To Borrow or Not to Borrow? That is the Question

 

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The last time I noted how comparatively high interest rates on small business loans discourage borrowings. Self-evident as this is, the comment was made after referencing the additional 100-200 basis points (1%-2%) that are charged on loan rates for small business in OECD countries when compared to rates charged on loans to larger firms.

This means that small business loans are more expensive despite the considerable degree of direct and indirect subsidization that exists in many countries to keep rates lower than unfettered markets would set for those small business loans. Therefore, lenders charge these higher rates due to perceived risk and other factors, such as the higher per unit cost of loan processing. As noted in the first newsletter, it is easier and less costly for banks and other capital providers to invest in government securities or other low-risk investments. Likewise, while putting greater capital at risk, larger loans for larger firms are often less costly for banks and other lenders to process on a per dollar (or euro, yen, pound, etc.) basis.

Comparatively expensive as small business loans are, some small businesses will borrow, while others will not. As the opening graphic shows, reasons for not borrowing include debt aversion, lack of collateral, cost, and loan processing complexity. Not included in the graphic is another factor (to be included in a future newsletter), which is small business reluctance to disclose information to avoid paying taxes. These choices and decisions say as much about the businesses and their risk appetites (or levels of debt aversion) as they do about the lenders and their perceptions and pricing of risk.

They also reflect differences in market landscapes. The graphic shows the North American market provides more loans (58%) to small business than does Europe (51%) where public support for SMEs is high and a bank-based system predominates. Asia-Pacific (41%) lags these two regions despite a higher level of overall credit as a share of GDP than Europe, and at levels roughly comparable to North America. Other regions (Latin America & Caribbean at 37%, Middle East at 34%, Africa at 28%) lag still, with varying degrees of public support for SMEs to increase access and/or reduce interest costs.

Therefore, the market landscape is nuanced and variable. However, even in markets where small businesses have access to credit and choose to borrow, they face challenges migrating up the firm size ladder to achieve medium-sized or large-scale status (with correspondingly lower interest rates on loans). As just one example, research I did a few years ago from Statistics Canada data from 2011-2022 showed little more than about 200 small businesses a year increased from small-scale to medium-sized status in Canada, a low rate of firm size growth in an economy with more than 1.1 million registered firms. Medium-sized firms only accounted for 1% of total registered firms in 2022, and large-scale firms were only 0.2% of total firms. This trend likely applies to other markets as well, showing how challenging it is for small businesses to grow.

My simple loan model below helps to illustrate why rate differentials are a factor in keeping small businesses small, even among those that choose to borrow:

 

• • higher interest rates make it more costly and difficult to manage for small business;

• • small businesses correspondingly often choose not to borrow in the end, which generally keeps them small;

• • when small businesses opt to borrow, these borrowings are typically for periods of one year or less, which makes it very difficult for small business to invest in tangible fixed assets, impeding their efforts to scale up and become more productive and automated.

As for this last point, some small businesses have lines of credit that run indefinitely, at the discretion of the lender. These are sometimes classified as short-term loans, with a paydown to zero expected at least once per year. Or they may be long-term loans exceeding one year, subject to the borrower continuing to manage within loan covenant requirements. (More on that below and as a core theme in a future newsletter.)

As these small business loans are revocable, the lender can call the loan whenever it feels the need to do so. This is not unreasonable, as the bank (or credit union, etc.) needs to account for total usage pressures in liquidity management practices. However, as these lines of credit are typically managed by borrowers on a cash flow basis, with no penalties for paydown of principal, lenders usually do not revoke these loans unless the borrower runs up interest expense to levels that violate coverage ratios. The added 100-200 basis points on small business loans helps lenders generate healthy net interest margins in exchange for the usage flexibility made available to the borrower. The flipside for the borrower is that the 100-200 basis points adds considerable cost over time.

