Bank loans are the most common way of financing for SMEs. However, there are plenty of relevant alternative financing types such as leasing, hire-purchase, trade credit, factoring and selling equity. The most common alternatives are (53):
Asset-based lending (ABL)
In general, the most popular alternative financing types are all in some way asset-based.
Asset-based finance, which includes asset-based lending, factoring, purchase order finance, warehouse receipts and leasing differs from traditional debt finance, as firms obtain funding based on the value of specific assets, rather than on their credit standing. Working capital and term loans are thus secured by assets such as trade accounts receivable, inventory, machinery, equipment, and real estate.
The key advantage of asset-based finance is that firms can access the cash faster and under more flexible terms than they could have obtained from a conventional bank loan, regardless of their balance sheet position and future cash flow prospects. Furthermore, with asset-based finance, firms that lack credit history, face shortfalls or losses temporarily, or need to accelerate cash flow to seize growth opportunities, can access working capital in a relatively short time. In addition, asset-based financiers do not generally require any personal guarantee from the entrepreneur, nor that she/ he give up equity.
On the other hand, the costs incurred and/or the complexity of procedures may be substantially higher than those associated with conventional bank loans, including asset appraisal, auditing, monitoring, and up-front legal costs, which may reduce the firm’s profit levels. Also, funding limits are often lower than in the case of traditional debt.
As unsecured loans, asset-based loans expose the lender to generic credit risk, that is, to the risk related to ‘integrity, moral character, debt-paying habits and ability of the proposed borrower’. In addition, the asset- based lender is exposed to risks that are specifically related to the securing mechanisms underlying:
In light of the above risks, particularly of the expected asset value dilution and losses, asset-based lenders typically lend at a discount to the actual value of the secured assets. For accounts receivables, a loan-to- value ratio (LVR) of 80-85% is considered normal (54). The interest rate applied to the loan also reflects the quality and liquidity of the assets and is often higher than the rate on conventional bank loans. Furthermore, a service charge to cover the costs of administration of the account adds to the costs for the borrower.
The most common types of asset-based (or related) financing models are described below.
Factoring is a supplier short-term financing mechanism, whereby a firm (‘seller’) receives cash from a specialised institution (‘factor’), in exchange for its accounts receivable, which result from the sales of goods or provision of services to customers (‘buyers’). In other terms, the factor buys the right to collect a firm’s invoices from its customers, by paying the firm the face value of these invoices, less a discount. The factor then proceeds to collect payment from the firm’s customers at the due date of the invoices. The difference between the face value of the invoices and the amount advanced by the factor constitutes the “reserve amount”. This amount is paid to the seller when the receivables are paid to the factor, less interest and service fees. Typically, the interest ranges from 1.5% to 3% over base rate, and service fees range from 0.2% to 0.5% of the turnover (55).
A key aspect of factoring is that the problem of asymmetric information between lender and borrower is addressed by focusing on the quality of a third party, the borrower’s customer. It is the latter that becomes the debtor and responds to its obligations directly to the factor, which entirely assumes the credit risk and the collection of accounts.
POF is a highly targeted form of asset-based finance, intended to allow a firm to fill a particular customer order, and thus, to seize the market opportunities that would be lost because of the lack of financial resources to buy inputs and deliver the output.
POF funds the production stage of an SME's activities, as it consists of a working capital advance to cover part of the production of a good or service demanded by one or more specified customers. In more details, through POF, the SME obtains a verified purchase order from a customer and estimates the direct costs required to produce and to deliver the product, which may include labour, raw materials, packaging, shipping, and insurance. The purchase order is submitted to a financier, which bases the credit decision on whether the order is from a creditworthy customer or is backed by an irrevocable letter of credit from a reliable bank, or on whether the SME can produce and deliver the product according to the terms of the contract. If the loan is approved, the financier advances a share of the total order value, typically paying the approved costs directly to the suppliers. Once production and delivery are completed, the accounts receivables from the customer are either assigned to the financier, as in the case of factoring, or customer payments are directed into an account under the financier’s control. Similar to factoring, when the financier receives payment, it deducts the amount advanced and interest or fees and remits the balance to the SME.
