Despite their massive economic impact, small and medium-sized enterprises (SMEs) find themselves at a huge disadvantage concerning access to financing compared to larger firms.
Other factors worsening the situation for SMEs include:
• The global estimate is that almost US$74 trillion of working capital is tied up in trade credit.
• The negative consequences of SMEs liquidity are worsened by customers who pay late or default.
• The time taken and cost for SMEs to manage accounts receivables and chase late payments.
One very important financial concept explained in Harvard Business Review is that growth requires cash. The following illustration explains the relationship among sales, profit, and cash flow for a growing business under normal conditions. When sales and profits grow, cash flow turns negative. This fact is a challenge (17):
This model explains why (especially) growing and profitable companies need access to external financing. So, if we want the 400 million SMEs worldwide to grow, one key requirement is access to external sources of working capital.
SMEs find themselves at a huge disadvantage in terms of access to financing compared to larger firms. This fact is especially true for microenterprises and SMEs in middle- and low-income countries (18).
When surveying the investment climate around the world, access to financing is usually one of the top constraints on doing business for SMEs. In several regions, access to financing is the single-most- important constraint. The resulting credit gap that SMEs face is about $1.5 trillion. Including informal SMEs, the gap widens even further, to around $2,6 trillion (19).
While the credit gap is widest in developing countries, it is also very real in the U.S. and Europe.
A 2019 study by https://www.fedsmallbusiness.org/ analysing American companies with less than 500 employees found that 64% of employer firms faced financial challenges in the prior 12 months. More than two-thirds addressed these challenges by using the owners’ personal funds and 54% of small employer firms that applied for $250K or less did not receive the full amount of sought-for financing (20). Especially young companies at five years old and less, had a 63% rejection rate, 42% of SMEs with low credit risk got rejected, and that 42% of profitable companies got rejected. In the Eurozone, the bank loan financing gap equals 3% of GDP in 2019 or €400bn (21).
With more than 400 million SMEs worldwide accounting for 27% of retail banking net revenues, it can be hard to understand why profit optimising banks are not eager to help growing and profitable SMEs with loans. Banks are reluctant to extend uncollateralised credit, and the cost of obtaining and accessing information on the true credit quality of small (and often) young companies is complex and costly.
Many SMEs do not have the necessary amount and type of assets that could serve as collateral for the loan. This situation results in many SMEs with economically viable projects being unable to obtain the necessary financing from the regular system of financial intermediation.
This phenomenon is often referred to as the SME financing gap: an insufficient supply of external financing to SMEs (OECD, 2006). A market failure typically drives this problem for the credit market: information asymmetries that lead to either adverse selection of low-quality borrowers (Akerlof, 1970) or moral hazard problems.
• Adverse selection occurs when banks cannot differentiate between good and bad projects, and therefore cannot change each different interest rate to reflect inherent differences in risk. Higher interest rates will discourage business with the least risky projects to take out loans. If good borrowers self-select out of the market, this, in turn, implies that, for any given interest rate, inherently riskier projects will be over-represented in the loan application pool (22).
• Moral hazard problems occur when limited liability in the event of default provides borrowers with an incentive to take up the excessive risk.
These problems mean that in the presence of asymmetric information, banks are reluctant to use higher interest rates because it reduces equilibrium profits. As a consequence, their rational response is to keep the supply of credit below demand, rather than to increase the interest rate charged on loans.
The problem is not only that banks are reluctant to finance SMEs, but also that SMEs are reluctant to apply for financing at banks.
Let us take a deep dive into why banks are reluctant to finance SMEs.
Why rejection happens:
A study from the Asian Development Bank (23) found the following four main reasons for rejecting the loan applications of SMEs:
Challenges with traditional credit underwriting
One of the major obstacles to SMEs in gaining access to credit is that lenders do not know how to access the credit risk of SMEs accurately.
The credit rating giant Moody`s (24) identified four main issues for accessing the credit risk of SMEs:
1) Limited and fragmented financial data
2) Insufficient risk models
3) Lengthy and time-consuming processes
4) Broader issues that exist internally, such as the tension between sales and credit
Underwriting is the process a lender uses to evaluate a borrower and decide if they are going to offer them a loan. Generally, underwriting consists of evaluating bank statements, tax returns, balance sheets, P&L statements, and credit reports with a pen, pencil, calculator and spreadsheet. A final decision is often made after visiting the borrower`s place of business. This antiquated process will not last forever.
