Not All Debt is Bad Debt

Published: 28 September 2021

Many SMEs are struggling to cope with debt that has accrued because of the hard lockdown in 2020 and the various economic restrictions to try to curb the Covid-19 pandemic. This has had a direct impact on some businesses’ ability to apply for funding, highlighting the importance of acting in time to protect credit records, says Retail Capital Head of Sales Chad Tessendorf. He adds that a number of those who do qualify for funding are holding back for fear of third-wave uncertainty, making the type of funding they consider even more important.

“There’s definitely been an increase in SMEs across sectors who are struggling to meet lending qualification criteria as a direct result of adverse credit bureau scores and bank account conduct. This is driven predominantly by rental arrears and overdue accounts with suppliers,” says Tessendorf. 

He says that in many instances business owners have left it too late and have waited for judgments before applying for finance. He says the more prudent step for business owners is to intervene quicker. “It is of paramount importance that business owners understand that their financial conduct has a long-term implication on their ability to raise funding. For example, judgments take time – there would have been a long process preceding this. 

“An SME may settle payments after a judgment has been made, and then follow that by applying for business funding. While there may be a marginal improvement in the credit score – the cumulative effect of missing payments and debit orders, along with the judgment, will rule out creditworthiness. When this happens it is too late, whereas funding may well have helped the business navigate out of trouble had the business owner acted sooner,” he says.

Tessendorf says the key for SMEs is to focus on getting their affairs in order and tightly controlling the costs in a business. “What we see is that SME owners who had a tight hold on the business’s expenses have been able to navigate the storm – they had a longer runway. On the other hand, those that were looser have either been casualties of the pandemic, or in many instances, have found themselves in the position of not qualifying for funding.”

He explains that those who have prioritised cost cutting and have come through 2020 and the first quarter of 2021 are in a stronger position, with many of them proving to be resilient businesses. “Now, if we look at these businesses, they may also have a backlog of rental arrears or supplier payments because of being unable to trade during the lockdowns. The difference is that if they need funding to take advantage of an opportunity, they can get that lender support, benefit from the opportunity and methodically pay off the arrears and get back onto a solid footing,” says Tessendorf. 

Tessendorf says that in the past three months, 49% of advances were used for stock. “This talks to cash flow pressure and would include settling supplier arrears, which reopens credit lines with preferred suppliers. The knock-on effect of this would be they secure stock at lower prices and lift their profit margins. When on stop-supply, they would be forced to buy elsewhere – and often at higher prices – which would further affect cash flow.”

He adds that over the same period, 20% of all advances were for general cash flow, including settling creditor and rental arrears. In both instances, he says, they would have needed to have their house in order to access business funding. He says that there are many credible funders, from banks to alternative lenders such as Retail Capital, that have a wealth of experience and knowledge, and that business owners would do well to ask for help. 

“If the business’s house is in order, and they need a step-up to recover, they can get advice from credible lenders on the best way to structure a funding arrangement. Our inhouse team of experts will sit down with an SME and plot out how best to structure the funding to suit the business’s requirements,” he says.

He says that in the past month, many clients who did qualify for funding have chosen to take a cautious approach. “We have found that many of those who are pre-approved approved are not taking the funds out of a fear that restrictions and uncertainty would affect their affordability to pay for the funding. This is where we have a responsibility in the industry to educate small business owners about products such as our MCA service, where the business pays in line with turnover performance. In other words, if the turnover drops by 50%, so does the repayment. This is quite different from traditional funding models.

Retail Capital’s Head of Treasury Alex Appleby agrees that it is important for business owners to communicate sooner than later – and not only with funders, but also with their creditors. “That’s probably one of the most critical things,” he says. “We find that many SMEs put their heads in the sand, so to speak, hoping problems will disappear. 

“But they’d find that if they engaged with people, two things happen. One, it makes it that much easier as a credit provider to put funding into a business that has demonstrated a commitment and put payment plans in place, and two, a funder would be able to work with an SME to find the best product and terms for them and their business,” he says.

Not all debt is bad debt

SMEs that are finding it tough to operate may find it difficult to appreciate that there are times when debt can be good for the business. Both Tessendorf and Appleby agree that debt for debt’s sake, or digging one hole to close another, is unsustainable. However, where there is an SME that has done well to keep its costs down and it has promising prospects, debt becomes a powerful tool to take advantage of an opportunity to increase revenue and ultimately grow.

“To illustrate this point, an SME could leverage its final position over a stipulated time period to make an investment – perhaps buy an important piece of equipment – that will result in higher revenue and growth over time,” says Appleby. “This is good debt.”

He says a working capital product would work in a similar fashion. “When used responsibly, debt can help an owner grow their business. For example, a business owner may wish to take advantage of a bulk stock purchasing opportunity. In this case – immediate access to funding will allow the business to secure and unlock supplier discounts, which in turn results in higher margin as the stock is turned. As the cycle repeats, it adds to the bottom line and the growth of the business. It becomes clear how a good relationship with a funder makes business sense,” says Appleby.

He adds that business owners should keep close tabs on the ratio of debt in their businesses. “Businesses that are highly geared may find it difficult to attract funding, especially if current funding levels are putting cash flow pressure on the business. There’s no one-size-fits-all approach here and it varies from business to business, but I’d advise all business owners to understand this aspect of their business, and where they don’t, seek advice and support,” says Appleby.