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High NPAs in SME sector: Who is responsible?


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SMEs operate without formal registration, registered as proprietorships, partnerships or a limited liability companies. Irrespective of legal status, generally SMEs are proprietary nature. They do not have a corporate management structure and they are managed by the sponsor himself, commonly called a “one man show” – Pic by Shehan Gunasekara

Non-Performing Assets (NPAs) of the banking sector have been increasing in the recent past. Gross NPA ratio reached about 3.3% as at end of May2018 recording an increase of about 0.8% over the past five months. The banking sector reached the best gross NPA ratio of 2.5% as at the end of 2017 for the past five years. Therefore deterioration of the ratio by 0.8% during the period of five months ended May 2018 should be a cause for concern across the sector. 

Although correct statistics on Small and Medium Enterprises (SME) sector is not available, chief contributor towards high NPA is generally SMEs. Naturally NPAs of SMEs is higher than corpor

ate sector due to various reasons which include aggressive credit growth, poor macro-economic conditions including high interest rates, Government policies towards SME sector, po

or incentives provided to the sector, political instability, natural disasters, SME finance gap, corruption, lack of business support services, poor entrepreneurial culture and skills, poor rate of innovations, Government bureaucracy, long delay in legal proceedings, etc. However, unlike in corporate businesses, entrepreneurs themselves and Financial Institutes can be considered as main contributors for higher rate of failure of SMEs and high NPA in the sector. 

This article aims at analysing major weaknesses of these two stakeholders and how to manage the issue by concentrating on basics.

ENTREPRENEURS’ SHARE

1.0 Absence of Business Plan

One of the fundamental weaknesses or mistakes that SME entrepreneurs do is starting a business without a simple Business Plan (BP). It is important that all SMEs intend starting a business or launching an expansion program prepare a business plan at least covering major and important areas of BP. Intension is not to engage in preparation of expensive BP by outside consultants but by the entrepreneurs themselves to the extent possible. 

A simple BP should cover at least areas such as financial plan, marketing plan, technical aspects and any other important areas which they think are necessary. Financial plan should include, financing plan, one to three years’ profitability forecast with clear monthly milestones to bench mark. Special attention to be given to the amount of borrowing planned against the sponsor’s equity contribution. Generally SME entrepreneurs tend to give less importance to marketing aspects or totally ignore it and do not prepare a marketing plan. Absence of marketing plan plays a big role in between success and failure of any business and no exception in SMEs. A basic sales and marketing plan should cover at least strategy on business volumes, product pricing, distribution, business promotions, target market, etc. 

Technical aspects, although not very vital in SMEs should be recognised as important. We learn businesses experiencing time over runs and thus cost overruns mainly as a result of technical issues. If correct utilities are not available or if correct approval are not obtained, one cannot start commercial productions although the factory is ready for production. If electricity connection with correct KVA rating is not available for example, the SME has to restart the process of enhancing capacity of electricity connection which may require a separate transformer costing beyond the original budget apart from time overrun. 

Therefore all SMEs should look at certain technical areas such as:

  • Availability of utilities in correct capacities
  • Waste disposal methods if applicable
  • Environment aspects such as obtaining Environmental Protection License (EPL) 
  • Required other approvals from relevant authorities
  • Accurate BOQ and building requirement
  • Selection of proper and suitable machinery with correct capacities
  • Suitability of the location for the selected business.

2.0 Resorting to informal borrowing at very high rates on the assumption that borrowing from Financial Institutes as a big burden

It is no secret that banks and other Financial Institutes (FIs) have to follow regulations such as Know Your Customer (KYC), anti-money laundering requirement, etc. Additionally, to carry out a reasonable credit evaluation, certain amount of information and documents are required. Therefore provision of these documents should not be treated as a burden even if it is so. 

