The shortage of affordable finance options for small and medium-sized enterprises (SMEs) in the UK has received widespread attention, and rightly so.
The data trends are especially disturbing given the importance of small business sustainability and growth to the nation’s economy. What has received less attention perhaps is a solution that is readily available to narrow the funding gap – asset-based financing models. The UK finance industry should move away from credit scoring models toward asset-based financing models to expand funding for smaller businesses.
Defining the gap
The Federation of Small Businesses (FSB) in May reported that small business credit approvals had fallen to a 30-month low. Only 60% of small firms that applied for credit were successful and just 25% of firms surveyed considered credit affordable, down from 30% during the same time frame last year.
“Almost two thirds (63%) of small firms successfully applying for credit are being offered interest rates of over 4%,” FSB also noted. The group estimates that 79% of small businesses that are applying for financing are pursuing traditional bank loans or overdraft facilities.
The SME funding gap not only is a finance industry challenge, it is a critical economic and political concern. An estimated 99.9% of UK companies are categorised as small or medium-sized enterprises and they are responsible for nearly 60% of all private sector employment, according to the FSB.
Credit scoring vs asset-based models
One major reason for the SME funding gap is an overemphasis on credit scoring in the finance industry. The big banks, in fact, have largely moved out of the SME funding space because many small business owners do not fit into the banks’ credit profiling.
Real-life examples abound of the shortcomings of credit scoring based financing models in making small business lending decisions. A typical scenario: a small business with demonstrated success and cash flow potential is denied financing because its owner has experienced personal financial difficulties, such as a divorce and mortgage default, that are considered major credit issues affecting the lending decision.
However, credit scoring alone is an inadequate means of evaluating the potential of a small business to repay its financial obligations. This is because capital formation is not as predictable in the SME sector as credit scoring would seem to indicate.
Instead, valuation of the equipment that the financing is tied to is a better indicator, as it considers the company’s ability to generate cash flow rather than past record. In asset-based finance models, loan or lease contracts are based primarily on asset usage or equipment pledged as collateral.
Terms and conditions can vary but rates tend to be lower than those for unsecured loans and lines of credit. That is because the lender has the ability to sell the assets if necessary to recover losses.
The finance industry should move toward a model of leveraging the underlying value of the equipment asset as well as the business asset. This is a better predictor than credit scoring of a company’s ability to generate cash flow and therefore pay down financing or maintain leasing.
Asset finance growth
Fortunately, asset-based financing models are on the rise. One compelling example are newer finance businesses that is using asset-based criteria to help close the funding gap for SMEs.
These companies offer lease financing based on the underlying value of the asset rather than current credit. Lease financing is a good option for SMEs, especially those that are not receiving the funding they need from traditional sources or are being charged high exchange rates.
The political impetus for encouraging asset-based financing models is evident in the capital raising of some of these finance businesses. These efforts and funding further expand asset-based funding options for SMEs. The Finance & Leasing Association (FLA) estimates that the nation’s asset finance market size is approximately £32bn. Of that, about 60% (£18.6bn) is asset financing for SMEs, a figure growing nearly 10% annually.
Technology, too, is playing a part in narrowing the funding gap for SMEs. Asset-based finance companies are using technology systems to drive the customer experience, increasing their competitiveness in an industry with tight margins.
Technology is also key to efficiently processing small-ticket transactions, otherwise, SME funding is not profitable enough for finance organisations to want to pursue. As the focus on the customer experience continues to drive innovation, cloud-based leasing platforms are offering a 360-degree view for improved user experience, helping deliver a differentiated dealer and lessee experience.
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