The Importance of Credit to SMEs

business factoring

Access to credit is the lifeblood of small and medium-sized enterprises (SMEs) as they evolve into profitable and sustainable businesses over the years. However, as they move along the growth curve, their funding needs change.

To understand how and why SME credit and funding needs change during their journey to maturity, it’s worth considering these within Harvard Business Review’s framework, The Five Stages of Business Growth, that it first published in May 1983 but remains highly relevant and useful.

Authors Neil Churchill and Virginia Lewis identified the five stages as existence, survival, success, take-off and resource maturity.

When first bringing the business into existence (phase 1), business owners typically have to rely on their financial resources to get operations up and running. At this early stage in the company’s history, the business is under-collateralised, has a limited credit history and has little expertise in producing sophisticated financial statements.

Securing bank loans at this time are likely to require personal collateral, such as fixed assets and property. It is during this phase that a small business owner’s financial security is most at risk because they rarely separate personal and business finances from each other.

During the survival stage, concerns about cash flow are top of mind for business owners because successfully managing cash flow during this period of the business’s lifespan determines whether the company will survive to move onto the next phase. Churchill and Lewis identify the following as the main issues confronting owners at this time:

  • Generating enough cash to break even and cover the repair and replacement of cash assets.
  • Generating enough cash flow to stay in business and finance growth opportunities.

Where cash flow does become a problem, business owners in this stage would rely on access to invoice financing to help the business navigate periods of restricted cash flow as a result of late or delayed customer payments. Two options are available to them, invoice discounting, which is suited to ad hoc or once-off invoice financing, or factoring, a contract between the invoice finance company and the business owner that hands over the collection and funding of invoices to the factoring company.

The business owner may also consider applying for a bridging loan at this stage but is only likely to gain access to this finance if the business is in a sound financial position. A bridging loan is short-term financing that bridges the gap between the cash scarcity the company experiences at this stage and the need to fund the growth of the business

During the third phase, success, the focus is predominantly on expanding the business and maintaining its profitability. Expansion usually requires funding, and at this stage, the funding is longer-term in nature than the short-term cash flow financing needed during the survival phase. Typically business owners will approach banks for loans at this stage, the success and cost of which will depend on the owner’s ability to prove to the bank that the business has a clean credit record.

Access to funding also varies depending on the nature of the company. Innovative and growth-focused firms that have unconventional and untried business models and profit outlooks that are difficult to forecast will have a more difficult time getting approval for conventional bank finance. 

Given the tight credit conditions in the wake of the financial crisis, however, and the difficulties small businesses often have in raising conventional bank financing, many SME’s are alternative funding options like crowdfunding or peer-to-peer lending. Whichever way the business owner decides to go, funding at this stage enables the business to scale the product offering it has successfully taken to market, so that it leaps to the next phase, namely take off.

During the take-off stage, the business focus is on sustaining a rapid growth rate and carefully financing the business expansion underway. If all goes well, the business at this stage should have a long enough track record of financial success to qualify for better financing terms at favourable interest rates.

The final stage identified by the authors of the Harvard report is resource maturity, a period when the business owner has built up a fully-fledged business and needs to keep it on track during the inevitable fluctuations in external market conditions. It’s clear that the vital funding needs – and access to credit – change dramatically for SMEs during their maturation into established businesses. Fortunately, the scope of credit alternatives is expanding as innovative players disrupt the invoice financing services industry, which gives SMEs a variety of options from which to choose.

Read More:
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