent 97% of all
enterprise in the economy (NBS, 1999) of these,
more than 85% failed in t heir first five years of
operation. High failures, low progress and low
intensification of SMEs are due to commercial bank
practices prevailing in high interest rates, high
burden of collateral guarantees and provision of
funds to large firms on the assumption that SMEs
1
involves high risk investment. The paper identifies
basic Islamic Financing Strategy that could be
adopted for reducing and sustaining SMEs risk and
failures, and Entrepreneurial development in
Nigeria. This paper revealed (Riba) interest rate
as a major cause of the problem. The paper
recommends the adoption of Islamic mode of
financing as a tool in reducing high rate of SMEs
failures, thereby increasing entrepreneurial
development in the economy.
ISLAMIC FINANCING AS A STRATEGY FOR THE REDUCTION
OF SMEs FAILURE IN NIGERIA
The health of Small and Medium Scale
Enterprises (SMEs) sector is very important for the
over all economic growth and development of all
nations especially in the developing countries. The
SMEs sector is a principal driving forces for
economic growth and employment. In most of these
countries including Nigeria, SMEs represents over
90% of business contribution to over 50% of GDP and
account for about 65% of employment. (NBS, 1999)
2
Thus, the significance of this sector in expanding
enterprises for economic development and employment
generation has attracted the attention of
researcher’s and academic policy makers in many
countries (Bernice and Meradith, 1997).
The existence of a healthy SMEs sector is necessary
for the growth of an economy not only in employment
generation but also in the increment of number of
products or services offered to the society.
Therefore, it improves the level of societal
welfare. SMEs make more efficient use of inputs
(raw materials, capital and labour than big
companies. They can be places of learning and
training for people of all levels and functions
(directors, managers, and workers), a capacity that
could be used in other sectors of the economy. They
facilitate the creation and use of other-wise non
existent or unused saving (Lassort and Clavies
(1989) in Onuoha, 2011).
Furthermore, SMEs helps in the diversification of
the economy, and more importantly, stimulation of
indigenous entrepreneurships (Onuoha, 2011). In
some cases, Inventions that were rejected by major
3
big firms were later brought to market by small
start up enterprise (Almaida, 1999).
In theory, these assertions holds, but in reality
especially in developing countries such as Nigeria,
the performance of SMEs falls below expectation, as
the number of failed SMEs keep increasing; the rate
of business failure is as high as 90% in the first
year of operation when failure was defined as
bankruptcy, 65% of the survived failed in their
second year and 55% of those that survived in their
second year failed in their third year of their
operation (Dun and bradstreet, 1963). Specifically,
the root causes of SMEs failures are likely to
differ from country to country depending on the
nature of the SMEs, its business cycle and
differences in the level of economic growth and
development of each country. As such, major factors
of SMEs failure for one economy might not be for
another. In Nigeria, the major factors inhibiting
the growth and development of SMEs sector are
corruption and financial factor hinging basically
on collateral and interest rate.
4
Therefore, the study attempt to point out the root
factors, that contributes to SME failures in
Nigeria. Additionally, effort is made in the study
to develop a strategy for the success of SMEs
basically using Islamic mode of Business financing.
The other sections are;
- Summary of SMEs sector in Nigeria and
government efforts towards its growth and
development.
- Interest rate and SMEs growth
- Summary, conclusion and policy recommendation
are offered in section five.
The SMEs sector constitutes the largest proportion
of the entire business in Nigeria. The Federal
office of Statistics (2009) reveals that about 97%
of the entire enterprises in the country are SMEs
and employ an average of 50% of the working
population as well as, contributing up to 50% to
the industrial outputs. It is suggested that SMEs
in Nigeria are the catalyst of economic growth and
development.
