Influence of credit access requirements on formalization decision of small and medium enterprises in Nairobi

Abstract

Many business people operating small and medium enterprises have no access to formal financing, a major reason being their perception of high risk as a result of informality. In order to access financial products, entrepreneurs are required to meet certain conditions such as; collateral, group guarantee, financial reporting and tax compliance. This study sought to examine whether there is a relationship between credit access requirements and formalization of small and medium enterprises in Kenya. The study took the form of a descriptive survey design which is an efficient method of collecting original data and systematic information from a wide range of respondents. The target population was 1200 SME’s operating in Nairobi Central Business District and registered with the Nairobi County government. The sample size was 369 respondents, calculated using Yamane Sampling Formula. The study employed stratified and systematic random sampling to select SME’s from 4 different sectors and also incorporated commercial banks and microfinance institutions in the sampling distribution. Data was collected by use of open and close-ended questionnaires supplemented by an observation checklist. Descriptive and inferential statistics such as mean, standard deviation, correlation and multiple regression analysis were used for analysis. Statistical Package for Social Sciences (SPSS) version 21.0 was used to aid in coding, entry and analysis of quantitative data obtained from the closed-ended questions. The quantitative data was presented in form of percentage tables, graphs and pie charts while qualitative data was presented in form of comments and statements. The study was limited geographically because only SMEs operating in Nairobi were considered. Equally, there was limited literature available to review formalization of SMEs in Kenya. Therefore, the sample size was increased and a larger number of international journals included to curb these limitations. The study findings on asset collateralization and formalization of SMEs showed that lack of business maturity limits the business ability to signal financial institutions of their capacity. Also, lack of adequate formal collateral by SMEs increases perceived credit risk among financiers thus limiting their financial access. On joint liability requirement and formalization of SMEs, findings obtained indicated that joint liability or guarantee from the group allows members to monitor each other easily thus enhancing loan repayment. Further, association to a group was related to a business' ability to access better credit terms since the group acts as the guarantor. On financial reporting requirement and formalization of SMEs, findings showed that availability of financial records eliminate information asymmetry thus allowing for better monitoring. Further, availability of quality and credible financial information enhances business access to loan facilities and better credit terms. Finally, on tax compliance requirement and formalization of SMEs, the study findings indicated that tax compliance is an essential tool in fostering formalization of business operations while enhancing its brand image. The study recommended that the SMEs need to formalize their operations for the businesses to realize growth and improved performance, every financial institution to establish a credit product for the SME segment using the informal associations as an entry point and the government should review business formalization structures such as the tax administration system and business registration to accelerate formalization.