Why is SME finance so challenging?

This article is based on a discussion paper compiled by Managing director of IPC, Dörte Weidig and published by CGAP (see http://www.cgap.org/comment/531#comment-531).

Although the discussion paper was published several years ago, the topic remains current. Matching external finance with the actual needs and capacities of small businesses was, is and most likely will continue to present a challenge. It remains a fact that inadequate financing – amounts, maturities, repayment schedules and security – can negatively affect not only actual repayment performance, but also the development of (small) businesses. Inadequate financing can lead to over-indebtedness and business failure. In other words, inadequate financing may actually contravene and undermine the actual goal underlying much of SME finance, i.e. to enhance small business development and strengthen the small business sector in an economy.

Three myths about SME finance

Small and medium enterprises (SMEs) are again at the center of attention of the international community. New international, regional and local initiatives aim at supporting and reinforcing SMEs as their crucial role in strengthening an economy has become obvious.  At the same time, achievement of expected results and indicators as set forth both in earlier and current initiatives is still in question.

Unfortunately, the environments in which SMEs operate are not always conducive to their growth and development. This is true for many commonly cited factors, such as regulatory framework, fiscal treatment, qualification of personnel and, last but not least - access to finance.

Being at the center of attention for many years meant that SMEs received significant support in terms of business development services, policy dialogue, “political” empowerment and – not least - provision of funding for external financing of these businesses.

The results of several recent studies on SME demand for loans confirm what we, as consultants who have been working with SMEs for decades in many countries on four continents, have seen on the ground: access to finance is not always the main problem.

Our hands-on experience has revealed a number of mistaken assumptions about SME finance. I shall highlight three core myths about SME finance:

Myth #1:

“There is a huge financing gap for SMEs – more funds are needed to close this gap”

Myth #2:

“Commercial banks know how to finance SMEs”

Myth #3:

“In order to foster economic growth it is important to provide finance to SMEs, no matter how”

Despite the abundance of liquidity available to financial institutions in many parts of the world, only few SMEs have access to finance that allows for sustainable growth. Some are fortunate enough to operate in markets where liquidity flows in a way that enables them to obtain a share of it–-but at the risk of either receiving too little financing or becoming over-indebted, if creditors lack responsibility.

One issue that many financial institutions face when starting to develop SME lending is that this segment is extremely heterogeneous. While it is fairly easy to identify common features among micro enterprises and corporate businesses, it is far more difficult to classify SMEs.

Hence, a more suitable approach to customer service and risk assessment is needed to serve these businesses adequately and control credit risk. More than for any other client group, the principle of “Know Your Customer” applies. However, the lack of capacity or willingness of many financial institutions to invest in understanding the financial needs of SMEs has caused and will continue to cause more harm than good for both - SMEs and the financial institutions issuing loans.

To underline my arguments, I shall focus on the financial situation of two SMEs that illustrate the “myths about SME finance”. Although every situation has its own unique features, the descriptions presented below are by no means isolated cases, and my colleagues and I often encounter similar examples. They reflect some of the negative consequences that can result if financial institutions do not understand the client’s business (potential) and financial needs:

Scenario 1 - irresponsible financing

Business description

An entrepreneur produces plywood and wooden components for doors. The business was founded in 2001 by Mirlan and Assel K. and developed steadily until 2006. In 2007, driven by the economic upturn, production capacities were expanded, followed by a series of further investments in view of optimistic business projections. The enterprise has 28 employees. A column on the right side shows the SME’s actual financial statements as of January 2008 and June 2009.

Behind the scenes

As of June 2009, the business had 14 outstanding loans received from five different banks and one leasing company. Although the main business income is generated in local currency, all loans were disbursed in EUR and USD, which means that currency risks were completely ignored by the lending institutions. As a result, the client incurred over-indebtedness as investments in equipment exclusively financed by external borrowing denominated in foreign currency require a respective increase in sales volume and/or profitability. In fact, however, the client’s actual sales and profits dropped. The impact of the financial and economic crisis on the business just was the top of an iceberg.

Balance sheet, in USD

 Profit & Loss statement, in USD

This SME is currently facing many problems, but has no difficulties obtaining access to finance. Although SME lending is apparently booming in many markets worldwide, irresponsible lending practices, such as ignoring currency risks or a client’s over-indebtedness may cause more harm than good for SMEs in transitional and developing economies. Therefore, financial institutions need to understand the businesses of clients and provide adequate financing in order to foster growth of the SME segment.

Scenario 2 – inadequate financing

Business description

Emil A., an entrepreneur, imports and produces perfumes. He founded his business 18 years ago. He owns three stores, of which two are in the center of the city and one in a large shopping mall. To optimize his taxation, he transferred ownership of the stores to his niece and two nephews. He purchased one of the stores quite recently. Emil has a diploma in business administration. He is the sole director of his business and has six employees.

The tables on the right presents information available on his 2010 official and actual financial reports.

Behind the scenes

Emil financed the purchase of the last store and replenished his working capital by means of credit cards and short-term loans. At the time of the analysis, the enterprise had 8 credit card with limits and five short-term loans received from eight banks. The only long-term loan was for working capital, for a maturity of 2.5 years and with 6-month grace period. Emil received this loan from a bank where he has been a permanent client since 1992.

Баланс на 31.12.2010, в долл. США

 Profit & Loss statement, 01.01.-31.12.2010, in USD (monthly average figures) 

This SME enterprise also has no problems accessing finance, but the funding it receives is not adequate. Credit cards are an acceptable tool for purchases abroad, but they should not be used to finance permanent working capital needs, as maturities of these debts do not correspond to the operational cycle of the business and the cost of fundinig is unnecessarily high. A maturity mismatch in financing structure creates a high liquidity risk for all types of business.

What these examples show is that many financial institutions do not understand the needs of enterprises and have not yet recognised the real potential of SMEs. This is the only conceivable explanation as to why so few have “invested” in developing a sustainable capacity to serve SMEs in a responsible way and to the client’s satisfaction. Catering to real SME needs requires a substantial up-front effort and SME lending models developed for stable markets with reliable documentation cannot be applied to markets that are still largely informal.

Financial institutions that are genuinely interested in serving SMEs need more long-term support from donors and development finance institutions so that they can develop the capacities needed to serve SMEs on a sustainable basis. In other words, support that goes beyond funding and short-term advisory is necessary for real institution building.

Readers of this article may note that the arguments are shaped in a way to make a case for more consulting and technical assistance. Well, yes, this is partly true. Opponents may come up with different arguments – but engage in real discussions with some SMEs about their lending experience – and some of the above-mentioned popular beliefs will be quickly demystified.