Traditional credit scoring does not serve SMEs well. The method is linear, static, and one-dimensional. The Altman Z-score (see appendix 3.1), a technique commonly used by lenders in traditional credit scoring, is unsuitable for SMEs because it is based on a highly selective number of files that do not consider other valuable accounting and non-accounting data. If an SME lacks information in one field, it is not rated by the lender. This process results in a “credit invisible” SME. Because lenders are unable to assess the creditworthiness of SMEs, a Fed study of American companies with 1-500 employees found that 86% of SMEs rely on their owners' personal credit scores. The same study found that the most used collateral to secure debt is a personal guarantee by the owner.
Another proof point on the importance of credit rating is that countries with credit bureaus are associated with lower financing constraints for SMEs. In countries with credit bureaus, only 29% of SMEs are reporting high financial constraints, but in countries without credit bureaus, 50% of SMEs are reporting high financial constraints. Studies also show a significantly higher probability of obtaining a bank loan for a small firm in countries with credit bureaus (25).
High fixed costs are killing the profit in smaller loans
The lenders' cost of a small business loan can be broken down to at least six key components: origination, underwriting, loan review, operations, monitoring, collections, and compliance.
The total fixed cost is estimated to be between $3,100 and $3,700 based on the following components (26):
These are mainly fixed costs that, depending upon the bank, can apply to loans as small as $25,000. These fixed costs have a huge impact on the profitability of small loans.
Let us take an example of a 100.000$ loan with the following conditions:
So, the net income and pre-capital costs for the $100,000 loan would range from negative $450 to positive $250. Over 55% of the loan applications from SMEs are below $100.000, meaning that with their fixed costs, these loans generate even worse economics (27). The natural tendency of a bank with this cost structure is to move upmarket to make larger loans that can cover the fixed cost and allow a bank to make a favourable return (28).
Cost of capital:
Bank loans are made with the deposits of retail investors and customers whose money the banks must keep safe. There is a huge appetite from institutional and accredited investors to invest in nonbank lenders. These nonbank lenders such as Funding Circle and Dealstruck then perform the underwriting and servicing of the lean and make money from origination and servicing fees. This capital structure has helped to drive down prices for customers and make less expansive, long-term loans more accessible (29).
Local bank branches are closing
The U.K. has lost almost two-thirds of its bank branches in the last 30 years. This situation has had a disproportionately negative impact on SME lenders. As these bank branches closed, the SMEs’ relationship with the bank managers who provided significant value beyond the loans they were underwriting also ended. The “soft interventions”, which included helping SMEs manage their finances, avoid the pitfall of unmanaged growth and understand the broader macroeconomic issues that could impact on them also disappeared. Lenders also lost out on the soft data collection engines that their branch managers had previously provided when it came to SMEs (30).
In the U.S., The shift from local to larger banks has also been dramatic. From 1997 to 2015, community banks share of originations less than $100.000 declined from 82% to 29% in less than 20 years. This phenomenon has pushed small businesses with limited credit needs information to business card products with higher revenue generation potential (31).
Most European banks are saying they see an increasing loan demand, and at the same time, they are expecting to tighten supply (32).
In general, microenterprises use less external financing instruments than larger companies, presumably because of difficult access to financing. Bank loans are only used by 12,2% of microenterprises (compared to 26% of medium companies). Interestingly, 45% of the microenterprises indicate that bank loans are a relevant source of financing (33). .
This result means that 65% of microenterprises do not think that bank loans are a relevant source of financing. The main reasons for this thinking are high interest rates, too much paperwork and insufficient collateral (34).
The process of applying for a bank loan is painful. Studies have demonstrated that the average loan application can take anywhere from 48-72 hours to complete. That is two to three days of non-stop work assembling paperwork. All of that effort is met by a rejection rate ranging from 50-80%, depending on the institution (35).
What are the “buying criteria” when SMEs choose a lender?
A study among U.S. companies with 1-500 employees found that chance of funding and speed of decision making were the top reasons firms applied to online lenders. The same study found that bank applicants were most dissatisfied with wait times for credit decisions, and online lender applicants were most dissatisfied with high interest rates (36).