SUMMARY OF SMES SECTOR IN NIGERIA
5
Recognizing the importance’s of SMEs in the
economy, the federal government has been taken
various initiatives including fiscal, monetary and
industrial policies that could promote the growth
and development of SMEs in Nigeria. The federal
government also established specialized financial
institutions such as; Small Scale Industry, Credit
Schemes (SSICSs), Nigerian Bank of Industries (BOI)
with the aim of providing long-term credit
facilities to SMEs.
The government also helped in facilitating and
guaranteeing external finance from World Bank and
other international financial institutions. The
government also established National Directorate of
Employment (NDE) to help the unemployed to acquire
skills necessary for self employment in 1990. The
National Economic Reconstruction Fund (NERFUND) was
also set up top provide medium to long term local
and foreign loans for small and medium scale
businesses. The industrial development centre and
Small and Medium Industry Equity Investment Scheme
(SMIEIS) were set up (Olorunshola, 2003). SMIEIS is
a scheme set up by the Banker’s Committee requiring
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all banks operating in Nigeria to contribute 10%
percent of their profit before taxation (PBT) for
equity investment and promotion of small and medium
industries and the transformation of Nigerian
Agricultural and Cooperative Bank (NACB) to Micro
Finance bank (MB).
Analyzing these SMEs developmental initiatives, one
would ask if SMEs in Nigeria are performing despite
government efforts to promote them. Not much
progress has been achieved judging by SMEs failure
rates.
The performance of SMEs falls below expectation
(Arinative, 2006) irrespective of all these
initiatives, SMEs in Nigeria still face many
obstacles including corruption, unfavorable macro
economic environment, debilitating infrastructures
and administrative challenges.
Gross under capitalization strained by difficulty
in accessing credits from banks and other financial
institutions are the most significant impediments
to creation, survival and growth of SMEs in
Nigeria. The chance of SMEs accessing loan from
conventional bank is low and difficult. Small
7
enterprises have no collateral that would create
opportunities for accessing loan. This will result
in limited recourses that are needed for innovation
and diversification of risk. Also, the exchange
parity rates, is not favorable, making importation
of raw materials too expensive and SMEs products
uncompetitive relative to foreign products.
Due to these financial disadvantages, there is a
tendency that most of the SMEs will fail in their
first five years of operation. Survived SMEs,
which could access credit in one way or the other,
do so, at high interest rates. Thus, the profit
generated will be reduced as the same percentage of
interest and proportionally as increasing the cost
of production.
This high interest rates dilemma leaves SMEs as a
high risks profile investment.
SMEs risk is observed, are basically intensified as
a result of high interest rates as a way of’; firms
profit reduction and increment in the firms cost of
production.
The consequence of profit reduction decreases the
firm financial resources thereby obstructing firm’s
8
expansion that could have generated economies of
scale.
Moreover, the high cost of production affects
firm’s competitive standing in a liberalized and
perfectly competitive market. In Nigeria, high
interest rates decrease firms` profit and increase
firms` cost of production while in the long run
lead to SME failure. Therefore, the most factors
leading to small business failure in Nigeria is
high interest rate (Altab and Rahim, 1989;
Expengong, 1983; Akamokor, 1983). High rate of
inflation; increasing cost of capital and
collateral has are basically an impediment to SMEs
growth; as its effects erode the profits of SMEs.
INTEREST
RATES
Financial institutions play an important role in
the growth and development of SMEs in all
capitalist economies. Interest rate is a key
variable in the financial system; it is capable of
affecting aggregate demand for money, and
consequently investment opportunities.
9
One common characteristic of conventional banks is
the charging of interest rates. Interest from
Islamic perspective means “RIBA”. Arabic words that
means an inverse, expansion or growth. It is
defined by Sharia as a “premium” that must be paid
by the borrower to the lender including the
principal as a condition for the loan (Nurudeed and
Ameh, 2011). Interest rate is the amount charged on
loan. It is usually expressed as the percentage of
the amount borrowed. Interest rates according to
Jighan (1999) are classified into; deposit rate,
lending rate, treasury bills rate, exchange rate
and inter bank rate. All these rates affect SMEs in
different proportions.
