SME FINANCING

INTRODUCTION

Commercial bank lending covers business loans from small business to corporate finance. In general, the
same principles of lending apply, but the nature and degree of credit risk will vary considerably with the size of
the business entity. The focus of this manual is the credit analysis of small business entities, particularly those
operating in Pakistan.

From a banker’s viewpoint small and medium enterprises (SME) tend to involve greater credit risk than a
larger business due to the fact that they:

• are generally smaller, less well established, have less power to demand leniency from creditors, tend to
work on smaller margins; and therefore are more subject to market forces.

• have fewer assets to offer as collateral on a secured loan;

• are less likely to have audited financial statements;

• tend to be undercapitalized due to the difficulties in raising equity finance for small business; and

• have a smaller pool of business management skills to draw on, particularly where financial management is
concerned.

Successful small business lending lies in sound lending policies and principles, and credit analysis—not
lending policies based on personal relationships. Lenders must not only pay close attention to the business at the
time of assessing a credit proposal, but they must also continue to monitor the business progress and results over
time.

SMALL AND MEDIUM ENTERPRISE (SME) LENDING IN PAKISTAN

Many small and medium businesses in Pakistan rely on short-term working capital funds to run their
businesses in the absence of long-term funds. Funds are also needed to grow and develop and to take advantage of
business opportunities when they occur. Yet access to formal sources of funds is restricted primarily because of
bankers’ inexperience with SME lending and small businesses’ fear of rejection rooted in the past.

At this writing, the banks are flush with liquidity and the economy is improving significantly. Supply and
demand are thus present but is not necessarily in equilibrium. The following discussion will seek to address the
issues of banker reluctance to lend to SMEs and the latter’s hesitancy to avail themselves of formal sector
financing. But first an overview of small business activity is in order to understand and seek appropriate solutions
to these issues.

Definitions and Types of Small Business

Small business can be defined as an independently owned and operated business that is not dominant in its
field of operation. It is also often defined for administrative or statistical purposes in quantitative terms, e.g. few
employees, low annual turnover, limited capitalization, etc.
A business is considered small when at least two of the following criteria are present:

1. Management is independent and, usually, the managers are the owners.

 2. Capital is furnished by an individual owner or a small group.
3. The area of operation is local: employees and owners reside in one home community.
4. Size within the industry is relatively small especially when compared with the biggest companies in its
field.

For the purposes of this Manual, the State Bank of Pakistan’s (SBP) definition will be the most frequently
used. Newly issued prudential regulations by the SBP stipulate that an SME means an entity, ideally not a public
limited company, which does not employ more than 250 persons (if it is a manufacturing concern) and 50 persons
(if it is a trading/service concern) and fulfills the following criteria of either (a) and (c) or (b) and (c) as follows:

(a) A trading/service company with total assets at cost, excluding land and building, up to Rs.50
million.
(b) A manufacturing concern with total assets at cost, excluding land and building, up to Rs.100
million.
(c) Any concern (trading, service, or manufacturing) with net sales not exceeding Rs.300 million per
latest financial statements.

Despite the precision of the above definition, the term SME covers highly heterogeneous groups of
business entities in Pakistan. Although reliable information is hard to come by, these groups of businesses can be
broadly characterized as follows:

(i) Very small enterprises or micro enterprises (an estimated 1.7 million) typically employ up to four
people, mostly from the same family. Activities include handicraft, textile, shops, trade, and services,
often at the home premises of the owners. Professional, managerial, marketing, and technical skills are
usually limited to producing single products or products and services for the daily needs of households.
The business is mainly oriented toward generating the necessary income for survival of the family and
very few have a growth orientation. There is anecdotal evidence of a high closure rate of such entities
within the first 2 years of starting operation. These enterprises usually work through a network of families
and are almost exclusively in the informal sector.

