Growing small businesses are faced with the frustrating process of securing financing needed to carry out everyday operations and remain liquid. For many SME owners, accessing financing is an onerous process that pulls them away from their core activities to successfully keep their businesses running.While South Africa has a relatively sophisticated banking market, where 69 percent of adults were banked in 2017, the country’s SMEs face significant challenges accessing financing. According to the FinScope small business survey, only 7 percent of South African SMEs accessed credit in 2010 with just 3 percent of this coming from banks. The IFC estimates the value of South Africa´s formal SME credit gap to be $30 billion, amounting to 779 321 firms with unmet financing demand.
It’s clear that accessing credit is no easy feat for a growing business. What are the options available to SME owners looking to meet their short term working capital needs?
1) Informal credit sources including family and friends, stockvels, and micro lenders
One of the main reasons for the high failure rate of SMEs in South Africa is the lack of access to external finance, meaning SMEs have to rely on internally generated funds which are typically not sufficient to finance expansion and growth. Given the huge miss-match between the supply and demand for SME credit, it is not surprising then, that many SMEs opt to take loans from friends and family or turn to informal micro lenders. However, as a business matures so will its capital requirements, and so too will the need to source credit from more formalised institutions.
2) Equity
It’s not uncommon for business owners experiencing cash flow difficulties to consider bringing on an equity partner, such as a venture capitalist or angel investor, expecting the cash injection to solve their financial woes. The math shows that this could in fact be the worst possible thing to do, with owners that fund 100 percent of their working capital needs with equity, earning a lower return on owner’s equity. Businesses should preferably use equity to finance long term assets and working capital to finance short term assets (i.e. those assets which will be repaid within 12 months). This is probably the most costly and least efficient option available to SMEs.
3) Bank loans or lines of credit
SMEs face immense challenges gaining access to financing from banks. As put by Bob Hope “A bank is a place that will lend you money if you can prove you don’t need it.” One study estimated that 75 percent of SMEs´ credit applications are rejected. Banks price SME credit with imperfect information. Being risk averse, they tend to over compensate by erring on the side of caution, which results in high financing costs for the SME. Even if banks are willing to lend to the SME, the loan will more than likely need to be secured with collateral. In South Africa, 75 percent of loans are secured by collateral. The value of the collateral required is typically over 100 percent of the loan amount. A study in 2002 analyzing South African SME loan application rejections found that the largest reason cited (45%) was lack of collateral.
4) Factoring
If SMEs cannot secure a line of credit or asset based loan with a bank, and have exhausted other forms of informal credit including family and friends, factoring is often the only option left. Factoring is a type of short-term accounts receivable financing, where an SME ‘sells’ their outstanding invoices to a third-party financing company, called a `factor´. This allows the small business to generate cash flow instead of waiting to get paid by their customer in 60 days. Most factors advance between 60 and 80 percent of the value of the invoice to the SME, and the factor takes on the responsibility for getting payment from the buyer, managing the credit control of the business, and processing invoice payments.
This may seem like a quick and easy option in times of cash flow crunches but there are several disadvantages to factoring. Factoring is expensive! The high interest rates charged are not because of risk (afterall the factor collects payment directly from the SME´s large stable buyer) but are rather a function of SMEs limited access to finance. SMEs who need quick financing often sign long term factoring contracts with confusing terms, numerous hidden costs and exorbitant factoring fees. Worst still is that the SMEs relationship with their buyers is at risk of being interfered with. When a business uses a factoring company, they authorise the factor to collect payment from their buyer. Problems between the buyer and factor could put strain on the SMEs business. When an SME choses factoring, they take on this risk!
None of these options are particularly attractive for SMEs in terms of cost, risk or ease of use. There must be a better alternative….
At Finvex.tech we use a supply chain finance model which allows SME suppliers to enjoy affordable and flexible financing, by picking which invoices to finance minus a small fee. The program is initiated and led by the corporate buyer (unlike factoring), helping to improve the relationship between themselves and their suppliers. 100% of the invoice value (less a small discount charge) reflects within 24 hours of the invoice being approved by the buyer, and is deposited directly into the SMEs bank account. The SME can leverage the credit profile of their corporate buyer to gain access to significantly cheaper sources of funding- sometimes up to 5x cheaper than those charged by factoring agents. The transaction represents a true sale of the SMEs accounts receivable (i.e. it is not reconciled as debt). SME suppliers gain greater visibility and control over their balance sheets, and know exactly what and when they will get paid.
Finally, the financing alternative SMEs have been looking for!