At the initial stage when there is no relationship, borrowers may feel as if FIs are demanding so many documents and information but when the relationship is established and basic information are provided, SMEs will not feel this as a big burden. Even if document requirement is excessive and take relatively long time to finalise, it is worthwhile and beneficial in the long run to obtain services of FIs rather than resorting to informal borrowing at very high interest rates. Majority of SMEs however, make this mistake frequently and resort to informal borrowing, unfortunately shifting their overall risk profile. 

Sometimes SMEs do not access formal sector for borrowing on the wrong assumption that their proposals will not be accepted by FIs. What SMEs should understand is that with stiff competition for SME projects, FIs will always keep their doors open for good and commercially-viable SMEs.

Also banks in particular offer SME specific credit lines for long-term investment at concessionary interest rates. All SMEs should try and utilise these concessionary credit lines to the extent possible, since these credit lines are well structured to meet SME requirement although it takes considerable time to finalise as a result of lengthy procedures. 

3.0 Not assessing the risk associated with excessive borrowing and underestimating importance of equity contribution

Generally SMEs fail to understand the impact on risk and return profile arising from level of borrowing. They start businesses without required initial capital and try to convince FIs about minimum equity contribution by various means, although actual equity contribution has not been made. When the sponsors’ contribution is accounted in kind such as owned land and buildings, etc., they tend to overstate values of same and try to overstate entire project cost with a view to artificially boost equity contribution. 

Generally borrowing level for SME businesses of over 70% of the total cost is considered not prudent. When it comes to establishing new SMEs, percentage of borrowing is to be kept to around 60%-65%. This will help new SMEs to deal with any unexpected situations smoothly, during initial stage. 

4.0 Misuse of borrowed funds and not investing on the intended purposes

Not divulging the correct purpose to FIs and misuse of funds have also been contributing to down fall of SMEs. Purpose and reason for borrowing to a great extent are decided by entrepreneurs. If SMEs do not disclose the correct purpose for which funds are required for whatever the reasons and if lenders do not identify the correct requirement, both SMEs and FIs will fall into difficulties. In certain instances although the purpose is discussed at the initial stage, funds are used for different purpose due to subsequent development without discussing with lenders. This is equally dangerous since structuring of facilities are done according to the purpose. 

For example, if funds earmarked for working capital requirement is used to finance long term assets, there will be mismatch of funds generated from operations and monthly dues and thus payment to FIs will be difficult. Therefore SMEs should always discuss the correct purpose with FIs and should not misuse borrowed funds.

5.0 Not disclosing correct level of borrowing

Although CRIB helps lenders to identify formal borrowing, there is no way of identifying informal borrowings unless SMEs themselves disclose. Though definitely undesirable, informal borrowing is fact of life in SMEs rather an exception. However, having resorted to informal borrowing, not disclosing correct facts for subsequent formal borrowing is a greater mistake. 

Naturally SMEs tends to avoid disclosing informal borrowings on the assumption that it will have negative impact on new borrowings. They should disclose all informal borrowings and circumstances under which they have to resort to informal borrowing to justify FIs. This in turn helps FIs to analyse the situation better and structure new facilities along with these informal borrowings or to suggest alternative solutions such as replacing informal borrowings by enhancing new facilities. SMEs should look at these kind of win-win situations rather than with holding some vital information and falling into difficulties.

6.0 Not recognising working capital fund requirement adequately

Availability of correct amount of Working Capital (WC) funds and in timely manner is key for success of all businesses. Unfortunately many SMEs do not recognise important role played by WC funds and they take it for granted. SMEs tend to make multiple mistakes in this area. 

Firstly, they assume that they can arrange Over Draft (OD) or Short Term Loans (STLs) to finance WC requirement at short notice. This is a fundamental mistake since permanent WC should never be financed through OD or STLs as it will create tremendous pressure on cash flow. Secondly, they do not plan for WC requirement sometimes due to ignorance and when the factory is ready for production, they find that they do not have required funds for operations. In these situations, they opt for informal borrowings due to urgency and eagerness of starting production as early as possible. 