Going by the Keynesian investment theory; low
interest rate as a component of cost administered,
is detrimental to increase in saving and hence
investment demand. It was further argued that, high
interest rates will have positive effects on saving
which can be utilized in investment; as those with
excess liquidity are motivated to save.
The excess liquidity generated from high interest
rate on saving is serving as loanable funds. The
10
determination of investment from interest rate can
only stand the test of time in the short-run. In
the long-run, high interest rate tend to choke off
investment ( Khat and Balhia, 1993). Interest rate
as an addition to the principal borrowed and hence
discourages investment. For SMEs operating with
small profit margins, increase in the cost of
borrowing not only reduce the profit but also
increase the level of inflation in an economy.
The effects of high interest rates on SMEs
profitability, is too significant. Normal profit
helps SMEs to transform from small to big. This
increase in size creates an ability to employ
skillful managers, workers and to acquire more
efficient technology and facilities needed for
growth (Nijewardena and Cooray, 1995; and Riding,
Scolf and Orser, 2000). The imposition of high
interest rates and collateral as a necessary
condition left SMEs trapped in a vicious cycle;
they can not get access to finance unless they
offer sufficient collaterals. They can not posses’
tangible collateral unless they build a strong
productive base, they cannot improve their
11
productive base unless they get access to finance.
They lack access to finance basically because of
high interest rate and collaterals (Argenti, 1976;
Dun and Braodstreet, 1969; Whichmann, 1983). it is
typical of Nigerian entrepreneurs to be lacking
collateral to meet the existing critical conditions
of risk averse bank (World Bank ,2000).
Specifically, exchange rate has served as the
lethal variables killing most of the SMEs in
Nigeria especially the textile industries. The
floating of Naira as a result of economic
liberalization policy has significantly led to the
devaluation of Naira; thus creating unfavorable
competitive environment for Nigerian SMEs relative
to their foreign rivals. As noted, with an exchange
rate of 1$ to about N150, this economic index will
definitely affect the performance of SMEs in
Nigeria. More importantly, higher interest rates
enhance investment in non real sector because; the
rate of return is more than the real sector. This
movement in interest rate retards the growth and
development of SMEs. The effects of interest rates
on economic growth and development are becoming so
12
pervasive, that businesses all over the world are
failing towards recession and depression.
By its effects on profitability, high interest
rates creates possibility of default i.e. SMEs
failing to repay some or even all of a loan and
interest. This possibility of defaulting May
therefore creates a recession or slow down in
economic activities that could further depress the
profitability of SMEs, expiring its ability to
repay its loan.
All notable depression right from 1929 depression
down to the current global economic meltdown is
attributed to high interest rates. Confirming this,
World Bank Report (2009) categorically stated
“where there is room, Central Bank should explore
in cutting down interest rates further and keep
them low until a durable recovery is underway. To
lend credence to the world trade report, IMF (2009)
says financial condition has improved more than
expected, mainly due to public intervention in
interest rates reduction.
Confirming the effects of interest rates on
inflation, compitiveness and profitability of SMEs
13
in Nigeria, the table below and its explanatory
analysis are results of a survey of Nigerian Small
and Medium Sized Enterprises Development under
Trade Liberalization (Oboko, 2008)
Analysis of the Aggregate of 25 SMEs Partly Finance
by Owners Funds and Loans
The ROI for this group was also computed using the
aggregate assets and aggregate profits posted for
each year by the 25 manufacturing SMEs that their
operations are partly financed by owners’ funds and
loans. The difference between the ROI and the
interest rates for each year gave the MOS. From the
table, it was observed that except for 1997, 1999,
2000 and 2006 years of operation, the computed MOS
for this group of SMEs were all negative. The worst
years of the MOS were 1995, 2002 and 2004 when the
interest rates ranged from 19.46% to 20.48%. Apart
from inflation and the naira depreciation, the
factor that affected these SMEs most is the
interest rates. Since they were partly financed by
14
loans or credit facilities which attracted monthly
or annually as the case may be, the cost of
operation increased by the financial cost or the
cost of borrowing which is the interest rate on the
loan facility. This was unlike the first group that
were most affected by the inflation rate and
depreciation of the naira. In other words, this
group of SMEs that financed their operation with
owners’ funds and loans were worse hit by the
deregulation of interest rates and the depreciate
ion of the naira.
