Enough has been written about the lack of access to finance Small and Medium Enterprises (SMEs) are faced with. Less is known about the high cost of interest they bear and how their own ignorance keeps their interest costs high.
We will discuss some of the underlying issues and reasons why this is happening and how and understanding of this can help SMEs reduce funding costs.
So why are interest costs so high? “Business loans” heavily advertised and sold come with rates as high as 21 per cent. These loans are what banks call “parameterised lending” or “scorecard lending” products.
Loan sizes are based on turnover evidenced by bank entries in statements, which form the core of the lending decision (other factors like industry, returned cheques, history, etc., play a role as well, of course).
If SMEs manage to cross the river of ignorance and graduate to borrowing based on their balance-sheets (working capital “facilities” like letters of credit, trust receipt facilities, bill discounting, etc.) then rates drop to around 10 per cent with security conditions (cash margins, personal guarantees, etc.) This sort of borrowing is superior to the business loan solution for two reasons:
* A three- or four-year loan may not be the funding the business needs (SMEs invariably need short-term trade financing and not long-term loans);
* Borrowing based on balance-sheets comes at half the cost and companies can borrow and repay at will instead of being stuck with a loan upfront when not all the funds are required.
However, the majority of SMEs (mostly companies with annual turnovers of less than Dh35 million) are not able to borrow based on their balance-sheets — because they do not have them or because they just don’t know how to obtain such facilities. Thus there is a huge gap between companies taking business loans at high interest rates, and those that use their balance-sheets to borrow at half or less.
This gap is one of lack of knowledge, the price of which can be very high indeed.
The demand for credit facilities far outstrips supply, and banks currently address this gap through the highly profitable product of “business loans”. So why is this gap there and what can SMEs do to make the leap from the world of high interest costs to the more appropriate one of borrowing based on their balance-sheets?
Some market characteristics need to be understood first:
First, most small firms do not produce audited financial statements. Therefore the question of them even trying to obtain anything other than expensive business loans does not arise.
Second, even those who have audited balance-sheets (perhaps even audited by dodgy audit firms — there is no shortage of these) have no idea how to:
a) prepare a plan and/or application for credit facilities;
b) structure appropriate credit facilities for themselves or even work out what, how much and when they even need financing.
Third, bad planning by SMEs and easy facilitation by banks. SME owners do not plan well in advance for financing and are happy to make last minute expensive loan decisions because banks can sanction them business loans in two weeks. Banks make this easy through huge marketing efforts and armies of sales people pounding the streets to sell loans.
Fourth, our experience shows that SME owners are aware of the cost of their own ignorance but do not know who to turn to for guidance and help. Trust is a huge factor and owners like to seek advice from trusted advisors. Seeking proper professional help is not often thought of.
SME owners seem to be taking a short cut in obtaining bank funding but this is at a huge cost. They need to seek professional advice on charting a bank financing strategy — this investment will not only get them bank finance at better terms but also lay the foundation for future growth with the right sort of financing in place.
All bank facilities are not the same. SMEs which have balance-sheets and manage to obtain credit facilities often make the mistake of accepting whatever the bank sanctions them without proper negotiation. Doing this comes at a heavy price — as any second bank coming in later will insist on the same terms and if those are expensive or burdensome terms, then the company is stuck for a long while.
Owners need to realise that consulting experts can bring them huge benefits in getting them good bank financing. After all everyone seeks experts when they do not know what to do — like going to doctors, lawyers or tax experts.
CREDIT: The writer is the Managing Director of Vianta Advisors.
