Arranging credit lines

In the past three - four decades, the role of small and medium enterprises in the economic and social development of a country has been proven adequately. The newly industrialised countries of North and Southeast Asia like Taiwan, Malaysia , China and South Korea are classic examples of where the major industries helped develop the peripheral industry for its own growth and for the general growth of the economy.

By Sirajuddin Aziz
December 26, 2022

In the past three - four decades, the role of small and medium enterprises in the economic and social development of a country has been proven adequately. The newly industrialised countries of North and Southeast Asia like Taiwan, Malaysia , China and South Korea are classic examples of where the major industries helped develop the peripheral industry for its own growth and for the general growth of the economy. The supply chain to the “Chaebols” of South Korea, allowed for the indigenous growth of the vendor industry, which today constitutes the backbone of its economy. The SME sector in India again has been largely responsible for the improvement in the economic life of the man on the street. Its promotion has led to greater employment opportunities, besides giving economic value to each constituent. Their (SME's) participation in the overall growth of China's economy is a classic case study of Small and Medium enterprises, and their role in the socio-economic upliftment of the common man.

The dilemma in seeking finance for the promotion and growth of SME lies in the fact that these enterprises themselves mostly remain unaware of their peculiar needs to start or to enhance their business operations; this piece therefore is meant for the promotion of SME growth and financing arrangements, and not the corporate sector. The intent is to create awareness amongst borrowers, of what bankers generally look at or ask for, while entertaining applications for credit facilities… the stance therefore of this article is from a borrower's perspective.

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Bankers generally are reluctant lenders. They are extremely conservative in parting money; but then, there are also in the marketplace some ‘Cowboy Bankers’ who lend money quite liberally and easily, sometimes without credentials and many times without looking at the viability of the business proposition. In doing so, they can be driven by a multiple of motives -- some wish to be popular, some establish lifelong friendships with clients, some do not have the gal to say no to anything, etc. None of these reasons, however, can stand in justification for bad lending or even following such lending practices.

A lending banker expects the clients (borrowers or depositors) to be upfront, honest and forthright in making the rightful disclosures that would help and facilitate in understanding the financial needs of any enterprise. As a matter of principle, no man should withhold information from law enforcement agencies, lawyers, doctors and in the same vein, bankers, too, must be provided with complete and full details.

Bankers besides establishing basic credentials for extending credit facilities will always ask questions and remain curious about the need/purpose of borrowing. During an interaction with a client, who wished to make borrowings in billions of Pakistani rupees against equivalent cash in rupee, he got upset with me when I asked the ‘purpose’ of borrowing. He, with apparent annoyance, harbouring more aggressive arrogance, said ‘your institution is fully secured, so why do you want to know what my organisation will do with the borrowed amount?’ I said, listen ‘your highness’ with equal sarcasm, which is against my own grain to such indulgence, I definitely want to know the ‘end-use of funds' being lent by my institution to your entity. A heated engagement took place. ‘No other institution asks about the purpose of borrowing when it is secured against cash’, he retorted. I am ‘surprised’, is all, I said. He did not divulge the purpose. We refused to even establish his account. End of story, if the purpose is unknown.

In the past three - four decades, the role of small and medium enterprises in the economic and social development of a country has been proven adequately. The newly industrialised countries of North and Southeast Asia like Taiwan, Malaysia , China and South Korea are classic examples of where the major industries helped develop the peripheral industry for its own growth and for the general growth of the economy..

For lending bankers it is critical to know how the depositors’ funds will be ‘used’ by the borrower. It is imperative because firstly, bank borrowings must be channelled into legal businesses and secondly it is significant to establish that the application of funds will result in generating cash flows from operations. If it fails this test, then the obvious question, banks would like to find an answer and understand from where “cash” will be generated to repay the borrowings.

Unfortunately, the lending to our SME sector has remained extremely challenging for bankers. There is no adequate disclosure by the enterprises. The financial statements are done shoddily, the gaps in financial statements are rampant. This makes lending decisions extremely difficult. It is therefore no surprise that the default rate and the non-performing loans of this segment of the economy have been the highest, perennially. The NPL’s of the SME sector are numerous too.

Lending bankers inquire about the purpose of borrowing to establish and understand where exactly on the typical operating cycle of the client will their lending be deployed. Bankers and clients alike, use liberally the term ‘borrowing for working capital requirements’. This in isolation is an extremely misleading statement. To begin with, working capital is not to be taken, by both, as ‘Capital’. The latter must come from the owner/promoters as equity contribution. Only in the case of project finance of a long term nature there can be a combination of equity and debt. However, in the day to day running of business, companies need working capital. This essentially is a ratio between current assets and current liabilities (defined as those items on the Balance Sheet that have a maturity for upto a year’s time).

Bankers want to know, where on the operating cycle of the business they would be lending -- Is the borrowing (cash shortage) due to delays from account receivables or due to short tenor of account payables or is it the inventory (raw material) that the institution is financing. In any circumstances, other than the capital, borrowings can be undertaken but these must be deployed not for purchases of the top line Tesla vehicle for the chairman or the CEO of the company. Bankers are extremely wary of lending for selling and general administration expenses. The operating overheads expenses must be settled from operational cash. Resorting to borrowing for administration is a telltale sign of cash issues and or of misuse of funds.

Bankers like to identify their lending with ‘liquidity gaps’ that arise out of business operations -- from say purchase of raw material on either cash or trade credit and its conversion to inventory and from inventory to sales (account receivables or trade debtors). Liquidity shortages also arise if the time difference between sitting inventory and actual sales is prolonged. From a lending perspective there is comfort only, when there is cash arising from core operations. In this process, a deeper study is made by banks in respect of the ageing and life of the following items; inventories - trade creditors, sales - trade debtors, income receivable and expenses payable, etc.

Financing needs for the vendor industry is a real necessity. This can be done easily if contractual arrangements between these small and medium enterprises that lie on the supply/value chain of the major industries are shared with the lending bankers. A contract for regular supply of any raw material, semi-finished or finished product to say the automotive industry is something that gives great comfort to bankers. The lack of proper documentation is a major challenge, as well.

There is in the marketplace a general complaint that banks do not facilitate lending of money to the S & M Enterprises; while the complaint may be partially true, but it’s also a genuine reason why banks are reluctant -- the non-availability of financials, inclusive of viability reports and the lack of governance standards are major impediments in developing the lending to the sector. It is not unusual to find succession issues with such entities. The problem is further compounded by deliberate denial of critical information. There is no harm to admit that the issue is also accentuated by bankers who are not adequately trained in the art of lending to this semi organised sector of the economy.

As we progress towards building a sound SME base, borrowers and financial institutions must keep in focus the ESG demands, and with unpredictable climate changes, this becomes very important.

There is a dire need for promotion of SME’s for the growth and development of the economy. They have greater significance and relevance in the context of CPEC and the allied special economic zones planned alongside the corridor.


The writer is a senior banker & a freelance columnist

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