Abstract: Small and Medium Scale Enterprises (SMEs) comprise essential elements in the lubrication and development of any economy. In Sri Lanka, the story makes no remarkable difference as SMEs outnumber the large business in the economy. Over the years the government of Sri Lanka has devised a number of policies aimed at developing SMEs. While most policies actually failed due to poor implementation, others however, succeeded. Few studies have been made in the past to identify the role of SMEs to the development of Sri Lanka’s economy, its problems and prospects which created a vacuum on the role of government and other financial institutions in the development of SMEs. This article evaluates the role of Micro Finance Institutions (MFIs) as a powerful tool for the poverty alleviation and entrepreneurial development in Sri Lanka. The paper reviews the existing literature. The findings of the literature reveal that Sri Lankan SMEs face many domestic challenges in achieving economies of scale. The challenges are question marks on the viability of the MFIs, absence of a cohesive regulatory and supervisory system for the micro finance, shortage human capital, inadequacy of IT knowledge, difficulty in up-to-date services access by the sub urban practitioners, and entrepreneurs’ personal shortcomings. Hence there is a need exist for a development of fully fledged micro finance industry. This paper attempts to identify the challenges as a positive step toward formulating a workable framework for the SMEs to overcome them.