Unlike with typical consumer transactions (where customers might pay for groceries with a credit card, for example), the B2B world is a place where sellers frequently wait weeks or months to get paid. In 2016, 56% of Swedish sales were made on credit while in Denmark the rate was as high as 69% (37). In the U.K., it is estimated that 80% of B2B transactions are undertaken using credit. Globally, the estimate is that almost US$74 trillion of business from SMEs is conducted on these types of credit terms (38).
Trade credit is the value of outstanding accounts receivable (A.R.) suppliers have invoiced and for which they are awaiting payments — hopefully, following the terms negotiated with their buyers. AR constitutes 8.5 per cent of annual revenues for the average U.S. firm (39).
A company that generates $1,000 per year will have $85 tied up in A.R. at any given time.
In the U.S. alone, the net amount owed to suppliers for services and products provided on any given day is $3.1 trillion - or when fully written out, $3,100,000,000,000 (40)
The same is true in Europe, where trade credits provide a significant source of liquidity - for example, on average, 23% of the balance sheet total of French companies or 12% for German companies (41). .
A sample of 202,696 SMEs across 13 European countries showed that account receivables represent €172 billion, or 30% of total assets, indicating that, on average,
SMEs are net providers of €62 billion in trade credit, equivalent to 14% of total assets (42).
The negative consequences of SMEs liquidity are worsened by customers who pay later than the agreed credit or default on the payment. Payment delays jeopardise around every seventh company, with serious economic implications. Nineteen percent of all invoices are paid late, 42% of all companies in the E.U. lose income to debtors, 39% battle cash flow problems and 14% are afraid of bankruptcy due to late payments or unpaid invoices (43).
SMEs are also forced to accept longer payment terms than with which they are comfortable. Six out of ten of the companies say that they have been asked to accept longer payment terms than they can manage in their daily operations and more than half (56 per cent) also admit to having accepted these demands (44).
For private consumers, the average number of days to settle their invoices is 22 days, and for business customers, it was 37 days in 2019. The public sector pays after 42 days on average. Eighty-four per cent of private consumers pay on time, but only 79% of companies succeed in doing so. The bad payment habits of both businesses and the public sector have worsened from 2018 to 2019.
The main reasons companies pay late are payment default by their customers (55%) and the use of supplier credit (51%) (45).
On average, European companies had to write of 2,31% of their revenue as a consequence of payment defaults. This number is up from 1.69% in 2018.
There are huge national differences in payment default rates, with 6.4% in Romania, down to 0.8% in Denmark (46).
Administrative tasks are major burdens for SMEs.
On average, SMEs spend 146 working days a year on administrative tasks, at an average $60.000 yearly cost. Thirty-six per cent of the total administrative tasks are spent on payment processing, invoices, and chasing payments (47)
According to Plum Consulting (2017), between 5% and 10% of all administrative work is related to chasing late payments. It differs how many employee days that SMEs use yearly on chasing payments. In the U.K. and the U.S., the average SME spends 15 full employee days on chasing late payments a year, compared to five days in Germany (48). A study done by Xero found that SMEs are spending 10% (or more) of their time managing the invoicing process, generating invoices, sending them, and tracking down late payments (49).
The monetary costs associated with chasing late payments as an administrative task (including the costs of facilities needed to perform the chasing in addition to the costs of human resources, but not software costs) vary in different markets. We see the highest costs in the U.S. about USD 6.000 yearly, USD 4.800 in the U.K. and USD 3.000 in Germany (50).
Eighty-two per cent of all companies do not have a digital accounts receivables process (51). The process of creating Invoices, tracking payments, reconciliation, bookkeeping, and dunning is carried out manually. This work gets extremely complex if the customer has questions or disputes the payment because then the work becomes cross-functional (and accounting software is never cross-functional). An example of this cross-functional work is that the finance department prints out a list with open balances and puts this information on the sales peoples' desks (hoping they will follow up). This process can be illustrated with the following flow-chart:
Cloud-based accounting / ERP software cannot remove all manual administrative work, but it can help SMEs streamline their A.R. process. In Denmark, 35% of all small SMEs use cloud-based ERP systems. The numbers vary from a low point in Hungary at ten per cent to 49% in Belgium (52).
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