Even if they do manage to tap bank funds, make sure to count the cost of capital
The state of SMEs’ financial management is a matter of concern and one that needs urgent attention. Especially in the post-pandemic era, this has assumed a colossal proportion – but there is no quick recovery in sight.
We need to analyze the root cause that ails this sector. To understand this, we must know why financing is always an issue with most SMEs. The answer is that most SMEs are conceived with a lot of passion, but not necessarily the planning backed by a feasibility study. Most SME owners lack the financial acumen – or discipline – needed to build the for its stability.
We blame it by correlating it to market conditions or other failures. Banks often take the lion’s share of the blame game, for the deficit in providing support. There is an inherent issue with the SME financing model – their financing structure is usually conceived on erroneous assumptions that are not necessarily in tune with the changing dynamics of the business ecosystem.
The basic rules of commercial prudence are often compromised, leading to recurring issues, including on cashflow management. Profit assumptions, break-even cost aspects or, for that matter, revenue scalability issues to meet overheads are often not considered. The very basic principles of prudence on gross margins to cover production and cost of sales are not aligned. These keep mixing profitability and cashflow instead of separating the two.
Coming up short
Not all SME entrepreneurs have the requisite insight on financial prudence. This critical aspect is gained with experience or by hiring competent resources. In reality, with a paucity of resources this is not an easy aspect to achieve as the former needs experience and the latter needs funding, which are challenging for SMEs to secure.
There are many factors to be considered for starting an enterprise, but often all prerequisites are missed when people scramble to start a business. It is therefore important that business owners maintain follow financial discipline and not digress from its core fundamentals. Seed capital and growth capital needs must be separated from cashflows.
Considering market sensitivities and routine business cycles, the seed capital must be adequate to support all eventualities. SMEs need to cast realistic business projections and ensure adequate working capital, preferably through shareholder support than bank debt. However, evaluate the opportunity cost of capital. Often long-term debt can be availed at a cheaper cost or the profitability margins can provide for cheaper debt.
Cost of debt
One has to be cautious that bank debt for SMEs is difficult in most markets, with banks usually charging high interest rates when providing such loans. The lack of access to funding is one of the major reasons for SME failures in the early stages. Contingency planning for meeting cashflow needs have to be defined as part of the business continuity plans.
SME entrepreneurs must not resort to funding the working capital gap from seed capital beyond its naturalized startup phase – and fund the capitalized phase from debt. Businesses at the startup phase need seed capital from shareholders or a long-term loan at reasonable rates. Any overtures to funding these at high rates can be fatal.
Mixing these two must be avoided. Therefore, SME entrepreneurs need to exercise utmost caution in managing their costs and to provide for these from within their operating cashflows. It has to come from their residual profits and cash collections on receivables, not paying them from seed capital or short-term debt.
Most entrepreneurs’ fatal mistake is to fund their growth activities from operating cashflows rather than from growth capital. These must be strictly sourced from shareholder loans or fresh injection.