By Phillip Niwamanya
The COVID-19 pandemic has disrupted lives, livelihoods, communities and businesses worldwide. While the pandemic has affected every corner of the world, not everyone has been affected the same way.
According to a report by the International Trade Centre titled “The Great Lockdown and its Effects on Small Business”, nearly two-thirds of micro and small firms reported that the crisis strongly affected their business operations, compared with about 40% of large companies.
The report further states that one-fifth of SMEs risked shutting down permanently within three months. With fewer resources to ride out the storm, SMEs have been particularly exposed to the consequences of the crisis.
To recover from the impact of Covid 19, SMEs need increased access to credit and banks are one source of this credit.
Banks have a direct role to play in economic recovery by lending depositors’ money to credit-worthy persons and entities.
When banks extend loans, they generate new money through what is known as the multiplier effect. This occurs when new loans flow through the monetary system to generate new deposits elsewhere in the system. The act of lending increases money supply, as it flows from the borrower to other entities from which the borrower buys products and services.
However, banks also have a responsibility to mitigate credit risk and protect depositors’ and shareholders’ money.
Banks have a duty to mitigate financial and management risk when making a lending decision. Financial risk refers to a risk that a borrower may fail to repay the loan.
This risk is usually assessed through two tests namely; liquidity and solvency test.
The liquidity test determines if the business is generating enough cash from normal day-to-day operations to cover all normally occurring expenses, including interest and debt amortization.
The solvency test determines if there is enough cash from other sources (primarily liquidation of assets in distressed circumstances) to pay all debt principal and any accrued interest.
Management risk refers to a risk that a borrower’s managers lack capacity, integrity, depth, or staying power to run the business in a way to generate enough cash to repay the loan as initially agreed. What then can SMEs do to improve their chances of accessing credit?
It has been said that cash is king and this is no different in the credit world.
SMEs need to focus on generating sufficient cash flows to cover day-to-day business expenses first before thinking of accessing credit.
Once this has been achieved and exceeded, the excess cash flow can then be put towards debt repayment and this is when one should think of applying for credit.
Lack of collateral is one of the hindrances to accessing credit. However, SMEs within corporate and government value chains can access cash-flow based finance within a closed loop.
Under this arrangement, a bank can advance uncollaterized-financingequivalent to 80% of an SME’s contract with a corporate or Government entity. The funds advanced would be paid directly to the supplier on behalf of the SME.
The supplier delivers goods and services to the SME, SME delivers goods and services to the corporate and invoices promptly.
The corporate then pays the invoice amount into an SME escrow held with the bank.
The bank collects what is due to it and pays the balance to an SME’s transactional account.
The old adage that past behaviour is the best predictor of future behaviour is one that banks devoutly subscribe to.
An SMEs credit history as well its management credit history is a key indicator of character.
Past defaults may imply negligence or irresponsibility, which are undesirable character traits.
In addition, management skill is important because managers who have appropriate experience improve a business’s likelihood of success.
SMEs can take advantage of the free skills development programs available in the market to improvement their management skills.
Overall SMEs should ensure that the character, integrity, reliability and capacity of their management meet industry standards to increase chances of accessing credit.
Whereas banks have a responsibility to mitigate credit risk, SMEs also have a role to play in increasing their chances of accessing credit.
SMEs should ensure that they have sufficient cash flows from operations to meet the repayment of debt (principal and interest) and this can only be demonstrated through books of accounts.
By extension, this makes record keeping very important.
SMEs must also ensure that management has the right qualifications, skills and experience required to effectively run a business. Management must also have integrity and this helps in demonstrating an entity’s commitment to repay the loan.
The writer is the Acting Chief of Staff and Strategy at Absa Bank Uganda.