Thirdly, it is important that SMEs recognise features of permanent WC and seasonal WC and obtain correctly structured facilities. As mentioned above, they should not finance permanent WC by using OD or STLs and equally important to avoid financing seasonal WC by using long term loans. If they do so, there will be extra cash during off seasons and SMEs may tend to invest these surpluses on non-yielding assets. Additionally, it is not prudent to operate on very tight WC situation since WC requirement can change fast with various factors beyond the control of SMEs. Hence availability of correctly structured WC facilities with suitable instruments and in correct volumes are very important, especially for SMEs which are involved in production and value addition. 

7.0 Treating business and entrepreneur as one

SMEs operate without formal registration, registered as proprietorships, partnerships or a limited liability companies. Irrespective of legal status, generally SMEs are proprietary nature. They do not have a corporate management structure and they are managed by the sponsor himself, commonly called as “one man show”. This in turn pushes these entrepreneurs to think that business and entrepreneur as one and tend to mix up personal finance matters and business finance matters. 

It is a common practice that entrepreneurs syphon out money from the businesses for personal requirement. These personal cash requirement may be genuine such as for meeting educational expenses of children, health requirement, house constructions, etc. or it can also be for non-business investments such as on lands, apartments etc. to make quick returns based on speculation. However, if they take out money for more than the realised profits from the businesses for non-business purposes, WC of the businesses will suffer and get eroded eventually. Finally they will find that existing WC is not adequate to manage the business and gradually business volumes will go down. Entrepreneurs therefore should address personal financial requirement separately with suitable non business loans if they can meet obligations from the profit of the business or any other income.

8.0 Not discussing issues with FIs when they know that they are facing difficulties

Another common feature that contributes to higher NPAs in SMEs is that they do not disclose certain ground realities proactively with lenders for possible solutions including restructuring of existing loan facilities when they face genuine difficulties. Most of the time, unfortunately they interpret these issues as enhanced WC requirement and try to borrow more. In a worst case scenario, SMEs resort to more borrowings, especially informal borrowings to meet losses or to meet existing loan commitment. Hence SMEs should discuss difficulties with relevant parties, especially with FIs to arrive at possible solutions when they realise that they are facing difficulties.

9.0 Over confidence of cash flows and repayment of loans

We need to be optimistic, very confident on our investments and should commit for repayment. However over confidence and asking very short repayment period has also been contributing to higher NPAs of SME sector. In certain instances SMEs resort to show their confidence of the investment by insisting FIs for shorter repayment period than what is logically required. SMEs must realise that if cash flows become better than originally forecast, there is always possibility of early settlement than the other way around. Thus SMEs should never make this mistake and it is always better to be conservative when it comes to repayment period.

FINANCIAL INSTITUTIONS’ (FI) SHARE

1.0 FIs share on areas discussed already 

FIs are also responsible for some of the major items indicated above under “entrepreneur’s share”. If an entrepreneur seeks a loan facility to start a new business or a major expansion of an existing business without a simple business plan, FIs should request a realistic and practical BP or should help SMEs to prepare a BP addressing all major and important areas. 

If gearing levels are not within tolerable limits and if equity contribution is not adequate, FIs should insist SMEs to increase it by explaining them of the repercussion of higher level of gearing. When entrepreneurs do not assess the correct WC requirement, FI should do it for them. Therefore the areas discussed above under entrepreneurs share are relevant to FIs also while some being directly relevant and others not so much.

2.0 Poor analysis of the business proposals and over relying on collateral

SMEs are not expected to be expert on business analysis and FIs should play a much bigger role here than the entrepreneurs themselves. FIs should critically analyse business proposals and if required they need to carry out sensitivity analysis on major assumptions made by entrepreneurs. Although it is complex and time consuming, they should carry out cash flow analysis properly. 

