Working Capital Financing and the Canada Small Business Financing (CSBF) Program

Phase I: Interviews with Key Informants

As a first step to providing empirical information to the current Canadian setting for working capital, a series of interviews was undertaken. Interviews included senior executives of banks, representatives of small business organizations, and other knowledgeable individuals. Qualitative data analysis was supplemented by examination of industry reports and research digests.

Representatives of financial institutions were queried as to their views of the current Canadian environments, about the specific lending policies of their respective institutions, and about their views of how the market for SME working capital needs might be further improved. Representatives of SME groups were asked about borrowing experiences of SMEs, firms' needs for working capital, and their ideas about how the marketplace for working capital might be further improved.

Analysis of Interview Data

Generally speaking, most commercial lenders have segmented the SME lending market into small borrowers and large borrowers. Small loans tended to be defined as lending facilities of less than $200 000 ($500 000 in some cases). Small loans tend to be treated as of they were personal loans to the business owners. They are, in almost every case, adjudicated through credit scoring models.

The last fifteen years have witnessed several fundamental changes in how banks relate to SMEs. In their 1991 review of the Canadian SME banking market, Wynant and Hatch (pp. 139-140) reported that loan account managers typically managed loan portfolios of 80 to 120 borrower clients. At that time, Wynant and Hatch (pp. 139-140) identified the following as the key criteria for screening loan requests:

• Character of the key principals of the firm
• Competitive position of the industry
• Borrower's ability to compete and viability
• Company's net worth position
• Borrower's cash flow prospects
• Availability of business and personal assets as security
• Sector (certain sectors were identified as high risk, including restaurants, small retailers, trucking firms, etc.)
• Start-up businesses
• Loans for assets with little collateral value

It is noteworthy that the purpose of the loan (that is, whether or not the proceeds of the financing would be used for working capital) was not specified. Perhaps the most striking change in SME lending Wynant and Hatch's work then has been the transition towards credit scoring as the preferred means of adjudicating credit applications. Credit scoring models were being used, or initiated, by almost every large commercial lender. However, none of the bank representatives interviewed for this work identified loan purpose as being among their lending criteria or as being incorporated into credit scoring models. The single most frequently mentioned risk issue identified by the lenders was whether a loan applicant was a start-up firm.

Where firms were not start-ups, the most-frequently mentioned reasons for loan turndowns were poor credit history of the owner(s), low personal net worth, insufficient equity in the business, and poor cash flow. In the case where the applicant was a start-up, the need for full security behind the loan was a core requirement. For several institutions, lack of security for a business start-up precluded any consideration for a loan, regardless of the use of the loan proceeds.

Lenders reported that small loans were usually structured as revolving operating lines of credit, overdraft facilities, or (increasingly) loans based on business credit cards. Small loans did not tend to be highly structured or closely followed. Several lenders commented that the administration costs associated with monthly tracking of inventory and receivables were too onerous for aligning the limit of the credit facility to levels of working capital. For small loans, borrowers typically faced a ceiling on the credit facility available and the requirement that the loan be revolving. Ceilings might be set at two to three times monthly sales (assuming reasonable inventory turnover). Interest rates on loans tended to be between prime and prime plus 300 basis points.

The CFIB (1993, p. 11) notes that “the majority of small businesses that have loans/credit lines are for amounts under $200 000.” This is confirmed by the Survey on Financing of Small and Medium Enterprises.⁸ It is the large loans (those in excess of $200 000), however, that tend to be managed by loan account managers. In such cases, the prototypical process is that a business approaches the lender for a loan which is then structured by the account manager, generally into a lending facility that comprises both an installment loan and an operating line of credit. Lending criteria tend to mirror those in effect for smaller loans with age of firm (start-up or not) and sector as being heavily weighted along with the owner(s)' track records (credit bureau report, relationship with lender). According to the lenders' representatives interviewed here the decision to grant a loan does not usually depend on the purpose of the loan; that is, on whether the loan is being used to finance working capital.

Larger loans for working capital financing tend to be linked to the level of working capital and structured in consultation with a loan account manager. One formula that was identified by several lender representatives was that upper limits on operating lines of credit were set at 75 percent of receivables (of less than 90 days aging) plus 50 percent of inventory. It bears emphasizing that for smaller firms, such lending formulae were not the norm because of the cost of monitoring.

