This is the first of a series of posts reviewing Finance For Growth, a recent report by Andrew Freeman, a director at the think tank, Demos Finance.
Published in September 2013, Finance for Growth took what some might consider a refreshing view of the problem of UK SMEs’ access to finance – by questioning whether a problem exists at all. It is a sign of the growing confidence in the UK’s economic recovery that such a question could be published; right or wrong, similar findings might have been circulated quietly or even shelved in 2010, to await better days.
ACCA’s SME experts delved into the report and found much that we could agree with; but we take issue with a great deal too. This series of posts reviews the fascinating debates behind and beyond the Demos report, and what they mean for accountants – the SME sector’s most trusted financial advisers.
Part I: Which SMEs don’t want to borrow – and why?
Part of Freeman’s argument is that incorrect and dangerous assumptions underlie the access to finance debate: that SMEs need credit, and more credit will deliver growth. The evidence, he insists, suggests nothing of the sort:
“most SMEs never borrow from a bank […] and they do their utmost not to get into debt, instead ploughing earnings back into the company or business so that they can remain debt-free. Which raises a question rarely asked and even more rarely answered. Why are we speciﬁcally concerned with SMEs and whether banks are lending to them? […] Why, in fact, do we assume that SMEs as a group want to grow, and that bank lending is the right way to fund that ambition?”
Plainly, Freeman is right about the SME sector’s active demand for credit. In Q1 2013, 61% of all UK SMEs used no external finance at all, and nearly half of all SMEs with employees didn’t either. Fewer than a third used any finance from banks. Only 4% of the sector actually applied for any bank finance at all in the 12 months to March. And 37% of SMEs had so few dealings with banks in the past and so little appetite for credit in the future they were classed by the independent authors of the survey as ‘disengaged’ or ‘permanent non-borrowers’ – businesses for whom the banks might as well not exist.
More curiously, the UK SME sector lends more money to the banks than vice versa, and has done so even in the boom times. By Q1 2013, SMEs had substantially more deposits in the UK’s banks (£125.9bn) than loans and overdrafts from them (£98.8bn), and only about 43% of agreed overdraft facilities were drawn. Even pre-crisis, the top short-term credit providers to SMEs were not banks, but their own suppliers. For every pound SMEs borrowed short-term from the banks, their suppliers put in two.
Where Freeman starts to take liberties with the data is in conflating (silently, for the most part), these ‘disengaged’ SMEs with SMEs uninterested in growth. Even that is not an unreasonable assumption. In the SME Finance Monitor’s massive dataset to Q1 2013 (40k observations), there were barely a handful of ‘disengaged’ businesses with 50 employees or more, almost none with turnover of more than £5m, and none (able? willing?) to report an annual profit of more than £500k. Clearly, a medium sized or large business cannot remain ‘disengaged’ from finance for long.
Taking calculated risks
But this does mean that these businesses have no growth prospects in the first place? No. If anything, the Finance Monitor figures suggest the opposite.
Ex ante, the ‘disengaged’ expect their turnover to grow less rapidly than the ‘engaged’ (data here). Ex post, the average permanent non-borrower is more likely to grow than the average ‘engaged’ business interested in external finance. The latter is true regardless of whether one looks at rapid growth (over 20% per year) or any growth at all. More importantly perhaps, the ‘disengaged’ are more likely to be profitable (comparison here), even though their profits are typically smaller.
Perhaps, then, the ‘disengaged’ are better at assessing their prospects and hence less prone to over-optimism? It’s possible to test this, too, by looking at what share of each group report growth over the last year and comparing them to the share that expected growth a year earlier. Turns out the expectations of the ‘disengaged’ as a whole are almost exactly in line (we’re talking just decimal points of a percentage off!) with their subsequent performance, while the ‘engaged’ group’s expectations are way off. You can see the comparison for yourselves here.
I should note here that the Finance Monitor is not a panel survey – so comparing expectations with outcomes tells us nothing about the prescience of individual businesspeople. But the fact that the group’s expectations are such a good predictor of its subsequent performance cannot be entirely meaningless, either.
But even this doesn’t tell us everything we need to know. What if the ‘disengaged’ are simply afraid of taking risks? That could explain both their poor appetite for finance and their spot-on record in anticipating growth.
You guessed right. We can test that too, by looking at what their growth plans tend to be and what their owners and managers are willing to do with their own money.
Turns out, the ‘disengaged’ that intend to grow are less likely to want to introduce new products and services, to enter new markets and especially hire new members of staff than the ‘engaged’. So it’s fair to say their plans are less risky, but is it fair to say their owners don’t like taking on risk?
I insist on this question because owners of ‘disengaged’ SMEs have big personal stakes in their businesses. In any 12-month period between mid-2011 and mid-2013, 20% of ‘disengaged’ SMEs received cash (i.e. equity) injections from their owners or directors as a matter of choice rather than necessity (see graph here), easily more than the figure for ‘engaged’ businesses, whose owners were more much likely to inject funds just to keep them afloat. These emergency finance needs are probably tied to the overconfidence issues we discussed earlier. Finally, owners and directors of non-borrowers were exactly as likely to inject cash as a long-term investment as their ‘engaged’ counterparts.
I think it’s fair to say, then, that non-borrowers are not afraid of risk – their owners, if anything, are more willing to put their own money at risk – but they want more control over the investment in return. That sounds pretty entrepreneurial to us, and ACCA’s research shows that the degree of SME self-financing is very strongly correlated with high growth.
Accountants can bring the ‘disengaged’ into the fold
One could argue that there is an equilibrium of sorts here. Non-borrowing entrepreneurs make a rational choice to take only moderate, carefully calculated risks which will keep decision-making simple, cheap, and ‘in the family.’ So they shun the banks and rely on their savings, suppliers and retained earnings. Except, of course, this would only be one of many possible equilibria, and one consistent at the macro level with low growth and rising inequality. Not everyone can tap into their savings to finance their business, and some investments, even of the moderately risky variety, are not efficient at a small scale.
But the Finance Monitor data hint at a different compromise at play. One thing does distinguish non-borrowers from other businesses: financial capability. The average disengaged SME is much less likely to produce regular management accounts, and less likely have a business plan or a financially trained person looking after its finances (data here). Even after accounting for size (larger businesses tend to have more professional finance functions), the difference persists – particularly when it comes to management accounts.
These figures on turnover x capability have a lot more to say. They show, for instance, how a business with more than £500k in turnover needs a properly trained person in charge of their finances and a proper business plan. Those that fail to put these resources into place become ‘disengaged’ by default – suffering the lower ambition and growth that comes with disengagement.
Second, it’s worth looking at the higher turnover size bands (£5m+) where ‘disengaged’ businesses are very rare. It’s clear from the analysis so far that at turnover levels of £2m-£5m, being ‘disengaged’ starts to become unsustainable. Only the very best-run businesses can continue to finance themselves from retained earnings and trade credit after this point – a very small, elite group of ‘luxury non-borrowers’. Unsurprisingly, their financial capabilities are top-notch.
There may be other variables we are missing here – a lack of confidence perhaps, or a mistrust of accountants and other numerate professionals. The ‘disengaged’ businesses are more likely to be owned by older entrepreneurs, women and people without a university education, and it’s likely that these factors influence the way they are run.