To demystify some of this, I use a simple model below to illustrate four basic scenarios. All four scenarios show the borrower has:

 

• • Annual revenue or turnover of 10 million (dollars, euros, pounds, yen, etc.);

• • A gross margin of 35%, which means gross profit of 3.5 million;

• • Earnings before interest and tax expense (EBIT) of 8.5% of revenues, or 850,000;

• • Loan principal for five years at three times EBIT, or 2.55 million;

• • Taxes paid of 22% after interest expense is paid.

The range of annualized interest rates (applied equally in each of the five years) is:

 

• • Scenario 1: 5.5%

• • Scenario 2: 6.5%

• • Scenario 3: 7.5%

• • Scenario 4: 10.0%

The scenarios presented in the table below show Scenario 1 as a kind of base case for preferred rates on credit that would be extended to larger firms. Scenarios 2 and 3 show the lower and upper bounds for incremental interest expense for small businesses above what a larger firm would need to pay based on the same rates (as per the OECD example of 100-200 basis points), amounts, and length (tenor) of loan. Scenario 4 falls into the more “alternative” finance scenario where small business has access, but also pays a larger premium (450 basis points). It is these differentials in Scenarios 2-4 that often dissuade small businesses from borrowing, even when credit is potentially available from banks, other traditional lenders, and alternative sources of finance.

The results show the increase in interest expense brings Scenario 2 down to the low end of the comfort zone for lenders in terms of debt service. Most lenders want at least 1.25x-1.50x coverage of principal and interest payments from cash flow (EBIT, or earnings before interest and tax expense; or EBITDA, earnings before interest and tax expense, depreciation and amortization). This brings Scenarios 3 and 4 below what conventional, regulated, deposit-taking lenders would be comfortable financing.

In addition to the financial cost to small business resulting from higher interest rates (interest expense differential in row 2), we can also see the opportunity cost associated with foregone investment in what could well be capital expenditures needed by small firms to scale up and generate the production and processing efficiencies needed for long-term commercial viability (row 6). Each additional 100 basis points (1%) decreases available cash for CAPEX by about 100,000, which is costly for small businesses seeking improvements in hotly contested markets. Ultimately, it is this inability to scale up that prevents small businesses from being able to tool up enough to reduce their per unit costs for long-term competitiveness.

This illustration is intended to demonstrate why small business sometimes walks away from loans on offer. Note that there are many wild cards in this illustration.

 

• • Many small businesses have gross margins lower than 35%, meaning less profitable operations than the above model. Likewise, higher operating costs than assumed for sales and marketing, general administration, and other support activities can bring down EBIT-to-revenues to less than 8.5%, further reducing cash flow available to service and repay loans. Those fundamental realities make such companies less creditworthy, making it more likely their credit requests would be denied, or at least reduced in terms of borrowing amounts and term of exposure.

• • Another wild card is that none of the above discussion has mentioned fees that lenders charge. Borrowers often have to pay origination or processing fees on top of the interest expense paid for principal (loan amount on which interest is paid) usage. This adds to costs for small business, further dissuading them from borrowing.

• • The example above also does not deal with costs associated with the compounding effects on interest.

In the next newsletter, which I promise will be less cumbersome to read, I will present some simple examples of compounding and how this adds even more to the cost of borrowing for small business. Then, I plan to pivot our focus back to business management issues alluded to in the first newsletter. These management issues are crucial and inescapable for the achievement of positive outcomes and results for small business. They are also highly influential in decision-making about whether the business should borrow, and if so, how much, for how long, and under what terms and conditions when credit is made available.

On that note, it might be worth remembering how inter-related and linked finance and operations are. After all, finance is a resource, and we are discussing both financial management and business management, with both impacting the effectiveness of the other. (These are key themes of my upcoming book, Right-Sizing Strategic Financial Management for Small Business, which will be available to the public later in the year. Stay tuned.)

In the meantime, if there are topics you would like me to address in the future, feel free to reach me on LinkedIn (https://www.linkedin.com/in/mike-borish-90a4321) or on my website: borish.com

I also encourage you to post comments to animate the dialogue on these issues, and to share this newsletter with colleagues to enrich the discussion.

In the meantime, thank you for your interest in this newsletter.

I’ll be back August 2 with my next one. Until then, have a good month