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Access to sufficient financing is the foundation of success for all businesses, whether large enterprises or Micro, Small, and Medium Enterprises (MSMEs). Large businesses have always had greater opportunities to raise capital due to their market influence, size, scale, and established financial history, which are typically not available to SMEs. They are able to attract business financing from different sources ranging from public equity markets, corporate bonds, and private placements to venture capital, private equity, and bank loans. These sources offer large businesses flexibility and scalability in raising capital, enabling them to pursue growth opportunities and strategic initiatives more effectively.
SMEs and MSMEs, on the other hand, face many challenges in accessing the financing they need to grow and expand. These challenges include limited collateral, lack of credit history, and perceived higher risk by lenders. Traditional business lending frameworks have been designed in favor of larger firms, which are considered a less risky proposition by lenders and financial institutions. In a study published by the Federal Reserve, smaller businesses secure bank financing successfully only 45% of the time, whereas larger firms record a 72% success rate. As a result, many SMEs resort to relying on personal savings or expensive alternative financing options to meet their capital needs. These challenges hinder the growth potential of SMEs and limit their ability to compete with larger enterprises on a level playing field.
However, the world is currently in an age where SME business owners should be able to get financing within a few taps on their mobile devices, just as they would with personal loans. Challenged by digital lenders, traditional lending institutions are working to reinvent their service delivery models to align with the standards of modern lending for SMEs. In this blog, we discuss the essence of business financing for SMEs, its impact, and how lenders can harness technology to steer their growth and that of SMEs.
The Magnitude and Nature of the SME Financing Gap
The global economy relies heavily on the success and growth of Small and Medium Enterprises (SMEs), particularly in developing countries where they are the backbone of the economy. However, inadequate financing has been one of the major impediments limiting their success. According to the International Finance Corporation (IFC), the financing gap among Micro, Small, and Medium Enterprises (MSMEs) in developing countries is $5.2 trillion a year, with East Asia and the Pacific accounting for the largest share (46%), followed by Latin America and the Caribbean, and Europe and Central Asia (15%).
This financing gap presents a significant growth challenge for more than 40% (65 million) of formal MSMEs in emerging economies. This challenge creates a ripple effect throughout economic development, as SMEs are pivotal in job creation and bolstering national income. Globally, SMEs have generated more than half of all employment opportunities, underscoring their crucial role as an economic driver. Moreover, in developing nations, SMEs contribute over 40% to national income (GDP), highlighting their substantial impact on economic growth and stability.
Considering the rigid frameworks within which traditional lenders operate, even SMEs fortunate enough to obtain financing remain vulnerable to economic shocks. This vulnerability arises from their inability to diversify their funding sources during times of economic uncertainty. That is because traditional institutions have created homogeneous financing solutions designed to address businesses with non-homogeneous operating models and financial needs, which creates a disconnect in addressing the needs of today’s SMEs.
As a result, modern Small and Medium Enterprises (SMEs) rely on alternative sources of financing to sustain their operations. A study examining these alternative sources reveals that 43% of SMEs rely on support from friends and family, 30% on credit unions, 28% on personal funds, and 27% on support from business partners. This reliance on non-traditional funding underscores the need for a more inclusive and flexible financial ecosystem that sufficiently targets the needs of SMEs to bridge the gap that SMEs have traditionally faced effectively.
While traditional lenders have historically posed a barrier for SMEs, the sentiment now appears mutual, as SMEs increasingly find traditional lenders unappealing compared to new digital lenders. This shift is driven by several factors, including excessive administrative work in the lending process (cited by 28% of SMEs), slow lending speeds (26%), arduous application processes (25%), and rigid lending criteria (25%).
With these challenges, SMEs are actively seeking financing from alternative sources, particularly from lenders offering simpler and more streamlined lending experiences. The study reveals that 92% of SMEs are willing to change their lenders to access such experiences, highlighting a clear demand for more accessible and efficient financial solutions tailored to the needs of SMEs.
SME Financing in the Modern Era
Modern lenders have recognized that each Micro, Small, and Medium Enterprise (MSME) faces unique challenges and financial needs. In response, they are developing frameworks that can accommodate these diverse needs. And unlike traditional lending institutions, modern lenders are using technology to shift the borrowing power from themselves to the customer by providing more simplicity, transparency, and flexibility throughout the lending process.
However, simplicity does not equate to compromising on risk assessment. Modern lenders are using data as the engine behind their processes. Leveraging technology and data analytics, modern lenders can enhance their risk assessment capabilities to make more informed lending decisions. Digital lenders can analyze a wide range of data points, including financial statements, bank transactions, credit history, and business performance metrics, to assess the creditworthiness and risk profile of borrowers.
