How money lenders chose SMEs to fund
Loans can be crucial in a company’s journey from their early beginnings to becoming a household name. Loans are not always easy to secure, especially for small and medium-sized enterprises (SMEs).
Many factors are considered in the loan process, and you may think that these are out of your control. However, this is not always the case. In this article, podcast host of How to Lend Money to Strangers we spoke to financial expert, Brendan Le Grange for us some insightful and valuable thoughts about getting loans for your SME business.
Money Lenders Focus on Your Past
When a bank lends to corporates, it can invest time and resources in understanding each borrower’s unique business and make its loan decisions based on what it thinks that borrower’s future will look like. Unfortunately, this is seldom the case when it comes to SMEs.
Increasingly, SME lending is looking like consumer lending, where volume and automation are essential for profitability. This means that business owners may need to make the painful switch to seeing their business as ‘just another number.’
This mindset shift is essential because lenders won’t be considering your unique future when making a loan decision. They’ll be considering your past and looking for patterns that they recognise.
Brendan Le Grange explains this as the process in which lenders “look at the loans they have made in the past, gather together those that went defaulted on the one side and those that never missed a payment on the other, and then look for patterns in the data that are shared within a group but not across groups - using statistical tools to measure how closely linked those patterns are to the eventual outcome. In the case of loans, it will be things like the recency and frequency of past missed payments; the ratio of total balances to total limits; the length and breadth of credit histories, etc.”
These patterns among loans gone wrong are important to identify to spot these same patterns when presented with a new, potential borrower.
He goes on to add that in the case of business loans, “some easily measurable business metrics like turnover, sector, business history” can also be considered, “but it is important to note that to work at scale, the data fields they use need to be comparable over thousands of applications, which limits the level of detail that will be considered in all but the biggest loans. Or in other words, if it can't be easily discerned from the black and white headline numbers, it won't play a role in the decision.’”
What SMEs Can Do to Improve Their Chances
“You'll probably be looked at as 'just another number', so try to take away as many unknowns as possible - your numbers need to stand on their own.”
If a business wants to avoid being rejected for a loan today, they need to do two things: they need to ensure that their credit data contains no negative patterns. They also need to do their best to ensure that their credit data includes positive patterns.
Avoiding negative patterns simply means not missing payments on your current obligations. If you have missed a payment or two, it is not the end of the world, but if your need isn’t urgent, it may be worth waiting. Where there is a delinquency on record, more than anything else, lenders will consider how recent that delinquency was, as well as how frequent and how late any missed payments were.
There are some other habits to avoid, but generally speaking, if you haven’t missed a payment in the last year or so, you won’t be a strong ‘no’.
So, this is where the positive patterns come into it because you need something to move you from a ‘maybe’ to a ‘yes’. And it stands to reason that, to display positive patterns in your credit data, you need to have viewable credit data. This is why you may have been told to take out a credit product, even if that felt counter-intuitive… because, after all, the only reason you’ve never had credit up until now is that you were making a profit.
That may be true, but it’s probably invisible to the lender, so you have to think about the balance of probability – for every hundred SMEs that have never had credit, how many were because they didn’t need it, like you, and how many were because no one ever considered them lendable?
Brendan Le Grange’s advice on this is not to “rely on being asked why you never needed credit, establish a credit history; don't bump up against your credit limit because you don't need that much more and the bank seems OK with it, ask for a credit limit increase; don't let payments run a few days late, build a track record for paying on time; etc.”
Taking these steps, being proactive, will increase your chances of success. Especially being proactive with managing your credit limits. We mentioned that the most significant cause of concern is a history of missed payments, but a habit of bumping up against your credit limit is the next closest thing. Remember, in most cases, it's a machine that’s looking at this, so a £1,000 balance is seen as risky against a £1,000 credit limit even if your lender would have raised your limit to £2,000 if they’d only been asked. So ask! That same £1,000 balance would be perceived as much less risky after your limit has been raised.
The final consideration is that, for very small businesses, lenders may even look at the personal credit histories of the owners. Small business owners often have to make sacrifices for their businesses, sometimes even financial sacrifices. And in markets around the world, it has been shown that small business owners tend to start missing personal payments before they start missing business payments, meaning personal credit histories can be an early indicator of brewing business problems.
But sometimes, small business owners are just too busy, and their payment patterns suffer from a lack of attention rather than a lack of funds. If this is the case with you, you’d do well to clean it up before applying for any new business credit.
Who Are the Ideal Borrowers?
Le Grange describes the ideal lender as the following:
“A business with (i) an established history in a stable sector, (ii) a well-established credit history that provides plenty of met opportunities to repay an obligation (12 months of credit data is a minimum for most models, and while longer histories are generally better, the specifics become less relevant beyond 24 months as a rule of thumb), and as annoying as this can be, (iii) that appears to be borrowing before it really needs the money (this is closely related the preceding point, but basically you want to borrow before you've used up all your available limits and before your business growth has been slowed by a lack of investment).”
Applying for business loans can be daunting, especially for SMEs, but it doesn’t need to be! Taking the correct precautionary steps and utilising the advice from financial experts will only increase your chances of success and benefit you and your business.