Table 3: Showing Aggregate Asset, Profits, Computed ROI of25 Sampled SMEs, Interest Rates, Inflation Rates, NairaExchange Rate to One US$ and the Rate of Naira Depreciationto One US$
Year Asset in Naira(N’ 000)
Profit in Naira (N’ 000)
Return onInvestment (ROI)(in %)
Interest Rate(COC)
(ROI)-(COC)=MOS(in %)
Inflation Rate
Naira Exchange Rate toOne US$
Rate of Naira Depreciation to OneUS$
1994 Nil Nil Nil 21.00 Nil 57.00 21.87 (0.82)1995 44916.8 13475.0 15 20.18 (0.18 73.10 81.02 270.46
15
0 4 )1996 64006.4
424541.42
19.55 19.74 3.76 29.10 81.25 0.28
1997 103084.20
49480.42
21.44 13.54 13.46 8.50 81.65 0.50
1998 122719.40
40308.59
17.15 18.29 2.71 10.00 83.81 2.65
1999 132858.60
52024.65
22.95 21.32 2.68 6.60 92.34 10.18
2000 141339.10
49810.87
81.97 17.98 3.62 6.90 100.8 9.16
2001 153739.00
47935.29
15.46 18.29 1.71 18.90 111.7 10.81
2002 189357.60
51694.62
14.45 20.48 (.28) 12.90 126.26 13.03
2003 193661.30
86071.68
19.44 21.16 3.84 14.00 134.04 6.16
2004 232393.30
86760.17
12.67 19.47 1.53 19.40 134.73 0.52
2005 257059.40
105047.00
19.41 20.00 4.00 17.90 145.82 8.23
2006 270182.90
130459.70
20.57 18.70 7.3 12.60 148.46 1.81
It was observed; that SMEs that financed their
operation with owners’ funds and retained profits
show a better performance than the other group that
their operations were partly financed by owners’
funds and loans does not put them above market and
environmental risk. The MOS as can be seen in table
16
2 are still too small to cater for dividend
assuming these businesses were to pay dividends to
shareholders.
Looking at SMEs from these perspectives, and
thinking about how loan should perform its function
effectively and efficiently in the financing of
SMEs, then interest rates must be reviewed
ISLAMIC FINANCIAL SYSTEM
AND SMEs
The basic frame work for an Islamic financial
system is a set of principles, rules and laws,
collectively referred as Shariah governing
economic, social, political and cultural aspects of
Islamic societies. By Shariah, we mean the
applications, practices and explanations that are
based on Quran and Sunnah.
Islamic finance therefore means that aspect of
finance that is based on Sharia. the basic
principles and practice of Islamic mode of
financing can be summarized as follows;
- Interest Free Mode of Finance: Under this
principle, the basic emphasis is on profit
17
and it is shared on an agreed term. In case
of loss; of the lost that was incurred does
not emanate from the entrepreneurs, then the
total loss will be born by the financier
which is the bank.
- It is based on social justice, equality and
property right regarding the societal
resources.
- More importantly, Islamic finance not only
provides free interest rate but also as one
of its practices, it is enterprise risk
management. Relating this, the cooperation
between potential entrepreneurs and
commercial lending financial institutions is
usually held back on the following reasons;
To protect their investment and ensuring
the safety of the loan, banks require
substantial collaterals. In some cases,
the value of the collateral is more than
the cost of the loan. In Islamic finance,
collateral comes from the concept of joint
liability. In this concept SMEs and Bank
involved in the operation.
