How to Supercharge Tiny Businesses

This means MSMEs can miss out on getting the financing needed to grow. For the smallest informal businesses, microfinance lenders and similar organizations can help, but at a cost. Research led by Md Hamid Uddin of the University of Bradford finds that microfinance institutions spend more than banks to mitigate the risks of lending to the poor, leading to higher rates for borrowers. The World Bank estimates that the average global microcredit rate is 25 percent, and in some countries, it can be 80 percent or more. Churchill also notes that, overall, while mitigating risks plays a role, “the operating costs relative to the small loan sizes make it [microfinancing] more expensive.”

Group lending, a microfinance model that allows small groups of borrowers to guarantee each other’s loans, can come with lower interest rates, but forming groups can be challenging for some borrowers, and being on the hook for others’ loans adds its own risk.

The independent nonprofit Finance Watch and the Green Coalition, an alliance of 20 development banks, analyzed MSMEs in India, Mongolia, Peru, Senegal, South Africa, Trinidad and Tobago, and Uganda, and find that informality limits performance and growth prospects.

Formalize, or not?

One approach to informality is to formalize. To address the financing gap, governments and global organizations have introduced many targeted programs—from the IFC’s MSME Finance platform to the G20 Global Partnership for Financial Inclusion’s Action Plan for MSME Financing—yet many informal MSMEs in developing countries are still invisible to the government. “So even if governments want to provide credit or means of accessing financing to these MSMEs, they’re not able to because they just don’t have a way of doing it,” says Booth’s Tomy.

Thus, many programs also emphasize registering MSMEs with the government, which both subjects them to the regulations and confers on them the benefits of recognized businesses. When a business formalizes, a government can collect taxes from it but can also monitor employment contracts and conditions, ensuring that workers have access to social protection and pensions, unemployment benefits, and health insurance. Owners can also be better protected legally, potentially gain access to a broader customer base, have the opportunity to participate in government programs and secure related contracts, and have an easier time obtaining financial relief during crises. “It is an important part of the economy in general,” Churchill says of formalization.

Aguilar says about 30 percent of the businesses involved with the Mia program have started to formalize. She notes that the Tegucigalpa Chamber of Commerce and Industry has worked with microenterprises looking to formalize and even start exporting their products, which most informal enterprises cannot do.

However, registration can be expensive and time-consuming. Formalizing can mean paying compliance costs associated with regulations, which may themselves be burdensome. There are also cultural aspects to consider, as Tomy finds in her research. Many informal microbusinesses operate according to long-standing traditions, such as working predominantly within a single ethnic community. And while it does generally make access to credit easier, formalizing does not guarantee that owners can obtain a loan.

Focus on accounting

There could be another way out of the finance gap that still emphasizes what lenders ultimately want to see, which is more financial information about a business.

In November 2019, the International Labour Organization surveyed 1,400 microenterprises in El Salvador, Guatemala, and Honduras. All the respondents had between two and 10 permanent employees (including the business’s owner) and were in retail, the service sector, or micromanufacturing. The ILO survey included both formal and informal businesses, and the median monthly sales amount for the group was $780. For the informal businesses, the median was $640.

Aguilar, University of Pittsburgh’s Gary Lind, and Rice’s K. Ramesh dug further into the responses. In Central America, formalization comes with expectations around financial recordkeeping, with the specific requirements depending on the tax and legal regime. Ninety percent of the formal business owners in the survey reported having recordkeeping systems. Of those, 71 percent used digital tools for recordkeeping, the researchers find.

In contrast, less than half of the informal businesses that responded to the ILO survey (and which aren’t legally required to keep accounting records) maintained systematic financials, with nearly three-quarters of them opting for a notebook. Notably, more than one-quarter of these notebook users did not separate business and personal finances. The rest used digitized systems.

Overall, informal firms were less likely than formal ones to have ever applied for a loan—34 percent and 52 percent, respectively. Their approval rate was also lower (77 percent) than for formal businesses (93 percent). But informal businesses looking for bank credit were 10 percent more likely to keep systematic financial records, and the researchers identified several links between the accounting quality of informal businesses and overall outcomes.

Businesses that kept records of financial transactions were more likely to have engaged in advanced operational strategies, such as offering installment credit to customers and launching marketing campaigns. They were more likely to have applied for and obtained credit from banks. Informal businesses that kept business records in notebooks that were clearly separated from personal finances—an indication of financial discipline for lenders—were 9 percent more likely to have applied for a loan and 13 percent more likely to have been approved.

The ILO’s Churchill says digital recordkeeping is the most effective form of accounting for smaller businesses seeking financing. “With this market segment, you want to be able to have the most efficient methods possible,” he says. “The more you could digitize, the better, so that it’s quite easy for a bank to see the data and be able to automatically say, ‘Yeah, cash flow can accommodate this amount, so here’s the loan.’”

