What factors do lenders and suppliers consider when extending loans and credit to SMEs?
With COVID-19 and the continual recession, businesses are struggling. The biggest concern at the moment is cash but in order to generate cash, you have to make sales. According to research, the average SME in the US does not have more than 30 days cash reserve available and in South Africa, this number is lower. From the National Treasury’s new loan guarantee scheme to banks and other loan providers, there is financing available for small businesses.
Bright on Capital’s role is to ensure sustainability and growth for small businesses:
“Our job is to help you prepare your business to access funding from us, banks or other suppliers. And the best way to prepare is to understand the factors considered when extending loans and credit terms to SME,” says Tsepo Headbush, CEO and co-founder of Bright On Capital. “Small businesses have to take action now – preserve cash and secure additional funding facilities.”
Assessing credit risk and affordability
In determining whether to extend a loan or credit terms to a SME, credit providers seek to assess an SME’s credit risk and affordability. In assessing a SME’s credit risk, credit providers assess three things:
- liquidity, and
In other words, a small business’s ability to generate profits, meet short-term obligations and long-term financial commitments.
In order to understand profitability, credit providers ultimately look at free cash flow, the cash left over in the business after it has paid all of its expenses and annual capital expenditure (property, equipment and technology). Free cash flow is a business’s disposable cash used to meet its loan repayments or pay out as dividends to shareholders.
What information do credit providers rely on to assess a SME’s credit risk?
Different types of information is used to assess a SME’s credit risk. To understand how well a business pays its credit obligations, the most common information used is:
- A business’s credit history,
- bank statements, and
- financial statements.
Did you know?
All credit providers pull a business’s credit history from credit bureaus to assess its payment history. Payment data, taken from SACRA, gives credit providers a very good view of how well individual consumers pay their credit obligations. Unfortunately, the same payment data for SMEs does not exist. Even though a SME’s business credit score can be pulled from credit bureaus, this score relies on the payment history and consumer credit score of the SME’s directors. In other words, how each director pays their personal credit obligations.
Is this a fair and reasonably proxy? If a SME is generating sufficient profits, the free cash flow will allow a director to draw from the business, allowing them to meet their personal credit obligations.
To determine a business’s cash inflows and outflows, the most reliable and important source of data is a businesses’ most recent bank statements. Bank statements help a credit provider to determine whether a business has the ability to generate revenue, profit and free cash flow as well as its ability to do the same going forward. This is why consistent and reliable reporting is key when it comes to SMEs accessing credit terms and funding. Determining the profitability, liquidity and solvency of a business depends on financial statements – a critical source of key data – but it is also important to assess the reliability of the financial information provided.
How do lenders determine affordability?
With reliable financial information, it is easy to determine a SME’s affordability. Trading history, which is usually assessed using three years* of financial statements, will help a credit provider to establish the size of a business, in terms of turnover, and whether it is a small, medium or micro business.
Income statements allow a lender to determine whether a business history has the ability to generate profits and free cash flow to meet short-term debt obligations. In distress, can a business meet its short-term obligations and continue trading? Liquidity and solvency are determined from a businesses’ balance sheet. Do your total liabilities exceed your total assets? If so, can a business sustain and afford new debt (i.e. a loan)?
Creditors also look for availability of security on the balance sheet. In the event of default, does a business have sufficient tangible assets to cover its outstanding liabilities? Credit providers calculate their loss given default – how much they expect to collect should the borrower default.
“Most SMEs will require external funding to meet their short-term operational obligations over the next 3-6 months as the result of the drop in sales due to lockdown. Don’t wait until after lockdown to apply for working capital or any other funding. Lenders and credit providers will look primarily at the quality of your balance sheet and your ability to determine free cash flows to determine whether to extend funding or credit terms to you,” ends Headbush.
* Bright on Capital looks at 12 months trading history