The analysis of qualitative indicators in lending to micro, small and medium-sized enterprises is of great importance. It is an essential part of the analysis and as important as collection and analysis of financial results. Moreover, a comprehensive and meaningful analysis of financial indicators is only possible if the current situation of a business and its qualitative characteristics are fully understood.

There have been quite a number of cases where businesses with - in principle - good financial performance did not meet their credit obligations due to irrational decisions taken by owners, disagreements among owners or other internal problems. By analysing only numbers without understanding their origin, their exact meaning, without understanding the business model, its main development milestones, the competence of management, relations between owners, their strategies and business development plans, it is extremely difficult to get a full picture of the potential borrower’s credit capacity and possible risks ...

In view of often extremely limited reliable and confirmed financial information, a qualitative analysis of data is of particular importance for the analysis of micro, small and medium-sized enterprises (MSMEs).

In this article, we discuss the main qualitative factors to be considered when taking lending decisions on MSME clients, we provide examples of risks relating to qualitative criteria, and give recommendations for conducting qualitative analyses.

The main areas of qualitative analysis^[1]

 

The process of qualitative analysis includes a detailed analysis of owners and the management team, the business environment, and internal organization.

The primary goal of the analysis is to understand the client's business, identify potential risks and assess their impact on the client's ability to repay the requested loan amount. However, you should take a broader approach to the analysis of each client and consider the potential for long-term mutually beneficial and profitable co-operation: business development support with the help of existing products,  cross-selling of other products and the perspective for successfully catering to most, if not all, financial needs of the client,  rather than focusing on a single transaction.

For such an analysis, you typically use information from the loan application, from the documents submitted by the client, information obtained during client meetings and interviews with owners and other individuals involved in the business, information obtained from observations made during client visits and from other available sources, including the Internet.

We take a complex approach to data collection and assessment. The information collected from the different sources can be grouped into blocks. Among other options, collected data can be grouped as follows:

• business background, owners and management, quality of management;
• business organization; risks arising from the business model; business environment and competitors and related potential risks;
• feasibility analysis of the client's loan request, the client's plans and the business development strategy;
• assessment of the likelihood of the business belonging to a group of related entities and the group’s impact on the borrower's business (and vice versa).

In the following, we go through key aspects of analysing each of the above areas, including examples for potential risks.

Business background, owners and management quality

 

To understand the current business situation and potential threats to successful development, it is useful and recommended to analyse the history of business development: who exactly founded the business and who is managing it? You should clarify the development strategy chosen by owners, the client's plans and the qualification/competence of business managers. It is also necessary to determine the real owner, as in some cases nominal owners may apply for a loan.

Generally, the following aspects should be analysed:

• how the business was founded; start-up capital and its sources;
• business development milestones; the current ownership structure, the level of competence of the management;
• the strategy of owners, development plans, analysis of the business environment;
• ownership with a view of identifying actual owners;
• key persons in the business and their competence in the respective area.

It is important to consider any changes in ownership or main activities over time, especially over the last year, and the main reasons for these changes. In addition, we recommend to check if there are plans for strategic changes (in the composition of owners/key persons, in business activities or geographical coverage, etc.), and to understand the reasons for planning these changes.

Meeting key decision-makers can give you valuable information, since the level of their expertise and competence can significantly affect the development of the business and, accordingly, the ability to repay the requested loan on time.

It is important to consider the sources of start-up capital as well as whether there is access to additional funding for business development if needed – to be provided either by owners or through alternative sources. For legal entities, it is worth paying attention to paid-up authorized capital rather than only the authorized capital indicated in founding documents as this may not yet have been fully paid in.

It is important to pay attention to the owners’ experience, character, the purpose of creating the business, the main business development plans, both short-term and long-term.

Most of the information for analyzing these factors can be retrieved during interviews with the management team and business owners. In the process of the analysis, we recommend to compare verbal information with statutory documents presented by the client and historical results as documented in the financial statements for previous periods.

