Bank lending is the most common source of external finance for many Small and Medium Enterprises (SMEs) and entrepreneurs, who are often heavily reliant on traditional debt to fulfill their start-up, cash flow and investment needs.
Yet, for a sector that accounts for 45 per cent of total employment and contributes approximately 52 per cent of the gross domestic product Sri Lanka, bank lending to SMEs has been relatively subdued over the years when compared to the total lending of banks as per available data published by the Central Bank of Sri Lanka (CBSL). When compared to regional peers, such as the Republic of Korea, Malaysia and Thailand, whose economic progress in recent years has surpassed that of Sri Lanka, bank lending to the SME sector has remained comparatively weak.
The importance of SMEs is felt now more than ever before, as they are considered the bloodline of the Sri Lankan economy, and their success is crucial to post pandemic economic revival. However, such SMEs that have been reeling for cash in the wake of the pandemic have not been able to easily access loans provided by banks, possibly due to rigid lending practices or loans being prioritized for more promising corporates. Although, there is some truth in this accusation, placing full responsibility on bankers is unreasonable as bankers undertake a significant amount of responsibility and accountability when taking decisions to disburse funds.
As a result, SMEs are left with no choice but to seek informal lending & alternate financing sources that may not be in their best interest; with implications that could sometimes be consequential. Not only does informal lending command a high interest rate, but it also comes with stringent conditions that may not be sustainable, eventually resulting in instances of insolvency & forfeiture of assets.
In this article, we aim to identify some of the more pressing issues and provide insights on how SMEs can effectively access traditional bank funding.
What are some of the key challenges faced by SMEs?
Banks and SMEs are equally responsible for the persistent anomaly faced by SMEs in accessing funds from the formal banking sector. The flow of funds from the banking sector is slow and limited principally due to structural weaknesses in SMEs and a negative perception among bankers that SMEs carry high credit risk due to the following reasons:
1. Non-availability of financial information
Banks fundamentally look at the ability of an enterprise to repay its debt, which is assessed based on the cash flows of the enterprise. Hence cash flows become the primary lending criteria. Future cash flows of an existing enterprise can be estimated only based on a company’s historical cash flows depicted in financial statements. Unfortunately, however, most SMEs in Sri Lanka do not maintain proper books of accounts, nor audited financial statements.
2. Inability to provide acceptable collateral (security to the bank in return for the loan)
Collateral is necessary to avoid willful defaults and in an extreme situation to realize assets. To newer, innovative and fast-growing SMEs, with a higher risk-return profile, traditional collateral such as physical assets should not be the only means of holding them responsible to their repayment.
3. Inadequate risk capital from promoters/owners
When banks provide funds to SMEs, they expect a reasonable equity or risk capital from the owners or promoters to be already injected into the business. If the owner of the business does not have an equity stake in the business, it forms an indication that the owner is not taking any form of risk to run the business. Risk taking is one of the primary characteristics of an entrepreneur. Today, banks expect around 30-40 per cent as risk capital from owners. Most of the SME entrepreneurs find it difficult to raise this minimum risk capital.
4. Unable to compete with imported products
Most SMEs in Sri Lanka use locally developed technologies in producing and delivering goods and services. The quality of the products and services produced by SMEs are of moderate quality that may not be on par with international standards. Hence, they may find it difficult to compete with relatively high quality, cheaper imported products.
5. Lack of managerial skills and strategic focus
Many SMEs may find it difficult to employ skilled managers to look after specific areas of their businesses. Owners and/or managers of SMEs often need to perform a wider range of tasks than those done in larger firms since there is less room for specialization. This lack of specialization makes management capabilities of SMEs weak.
6. Inability to establish a going concern
Banks would expect SMEs to prove a going concern or be able to communicate the sustainability of the business. Relevant and valid business permits, environmental licenses, proven technological processes need to be in place for banks to enjoy the comfort that the business has sufficient backing to sustain over a longer period of time.
Best practices for lending
In order to overcome these issues, SMEs can explore some of the following options.
1. Apply for CBSL and foreign funded credit schemes
There are many credit schemes available for SMEs such as the Saubhagya Loan scheme that are either funded or subsidized by the government of international funding agencies like the Asian Development Bank, International Finance Corporation & World Bank. Proper awareness needs to be created and SMEs can request information and identify eligibility criteria and thereby access these funds which are usually offered at subsidized interest rates and grace periods.
2. Leveraging on buyer, supplier data sources
Even for SMEs that do not have a traditional banking relationship, real-sector companies (such as suppliers that provide trade credit) and non-financial creditors (such as retailers and utility providers) can provide valuable information on a firm’s repayment history, allowing potential lenders to assess their creditworthiness. This information and data sources need to be explored and referenced at the point of applying for credit facilities.
3. Venture beyond traditional collateral
Intangible Asset–Based Lending (IABL) leverages a portfolio of Intellectual Property (IP) or other intangible assets to secure a loan. The loan can be backed by the stream of revenues tied to a single intellectual asset or to the SMEs entire portfolio. In either case, firms can secure their intellectual assets in addition to a blanket lien against common collateral such as real estate or receivables. Another way to solve this problem is to introduce Government sponsored credit guarantee scheme or call for the establishment of a permanent credit guarantee institution; a proposal for which is currently being discussed according to market sources.
4. Maintain accurate financial records
SMEs need to maintain accurate and timely accounts and prepare proper periodic financial statements reflecting their actual level of performance. This information is fundamental for banks to assess the performance and make informed credit decisions.
5. Clear strategy and project plan with proper references
SMEs could submit a comprehensive strategy document with realistic deliverables supported by easily accessible market data that can go a long way toward securing credit in instances where certain other financial commitments are not available.
In order to successfully access bank funding, SMEs need to look at the issue from a banker’s lens, and try to provide the required comfort and justification for credit while ensuring proper monitoring mechanisms are in place to ensure sustainable and long-term funding objectives are met. On the other hand, banks should also conduct training and development to their front-line credit officers to logically evaluate SME credit facility requests, create a culture that encourages officers to look at SMEs with a positive frame of mind, and look towards forming mutually beneficial partnerships based on trust and reciprocation. While the challenges are many and complex, navigating through them will require a concerted effort of all stake holders including the government, industry experts, international donor agencies etc. for increasing SME sector lending to induce a more vibrant and prosperous post pandemic recovery!
“Credit Supply survey” – CBSL; “Corporate and SME workouts” – World Bank, 2011; “National Policy Framework For Small and Medium Enterprises (SMEs) Development” – Ministry of Industry and Commerce, May 2016; “Sri Lankan SME sector needs more family-oriented business research” – Daily Financial Times, December 2020; “Small and Medium Enterprises (SMEs) Finance” – The World Bank; “New Approaches to SME and Entrepreneurship Financing: Broadening the Range of Instruments – OECD; February 2015; “Evaluation of small and medium-sized enterprises line of credit project (2016–2019) – Asian Development Bank, 2016; “Issues in informal finance” – World Bank.