SME Lending – Market Environment
“Becoming the opponent means you should put yourself in an opponent's place and think from the opponent's point of view.”
Miyamoto Musashi
Whilst lenders are not the opponent, Business Finance Professionals know that understanding what credit analysts are looking for when assessing a finance or loan application can be extremely beneficial in securing funding for their SME clients.
Simply put, in analysing a SME, lending assessors want to know whether the business will exist in the future. And, to do this they start by considering the SME’s place in the market. They seek to understand the market environment and whether the SME has a product or service that clients want to purchase and will continue to purchase.
The market environment essentially consists of elements that are external to the SME’s operations. However, some of these can be influenced by the SME themselves. As such, Business Finance Professionals that work with their SME clients in considering the market environment are not only assisting them with their lending positioning but also fundamentally helping them with better business practices.
In thinking about the market environment from a lender’s perspective, the following are key components of a market environment analysis.
Products
As well as knowing what products or services the SME provides, the fundamental question lenders want an answer to is, whether there is an increasing or diminishing demand for those products or services. Additional questions they may ask include: -
Is there changing consumer sentiment that may affect future sales?
Are there environmental or safety issues that will have an impact?
Are products perishable or do they have a long shelf life?
Are services repeatable – will the service be required again or is it a one-off transaction?
Client Base
Information that lenders seek in relation to the SME’s client base includes: -
Demographics – types of clients. Different generations have different purchasing behaviours
Numbers – how many clients does the SME provide their products/services to? Small numbers of clients put the SME at greater risk if clients move to a competitor
Locality – where do the clients come from? Foreign clients may be susceptible to political or economic conditions in their home countries.
Size – are they individuals or corporate clients? Large corporates have a tendency to take their time in paying, impacting on SME cash flow
Pipeline
Another question that lenders can have is ‘where are the next clients coming from?’ Depending on the SME, a healthy pipeline of new clients may be critical. Service professionals and contractors fall into this category and lenders look past the current client-based numbers for assurance that sales and revenue levels are sustainable.
Suppliers
Similar to the questions for clients, lenders want to know who the SME’s suppliers are, where they are located, how many suppliers the SME uses and are there alternative suppliers that the SME can call on. A possible warning sign for lenders is a SMEs reliance on one supplier for the materials they need to produce their products or services. If that supplier goes out of business, where does that leave the SME? Lenders are also interested in the credit terms that SMEs have been able to negotiate with suppliers. Favourable and flexible credit terms are viewed positively.
Business Location
For this area of their analysis, lenders are focusing on where the SME is located in relation to clients and suppliers. Shops that rely on foot traffic to bolster sales need to be situated where their clients congregate and also be readily visible and accessible. For manufacturers, it may be more important for SME operations to be positioned closer to suppliers so that raw materials are easy to acquire and stock levels do not need to be held in high volumes.
Distribution
Related to business location is distribution, which looks at how the SME gets its products or services to its clients. It can be important in this area to distinguish between wholesale and retail SMEs and the flow of distribution. Farmers have experienced sudden change when a decision by a large retail chain has cut their distribution off at the knees. The relatively new world of online sales and marketing, and the international options it brings, raises another set of distribution questions for lenders.
Seasonality
For some SMEs, their products or services are in more demand during certain parts of the year. This can put a strain on revenue and the SME’s capacity to meet expenses during the quiet periods. Lenders want to be assured that the SME has catered for this and has sufficient working capital throughout the year. A SME’s cash flow projections are a good source for demonstrating this forward planning.
Porter’s Five Forces Model
Both Business Finance Professionals and lenders use Porter’s five forces model to assess the viability, opportunities and risks to a SME’s operations. The model, developed by Michael Porter of Harvard Business School, contemplates a business’s current and future positioning given the existence of, what he described as, the five forces of competition. Its application, from a finance and lending standpoint, gives insights into the factors that can promote or hamper a SME’s future sales, revenue and profitability – and therefore its ability to secure funding.
