SME Financing in Africa: Collateral Lending vs Cash Flow Lending

Abstract

It is argued that economic growth in Africa will be enhanced by the expansion of small and medium-sized enterprises (SMEs) but these businesses face financing constraints which tend to hinder their business success. Starting from a discussion of the various sources of financing for SMEs in Africa, it is established that the most effective and cheapest source of capital for the SMEs is debt financing from banking and other microfinance institutions because of lender monitoring and the tax-deductibility of the interest expense. However, collateral requirement which tends to be a major significant factor for mitigating the credit risk of the SMEs presents a problem to lending institutions because of market illiquidity, legal, administrative, and valuation difficulties. SMEs tend to be owned by low income entrepreneurs and families who normally do not have tangible, valuable and liquid collaterals, and even when collaterals are offered, it is a challenge to determine their market value. Often these problems result in the rejection of SME loan applications. As a solution to this problem, the paper introduces a concept of cash flow lending as a better alternative to the traditional asset-backed lending. While asset-backed or collateral lending emphasizes loan default and recovery from collaterals, cash flow lending is based on projected corporate positive cash flows, the required return of equity, equity valuation of the business, and finally, on the risk-sharing principle between the lender and borrower. For the loan application to be approved, the requested loan and all existing debts of the SME should be less than the equity value of the company as estimated from the free cash flow model.

Investigating the relationship between government support and SMEs’ sustainability through financial and green lenses

“…Free-interest loans provided by the government may boost the starting operations of the organization. Most SMEs start businesses with private or personal savings or ask friends, family and relatives to make capital available in return for a profit or share in the business (Amoako-Adu and Eshun, 2018). If SMEs need more finance for expansion, innovation and survival, GS policies help them stand in the market (Ahlstrom et al , 2018).…”

The impacts on informal financing strategy of small and micro enterprises by interest rate risks and public health emergencies

“…(Mukete et al, 2021 ; De Haas and Millone ( 2020 ) discovered that collateral and guarantee requirements may decrease during the course of the lending transaction. According to Amoako-Adu and Eshun ( 2018 ), collateral has been utilised to lessen the credit and information risks of SMEs. Naegels et al ( 2018 ) shown that collateral and guarantee should be the primary considerations for SME informal borrowing.…”

“…Fintech plays a crucial role in IFS, as stated by Correia et al ( 2022 ). Cash flow financing using big data analytics methodology may alleviate SME financial access difficulties, as it is based on SME cash flows, equity returns and value, and risk-sharing, according to Amoako-Adu and Eshun ( 2018 ). SME finance was analyzed by van Klyton and Rutabayiro-Ngoga ( 2018 ) using the k-score, which evaluates SME business networks on social media (Facebook, Twitter, and LinkedIn), emails, and mobile phones.…”

Constraints to formal small business performance in the service sector in Cameroon

“…In the absence of relevant information on SMEs, lenders can resort to collateral to mitigate risk. However, most African SMEs do not have adequate collateral (Amoako-Adu and Eshun, 2018). In the absence of adequate collateral, lenders tend to charge very high-interest rates.…”