But Aguilar, Lind, and Ramesh observe that even though banks generally wanted to see digital records from formal businesses, if an informal business showed up to a bank with records in a simple notebook, that wasn’t a deal-breaker. “In regions like Central America, where informality is pervasive, it’s possible that formal banks have adapted their risk assessments to include lower-tech forms of recordkeeping,” Aguilar says. She also notes that “informal firms may have an optimal level of recordkeeping for the type of financing they seek, as their choices arise from a cost–benefit trade-off rather than from compliance with formal recordkeeping requirements.”

The researchers find similar patterns in an ILO survey administered in the Dominican Republic in 2023. Recordkeeping generally helped at larger banks, which were 27 percent more likely than small ones to have lent to any business that had strong accounting practices, according to the study.

Overall, they consider the takeaways from both analyses to be promising for informal businesses, in that they indicate quality accounting can help bridge the financing gap, even for less sophisticated enterprises. “Structured recordkeeping plays a key role in how lenders evaluate informal businesses,” Aguilar says.

The findings challenge the idea that formal legal status is the sole channel for accessing bank loans. The researchers also find that entrepreneurs with higher-quality accounting systems are more likely to plan for business expansion, which suggests that accounting plays a forward-looking role even before businesses formally register. Aguilar says that adopting accounting practices could indeed be a “quiet catalyst for formalization, potentially one of the earliest steps in the formalization process.” Yet even if that transition doesn’t happen right away, or at all, accounting could still be a force in helping MSMEs integrate into the economy.

The role of community

Accounting is, at its core, a system of accountability and a way to build trust. Informal businesses track information and can maintain trust without official records, as research by Tomy and Northwestern’s Regina Wittenberg-Moerman demonstrates. The pair studied trade credit arrangements made by retailers and wholesalers in India’s bazaars, and their results illustrate the role community plays in informal economies.

The researchers focused specifically on the Iewduh market in the city of Shillong in northeast India. The market includes shops that sell a variety of foods as well as items including household supplies, tools, jewelry, tobacco, and clothes. Most Iewduh retailers don’t have the means to pay cash up front to wholesalers, and lack access to formal financing, so they rely on trade credit.

The researchers surveyed about 500 retailers and wholesalers between December 2019 and January 2020. They ended up with a dataset of 1,230 retailer-wholesaler relationships and collected information about the length of each relationship, the terms of trade credit, and wholesalers’ responses to delinquencies. They also collected demographic information—including gender, age, and education level—about all the traders.

They find that community played an important role in whether wholesalers offered credit, and if they did, how much they offered. Wholesaler respondents to the survey indicated that they were 12 percent more likely to provide credit to retailers from their own ethnic community and offered them 8 percent more credit. Retailers from the same community were 14 percent less likely to default. When they did, wholesalers were less likely to repossess goods or deny future credit.

Such preferential lending terms can be costly to wholesalers but also have advantages. When the researchers returned to Iewduh between January and March 2022, they find that wholesalers who lent preferentially were more likely to have received help from their communities during the COVID-19 pandemic, including through reductions in charges for rent.

Overall, the researchers find that for businesses in areas lacking in traditional banking and lending systems, a community-driven reciprocity system can benefit both parties. But this system doesn’t necessarily replace accounting practices, further research by Tomy and Wittenberg-Moerman indicates. Indeed, there’s an interplay between the two, and establishing formal accounting could be a step toward growth.

Financial reporting matters too

In the follow-up surveys they administered in 2022, the researchers explored the use of financial information in the credit assessment relationship. They ran a choice experiment, presenting 140 wholesalers with 24 theoretical scenarios, each involving two retailers. The wholesalers were told each retailer’s community (“Bengali,” for example), the length of the trade credit relationship (“6–10 years”), and how the retailer’s business was doing (“sales higher than typical retailer” and “profit higher than typical retailer”). In some scenarios, the fictional retailers declined to provide any financial information when requesting credit.

Wholesalers generally favored retailers who provided financial information. On average, they were willing to give about 11 percent more trade credit to retailers with strong sales, and 2 percent more to retailers with so-so sales than to those who provided no sales data. Similarly, they were willing to provide about 6 percent more trade credit to a retailer with better-than-typical profits and about 3 percent more to a retailer closer to the average. But while they valued community membership and credit relationships, they didn’t overlook bad financial data: Wholesalers indicated they would provide nearly 3 percent less credit to retailers with worse-than-typical profits.

The researchers identified one major barrier to lending on the basis of accounting records: trust. Wholesalers valued the idea of evaluating retailers’ finances, but about a third of them said they didn’t believe retailers would provide accurate information. As in the first study, they trusted those from their own community more than they did others.