This data-driven approach enables them to identify potential risks and tailor their lending terms accordingly. Modern lenders also employ advanced algorithms and machine learning models to predict borrower behavior and default risk more accurately. These models can analyze historical data and identify patterns that traditional lending methods may overlook, thereby improving the overall risk management process. Statistics show that using machine learning in digital lending platforms can increase accuracy level by up to 99%.
Types of Financing Solutions for Small and Medium Enterprises (SMEs)
SMEs engage in a range of operations that require financing at different capacities to run effectively, and this presents an opportunity for digital lenders to offer solutions and thrive. While some of these financing solutions have been offered by traditional financial institutions, they are not as effective and easy to access as modern entrepreneurs and business owners want. Digital lenders, with their changed mindset about business financing and access to technology, are at the frontline of reinventing lending frameworks to make financing easily accessible and convenient. Some of the types of business lending opportunities that digital lenders are targeting include:
Invoice Financing
Invoice financing is a type of financing where SMEs borrow money against their outstanding invoices. Instead of waiting for customers to pay, SMEs can access funds quickly by using their invoices as collateral. This form of financing helps SMEs improve cash flow and manage their working capital more effectively. There are two main types of invoice financing:
- Factoring: In factoring, SMEs sell their invoices to a third-party finance company (factor) at a discount. The factor then collects the full amount from the customers. Factoring is beneficial for SMEs that need immediate cash and are willing to accept a discount on their invoices.
- Invoice Discounting: Invoice discounting is like factoring, but instead of selling the invoices, SMEs use them as collateral to secure a loan. The SMEs keep control over collecting payments from their customers. Invoice discounting is more suitable for SMEs that want to support their customer relationships.
Supply Chain Financing (SCF)
Supply chain financing, also known as supplier financing or reverse factoring, is a financing solution that helps SMEs optimize their working capital by providing early payment to suppliers. SCF works by using the creditworthiness of large buyers to provide financing to their suppliers at lower interest rates than they would typically receive.
In SCF, a financial institution partners with a large buyer to offer financing to the buyer’s suppliers. When a supplier invoices the buyer for goods or services delivered, the buyer approves the invoice for early payment. The financial institution then pays the supplier, deducting a small fee or interest, and the buyer repays the financial institution at a later date.
SCF helps both buyers and suppliers. Buyers can extend payment terms with their suppliers without negatively affecting the supplier’s cash flow, while suppliers can receive early payment for their invoices, improving their liquidity and reducing financial stress.
SCF is particularly beneficial for SMEs that operate within complex supply chains and have limited access to traditional financing options. It can help SMEs improve their relationships with suppliers, reduce operating costs, and enhance their overall financial health.
Asset-Based Loans
As the name suggests, asset-based loans are those secured by the borrowing company’s assets. These assets can include accounts receivable, inventory, equipment, or real estate. The value of the assets serves as collateral for the loan, allowing SMEs to access funds based on the value of their assets.
Asset-based loans are suitable for SMEs that have valuable assets but may not qualify for traditional bank loans due to limited credit history or financial performance. These loans can provide SMEs with the capital they need to fund operations, expand their businesses, or take advantage of growth opportunities.
One of the key advantages of asset-based loans is that they are often more accessible than traditional bank loans. Lenders are concerned with the value of the assets used as collateral rather than the borrower’s creditworthiness. This makes asset-based loans an attractive choice for SMEs that may not qualify for other types of financing.
Additionally, asset-based loans can provide SMEs with greater flexibility than traditional loans. Since the loan amount is based on the value of the assets, SMEs can typically borrow more as their assets increase in value. This can help SMEs manage their cash flow more effectively and access the capital they need to grow their businesses.
Inventory Financing
Inventory financing is a type of asset-based lending that allows SMEs to use their inventory as collateral to secure a loan. This form of financing is particularly useful for businesses that have a significant amount of inventory but need additional working capital to support their operations.
With inventory financing, SMEs can borrow against the value of their inventory to access funds quickly. The lender evaluates the quality and value of the inventory to decide the loan amount. The inventory serves as security for the loan, reducing the lender’s risk.
Inventory financing can help SMEs manage seasonal fluctuations in demand, fund growth opportunities, and improve cash flow. Leveraging their inventory, SMEs can access the capital they need to support their business operations without having to sell off inventory at a discount or wait for sales to generate cash.
Equipment Financing
Equipment financing is a type of loan that allows SMEs to get the equipment they need to operate their business. This form of financing is particularly useful for SMEs that need to buy expensive machinery, vehicles, or other equipment but do not have the capital to do so upfront.
