What are the borrowing risks for a SME?

For small and medium enterprises (SMEs), nothing is more important than cash flow.  If funds are lacking, a company falls behind with purchasing, product development and payment of business expenses. Not only will the scale of operations be reduced, the very basis of the business will also be undermined, so small companies must always be ready to plug any funding gap. Borrowing is one of most common methods of fund procurement, but it entails a number of risks.  Let’s look at the risks that an SME needs to bear in mind when borrowing.

 

How does borrowing differ from securing new investment?

Fund procurement methods can be broadly divided into borrowing and “receipt of contributions” (i.e. raising funds through securing new, or further, investment). If we compare the two methods, the important characteristics of borrowing will become clear.

The main difference between borrowing and securing investment is the obligation, or lack of obligation, to repay the funds procured. When borrowing from a bank or other financial institution an obligation arises to repay the amount borrowed, plus interest. The total amount repayable varies depending on the amount borrowed and the company’s creditworthiness and, depending on the sum involved, there is the risk that repayments will impact negatively on cash flow. On the other hand, securing new or further investment entails no repayment obligation; investors are usually rewarded by dividends rather than interest.

Another difference between the two methods is the degree of involvement in operations. In return for their investment, investors are assigned an appropriate number of shares. They have voting rights at the shareholders’ AGM in line with their stake and so acquire a degree of managerial power. On the other hand, the basis of borrowing is the creditworthiness of the enterprise involved and, in return for advancing the principle sum, the lender gets an appropriate interest payment. The lender therefore has no direct involvement in operations.

 

The risks incurred when an SME borrows

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Let’s consider what kind of risks an SME incurs when it borrows.

When a company borrows money, it must repay the amount borrowed, plus interest. Depending on how high the interest is, there is a risk that the cash flow of the business will be squeezed. The interest rate varies in line with the creditworthiness of the borrowing company and the period of the loan. For example, a ten-year loan from the Japan Finance Corporation has an interest rate of around 1.21%. The level of the interest rate also varies depending on whether the loan is secured against the assets of the business.

If the borrowing company falls behind with repayments, it will receive a demand from the lender, which in the worst case will lead on to legal redress. A court may order the company’s assets to be seized, and it risks losing any bank deposits or real estate that it owns. Also, the company’s standing in the community will be damaged by being labelled as unable to repay its debts. Thus, when deciding to borrow money, it is essential that a small business has a realistic plan regarding repayment based on the level of interest charged and that it sticks to that plan.

 

Risks for the lender

Conversely, what risks are faced by the party that lends money to a small or medium enterprise?

The lender has the right to receive back the principle sum lent plus interest. However, there is a risk that repayment may not proceed as planned because of inadequate credit checks on the borrowing company and also a risk that the lender’s right to repayment may disappear if the borrower seeks the protection of the bankruptcy courts. In addition, if the borrower falls into arrears with repayments, the lender must issue a letter of demand or engage a debt collector. Even such action may not result in the monies being repaid, and a legal solution may have to be sought, with attendant costs. The risks for the lender include the possibility that a debt will have to be written off and the possibility that debt recovery costs will be incurred.

 

Procure funds wisely, after due diligence

Thus, for an SME, procuring funds through borrowing entails some risk. When considering borrowing as a method of fund procurement, the small business must think carefully from a long-term perspective and be certain that repayment of the loan, including the interest due, will not put undue pressure on cash flow. If funds are to be procured through borrowing, this should be done wisely, in full knowledge of the risks.

(By ZUU)

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