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 also a critical economic and political concern. An estimated 99.9% of private sector UK companies are categorized as small or medium-sized enterprises and they are responsible for 60% of all private sector employment, according to the UK Department for Business, Energy & Industrial Strategy.

Funding concerns may affect family-run SMEs the most. An IFB Research Foundation study prepared by Oxford Economics reported that family-run small and medium-sized businesses were less likely than their peers to apply for financing and slightly more likely to have an application rejected. About 10% of businesses had not applied for external financing despite indicating a need for it, “discouraged by the additional risk, potential cost and associated time burden of applying for and obtaining finance, and by the belief that they might be rejected by potential lenders,” according to the 2017 report.

The report estimated that 74.5% of private sector firms with 1-9 employees, 59% with 10-49 employees and 47.2% with 50-249 employees in the UK are family run.

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. The lender then 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 cashflow and therefore pay down financing or maintain leasing.

Asset finance growth

Fortunately, asset-based financing models are on the rise. One compelling example is Simply Asset Finance (SAF), a finance business that is using asset-based criteria to help close the funding gap for SMEs. The company, launched in 2017, offers 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. Some small and medium-sized businesses are also using SAF’s asset-based financing to structure payments in a way that corresponds with the ups and downs of cyclical cashflows.

Ylva Oertengren, COO of SAF, notes that the reluctance of banks to lend to the SME sector is a remnant of the last financial crisis. Consequently, banks are often making financing decisions based on data alone, which does not always reflect the full reality of a business.

“Scorecards miss the point and credit is unduly being declined. We would never look at a scorecard, we look at a company’s whole story in making a lending decision,”she says.

Think of it this way: “There is an entrepreneur out there who needs to buy a new machine to expand business and because of this will hire one or two more people. These workers will now be able to support their own families. It trickles down to positively affect the economy. Lending to small and medium-sized businesses enables more job creation and provides for families and supports communities. That’s what this is all about,” she explains.

The political impetus for encouraging asset-based financing models is evident in SAF’s own capital raising, for which the British Business Bank has provided the company funds to lend more than £60m to create liquidity of finance options for SME owners. The transaction, announced in January, was the sixth made under British Business Bank’s ENABLE Funding programme to increase the supply of leasing and asset finance available to UK SMEs.

These efforts will further expand asset-based funding options for SMEs. The Finance & Leasing Association (FLA) estimates that its members provided approximately £32 billion of asset financing to UK businesses and public services in 2017. Of that, about 60% (£18.6 billion) was asset financing for SMEs, 12% higher than in 2016.

Technology’s role

Technology, too, is playing a part in narrowing the funding gap for SMEs. SAF and other asset-based finance companies are using technology systems to drive the customer experience and increase 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 pursue and their staff are too consumed with paperwork to provide customers the attention they need.

This reality runs counter to the preconceived notion that customer requirements in the SME space are at odds with the high-tech requirements of finance organisations. They shouldn’t be.

Technology enables speed of service so companies can receive the funds they need quickly. It improves data analysis and expands communications channels. It helps finance companies efficiently manage the regulatory requirements that safeguard customers.

“Without the technology piece in place you cannot service this community,” observes Oertengren. “Technology is allowing our teams to focus on customers…and make sure that a farmer or construction company receives a human touch and speedy service.”

The innovation imperative

To increase asset-based funding to small and medium-sized businesses, the UK finance industry should also make innovation a higher priority. Oertengren sees this as providing SMEs with the right finance product, at the right time, using the right means and the right communications channels preferred by the customer.

There is a lot of talent in the industry trying to drive this forward that is being held back by legacy technology or preconceptions in their organisations. Innovation requires that they keep pushing forward. The momentum is building, and this is an exciting time,” she says.

Mukul Mittal
Executive vice-president-lease
Cloud Lending Solutions