Apart from cash flow analysis, FIs tend to ignore very important management appraisal of entrepreneurs. Though it is difficult and no proper structured way of accessing managerial skills, FIs must evaluate entrepreneur’s leadership skills and entrepreneurial skills by using available qualitative models rather than totally ignoring. However, usually due to competition for limited businesses and target driven culture of FIs, they tend to move away from good credit analysis for better immovable collateral. 

In certain instances, FIs do not find required skills to carry out good credit analysis at branch level and moving towards collateral based lending have become inevitable. Over relying on collateral for granting loan facilities is a very common reason for higher NPA in SMEs. Collateral does not address the issue of NPA and all FIs therefore should look at shifting towards cash flow based lending. FIs should never dilute quality of credit analysis when SMEs offer good security.

3.0 Granting poorly-structured facilities

  • Offering short-term loan facilities to finance long-term fixed assets 

This is very common mistake that many FIs make which contributes towards higher NPAs. Investment in land and buildings, machinery, utilities, infrastructure, vehicles, R&D, quality assurance and testing facilities, waste disposal and environment hazard control systems, permanent working capital, etc. are treated as long-term investment since returns are expected in the long run. In practice what we see in some SMEs is that they seek short-term facilities to finance these assets without realising repercussions of financing long term assets by short-term loans. FIs have the responsibility of educating SMEs in this area and grant suitable facilities to address this issue. This is considered to be another major contributor towards high NPAs in SMEs.

  • Not offering correct repayment terms

Offering correct repayment period based on business development plan, cash flow of operations, useful life of assets, etc. is very important in maintaining healthy NPAs in SME sector. Over confidence shown by SMEs and risk associated with tenure encourage FIs to consider short repayment period without underlying justifications. Problem aggravates when it requires to offer a grace period and FIs do not consider a grace period as a result of not recognising this project specific requirement . Any new project will take some time for building construction, machine installation if applicable, market development and to realise cash cycle etc. Thus offering correct repayment terms with required grace period is very vital to maintain healthy NPA ratio in SME sector. 

  • Not granting optimum loan amount 

It is the responsibility of the FIs to evaluate investment proposals and business models and decide on the optimum loan amount. It is natural that SMEs may accidently miss some important items as well as include unnecessary items in the project cost calculations. Hence FIs should not totally rely and depend on the loan amount requested by SMEs. Therefore in certain circumstances, FIs may have to increase the loan amount with the consent of borrowers as well as reduce same should the circumstances warrant. FIs must realise that they have a huge responsibility of granting correct requirement to see a successful SME venture and manage NPAs of SME sector.

  • Not offering suitable WC facilities

Calculation of WC requirement for a business may not be very simple process for a SME client, particularly when it is involved with both permanent and seasonal WC requirement. Even in pure trading operations assessment of correct WC package is not an easy task. SMEs may need assistance of FIs in these areas. Financing permanent WC requirement with short term facilities such as STL and Temporary OD as well as inaccurate repayment frequency for seasonal WC loans are not prudent. Therefore FIs must carefully structure WC facilities to ensure smooth functioning of SMEs.

  • Not offering correct trade finance facilities in case of SMEs involved in import and export businesses

SMEs generally are not very conversant with facilities offered by FIs for export and import businesses. They may not be fully aware of LC facilities, short-term revolving import loans, packing credit etc. and more importantly benefits of non-funded based facilities against funded- based facilities. Understanding and structuring of a trade finance package may be complex process for a new SME. Therefore FIs should educate SMEs in these situations to make use of correct facilities to finance their businesses.

4.0 Not adhering to prudent and logical way of disbursement of funds

Once loan facilities are granted and accepted, general tendency of SMEs is to request the entire loan to be disbursed in one stage due to various reasons. However, generally, entire funds are not required at once and it is required in stages depending on the purpose. Proper usage of funds already disbursed is also to be checked for subsequent disbursement. A new SME business involving building constructions, import and installation of machinery for example may not need funds earmarked for machinery installation until building construction is completed. Similarly WC funds are generally not required until machines are fully installed and tested for commercial operations.