For reference, the table below outlines possible risks in this area.

Examples of risks associated with business owners and governance

Disputes among owners, business separation, disagreements on strategic issues.

No successor in case of a sole owner.

Borrowed start-up capital; the owner must repay a large amount in bulk or repays in monthly instalments.

The owners fail to understand important business aspects, do not have sufficient experience, highly depend on key management staff (accountant, director).

Misunderstanding of business results, leading to unsound business decisions.

Inability to react effectively to changes in the market environment.

Family problems of the key owner that require sizeable investments or lead to his/her frequent absence; no authorized officer/partner who would be capable of backing up/acting in place of the owner.

Highly optimistic projections, risky decisions on business development/major investments in other areas of activities which are new for the owner.

The client’s character: irresponsible, unwilling to repay his/her debts, lacking punctuality, concentration.

The client may attempt fraud

Internal risks associated with business management and ownership structure are quite common, so it is important to pay due attention to the analysis of the factors described above. Their critical assessment helps you to identify weaknesses in the management system and thus identify potential risks for your financial institution. You should bear in mind that one client may be exposed to several of the above risks.

Business organization: risks associated with the business model

 

In addition, we recommend to analyse the organizational details of the operations of a potential client, the client’s relations with major customers and suppliers, the level of staff qualification and other aspects of the business model. The main factors to be considered at this stage are:

• Dependence on certain suppliers (supplier concentration), main terms of cooperation;
• Dependence on certain customers (customer concentration) and who is responsible for client acquisition;
• How well-established sales channels are;
• Staff turnover, labour shortages;
• Risk of business interruptions; risk that business operations may be temporarily suspended or stopped completely
• Internal control over the business.

Risks arising from the respective business model are inherent business risks, regardless of business size and experience. Therefore, when analysing a loan application, we recommend to try to fully understand how the client's business is organized. Understanding the business model is the basis for identifying and assessing potentially existing risks.

The table below presents a short list of potential risks associated with the business model:

Examples of risks associated with the business model

Customer dependence: the business has only a few but major customers. The termination of cooperation with one or several of these major customers can have a significant impact on the business and its financial results.

If a business is dependent on one or two major suppliers, and depending on the possibilities of and time required to arrange alternatives, the loss of one or both of these may have a potentially devastating impact on the business.

Dependence on the import of raw materials/goods or on the export of own products.

Limited bargaining power when dealing with large customers and suppliers.

Cooperation with government agencies (under government contracts): possibly long payment terms or even delays, weak negotiation position, unpredictable demand due to nontransparent placement of orders.

Payment delays by debtors, delays in recovery of accounts receivable due to lack of adequate control, provision of deferred payment conditions without verification of solvency.

A niche product: difficulty attracting new customers.

Lack of rational procurement planning: excessively large purchases, losses due to obsolete inventory.

Lack of quality inventory accounting (the client does not know how much exactly was invested into which inventories).

Weak internal control: possibility of theft, lack of effective planning or control over results.

In the case of a retail network: unsuitable location of retail outlets (poor visibility, low customer traffic, few potential customers).

Opening new retail outlets in high-rent premises. High rent can lead to unprofitable retail outlets, but the client does not take this into account.

For customers operating in sectors such as manufacturing and transportation, the following risk factors may be of particular relevance: improper equipment maintenance leading to breakdowns; dependence on narrowly specialized staff; licensing problems; fixed asset registration to third parties; high workplace injury risks, fire hazardous production process.

It is necessary to carefully analyse business organization, the owners’ awareness of potential risks and the measures they can realistically take to reduce them.

Feasibility analysis of the client's loan request, the client's business development plans and strategy

 

 One of the most important parts of any qualitative business analysis for the purposes of loan decision-making is the analysis of the feasibility of the client's loan request (loan application). First, it is necessary to have a clear understanding of the purpose of the loan requested: will it be used for the needs of an existing business, to expand an existing business, to develop a new business line,  to penetrate a new market or start a completely new business.

