SME Credit Risk Assessment – An Intorduction
Small and medium (SME) businesses have always been an important player in the development of any economy. Most of the times SMEs are the supply chain for the large corporates and hence adequate funding of SMEs in any economy is critical for GDP growth.
SMEs have very significant credit needs and as most of them are not so formally managed, hence their credit analysis always require an approach different than that of the large corporates. SME Credit Risk assessment is harder because
- Mostly unstructured information in terms of accounting and bookkeeping
- Key man risk is high as many businesses are in fact, one man show
- Lack of adequate management reporting
- Lack of collateral offering
- Default rate is considerably high
Approach towards SME Credit Risk Assessment
Credit Risk Assessment primarily consists of two areas i.e. Financial Assessment and Subjective Assessment. However, there are few primary questions which needed to be answered before even starting the formal SME credit risk assessment, i.e.
- Whom to lend?
- Why to lend?
- Primary repayment source?
Money lending to SMEs should always be tied up with a specific purpose. It could be even for general business growth, however the growth plan should be clear in the mind of SME owner so that your funds are utilized for that plan only.
Understanding the Business Model
Understanding of SME business for a Credit Analyst is very important. You should know the cash flow requirement of the business to better assess the finance needs of SME business. Once you understand the business model, the next stage is Analysing the business mode. The key questions to ask in this regards are:
- What are the profit drivers for the business?
- What target market do the business serve?
- What is the value proposition of the business?
- What are the operation advantages of the Co?
- Co’s relationship with its suppliers
- Expansion plans – medium and long term
Company’s borrowing requirement is directly related to its business plans, capital availability, suppliers’ credit, expansion plans and other factors requiring capital expenditure or working capital requirements. Different factors need to be considered for short term lending & long term borrowing of the company
Formal SME Credit Analysis
While SME Credit Risk Analysis is a comprehensive process, here we will discuss the start of subjective assessment which is based on 5Cs of Credit, i.e.
- Conditions, and
Banks want to put their money with clients who have the best credentials and references. The fact-based assessment of character involves
- a review of credit reports on the company,
- the personal credit report of the owner.
- The bank will also communicate with your current and former bankers to determine how you have handled your banking arrangements in the past.
- The bank may also communicate with your customers and vendors to assess how you have dealt with these business partners in the past.
- Your conduct of account (in case of existing relationship)
Capacity analysis involves the company’s ability to service its debts. While assessing this following should be considered
- What is your company’s borrowing history and track record of re-payment.
- How much debt can your company handle?
- Will you be able to honor the obligation and repay the debt?
In order to determine this, the banker will be looking at your company’s historical and projected cash flow and compare that to the company’s projected debt service requirements.
Capital is important for two reasons. First, having sufficient equity in the company provides a cushion to withstand a blip in the company’s ability to generate cash flow. Secondly, when it comes to capital, the bank is looking for the owner to have sufficient “skin in the game”. Few key considerations in assessing the Capital risk for SMEs are:
- How well capitalized is your company?
- How much money have you invested in the business?
- What is owner’s financial commitment?
SME businesses, like any other business, are sensitive to changes in external conditions. You may consider your company’s sensitivity to changes in conditions by answering the following questions:
- What are the current economic conditions and how does your company fit in?
- If your business is sensitive to economic downturns, the bank wants to know that you are good at managing productivity and expenses.
- The competitive landscape of your company – who is your competition?
- The nature of your customer relationships – are there any significant customer concentrations (do any of your customers represent more than 10% of the company’s revenues?)
- Supply risks – is the company subject to supply disruptions from a key supplier? How is this risk mitigated? What is the nature of relationships with key suppliers?
- Industry issues – are there any macro-economic or political factors affecting, or potentially affecting the company?
While cash flow will nearly always be the primary source of repayment of a loan, bankers look at what they call a secondary source of repayment. Collateral represents assets that the company pledges as an alternate repayment source for the loan. If the company is unable to generate sufficient cash flow to repay the loan at some point in the future, the bank wants to be comfortable that it will be able to recover its loan by liquidating the collateral and using the proceeds to pay off the loan.
The 5Cs of credit are the beginning of formal SME Credit Risk Analysis. This is followed by
- Macro-level subjective risk assessment
- Financial Assessment including profitability, cash flow, financial trends etc.
- Off-balance sheet risk assessment
- Putting the credit risk assessment in the context of lending