The researchers then surveyed about 370 retailers and find that they, too, lacked trust in their counterparties. Nearly 70 percent of retailers said they wouldn’t provide sales and profit information to wholesalers even if it increased their chances of obtaining trade credit. Of this group, 35 percent said they didn’t trust that any information they shared would remain confidential. Retailers also expressed a lack of trust in other retailers, doubting they would report their information truthfully.

In their surveys, Tomy and Wittenberg-Moerman included questions that measured respondents’ financial literacy, which programs such as the Mia project indicate is an important aspect of successfully running a small business. However, Tomy notes that in markets such as Iewduh, “the friction is not so much financial literacy but the nonexistence of trust. That seems like the first-order issue.”

Tackling that, the researchers argue, would mean adopting systems that verify the accuracy of financial information while also safeguarding privacy, like those widely used in more developed economies. Merchants in Iewduh, as well as informal businesses broadly, might benefit from a digital platform that transparently tracks sales and profits, as well as from third-party audits and certification processes that validate financial data.

The researchers advise that Indian policymakers should establish legal frameworks to ensure the confidentiality of financial data shared by retailers, and implement community-based trust-building programs that promote the growth benefits of sharing financial information.

The use of digital transfers and business-to-business apps may help informal MSMEs move toward formality, Tomy says. However, she notes, “the risk is that if you replace something that exists and that works, even though not completely efficiently, are you going to lose more than you gain?” An informal business culture with entrenched practices has existed in these markets for so long that “it’s not going to go away overnight,” she says.

Beyond formalization

And perhaps informal business culture shouldn’t necessarily go away. Toussaint Bugandwa Ciza, a visiting lecturer at the Higher Institute of Computer Science and Management of Goma, led research demonstrating that for MSMEs in some regions, informal financing can have benefits over traditional loans. The research—which involved a survey of more than 300 MSME managers in the Democratic Republic of Congo, a country with a poorly developed financial system—finds that reliable accounting practices led to better credit access. This aligns with the findings of Aguilar, Lind, and Ramesh, as well as those of Tomy and Wittenberg-Moerman.

However, the research by Ciza and his coauthors also suggests that when MSMEs move toward getting bank loans, they may neglect less formal means of financing, such as family assistance, grants, and trade credit. In the DRC, where bank credit can be more expensive and less accessible than informal financing, neglecting these routes can hurt a business’s overall financial performance. As Ciza notes, “Higher-quality accounting information improves access to bank financing and reduces the reliance on informal financing, which, in the DRC, offers several advantages for SMEs. This dynamic may therefore mitigate the positive effect that informal financing has on their financial performance.”

This contrast may suggest that solutions that can work in, say, Honduras, may not be as effective in other countries with different economies and conditions. Aguilar, Lind, and Ramesh show that microentrepreneurs may adopt a recordkeeping system to access formal credit. But the researchers also document that these accounting decisions are often motivated by broader considerations, including whether the business owners plan to put their own funds into an expansion. This suggests that the choice of accounting quality reflects a conscious cost–benefit trade-off that extends beyond just improving access to external finance.

Informal networks and credit systems are also critical to women in developing countries because they may have less access to formal financing than their male counterparts do, Tomy notes. In some cultures, looking for formal financing “may not be socially acceptable” for women, she says. “And then you might have these formal networks that are dominated by men. Women may not be accepted to those networks.” Indeed, the G20 Global Partnership for Financial Inclusion’s plan lists lender and investor bias among the challenges faced by women-owned MSMEs.

Still, Tomy notes that while community-based lending has advantages and is unlikely to disappear anytime soon from marketplaces such as Iewduh, depending on it can ultimately limit growth potential. She says that as India modernizes and migration accelerates, some centuries-old norms and traditions have begun to erode. If retailers can learn to trust more modern forms of credit, their businesses may have better chances of succeeding and growing in a more sophisticated economy. And both Tomy and Aguilar find that strong recordkeeping can be part of that more sophisticated path for informal businesses.

Aguilar sees the Mia program, and others that aim to help informal business owners in developing countries, as key to getting small entrepreneurs to succeed and their countries’ economies to thrive. “There’s big potential for accounting to help microenterprises in the informal economy,” Aguilar says. “And there are a lot of aspects through which to explore it. It’s exciting to see that we, as researchers, can help them to grow in a more sustainable way.”

Now that the initial project has ended, she says she is designing a replication of Mia in both Honduras and Costa Rica to test a hybrid model in which mentors work alongside the AI program.

Such technological advances are making education and outreach cheaper and easier—and could enable small entrepreneurs to borrow their way to growth. A loan may not turn a tiny business into a large multinational, or even into a supplier for one. But a loan could help companies invest in basic inputs such as livestock feed, maybe hire employees, and eventually expand. It could additionally be part of what makes an entrepreneur decide to formalize. And all of this could amount to a better quality of life for both business owners and the surrounding community.