The five forces and how they are considered from a credit analyst’s perspective are described below. And because we are again looking at them from a risk perspective (lenders determining whether the SME will have future capacity to repay loans) they are positioned as threats. Conversely, they provide the Business Finance Professional the opportunity and ability to work with their SME clients to overcome and address these threats.
Competitive Threat
The vast majority of SMEs that Business Finance Professionals work with will have competitors that offer the same service or product that they do. The mere existence of competitors is a negative, from a business and lending point of view. However, it is the intensity of the competition that is the relevant analytical factor. Having competitors will naturally detract from sales and revenue, but heavily intensive competition and the degree of rivalry can have a much greater impact. SMEs that have to spend more on marketing and advertising to maintain income levels see the negative result in their bottom-line profitability.
This is where terms like “Unique Selling Proposition” and “Sustainable Competitive Advantage” come into play. SMEs that can demonstrate they have strategies in place and/or under consideration, to differentiate themselves from the competition, are better placed for business success. Business Finance Professionals that can work with SME clients to come up with these strategies are adding direct business value as well as positioning the SME positively in the eyes of lenders.
Threat of New Entrants
As well as the existence of current competitors, SMEs must also be aware of the potential on new entrants, and therefore additional competitors, into their market. Lenders are particularly wary of this threat. SMEs that are operating in a buoyant market, may well be highly profitable, but new entrants are attracted by these conditions. When more competition arrives, it can put a strain on sales.
To combat this threat, Business Finance Professionals and SMEs can consider barriers to entry for their industry or market. SMEs may be able to control their environments, to an extent, in limiting or making it less desirable for new entrants. Supplier contracts, exclusivity or good old-fashioned relationships and goodwill can make new entrants think twice before joining a particular market.
Threat of Substitutes
With innovation, technology and cultural change come the threat of substitute products and services to a SME’s offerings. Whilst these substitutes are not the same as the SME’s offerings, they have the likelihood to take clients and revenue away from a SME. A historical example may be Record/CD shops. They still have a place but they have been almost totally surpassed by music streaming services. And the trend towards a more vegetarian-based diet is an example of substitution for traditional restaurants and food outlets.
Maintaining currency, is important for SMEs, ensuring that they counter the threat of substitutes for their products and services. In fact, there can be a competitive advantage by also offering substitutes through the business thus attracting clients from slower reacting rivals. However, chasing every new trend or fad can be detrimental, taking the focus from the SME’s core business.
Threat from Buyer Bargaining Power
For some SMEs, the ‘power of the people’ can be a threat. With an air of confidence and perhaps a sense of entitlement, and fuelled by the information superhighways and social media, more and more clients seek to negotiate terms, price, quality and convenience. With loyalty less of a factor, SMEs can be forced to meet these client demands which affect profitability. For wholesalers, multi-national companies with deep pockets also can exert their bargaining power on SMEs. Lenders will consider whether there is a future buyer bargaining risk to the SME that will see their profitability diminish.
Overcoming bargaining power can be difficult. With the immediate threat of loss of revenue, it can be hard to say ‘no’ and stand behind your product or service and stick to your pricing policy and value proposition. However, in the long run, it may be better to ‘lose’ a few potential clients and continue to promote quality over quantity. And, it may be temporary, those potential clients may be back when they realise ‘you get what you pay for’.
Threat from Supplier Bargaining Power
For SMEs that rely on purchasing raw materials, component products or contract services from others can be at the mercy of supplier bargaining power. The threat is related to the power differential between the SME and the supplier – who relies on the other more? If the supplier has a finite amount of materials and multiple SME clients to sell them to, they can afford to drive up the price. If they are the only supplier for a market, they have a monopoly and can do what they like! (which is why governments try to prevent this).
Having a range of suppliers and potential suppliers is good business sense for SMEs in limiting the threats from supplier bargaining power.
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