Working capital, rural nonfarm firms and rural financial markets

This paper documents the diversity of rural commercial activities in developing countries, examines the effect of these activities on the supply of and demand for working capital, and recommends policies to increase market responsiveness to the short-term credit needs of these firms. The authors stress the important relationship between small rural enterprise and the short-term capital market, noting that: lack of capital is a major constraint; capital markets have poorly served the rural nonfarm sector; short-term capital is relatively more important than long-term credit to the small entrepreneur; and short-term credit operations could be both efficient and profitable for the lender. The authors proceed to investigate the level and composition of working capital in rural manufacturing enterprises; analyze the demand for working capital as a function of volume of sales, capital intensity, length of the production period, scale of production, risk, managerial efficiency, and the cost of borrowing; and examine the supply of short-term finance. Based on their findings, the authors formulate and test a model of demand for working capital using data from small enterprises in Sierra Leone. Inventory - the principal component of working capital - is the major dependent variable. Of the independent variables, level of sales and economic profits are important, and type of industry (e.g., carpentry, baking, tailoring) is statistically significant; location (rural/urban) is not significant. The evidence suggests that a substantial proportion of rural nonfarm activities are economically viable and are thus generating a strong demand for working capital. It is the lack of short-term credit which is constraining their activities. Recommended to alleviate this problem are: (1) reductions in the administrative cost and risk of lending; (2) removal of market imperfections and greater integration of the rural financial market; (3) more flexible loan terms; and (4) greater experimentation with informal sources of short-term credit. A 37-item bibliography (1952-81) is included.