What are the top business risks involved which every serious microfinance company must take into consideration before granting loans to small and medium enterprises?
Most entrepreneurs access loans from banks and other financial institutions which helps them to expand. Over the years, SMEs have resorted to accessing funds from microfinance companies since most of them are not served by the commercial banks due to certain requirements, mostly, documentation they don’t meet.
Though microfinance companies earn profits from these loans and even have their clients saving with them it’s important for them to consider the following risk before granting loans to any business:
1. Financial Risk
Before any financial institution grants a loan to any SME it must consider the financial risk involved in the client’s business or sector with regards to the loan to be granted. These financial risks include;
- The client’s relationship with other financial institutions is necessary in order to avoid multiple borrowing. It’s important for microfinance institutions to laisse with the credit bureau within the country it operates to have accurate data.
- Loan purpose: The purpose of a loan is very important since it’s prudent for a business to invest loans in current trade other than new projects.
- Repayment capacity: This enables the institution to ascertain whether its client’s business is in the position to pay the loan back. It’s important to note that repayment capacity must be calculated on the current business activity of the client before accessing the loan.
- Price hike in foreign goods and this normally affects importers whose capital reduces after goods are sold to the foreign exchange.
- Other businesses owned by the client aside the one to be funded to avoid diversion.
- The credit history that the client has with other financial institutions which can determine the client’s payment habit aka credit score. Usually, the banker’s opinion of the other institutions the client has worked with is requested.
- Microfinance companies must also enquire about their client’s mode of transferring money for a purchase, especially importers.
2. Commercial Risk
Commercial Risk is also important to consider before granting a loan as a microfinance firm. Commercial risks that ought to be considered by microfinance companies include:
- The seasonality of the product or source of supply. This reveals how regular clients get his/her goods and their impact on the cash flow.
- Replacers or assistant that handles client business in his/her absence. This is very important especially when the supposed client travels for stocks.
- The business owner’s technical knowledge of the business. Most entrepreneurs have businesses such as hairdressing and other skilled trades without having the technical idea and usually if their key staff resigns their businesses come to a halt which affects their finances. Without technical knowledge, it’s difficult for the owner to detect pilfering which would eventually affect their finances and cause a default.
- Stability of the business: This has to do with a tenancy agreement or prove of ownership of the business location. If a business is ejected from its location, business operations are affected, hence income. Therefore, it would be prudent for a microfinance company to check the stability of the business before granting a loan.
- Regulatory bodies’ approval for the various businesses must be requested by the microfinance institution before granting loans. For instance, hotels need approval from the Ministry of Tourism, schools need approval from the Ministry of Education, security companies need approval from the Ministry of Interior, etc.
These letters of approval from various ministries/departments must be presented to ensure businesses financed are working according to regulations of the sector they belong so as to avoid issues that can affect their operations and finances.
3. Collateral Risk
Most microfinance institutions require collateral to secure the facilities given and it could either be a mortgage, cash collateral, or other fixed assets such as vehicles.
Policies on collateral coverage vary from one institution to another. It’s important for a microfinance company to have policies on collateral coverage to ensure that all loans are secured in event of a default.
For institutions that accept guarantors, it’s appropriate to ensure that all guarantors meet the requirements of the financial institution involved.
4. Client Risk
This has to do with the individual accessing the facility or individual shareholders if it’s a limited liability company. These risks include;
- Age: It’s important that you only grant a loan to a client within the age requirement of the insurance company that secures the loan of the financial institution. That way, insurance claims can be paid in event of death. Secondly, an active client is able to perform his/her duties well which generates more income. Most institution grants loans to clients between the ages of 18-60years.
- Stability of the client: This has more to do with where the client stays and whether he resides mostly in the country where the facility is taken. Some institutions involve spouses or close relation of their client in the loan as psychological guarantors to minimize risk.
5. Global Risk
It’s important for microfinance institutions to identify global risk for the businesses they fund.
Global risk has to do with the risks involved when there’s a change in government policy, international trades and the risk involved in the industry or sector of the client.
The microfinance sector should know government policies on all the businesses they fund since it can affect these businesses they are loaning money to immensely.
For instance, the COVID-19 pandemic in the world has affected most businesses. In the United States alone, over 100,000 has been shut down due to COVID-19. Right now, before a loan is granted it would be prudent for the microfinance to access the impact of COVID-19 on that business with regards to demand, supply, etc.
Microfinance companies have helped small businesses in most African countries because these businesses had little or no access to commercial banks due to the requirements.
Microfinance institutions have also introduced the habit of savings among these entrepreneurs. With a savings app like PiggyVest entrepreneurs now save millions every month. However, for the microfinance companies to remain in business it’s appropriate for these risks to be identified in the businesses they fund and for measures to mitigate these small business risks to be met.