18
More importantly, the conditions set by
the commercial banks are extremely not
feasible for most of the entrepreneurs.
Given these reason, securing finance for SMEs are
extremely difficult leaving SMEs seeking for
another financing alternative.
An Islamic financial system can play vital roles in
the growth and development of SMEs in Nigeria. This
is possible through the mobilization of dormant
saving that are been intentionally kept out of
interest based financial channel and by
facilitating the development of capital market at
the same time. The development of this system would
enable savers and borrowers to choose financial
instruments compatible with their business needs,
social values and religious belief. Under Islamic
mode of financing, borrowers and lenders share
rewards as well as loss in an equitable
distribution. Thus, the process of resource
allocation and distribution in the economy can now
be fair and representative of true productivity. As
interest is free, suppliers of funds become
inventors, t he provider of financial capital and
19
entrepreneur share risk in return for profit
sharing. Moreover, borrowing-lending process with
charging interest as practiced in today’s financing
are leading SMEs to failure. This is because the
creditor is not encouraged to take or make
financial assessment. As a result, the volume of
unhealthy credits will substantially increase and
lead to excessive leverage, and to an unsustainable
rise in asset prices, living beyond means, and
speculative investment. (Chapra, 2008)
All these are possible through the adoption of
Islamic modes of financing.
ISLAMIC MODES OF
FINANCING SMEs
There are various modes of Islamic financing that
are available for any particular SMEs. The most
effective of these are;
Murabaha (Cost–Plus Financing): The
Murabaha is a method of asset acquisition
finance. It involves a contract between
the bank and its client for the sale of
goods at a price that includes an agreed
profit margin, their percentage of the
20
purchase price or a lump sum. The bank
will purchase the goods as requested by
its client and will sell them to the
client with a mark-up. The profit mark-up
is fixed before the deal closes and cannot
be increasd, even if the client does not
take the goods within the time stipulated
in the contract. Some Islamic banks use an
agency arrangement, where the client takes
delivery of goods from the seller as an
agent of the bank. Payment will usually be
over time by installment.
Mudaraba (Profit Sharing): The Mudaraba is
a profit sharing contract, with one party
providing 100 percent of the capital and
the other party (the Mudarib) providing
its expertise to invest the capital,
manage the investment project and, if
appropriate, provide labour. Profit
generated is distributed according to a
predetermined ratio, but like the capital
itself, cannot be guaranteed. Losses
accrued are therefore borne by the
21
provider of the capital, who has no
control over the management of the
project. Mudaraba structures are often
used for investment funds, with investors
providing money to the Islamic bank, which
it invests as Mudarib, taking a management
fee.
Musharaka) Partnership Financing): The
Musharaka involves a partnership between
two parties who both provide capital
towards the financing of new established
projects. Both parties share the profits
on a pre-agreed ration. Allowing
managerial skills to be remunerated, with
losses being shared on the basis of equity
participation. One or both parties can
undertake management of the project. As
both parties take on project risk, it is
relatively rare for banks to participate
in Musharaka transactions.
Ijara (Leasing): The Ijara is a contract
where the bank buys and leases out
equipment required by the client for a
22
rental fee. The duration of the lease and
rental fees are agreed in advance.
Ownership of the equipment remains with
the lessor bank, which will seek to
recover the capital cost of the equipment
plus a profit margin out of the rentals
payable. There are two types of Ijara:
operating leases and lease purchase. In a
lease purchase, the obligation to purchase
the equipment at the end of the lease and
the price at which the assets will be
bought is pre-agreed. Rental fees already
paid constitute part of the final
purchasing price. Where an asset is
financed through floating rate funds, the
owner will usually pass the risk of rate
of fluctuations down to the lessee through
the rentals payable by the lessee. This
creates a problem under Islamic finance
principles as lease rentals cannot be
expressed by reference to interest rates.
