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Five Reasons Why Your Risk Model For Large Corporates May Perform Poorly For Your SME Exposures

Are you using your risk model for large corporates to assess your exposures with small and medium-sized enterprises (SMEs)[1]? Here are five reasons why that could be problematic:

  1. Poorer quality financial reporting with SMEs
  2. Need for different liquidity measures
  3. Larger key man risks
  4. More vulnerability with customer and supplier relationships
  5. Less consistent levels of profitability year-to-year

Bob introduces these five reasons in this two minute video.

5 Less consistent levels of profitability year-to-year

  1. Poorer quality financial reporting with SMEs

Large corporates typically use major accounting firms to audit and regularly monitor their financial statements. With SMEs, the credibility, transparency, and timeliness of this information needs to be taken into account. Late data, frequent revisions, unreliable forecasts, and/or audit reports with adverse opinions or disclaimers should raise a red flag for lenders.

  1. Need for different liquidity measures

Liquidity is a highly important factor within an issuer's risk profile, since problems on this front could lead to the default of an otherwise healthy entity. While large corporates can tap into long-term capital markets for funding, this is more difficult for SMEs, making current liabilities one of their main sources of external finance. As a result, lenders should consider different factors when assessing the liquidity of SMEs, such as the cash conversion cycle.[2] In general, SMEs with solid working capital management skills exhibit shorter cash conversion cycles than their lower-skilled peers, providing monies needed to invest in different areas of the business.

  1. Larger key man risks

Large corporates generally have very well-defined structures with boards of directors, checks and balances, and formal succession plans, which help minimize any disruption when key personnel leave the business. With fewer layers of management at SMEs, the departure of founders or partners, who often wear multiple hats, can leave critical gaps and may alter the strategic goals and direction of the firm. It’s important for lenders to look at the stability of the management team at these smaller firms, and their succession and continuity plans, to evaluate the long-term sustainability of the business.

  1. More vulnerability with customer and supplier relationships

Large corporates typically serve multiple customer segments and have extensive and professionally managed supply chains. SMEs are more likely to have fewer customers and suppliers, putting them at risk if there is a deterioration in any one relationship. Lenders should assess the concentration of business volumes by product, customer, and geography, as well as concentration in the production or supplier base, to determine whether revenues and profits are stable and predictable.

  1. Less consistent profitability year-to-year

By diversifying their revenue streams, large corporates can minimize the variability in their profits, so it’s sufficient to look at the absolute level of profitability when assessing risk. For SMEs with less revenue diversification, there needs to be a much greater emphasis placed on the volatility of profits over time. Lenders should look at the historical change in EBITDA, as well as the respective industry average.

Late data, frequent revisions, unreliable forecasts, and/or audit reports with adverse opinions or disclaimers should raise a red flag for lenders.

Getting risk assessments right with different Scorecards for SMEs and large corporates

In our August 2017 webinar, 7 Key Drivers of Credit Risk and Top Trends in U.S. Commercial Loan Portfolios, we described the proprietary Credit Assessment Scorecards we use to evaluate the creditworthiness of different types of firms. The analytic framework draws on established risk dimensions employed by S&P Global Ratings, including:

  • Country/industry risk
  • Competitiveness
  • Cash flow/leverage
  • Management/governance
  • Liquidity

While the categories are the same for SMEs and large corporates, the factors that are considered within each category vary given the five reasons outlined above. It’s essential that these differences be taken into account to ensure that sound decisions are being made.

For more information on how you can leverage this scoring methodology and associated workflow tools, please request a demo.

[1] For the purposes of this article, SMEs are defined as businesses with fewer than 500 employees and an annual turnover that doesn’t exceed $250 million.

[2] For the purposes of this article, the cash conversion cycle is defined as days' investment in inventory and receivables less days' investment in accounts payable.

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