(ii) Small informal enterprises typically employ from five to nine staff and are largely family-based, having
grown from the micro stage. Business sectors are similar to those of micro enterprises. Professional,
managerial, and technical skills are higher than in the micro enterprises, obtained mainly through on-the-
job experience of the owners. These units are more growth oriented, and use a significant part of their
business revenues to invest in expansion. Business growth relies heavily on family relationships.
Typically, these enterprises lack access to formal credit and support services. They have good growth
potential if the financial sector and other business services support them.

(iii) Small formal sector enterprises typically employ between 10 and 100 staff. Based on family
management, these enterprises usually have well-established relationships with larger manufacturing and
trade concerns and are growth oriented. Because of their family roots, a number of enterprises in this
group face challenges of leadership and management as the business grows and with it the complexity of
management. Most enterprises in this category draw their financial resources from retained earnings, and
long-standing supplier and buyer relationships. Since business information and documentation is not
readily available, many enterprises in this group face difficulty in accessing finance from financial
institutions (FIs). This segment, which the Small and Medium Enterprise Development Authority
(SMEDA) estimates at 80,000 units, has, however, significant growth potential if external support for
business services and finance is available.
(iv) Medium-sized enterprises typically employ between 100 and 250 people, and have well established
supplier and buyer relationships with small formal and informally operating enterprises, as well as with
large domestic and international corporate entities. Usually, these enterprises are in the manufacturing
business both in the domestic and export markets. Although this segment normally has professionally
 sophisticated management, there is a need to maintain competitiveness in these markets. This enterprise
type is an important source of employment and of linkage between the formal and informal economies.
Access to finance is normally constrained through the FIs’ still existing focus on large and government
customers.

It may be appropriate that each bank continues to define an SME in the light of its own lending strategy
rather than relying exclusively on an official definition. However, this may be detrimental to the formation of
uniform policies and standardized procedures inn lending to the sector.

Characteristics of a Small Business

Management. Since the managers of small businesses are the owners, they are in a position to make their own
decisions. As a small operator, the owner is both investor and employer. This gives him or her complete freedom
of action.

Capital requirements. The amount of capital required is relatively small compared with that required by most
corporations. It is often supplied by one person or at most by a few people.

Local operation. For most small firms, the area of operation is local. The employer and employees live in the
community in which the business is located. This does not mean, however, that all small firms serve only local
markets. Some small importing and exporting firms and canning and packing plants operate nation-wide. Small
enterprises are most often non-incorporated, i.e. they are run as either sole traders or partnerships, and others are
incorporated as private companies.

What are the advantages of being small?

Freedom of action. The owner-manager of a small business enjoys freedom of action, flexibility, and upfront
involvement. Change is characteristic of business today. There are always new products, more modern machines,
and new technology. The small business owner is in a position to act quickly to meet changing conditions. The
small retailer can order goods on a short lead time.

Ability to adapt to local needs. Most small business owners are in a good position to assess and meet local
needs because they are long-time residents of the communities they serve. The local merchant has close contacts
with customers and employees and can cater to their needs and wants. The volume of business may be small, but
local owners can often operate profitably in a market that is small either in numbers of people or in geographical
area.

Flexibility of structure. The small business gives the owner (or owners) a chance to participate in management.
Often a valued employee's services can be retained by offering him or her an opportunity to become part owner.

Low overhead costs. Many small businesses begin in one person's basement or garage. An owner and a few
helpers working part-time keep expenses low. When a new building is built, it is usually located away from the
high-cost district. Low overhead allows competitive pricing of the finished product

Banker’s Role in SME Development

In developed and developing countries alike, small businesses represent a cornerstone of the economy.
There is normally a tremendous demand for bank credit by SMEs but the latter are at present meeting most of
their financing needs through friends, family, and informal sources. At the same time, banks have surplus
liquidity—particularly in Pakistan—which they would like to deploy to earn better rates of return on depositors’
funds. But there appears to be a market failure as supply and demand are not being cleared. The result is dis-
equilibrium in the credit market for SMEs. The role of the bank is to restore equilibrium through its
intermediation activities.

