With Buy Now, Pay Later (BNPL) regulation on the horizon in the UK, the concept of borrower affordability is in full focus. The popular discussion around affordability typically focuses on consumers and with good reason. However, focusing exclusively on consumer affordability factors overlooks the vast SME market: in 2022, £24 billion of new loans were disbursed to SMEs.
We’ll take a look at what affordability means for SMEs, and how borrowers and lenders alike approach this ever-important topic.
At its simplest, affordability refers to a borrower’s ability to repay a loan. Lenders use a borrower’s financial health and credit history to determine the amount that a borrower can feasibly and sustainably repay.
There are three core components of affordability:
While the question of affordability might seem like a simple financial calculation, determining the optimal level of borrowing for a particular person or entity requires a lender to interpret a vastly complex set of risk factors with nuanced weightings. The future inflows and outflows of any entity are uncertain, and each lender places a differential emphasis on these different credit indicators.
Since lenders profit from lending and have an incentive to disburse more loans, a core regulatory concern around affordability is that borrowers not take on more debt than they can reasonably repay.
To help protect consumers from harmful lending, UK regulation uses “treating customers fairly” policies as a value-based rubric to ensure that lenders are not putting consumers in danger. In many cases, this involves a multi-faceted approach of educating consumers about lending products while strengthening credit reporting standards.
As of the time this article was written, the first BNPL regulation in the UK is being drafted. BNPL products were previously unregulated, but by 2024 the UK government intends to pass legislation protecting consumers.
For information about the UK’s BNPL regulation and it’s impact on B2B lenders, read more here.
While consumers will soon be protected by new BNPL regulations, businesses will not be. This light regulatory environment assumes that business directors are generally savvier about the risks and benefits of borrowing.
Yet in the era of blitzscaling and hypergrowth, many borrowers come to the credit world without the same expertise as their lenders and peers. That’s why we’ve created a guide to B2B affordability.
One of the first stops in understanding a business’s affordability is to understand its cash flows. In principle, the goal is simple: understand whether the borrower will have enough cash on hand to repay the obligation.
There are two types of cash that a lender will consider: inflows and reserves. Because applicants are applying for a loan, they often have fewer cash reserves, making projected inflows a more salient factor.
Subscription businesses with recurring cash flows, such as SaaS companies, have a simpler task projecting their future cash flows and gaining lender’s confidence. By contrast, service-based companies that rely on larger, lumpier inflows may have more trouble proving their forecasts. In these instances, revenue pipeline data is especially important.
The high prevalence of loss-making companies, especially amongst high-growth tech startups, complicates the way that lenders understand cash flows in certain instances. Because these companies don’t generate a profit, their lenders rely more on revenue projections to ensure that their loans can be serviced.
After gaining confidence in a company’s business model, the lender needs to understand who is in the queue for repayment ahead of them. For example, a software company may be financially healthy enough to borrow £1mn. However, if it has already borrowed £800k from other banks, then its application for a £500k loan is likely to be denied.
A business’s capital structure also tells a story about its history and financial health. If two rival businesses both managed to reach £5mn in annual turnover in the same amount of time but one required a £10mn loan to do so, then the lender will rightfully dig into why the company was so capital intensive.
There’s no one-size-fits-all approach to understanding a healthy level of debt for a particular company. In general, more mature companies can sustain greater levels of debt in order to strike the right balance between growth today and repayment in the future.
Experienced B2B lenders understand that acquiring new borrowers can be very costly. The sales process often requires several months of deep relationship-building and due diligence – two things that, while enhanced by technology, cannot be fully automated.
With high acquisition costs, lenders aim to retain their customers for as long as possible. So while a loan may have a 6-month maturity, lenders will typically evaluate the next 12 months of financials when forming a decision. Not only do they want to gain confidence in the business’s ability to repay the loan, but it's an added bonus that they may be able to do repeat business with the customer.
SMEs are not subject to the same affordability regulations as consumers, but that doesn’t mean that affordability is unimportant or potentially harmful. This looser regulatory environment has created a flourishing ecosystem of lending options, so directors should be judicious about their timing and use of lending.
Borrowers should not assume that borrowing is safe because a lender is willing to offer it. As a borrower, you should build your own perspective on how much debt your company is willing and able to shoulder.
There are two reasons that a lender’s perspective may be misaligned with the borrower. The first is related to data. The lender may not have all of the information about a company’s pre-existing debt levels or cash outflows when making a decision. For example, a BNPL lender may believe a company has the cashflow to pay for 5 laptops, though they may not know that the company is already struggling to service a £100k business loan.
The second s related to incentives. As mentioned earlier, lenders have an economic incentive to disburse more loans because they profit from it. In these calculations, they will price the debt factoring in a certain default rate – meaning they are still profiting despite some borrowers not repaying. A default impacts the lender and borrower very differently. Defaults are ‘priced in’ for the lender, so a default (potentially by your company) may still result in a net profit. From the borrower’s perspective, however, a default may trigger bankruptcy. In this sense, borrowers may face much more risk from a dangerous debt burden.
A common debt pitfall is borrowing too early in a company’s lifecycle. Not only are smaller companies at higher risk of default, but directors cede significant control to their lenders in the agreement. If a company misses enough payments, then the lender may trigger a default and force a company into liquidation against the directors’ will. Unlike equity financing, where investors bear risk as shareholders in the company, lenders do not have the same ‘skin in the game’.
In general, top-performing businesses avoid using debt financing for incidental expenses or high-velocity items, such as dinner or travel expenses. These types of costs are often less impactful on sales, happen at pace, and are delegated to more junior levels in the organisation, which puts this category at higher risk of mounting unexpectedly.
Conversely, debt is best used for higher-value items with better recovery rates, such as computers, equipment, and machinery. In the event of financial distress, tangible assets can be sold off to make partial repayments or negotiate a debt restructuring.
The diversity and availability of alternative lending types, like BNPL, provides borrowers with a wealth of options to grow their businesses. The most important thing, though, is to approach lending with a mindset of safe, sustainable growth.
Empowering smarter, faster lending
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