For both small and large loans the lending decision does not appear to reflect whether or not the credit sought is to finance working capital: risk, according to the lenders, is determined primarily by the quality of the borrower and the quality of the collateral.

When asked if they believed that there was a “credit gap” related to working capital, several replies indicated that the issue was not supply of capital; rather, the issue was one of risk. Some examples of lenders' responses include the following.

There are always businesses looking for more than we are willing to lend; but we would not lend more given the risk of borrowers at the margin.

The supply exists but is not accessible to SMEs with weak balance sheets; security is not sufficient, [there can be] little depth to address 'bumps in the road'.

Banks are low risk lenders - some firms (especially start-ups) are off their risk scale.

When asked specifically if loans for working capital were relatively risky, several of the interviewees opined that “working capital loans are much riskier” and “working capital is the most risky loan you can do.” A more moderate response from one lender was that working capital loans were …

Not necessarily more or less risky [but that the] relative risk of working capital loans goes to why liquidity needs to be financed … [whether the problem is] poor management [or the need to finance] growth.

As a response to the risk, lenders usually require such loans to be fully secured, especially those to start-ups. In terms of risk, the primary issue identified by the lenders was related to the risk of financing start-up firms and not the risk of financing working capital needs. According to one lender,

“Start-ups are the issue [and] the owner needs to bring working capital financing to the table.”

Several other responses identified the problem as being related to start-up firms:

For new entrepreneurs, financing working capital is a key challenge.

Is there an adequate supply? No – the turndown ratio for start-ups [is high].

By and large, SMEs have very good access to capital [but there are] … issues for early-stage firms with respect to working capital.

This result is reinforced by the CFIB (2003, p. 13, who noted that “younger SMEs face higher rejection rates”) and is confirmed by the 2004 FDI Survey of Financing SMEs (Table 7). Several lenders noted that they expected that business owners would finance part of working capital using their equity stake in the firm.

The query to lenders about a “gap” really put forward the same question posed at the outset of the section of this report that reports on the literature, namely, “what is a gap?” Lenders are often in the position of turning down loan requests; however, this does not mean that a gap exists. Turndowns represent a pricing decision only to the effect that the lender, if pricing the loan to risk, would assess such a high interest rate that no loan agreement would result. In the words on one lender representative:

“We control by how much we are willing to lend rather than by a pricing premium.”

It was interesting that respondents did not generally know how to respond to the direct query of whether or not they believed that there was an adequate supply of working capital for Canadian SMEs. The respondents were evenly split on the question. Those who believed the supply of working capital was inadequate offered responses such as:

The availability of working capital is tied to cash flows of SMEs, with changes in the dollar profit margins are squeezed, cash flows are down; so it is more difficult to get working capital.

Others expressed concerns that firms in rural areas faced a shortage, in part because of the centralization of lending authority. For example, several of the responses included:

May not be a question of availability as accessibility - rural areas more of an issue.

[The problem is] centralization, rotation of account managers, of lending authority in cities.

Lack of local lending authority in rural areas.

Both lenders and SME representatives were asked if applications for working capital were increasing relative to applications for other types of loan and whether or not such applications were being turned down with greater frequency. However, none of the respondents maintained records of application rates or turndown frequencies. Lenders using credit scoring methods could query their systems to report application and turndown rates for loan applications that had entered the system but, universally, could not estimate the frequency of “informal” applications and turndowns (for example, where a business owner would be discouraged from seeking a loan based on a discussion with a loan account manager).

During the interviews, several groups referred the research team to publications. For example, the CFIB declined to be interviewed but referred the research team to its 2003 report. These reports have been summarized in a preceding section of this report as part of the review of the literature.

To explore further the needs for working capital, the report turns to the findings from analyses of survey data that comprises Phase 2 of this work. However, the review of literature and the interview data provide important direction for the empirical analysis of survey data. The interviews and literature indicate several factors, aside from the use of loan proceeds, that are widely used in commercial lending decisions: these include the age of the firm (whether or not it is a start-up), the industry sector, the track record of the business and that of the firm's owners, the availability of collateral, the firm's location (urban or rural), whether the firm is an innovative firm, etc. Therefore, the analytical challenge of the Phase II analyses is to determine the extent to which, after allowing for these determinants of credit decisions, use of proceeds for working capital remains a factor in credit decisions.

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⁸ According to the Survey on Financing of Small and Medium Enterprises (2004, Table 12), the average loan authorization is approximately $145 000 and 85 percent of loan applications are for less than $200 000.