Warehouse receipts (WHR) are an asset-based financing mechanism, whereby loans are secured by commodities deposited at a certified warehouse. Under this arrangement, commodity producers and traders deposit commodities at a warehouse, which offers secure storage and issues a receipt that certifies it has a specified quantity of a commodity that meets specified standards. The depositor can then use the receipt as collateral for a loan, whereby the lender places a lien on the commodity so that this cannot be sold before the loan is repaid. The amount that the firm can borrow is typically a share (50-80%) of the stored commodity value. The costs implied by the mechanisms for the borrower include interest, taxes and storage fees.
In many countries, leasing is a common mechanism to finance the use and purchase of equipment, motor vehicles and real estate by firms. Analogous to other forms of asset-based financing, underwriting depends on the value of an underlying asset and the ability of the firm to generate sufficient cash flow from business operations to meet regular payments, rather than on its overall creditworthiness as assessed through financial statements, credit history and fixed assets. Typically knowledge about the results of business operations
is used by the financier to generate indicators of the adequacy of prospective cash flows. Specifically, a lease is an agreement whereby the owner of an asset (lessor) provides a customer (lessee) with the right to use the asset for a specified period, in exchange for a series of payments. The lessor remains the legal owner of the asset throughout the contract, and ownership may or may not be transferred to the lessee at the end of the contract.
A “hire-purchase” contract works in a similar way to a finance lease, as the customer pays for an asset in regular instalment while benefiting from its use. However, hire-purchase is a type of instalment purchase, with a well-defined purchase option for the customer, who agrees to pay the cost of the asset over time, including principal amount and interest for the period the asset is used. In this case, the purchaser acquires the asset on signing the agreement, but the ownership is transferred only upon the full payment of the purchase amount.
When companies want to use their accounts receivables (invoices) as assets to get financing via factoring, a way for the factor to reduce risk is to insure the invoices. A credit insurance covers the risk of non-payment (“default”) by customer enterprises (“buyer”) that a supplier of goods or services (“seller”) bears when selling on a deferred payment basis (“trade credit”).
The “product” can be illustrated with the following graph:
The illustration depicts the basic relationship underlying a credit insurance contract.
(1) The seller sells goods or services to the buyer (an enterprise, not consumers), due for payment after a specified period (trade credit). After an appraisal of the risk involved in transactions with a specific buyer
(2), and against premium payment
(3), the credit insurance company covers the risk of non-payment
(4), the default risk and may – depending on the specific contractual arrangement with the seller – try to collect the debts from the buyer.
The primary risk covered by the insurance is the “default” risk.
The SME can principally cover two different default risks inherent in trade credit transactions:
For SMEs with several low-level transactions or with small business partners about whom little information is available, the costs of monitoring risks, analysing customers and drawing up insurance contracts are hard to justify. In the case of an SME doing business with similar companies, the monitoring costs will constitute a fixed cost, resulting in a tendency for SMEs serving larger customers to enjoy more favourable insurance conditions.
The standard insurance contract covers the trade credit risk of all the company’s buyers for standard premiums of around 0.3–0.7 % of the turnover. This circumstance may absorb a significant fraction of an SME’s profit margin. For example, for German SMEs, the empirical profit margin since the mid-90s is around 2.5 % of the company’s turnover (56).
The world credit insurance market is highly concentrated. There are only three big companies left, all based in Europe. The three companies Coface, Atradius and Euler & Hermes together have 84 % of world premiums (57).
Firstly, the size of the premium seems to discourage SMEs. Credit insurance is a product whose final design depends on a variety of factors, making it highly specific to the transaction covered. In other words, credit insurance is not a homogeneous “product but the various contract(s) between one seller and one buyer. The insurer regularly covers the portfolio risk of a bundle of different contracts. A standard Credit Insurance case or a standard risk does not exist, so for each seller, the insurer must assess the risk of the specific portfolio of contracts. Initially, this case- specific variety results in costs for insurers and sellers as well, creating economies of scale for larger sellers ensuring higher sales volumes with each respective customer. The industry’s association addresses this fact: “The reason for the lack of success in making credit insurance attractive to smaller companies has been the perceived expense of credit insurance, combined with its complicated nature and jargon ..., and the fact that it is just not seen as a must-have class of insurance.
Secondly, SMEs are less – if at all – aware of this particular insurance means. The degree of information available in a medium or a small enterprise is limited. In some cases, even a traditional lack of "insurance conscience" that sometimes characterises family- owned and run enterprises might explain the existing de facto reluctance to join an unknown scheme.
54 Caouette et al., 2008
55 Milenkovic-Kerkovic and Dencic-Mihajlov, 2012
56 Plattner 2001