If we do not adhere to this logical way of disbursement of funds correctly, idle funding at the hands of SMEs can be used for various other purposes not originally intended. Also in certain instances it is always advisable to disburse funds directly to the suppliers with the consent of borrowers to ensure that funds will be utilised for the intended and correct purpose. Hence FIs carry a big responsibility to ensure that funds are disbursed properly and used for the correct purpose.

5.0 Poor post disbursement monitoring and relationship with SMEs

FIs are expected to guide and advice SMES continuously since SMEs may not understand impact and gravity of certain risks that SMEs are exposed while carrying out normal business operations. Insurance of stocks, fixed assets and other items for example is very important for business continuity and SMEs generally try to avoid insurance due to extra cost. FIs must educate SMEs about importance of addressing these operating risks and it is worth taking an insurance cover rather than exposing to a huge risk which can be as bad as losing the whole business. FIs must help and get them to understand importance of certain concepts of managing businesses.

Starting from maintaining proper records, importance of preparing monthly management accounts, importance of variance analysis, budgeting process, basic HR concepts, compliance of labour rules, taxation, importance of management concepts such as motivation, delegations etc. What generally happens is that when SMEs grow they think that they can manage bigger operations similar to the way they manage small operations. 

Unless they understand the importance of such concepts, growth from micro to small industry, small industry to medium industry and finally to a big corporate may not be a reality. A small unit performing brilliantly well on the basis of proprietary nature cannot ensure same success when they are graduated to a medium size industry and beyond unless they address these areas. Therefore enlightening SMEs on the importance of these aspect by way of post monitoring will definitely help to address high NPA in SMEs.

6.0 Not offering turnaround options when SMEs face problems

SMEs are very sensitive and vulnerable to environmental changes. They may not reach original performance levels due factors outside their control. Performance can also be affected due to wrong assumptions made at the beginning or subsequent changes to the original status. General country recession, world recession, higher inflation and higher commodity prices, adverse movement of foreign exchange rates, adverse weather conditions, natural calamities, political instability, etc. impact on SMEs and they may not have financial strengths to withstand these unexpected adverse situations. 

Under these circumstances, FIs should not wait till SMEs approach them but FIs should proactively offer suitable restructuring package for loans including moratorium on capital payment and extension of total tenure if it is required to address the issues. If the SMEs need total restructuring efforts such as introducing new equity partners, helping them in finding new markets, introducing partners with good management background, etc., FIs should try and assist SMEs.

7.0 Delay in taking correct recovery actions

Generally failure rate in SMEs are higher than big businesses. When businesses face problems, all stake holders should team up and find suitable solutions as indicated in 7.0 as early as possible. However, if all attempts are not going to help the affected enterprises, all stakeholders should willing agree on winding up operations to avoid further losses. Unfortunately we do not find this win-win situation in practice. Most of the time entrepreneurs do not agree on closure due to unreasonable optimism and want to continue without any basis. In such situation, FIs should proceed with correct recovery action to recover their dues by offering whatever possible concessions, thereby reducing NPAs. 

Conclusion

The factors indicated above are not comprehensive and cover only major areas contributing higher NPAs in SMEs arising as a result of weaknesses of entrepreneurs themselves and FIs. These factors are within the control of both parties to a greater extent. Hence these areas can be considered as priority areas in controlling NPAs in SMEs. 

[The writer, MBA (AIT, Thailand), BSc Eng. (University of Moratuwa), CIMA, MIE (SL), is CEO of a Non-Bank Financial Institution and past Senior Vice President (Branch Banking and SME) of DFCC Bank and counts over 25 years of experience in SME funding. He can be contacted on dharmasiriwic@yahoo.com.]

 


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