With equipment financing, SMEs can borrow money to buy equipment, and the equipment itself serves as collateral for the loan. The lender evaluates the value of the equipment and the borrower’s creditworthiness to decide the loan amount and terms.
Equipment financing offers several benefits to SMEs. It allows them to get the equipment they need without having to pay the full purchase price upfront, preserving their working capital for other business expenses. Additionally, equipment financing can help SMEs manage their cash flow by spreading the cost of the equipment over time through monthly loan payments.
Business Line of Credit
A business line of credit is a flexible form of financing that allows SMEs to access funds up to a predetermined credit limit. SMEs can draw funds from the line of credit as needed and only pay interest on the amount borrowed. Once repaid, the credit becomes available again, providing SMEs with ongoing access to capital.
A business line of credit is suitable for SMEs that have fluctuating cash flow or need access to funds for short-term expenses. It can be used to cover operating costs, manage inventory, or take advantage of business opportunities as they arise.
One of the key advantages of a business line of credit is its flexibility. SMEs can borrow as much or as little as they need, up to the credit limit, and repay the borrowed amount on their own schedule. This flexibility can help SMEs manage their cash flow more effectively and avoid taking on unnecessary debt.
Working Capital Loans
Working capital loans provide SMEs with the capital they need to fund their day-to-day operations. These loans are used to cover expenses such as payroll, rent, utilities, and inventory purchases. Working capital loans are typically short-term and are intended to help SMEs manage their cash flow and meet their immediate financial needs.
Working capital loans are suitable for SMEs that need to bridge short-term gaps in cash flow or finance seasonal fluctuations in demand. These loans can provide SMEs with the flexibility they need to manage their working capital effectively and ensure that they have the funds necessary to operate smoothly.
One of the key advantages of working capital loans is that they are easy to qualify for compared to other types of financing. Digital lenders are primarily concerned with the cash flow and financial health of the business rather than the value of assets or credit history. This makes working capital loans an attractive option for SMEs that may not qualify for other types of financing.
Buy Now, Pay Later (BNPL)
Buy Now, Pay Later (BNPL) is a financing option that allows SMEs to buy goods or services and defer payment for a specified period. This type of financing is becoming increasingly popular among SMEs as it offers flexibility and convenience.
With BNPL, SMEs can make purchases upfront and spread the cost over several installments. This can help SMEs manage their cash flow more effectively and avoid large upfront expenses. Additionally, BNPL can help SMEs access goods or services that they may not have been able to afford otherwise.
Among the main reasons BNPL is increasingly becoming popular is because it is often interest-free or comes with low-interest rates. This makes it a cost-effective financing option for SMEs, especially compared to traditional loans or credit cards.
Merchant Cash Advances
With Merchant Cash Advances (MCAs), lenders provide SMEs with a lump sum payment in exchange for a percentage of the business’s daily credit card sales plus a fee. MCAs are typically used by SMEs that have a high volume of credit card sales but may not qualify for traditional bank loans.
One of the key features of MCAs is that repayment is based on a percentage of daily credit card sales. This means that SMEs repay the advance more quickly during periods of high sales and more slowly during periods of low sales, providing some flexibility in repayment.
Tapping into the SME financing gap requires a proper understanding of the business segment you are targeting and the challenges businesses often face when accessing it, to effectively address them in your solutions. From invoice financing to working capital loans, equipment financing to buy now, pay later options, the range of funding solutions available to SMEs is diverse and adaptable to their varying needs. By offering a comprehensive suite of financial products, digital lenders can empower SMEs to navigate financial challenges, seize growth opportunities, and contribute to economic prosperity. This not only supports their business growth but also fosters economic growth while creating revenue for your lending business.
Opportunities for Financial Institutions and Lenders
Challenges often conceal lucrative opportunities for those willing to innovate and adapt. The financing gap encountered by Small and Medium Enterprises (SMEs) presents financial institutions and lenders with a prime opportunity to reimagine their services and cater to this underserved segment. By leveraging technology, embracing flexibility, and focusing on financing solutions that appeal to small business owners, FIs can not only address the financing needs of SMEs but also cultivate lasting relationships and drive economic growth.
Some of the key strategies for FIs and lenders to capitalize on this opportunity, supported by our Digibanc SME Lending solution, include:
- Going fully digital
Embracing a fully digital approach can significantly enhance the efficiency and effectiveness of financial institutions (FIs) and lenders in serving SMEs. This involves digitizing the entire lending process, from application to approval and disbursement, to provide SMEs with a seamless and convenient experience. Going fully digital enables FIs to reach a wider audience of SMEs, including those in remote or underserved areas, thereby expanding their customer base and market reach. Our Digibanc SME Lending solution enables FIs and lenders to build fully digital solutions accessible via both mobile and web platforms.