The banking business is characterized by asymmetric information. The borrowers willingness and capacity
to service a loan on time is known to them. But this information is not available to the lender. In order to
compensate for this information asymmetry the lender asks for securities and collateral from the borrowers. Thus
the collateral acts as a key input into the process of financial intermediation. As the small businesses cannot offer
adequate collateral most of the time, the banks are unable to determine whether the borrower possesses technical,
managerial and marketing skills that will allow the borrower to generate adequate cash flow and repay the loan on
time. The process of financial intermediation therefore breaks down for the SME borrowers. In order to revive
this process, the banks have to be reassured that the borrowers' technical capacity, management and marketing
skills are being taken care of and at the end of the day they will have sufficient cash flow to service their debt to
the banks.

The Financial Needs of Small Business

Small businesses represent a very significant proportion of credit applicants which, from the lender's
viewpoint, requires particular care on the part of the credit analyst. In order to appreciate the difficulties involved,
it is preferable to develop an appreciation of some of the financial aspects of a small business.

Small businesses require funds for four main purposes:

• initial business acquisition or establishment—often referred to as “seed” capital;

• capital for expansion and to support purchase of new plant/equipment, etc.;

• working capital needs for raw materials and stock purchases, customer credit support, and the running
expenses of the business; and

• emergency funds sometimes required to cover short-term liquidity problems.

In the initial phase, most small enterprises suffer from problems of under-capitalization.

Financial institutions are reluctant to extend finance to such applicants because without a trading record,
character and capacity to repay cannot be established. Funds may be obtained, however, if the borrower can offer
satisfactory collateral, or if he/she has a particularly good record of past business success.

Cash flow is established during the growth stages, however, expansion pressures and a tendency to “over-
trade” frequently result in liquidity problems. This often leads to

• an erosion of retained earnings, which would normally be used to fund expansion plans; and

• a temptation to finance long-term investments with short-term funds.

Reliance on trade debt and possibly bank sources is most pronounced. Small business managers also tend
to seek out bank sources for financial planning advice. The major cause of small business failure is frequently
identified as lack of management skills, particularly in the area of financial planning.

Risks Associated with Small Business Lending

The risks inherent to SME lending are numerous. An SME is traditionally owned and operated by
one or very few individuals and is oftentimes a family affair. On average, an SME employs about one
hundred people but the number is really relative to a particular country (or even bank as in Pakistan). The
financing needs of an SME usually are limited to working capital requirements: purchase of raw materials,
financing of finished goods, supporting credit to debtors, and payment of the most important operating
expenses. Other characteristics include:

• high failure rate

• limited security/collateral
• financial analysis not evident
• high management costs

The banker, however, can take certain measures to mitigate the risks inherent to SMEs. These
include:

1. Do not lend without a viable business plan which outline in detail:

• the SME's business activities

• the capacity of its owners or managers to run the business
• the adequacy of capital
• that modern management techniques are being followed

2. Make sure that the owners or managers have the following qualities:

• technical expertise, if required, in the business

• the mental temperament to run a business
• a feel for human relations
• creativity—not only in product ideas but in overall management

3. Keep a close eye on the SME's account with the bank:

• do not over rely on the company's financial statements as they represent the past and are
often unreliable
• visit the company's premises as often as feasible
• obtain business plan updates

• follow the company's sales, profits, capital, etc. through its budgets and discussion
• request pro forma budgets and financial statements
• in the case of absence, assist the borrower in the preparation of such statements

Other Risk Mitigants

One of the most important risk reduction techniques in SME lending is an appraisal of the borrower’s
capacity to generate sufficient cash flows from business operations to meet loan repayment obligations. Cash flow
analysis is thus key and cash flows from operations are to be viewed as the primary source of repayment.
Collateral is secondary.

