What banks consider when lending to SMEs

Introduction

In most countries, small to medium enterprises (SMEs) contribute significantly to economic growth. Most employees in a country are employed by an SME.

Banks consider lending to a SMEs risky. Generally speaking, SMEs are not able to provide sufficient financial information to enable the bank to make a decision. Because banks still want to lend to SMEs they, have become a little more flexible in their requirements for loans and are therefore able to offer loans even when they do not have sufficient financial information. They are able to do this using “soft” information to complement any financial information an SME is able to provide.

Hard data is the data recorded in numbers e.g. financial statements. Soft data is recorded in text or told in words e.g. market outlook, the reputation of the owner, etc.

SME lending considerations

These are the Five things a bank considers when lending to an SME:

Integrity of the owners

The Merriam-Webster dictionary defines integrity as the firm adherence to a code of especially moral or artistic values.

When assessing the owners’ integrity, banks are trying to determine whether the owners give loan commitments high priority. What they want to determine is, if the company has financial trouble, will the owners decide to default on loan obligations or will they give priority to paying loan obligations.

 Ability to repay the loan

The ability for a small business to repay loans is determined by assesses the business’s cash flow not just profitability.

The bank will calculate incoming cash flows and compare them against outgoing cashflows each month.

Collateral

Collateral is also known as security. It is a secondary source of loan repayment should the borrower be unable or unwilling to repay the loan.

Collateral also gives the bank some assurance that the SME will keep its obligation to repay the loan. This is because if the owners are willing to pledge an asset or assets as security, then it means that they are likely to take the repayments seriously.

Capital

Capital as also called shareholder equity. It’s the difference between the company’s assets and liabilities and represents the owners’ stake in the company.

Banks assess the amount of debt against the shareholder equity. This gives them an indication of the riskiness of the company.

A high level of debt in relation to shareholder equity makes banks nervous about lending to the company.

Economic forecast

Banks will do an assessment of the economic forecast and also assess how much they believe the SME would be affected by an economic downturn. For example, when assessing whether to lend to an SME that offers ICT services, banks would take into account that a forecasted economic downturn would affect the SME’s business.

Conclusion

SMEs are important to any economy since they employ many individuals. However, because many SMEs end up going out of business, banks tend to be very careful about lending to them.

Hope this article helps prepare for your next loan application.