- Creating easily accessible financing solutions
Financial institutions and lenders can leverage technology to offer faster approval and credit disbursement, reducing the time SMEs spend waiting for financing. Technologies such as AI and machine learning can be used to assess creditworthiness and streamline the application process, making it easier for SMEs to qualify for financing. Our solution utilizes advanced alternative data sources and innovative credit assessment models to facilitate this process. This flexibility makes it easier for SMEs, especially those with limited credit history or assets, to qualify for financing.
- Seamless onboarding
Onboarding is the first step in fostering a positive relationship with business customers. Simplifying the onboarding process minimizes friction and enhances SMEs’ ability to register and secure financing. Digital platforms like Digibanc SME Financing offer an intuitive onboarding journey for business customers throughout onboarding processes such as business verification, owner’s identity verification, and document submission, which sets the stage for a productive and long-lasting relationship with financial institutions.
- Modern UI/UX
Business owners today expect an impressive user interface (UI) and a seamless user experience (UX) that reflects the smooth interactions they enjoy as consumers. This includes intuitive layouts, clear navigation, and visually appealing interfaces, all of which are crucial for SMEs to easily understand and navigate the lending process. A modern UI/UX not only simplifies the lending process for SMEs but also enhances their overall perception of the financial institution. Our SME Lending solution features modern design methodologies that prioritize simplicity, clarity, and ease of use.
- Integration with Business Tools
Integrating with SME business tools is not just for convenience; it’s a strategic imperative for financial institutions and lenders aiming to empower SMEs. Our Digibanc SME Lending solution seamlessly integrates with accounting software, CRM systems, and e-commerce platforms, enhancing SMEs’ operational efficiency and financial management. This integration enables SMEs to automate loan repayments, access financing based on real-time business data, and make informed decisions swiftly.
- Wide Catalog of Products
Expanding the range of financing products available to SMEs is essential for financial institutions and lenders seeking to meet the needs of these businesses. With a broader selection, SMEs can find financing options tailored to their specific needs, whether they’re seeking short-term working capital or long-term investment funding. Our Digibanc SME Lending solution encompasses a diverse array of these offerings to empower FIs and lenders to integrate them into their solutions. This integration not only supports a greater number of businesses but also contributes to increased revenue generation.
- Flexibility and Scalability
Successful SME lending solutions are those that can adapt to the dynamic fintech market with speed. They are built using composable architectures that leverage APIs and Microservices to ensure easy integration of new solutions and products. This flexibility allows financial institutions and lenders to respond quickly to market changes and customer demands, staying ahead of the competition. Additionally, these solutions are scalable, meaning they can handle increased demand and growth without compromising performance or user experience. Our platform’s composable architecture enables FIs to integrate new features and services seamlessly, enabling them to stay ahead of the market.
Closing Thoughts
While Small and Medium Enterprises (SMEs) have struggled to secure adequate financing from traditional banks and mainstream lenders, technological advancements have opened new avenues for democratizing access to financing and various business operations. Modern technologies enable both traditional financial institutions and new FinTechs to automate the entire lending process and develop new products tailored to address the financial challenges faced by SMEs. This enables them to effectively meet the financial needs of SMEs, providing them with the necessary capital to grow and thrive. This, in turn, creates new revenue streams for FIs and lenders and facilitates market expansion, contributing to the development of a more inclusive financial ecosystem, which is crucial for sustainable economic development.
Building such solutions, however, requires a joint effort among different industry stakeholders. While lenders need the technology to streamline their business operations, their focus should be on finding innovative ways to support more businesses and not on building the technology stack. Building the solution from the ground up would prove more costly, time-consuming, and inefficient for lenders. At Codebase Technologies, we support financial institutions and digital lenders in building industry-grade solutions at a faster pace and lower cost through our Digibanc SME financing solution, enabling them to achieve success faster. Book a demo to learn more.
Tagged:
- bnpl, digibanc, digital banking, digital transformation
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Omar Mansur - Managing Director APAC
Tech focused and savvy disruptive strategy expert with a strong passion for exploring innovation and making a difference. Having an extensive history working with various Tier 1 and 2 financial, government and fortune 500 institutions across the GCC, Africa, ASEAN and South Asian region whilst delivering game changing and revolutionary initiatives to change the world.