This difficulty is partly surmountable. In
leasing transactions the lessor is
23
providing an asset, not funds, so t he
return is in the form of rent, rather than
principal and interest. In an Ijara lease,
t he amount and timing of the lease
payments should be agreed in advance,
though the amount of those payments may be
subject to adjustment on a predetermined
basis. Way in which the problem has been
overcome therefore include: referring to
the rent payable under the lease at the
date of signing but subject to adjustments
by reference to provisions in other
documents; or adjusting the rent be cross-
referenced to LIOBOR or to a fluctuating
rent payable under a non-Islamic lease
singed at ..
Istisna’a (Commissioned Manufacture):
Islamic principle of Gharar prevents one
from selling something that one dose not
own. The technique of Istisna’a has been
developed as an exception to this. As
defined by the Islamic Development Bank.
Istisna’a is a contract whereby a party
24
undertakes to produce a specific thing
that is possible to be made according to
certain agreed specifications at a
determined price and for a fixed of
delivery’. Accordingly, the technique is
particularly useful in providing an
Islamic element in the construction phase
of a project, as it is akin to a fixed
price turnkey contract. As the Istisna’a
contract is one of procurement and sale of
an asset, it also lends itself to non-
recourses financing. In an Istisna’a
transaction, a financier may undertake to
manufacture an asset and sell it one
receipt of monetary installments. As banks
do not normally carry out manufacturing, a
parallel contract structure will typically
be used. T he ultimate buyer of the asset
will commission it from the bank, which
will institute a parallel contract under
which the bank commissions the asset from
the manufacturer. The bank charges t he
buyer the price it pays the manufacturer
25
plus a reasonable profit. The bank t her
fore takes the risk of manufacture of the
asset.
SUKUK: The significant importance of Islamic
financing is the development of SPV (Special
Purpose Vehicle) known as Sukuk. This vehicle helps
SMEs through capital market to generate funds from
the public.The issuance of Sukuk, while helping
SMEs to benefit from both debt and equity financing
from the Islamic Financial Institution. Under this
mode, Assets and inventory are financed on debt
terms. While other aspects that require financing
can be on an equity (revenue sharing) basis as
mention above. More importantly, Sukuk helps in
spreading SMEs risk between Islamic Financial
Institution and the public through the capital
market.
CONCLUSION
As observed, access to capital is an impediment to
the growth of SMEs in developing countries and in
particular Nigeria. SMEs are considered to have
high risk investment profile, as such, the
26
conventional bank attached a stringent stiff
conditions: High interest rates and collateral in
other to safeguard the loan going to SMEs. These
conditions further increased the chance of SMEs to
fail. High interest rates extremely reduce the
profit that could have been used for innovation
needed for expansion and growth.
Assessing SME failure from these; high interest
rate and collateral, the best alternative for
financing SMEs in developing countries should be
Islamic financing; as its principles and practice
depend neither on interest rate nor collateral but
on profit sharing and risk mitigation.
RECOMMENDATION
The introduction of Islamic mode of financing in
Nigeria is a step forward. It is an opportunity not
only for free interest rate and collateral for
loaning credits to SMEs, but also an opportunity in
exploiting new market that will attracts Foreign
Direct Investment (FDI) from most of the Arab
economies with their significance funds of Islamic
investor seeking for Shari’ah compliant investment.
27
Therefore, it is recommended that, entrepreneurs
should tap into these pools of opportunities to
explore the nascent market either by creating a
global partnership with the Arab investors that
need interest free investments or partnering with
available Islamic financial institutions such as
JAIZ.
For this to be an effective SMEs financing
strategies, the global human resources must be
developed to acquire the necessary techniques and
applications that are necessary for an effective
operation of Islamic mode of financing.
An effective legal regulatory framework must be
clearly laid by government as support guidance.
More importantly; business professional, academic
practitioners and the entire public
should be motivated to promote the
significances of Islamic modes of financing
through seminars, conference and more
importantly, the introduction of Islamic
financial courses in our higher institution is a
priority.
28
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