SME Lending – Risk Analysis
There is little argument that Small to Medium Enterprises (SMEs) play a vital role and can be considered the backbone of the Australian economy. SMEs make a healthy contribution to the Australian Gross Domestic Product (GDP) – estimated at 20%, and employ around 50% of the workforce.
A historical factor, in the significant contribution and importance of SMEs to our economy, has been their ability to access adequate funding. Whether it has been to get things started, to fund growth or see them through a difficult patch, SMEs have called upon banks and finance companies for assistance.
However, many lenders find that assessing the credit risk of SMEs particularly challenging and struggle to come up with effective models to compare and analyse funding requests. Equally, SMEs need to understand the risks to them in undertaking a lending application in order to maximise their result from the process.
As a Business Finance Professional, you can play a crucial role in assisting your SME clients to overcome the issues faced in the finance and lending process by recognising and working with the following key challenges relating to credit risk and lending risk analysis.
The challenges can be categorised into two areas: -
Understanding the SME Business – the ability to borrow
Understanding the Lenders – choosing the right finance
SME Business Risk
1. Financial Data
In speaking with finance companies and their credit lending analysts, a common cause for frustration and blockage for their models, systems and processes is that they consider the financial data provided by the SME to be insufficient. Whether it is the lack of detail, its accuracy or currency, lenders argue that they are unable to grasp, with confidence, the positioning and future drivers of the business.
On the other hand, SME owners are perplexed, because the information they provide is the same data they utilise to successfully run their business.
It seems that there exist two ‘sets’ of financial data. One set that, along with ‘gut feel management’, is used by SME owners to make day to day operational and business decisions. The other a set of comprehensive statistical measures and ‘bespoke’ figures that provide explicit and comparable information.
Some examples of financial information that lenders look for, but may not be readily available from the SME’s reporting are: -
Sales Analysis – a breakdown of how revenue was generated – a differentiation across products or services, client demographics, geography and time frames etc.
Budget Comparisons – how well a business performed against expectations
Cash Flow – is cash flow healthy in relation to sales revenue and expenditures.
Where a gap exists between the two sets of financial data, amendments, in what is provided to the lender, will be requested. This can put a strain on the SME as additional resources need to be expended to produce the additional funding application requirements. The expertise a Business Finance Professional can bring to these scenarios is extremely valuable. They can help position the SME thinking, assist them to collate meaningful business information prior to application and be an informed communication liaison between the SME and the lender.
A longer-term outcome from a focus on financial data is the existence of data structures and systems within the SME that captures financial data and utilises it in a meaningful way. Such established systems are beneficial from both operational and financing perspectives; however, they need to be maintained with discipline and accuracy.
Technology can also assist with the efficient transfer of required business financial data from SME to lender. Links between the SME accounting software and the lender’s systems can provide missing information, streamline timelines and mitigate resource costs.
2. Future Cash Flow
An obvious and critical factor, in a lender’s decision making, is the SME’s ability to generate future revenue and have the cash flow available to meet expenses, including borrowing costs. A basis for predicting future cash flow is referencing historical income and previous years’ financial statements. However, it is the economic and business trends and the expected positioning in the SME’s market that lenders are keen to have a better understanding of. They are more interested in looking ahead than into the past.
In addition, capital injections from the borrowed funds should have an impact on future cash flow and these need to be accounted for as well.
Like current financial data, the role of the Business Finance Professional can be to work with the SME to predict and budget the upcoming financial position and cash flows of the business. Powerfully, these are the foundations of strong and useful business plans.
3. Business Sustainability
Many lenders also look past the current financial data and predicted cash flows and consider the sustainability of the business in consideration of prevailing market conditions. An SME business plan and marketing strategy should take into account the strength and weaknesses of the sector and market they operate in. These may take into account a PESTLE analysis – the impact of potential political, environmental, social, technological, legislative and economic factors on the SME. A competitor analysis can also be influential on business sustainability.
SMEs that approach operations with a strong risk culture will be prepared for the variables that come with running a business. This makes them more sustainable and attractive to lenders. SMEs that don’t have contingency plans in place and work on skinny profit margins run the risk of being forced to take undue risks to stay afloat when there are downturns. A risk analysis that highlights these shortcomings would be looked on unfavourably by lenders.
Nearly all modern-day lenders are using system-generated models and algorithms to validate and compare the SME financials they receive against benchmarks. However, not all systems and models are the same and sometimes the lenders end up comparing ‘apples with oranges.’
As a Business Finance Professional, you will build experience and understanding of how different lenders’ systems work and know which lenders benchmarking stacks up best for your SME clients borrowing applications, lessening the risk of being turned down on the loan.
5. Time to Cash
Time to cash refers to the lender's efficiency to process an application and make payment to the SME. It takes time to complete the exercise and is a result of the lender's infrastructure. Where the lender has outdated systems, manual overlays, duplication or multiple processes, inefficiency and slower response times are the results. This can pose a risk to the SME.
As well as these factors, lenders processing efficiency can be impacted by market conditions (for example, post-GFC all lenders reviewed and slowed down their application processes) and the quality of credit analysts (more experienced lending personnel can shorten time to cash through quicker decision making and analysis).
The environment for loan application analysis and processing is forever evolving with cloud-based technology solutions and improved infrastructure replacing antiquated systems and methods. The Business Finance Professional is uniquely placed to stay updated on various lenders’ time to cash efficiencies and utilise this knowledge in streamlining the lending process for their SME clients.
Whilst there is a tendency for an ‘us and them’ mentality between borrowers and lenders, a good working relationship can be advantageous to both. Lenders should have early warning flags in place and communication specialists to monitor and alert SMEs when they become concerned about loan repayment capacity.
SMEs can be busy and embroiled in their businesses and a query raised by an outside party can help raise awareness and correct issues before it is too late. Alternatively, it may be that the business is well-positioned and additional information is all that is required to alleviate concerns.
Some lenders are moving from the traditional transactional space and recognising the fiscal and marketing rewards from being a working partner of their SME lending customers. Business Finance Professionals are an inherent part of these relationships.
Risk analysis for SME lending has been long considered an exercise for lenders. However, more recently it has been recognised that it is multi-faceted, needs to be considered from both lender and borrower perspectives and that a partnering approach is in the best interests of all. Your role as a Business Finance Professional is central in analysing the risks from all angles.
In conjunction with industry experts, elevateB has developed a self-paced, online, interactive Business Finance Certification. This program will provide you with the knowledge and skills required to become a successful Business Finance Professional and work in the SME space. In addition, it provides strategies and soft skills to assist you to better market and deliver your existing and new-found client offerings.
For more information on the Business Finance Certification, click here.