Cash flow based lending should be the lender’s focal point. This assumes the availability of accurate and
reliable financial information from the small business yet such information is oftentimes the most vital item
missing. Credit analysts should attempt to either check or assist customers to construct cash flow projections
during a review of financial data. During the process, the credit analysts should pay heed to the customer's
technical and overall management skills including their ability to lead the company successfully, and the
likelihood of future success.

Other methods by which a lender may seek to reduce SME default risk are:
• collateral
• guarantees
• owner's equity contribution
• insurance
• loan packaging
• syndication
• government participation.

SMALL AND MEDIUM ENTERPRISE (SME) LENDING IN PAKISTAN—Part 2

Mindset Issues in SME Lending

Although SMEs are a cornerstone of economic activity in Pakistan, industrial and trade policies and laws
have favored larger businesses; smaller units are particularly affected by the poor business climate. Many laws,
regulations, and practices developed prior to Pakistan’s independence and during a period of interventionist
approaches to development are now redundant. Written in the English language, laws and most policies are not
accessible to the vast majority of the population which is largely Urdu-speaking. Unprotected and ignorant of
their rights and duties, many SMEs are exposed to “predatory” practices of inspectors, who are claiming fees for
alleged noncompliance with laws and regulations.

Document requirements and, perhaps, a misplaced mindset of the formal financial sector further
complicate SME life. The lack of suitable collateral, viable qualitative information, and financial statements and
accounts usually places the SME in the high-risk category and therefore non-bankable in the eyes of most FIs.
Not helping is the absence of a uniform and clear definition of SMEs making it difficult for various institutions to
form uniform policies and devise standardized procedures to deal with this sector.

Many SMEs interviewed for the purposes of an SME Lending market study highlighted their
unsatisfactory experience with banks: the insistence on collateral, the requirement for financials, and request for a
seemingly endless list of official documents (registration and business-related certificates). The point was
emphasized that most informal SMEs would have none of the preceding elements with which to constitute a
credible loan application. A “closed door” perception flourishes among small business owners when it comes to
approaching a bank for financing. If indeed the SME had the requisite data and documents for loan submission,
most interviewees were surprised by the long turnaround time for approval (exceeding several months with some
banks).

For loans that were approved finally, repayment structure did not fit the realities of the SME’s business
cycle, i.e. most bank loans are at fixed interest rates and on a fixed repayment (annuity-type) repayment schedule.
Many businesses are cyclical or seasonal in nature and loans adapted to individual cycles would be preferred.

Needless to say, dissatisfaction was also expressed concerning the rates charged by banks for a loan.
Interest rates charged the SME in the formal banking sector range from 10 to 15%, compared to around 8% for
“big name” corporate. The major non-financial sector complaint centered on the high cost and instability of
energy supply (electricity generation).

On the other hand, the SME’s tendency towards secrecy when providing whatever business and financial
information is available and the long tradition of borrowing from friends and family, hampers a rapprochement
with the formal banking sector. To address issues on both sides and stimulate SME development, the SBP has
proposed a participatory process which involves the following stakeholders:

• Government and regulatory agencies (such as the State Bank of Pakistan)

• Provincial and local governments
• Provincial Small Industries Corporations (to be revived)
• SMEDA
• Technical and vocational training institutes
• SME Bank
• Commercial banks, leasing companies and modarabas
• Institute of Bankers Pakistan (IBP)
• Large firms
• Associations of SMEs

Room for Growth in Lending to SMEs

Although SME share of loans granted by the banking sector has grown slightly to 15%, the level does not
appear satisfactory given a robust economy, easing monetary policy, and high liquidity. This is partly explained
by the lack of expertise, the risk-averse attitude of banks and the previously rigid prudential regulations of the
SBP (unrealistic lending limits set for SMEs and the restriction on FIs to lend against collateral). Fortunately, the
latter obstacle has been removed as new prudential regulations issued in the final quarter 2003 refer pointedly to
cash flow based lending and “clean exposure”: