It’s no secret that SMEs are struggling to access credit thanks to a perfect storm in lending markets.
We estimate an SME funding gap of over $70B. The Hayne Royal Commission, global regulations requiring banks to hold more capital and a slowing economy have all contributed to traditional lenders tightening the purse strings.
What’s less well known is the plethora of emerging alternative financing options for SMEs – and how to find the right one for your business.
Firstly, it helps to understand how credit markets work. Over 70 per cent of the debt capital supplied to SMEs comes from regulated banks. Banks measure the risk of a commercial loan by assessing the risk of default and the subsequent potential loss.
Default risk is the risk that a borrower does not service their debt in full and on time. This risk is closely linked to the debt capacity of SMEs and their ability to withstand industry shocks and defend their market share.
Banks and rating agencies typically use industry benchmarks of operating and financial metrics to anchor their credit risk assessments. This means, for example, having a benchmark figure for the expected profitability of construction companies. A business’ finances will be reviewed against this benchmark and rated accordingly.
But benchmarks present challenges for SMEs, which tend to face greater intensity of competition and greater vulnerability to industry downturns than larger businesses. Their relatively weak bargaining power also exposes them to risks with supply chain funding, bottlenecks, and customer and market segment concentration.
As such, SMEs often compare unfavourably to the benchmarks, which is exacerbated by a lack of quality collateral. If collateral is connected to the performance of the business, it is viewed as lower quality as its value is likely to drop if the business is struggling. This
SMEs without quality collateral operating in sectors that exhibit a high level of cyclicality and intensity of price-based competition and have little differentiation in product or service, such as construction or hospitality, will struggle to access funding from traditional lenders.
Unfortunately, most SMEs face this predicament. So, what could a small business that can’t access bank funding and that is facing onerous payment terms from large customers and suppliers do to maximise their opportunity of securing credit?
Thankfully, alternatives are entering the market to meet this need and tap into the $70B opportunity. But the variety of new players can itself be challenging, making it tricky for SMEs to choose the right lender.
As a first step, SMEs should consider what the financing is for. Is it a short-term fix to cover salaries? If so, the speed of an online lender may be an attractive option, with the downside of high-interest rates mitigated as the loan will be quickly repaid.
Or, is financing required to scale the company over time, requiring a larger sum and a deep understanding of the business? In that case, it makes sense to find a strategic partner who can provide funds while adding value with advice or other forms of support.
Payment terms are a major issue for SMEs but there is innovation in this space too, with financiers willing to lend against the value of outstanding invoices.
Importantly, SMEs must understand what potential funders are looking for and the type of financier that will add most value to their business.
Johann Kenny, Head of Risk Management, Arowana