Collateral Assessment: How Lenders Evaluate and Determine Loan Eligibility for SMEs

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Funding Souq Editorial Team
Tech Writer
Apr 06, 2024
Funding Souq’s editorial team comprises experienced finance and investment professionals that are on a mission to fuel SME growth, create jobs, and drive the economy forward. They aim to share their extensive experience and industry know-how to empower entrepreneurs and investors alike.
Apr 06, 2024
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When banks evaluate whether to extend a small business loan, it’s often more art than science. Unlike large companies, which can present banks with years of audited financial statements, SMEs have less to work with. Banks consider SMEs less transparent and more difficult to assess for credit. That’s partly why SMEs in the Arab world face a $123 billion funding gap. 

 

When SMEs do get loans, they tend to get less competitive rates. Unlike big businesses, which can shop around for better rates and thus have bargaining power, SMEs usually must take what they can get.

 

Herein lies the catch-22: SMEs need access to cheap credit to grow into large companies. But more often than not, they can’t get it, because they’re not already large companies. Fortunately credit guarantees and lending facilities for smaller businesses are a rising trend.


Read more about:  UAE Lending Incentives Guide For SMEs

The five Cs of Credit

 

So how do banks decide to give loans? They need as much information as possible. This process is often broken down as “the five Cs of credit”. It looks like this:

1-   Character : How good were you at paying off debts in the past? Banks look at your past credit history, tax returns, and how previous ventures panned out. 

2- Capacity : Are you in a good position now to pay off the loan? Key here is your debt-to-income ratio (DTI), or total monthly debt payments divided by gross monthly income. A low DTI will help convince the bank. The stronger the cash flow the better.

3-   Capital : This is how much money is already invested by the business owner. Banks prefer business owners with skin in the game. They’re less likely to default.

4- Conditions: What is the current state of your business, its industry, and the economy?

5- Collateral : These are assets that you can use to guarantee the loan. If you fail to repay, the bank has something to fall back on. 

 

How Strong Collateral Can Increase Your Loan & Reduce its Interest Rate?

 

Since banks have less information when lending to SMEs, strong assets for collateral can be a determining factor. Banks can even use collateral as an informal screening mechanism, sorting quality borrowers from risky ones by the value of their collateral. Strong collateral can increase the amount you can borrow and reduce its interest rate. It’s key in unlocking access to financing for borrowers with below-average credit.

 

All sorts of assets can serve as collateral. Common examples are commercial buildings, land, machinery, company cars, and inventory stock. Investments like stocks and bonds can also be put up, along with cash. Long-term loans are seen as riskier, so the longer the loan maturity, the more collateral is likely to be required.

 

What Makes Good Collateral?

 

Banks prefer assets that are tangible (i.e. physical) Tangible assets range from the building of the headquarters to the machinery that makes up an assembly line. Even unsold goods sitting in the warehouse can be put up.

 

Whatever the case, banks prefer collateral assets with stable prices and which are highly liquid – if there’s a strong secondary market for them, that’s a good sign. They should be easy to transfer ownership on. The bottom line: the bank wants assets it can easily take control of and sell in the event of a default.

 

Intangible assets can also work, but are less desirable. These include things like patents, copyrights, contracts and even simply goodwill (the company’s reputation in the market and its brand).

 

How Does Loan-to-Value (LTV) Ratio Impact Your Borrowing Potential?

 

Banks use what’s called a loan-to-value (LTV) ratio to calculate how much they’re willing to lend based on your collateral. This is the percentage of the collateral’s value they are comfortable giving you a loan against. For example, if you put up a $1,000,000 property as collateral, a bank may go with a 75 percent LTV ratio. That means you can borrow up to $750,000 against the property. More tangible assets typically get a higher LTV.

 

2024 Collateral Trends

 

Lending practices are highly subjective and can differ from bank to bank. There are some trends though. Studies have found that businesses that develop long-term relationships with banks get better rates and are asked to put up less collateral. That’s not surprising, since much of lending is based on reputation and trustworthiness.

 

Other trends are more surprising. For example, family-owned firms are typically required to put up more collateral. That’s likely down to the so-called free rider problem (family members getting paid to do little work).

 

More worrying is that female-owned businesses are required to put up larger amounts of collateral than similar male-owned firms. Some studies put this down to gender bias among loan officers, who may perceive women as riskier borrowers with less business experience.

 

What Are The Alternatives For SMEs Loans Without Collateral?


If you don’t have collateral to offer up, there are other options. Some online lending platforms don’t require them. Loans without collateral, or unsecured loans, still often require a personal guarantee, meaning pledging personal assets in the event of a default, or a lien tied to specific assets. Unsecured loans typically carry higher interest rates.


References

Collateral Requirements for SMEs Loan

The Value of Relationship Banking

Gender and bank lending after the global financial crisis?

Gender Bias in SME Lending

 

Disclamer:
"Funding Souq Limited (DIFC) is regulated by DFSA. The post is for educational purposes only and the Firm does not directly or indirectly provide these services"

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