However, for a feasibility analysis of the requested loan, it is not enough just to note down the client's request and clarify what exactly the funds will be invested in. It is important to understand what goal the client is pursuing with the requested funding, what (s)he plans to achieve, why (s)he decided to apply for a loan, how exactly the loan will affect business performance. It is also necessary to carefully analyse the grounds for these expectations of the client, assess their feasibility and the time frame for project completion/full implementation of the project.

An interview with the owner and/or management of the business is the main source of information for this analysis, supported by documentation confirming that the request is financially sound (issued bills, business plans, assessment of investments in construction and renovation, Internet research to verify data provided by the client, etc.).

Depending on the loan purpose, you need to pay attention to various factors.

Request for a working capital loan

In general, working capital loans tend to be less risky than investment loans for the purchase of property, production plants, and equipment. Nevertheless, the loan officer/client relationship manager must carefully assess the main reasons for requesting additional working capital financing.

Once the loan officer/client relationship manager has identified what exactly the client is requesting, (s)he must take a closer look at what really prompted the application. If the purpose of requesting a working capital loan is to increase production or replenish inventory to meet increased demand, then the request seems reasonable. However, it is necessary to cross-check the client's calculations and the availability of sufficient resources, premises and potential demand, to make sure that increasing production volumes is feasible and necessary. If the loan officer/client relationship manager finds that the client does not yet have the necessary additional resources, (s)he must check if the client has a clear plan for acquiring the necessary resources (hire and train additional employees, find extra premises, conduct an additional advertising campaign) and a realistic time frame for implementing these plans.

If the client is requesting financing for the purchase of additional inventory that is noticeably different from normal inventory levels, you should pay particular attention to the reasons for the request and make sure there are no potential problems behind this. It is important to check the client's capacity to achieve the planned increase in sales, the client’s warehousing capacity to store larger volumes of inventory, the feasibility of forecasts, to verify what measures were already implemented with what result and whether the client's expectations are/can be met.

Fixed asset financing

Fixed asset financing can be requested by an existing business to replace existing assets or for business expansion: introduction of a new product/service or opening new business locations / entering new markets, opening a new business line or starting a completely new business. It is important to understand the reasons for investing and carefully analyse the loan purpose, since the cost of such investments is usually high and payback periods are long. Investments in fixed assets can affect a client's existing business in different ways, and impact can quantitative and qualitative.

Quantitative effects usually involve an increase in production, sales, net profit, equity, reduced operating costs (maintenance, labour, rental costs) or increased operating costs - if additional staff is needed.

Qualitative effects usually involve an improved competitive position in the market, an increased share in an existing market, improved product quality or reduced environmental pollution.

In any case, it is important to double-check the client's expectations, question the forecasts and check them against own market research and main trends in the sector.

Employees of the financial institution must evaluate the entire business plan of the client, and not just the part that will be financed by the requested loan. Among other things, it is important to determine the investment and repayment deadlines and sources. The investment plan of a business must be assessed in a comprehensive manner, and it must be demonstrable that there are sufficient resources (including time, labour, expertise) for its implementation, that expected results are reasonable, not inflated, and that the business will actually benefit from financing.

Having analysed a given business plan you will not only understand the loan purpose, but also all impact (direct and indirect) on the client's business in the short- and long-term. In conjunction with this you should also analyse the owners' business development plans and compare whether the current request for financing is logical in the context of the chosen development strategy.

Development plans and strategy

In general, it is extremely important to analyze the plans of a client in MSME finance. It is not uncommon for the MSME sector that a profitable business may deteriorate due to irrational decisions made by owner(s) or overly ambitious development plans.

You should assess the attitude of the business owners to business development: do they plan to develop the business only at the expense of their own funds, or are they applying for more and more loans every year? Are profits reinvested in the business, withdrawn completely or invested in other areas? Do owners prefer stability or focus on aggressive growth and market capture?

For financial institutions, the risk level largely depends on the business owner’s style of decision-making about changes in the business: how carefully does the owner approach these decisions? Does the owner conduct adequate preliminary analysis? Does (s)he prepare for remedial measures in response to possible negative scenarios in advance or are his/her decisions spontaneous?

It is also advisable to check the targeted and actual use as well as conditions of earlier loans. The fulfilment/non-fulfilment of the terms and conditions for earlier loans is an additional sign of the potential borrower’s organized nature, diligence, and good faith. In addition, the client’s past behaviour can help assess his/her qualities as a leader, a successful entrepreneur, a quality manager who really can competently create and implement plans, including resolving obstacles that may arise during plan implementation.

Assessing the likelihood of a business belonging to a group of related entities and the group’s impact on the borrower's business

 

As a separate aspect of the analysis, it is worth mentioning the analysis of the likelihood of the borrower’s relation/connection to a group of related entities and the group’s impact on the borrower’s business results (and occasionally vice versa). If a business owner has a parallel business (or businesses), the sources of potential risks increase and the overall risk profile may change, since there may be counter-flows of goods and money between connected entities (both regular, easily traceable, and irregular, unsystematic).

The financial situation of connected entities can be stable, or it can deteriorate and require significant investments, so that owners may withdraw funds from one business to stabilize another business, thus weakening the financial position of the first business. In addition, any related business may be exposed to the different risks described in this article, which may negatively affect the performance of the entire group.

Regardless of a thorough analysis of the borrower as a stand-alone business, financial institutions will often not have all information needed to fully assess risks without an analysis of the group of connected entities. In practice, various tools are used when financing such clients, taking into account the possibility of additional sources of potential risks. The main tools involve mitigation of potential risks by requesting additional or harder collateral, using a higher collateral coverage ratio and/or consolidation of the group's financial results to assess existing risks.

Consolidation of the results of a group of connected entities for a more informed decision (when appropriate for a given segment) means analysing the financial results of all related businesses. Thus, you can assess the entire range of risks, as well as identify all potential needs for additional resources. ^[2]

For segments or cases where fully-fledged data consolidation of connected entities is not economically justified (the work and trouble involved is too high if compared to loan amount, possible profit etc.), it is advisable at least to analyse the existing connections in the group to a level that makes it possible to understand the main interrelations, measure and foresee/eliminate the main risks associated with the group. For such situations, the requirements for loan security are usually higher (including the possibility of additional disbursement preconditions and provision of additional guarantees) than in the case of a fully transparent group of entities.

How can we determine if a potential borrower belongs to a group of connected entities? You should pay attention to indirect evidence. The table below outlines basic examples.

Examples of evidence/red flags signaling the possibility of connected entities

Regular cash inflows (or outflows) in similar amounts from/to the same legal entity (ies).

The borrower/owners act as guarantors for a loan received by another legal entity.

Receipt of financial aid from a specific legal entity; large cash outflows in favor of a legal entity that is not a supplier/confirmed counterparty.

Lease agreements with individuals / cooperation with sole proprietors with the same surnames, patronymic names; presence of counterparties with a similar name

Accounts payable or receivable on the balance sheet, carried forward from year to year, to/from entities that are neither customers nor suppliers.

"Other assets" (or “Other liabilities”) on the balance sheet, which include an outstanding debt from (or to) a certain legal entity.

Counterparties registered at the same legal address as the borrower.

A parallel business mentioned by the client or accountant in the course of an interview.

In Central Asia, groups of connected entities and operating businesses in parallel in the SME segment are quite common. Identifying related individuals is critical to assessing the risks associated with the group and making an informed decision. Therefore, such information should be double-checked with due care.

The list of qualitative analysis factors can be continued, including the cross-checking of information provided, of the declared scope of activities etc. In this publication, we cover the most significant factors, and their detailed analysis will allow us to come to a comprehensive understanding of the client's creditworthiness and the factors that can have an impact on it.

It is important to remember that the presence of any of the listed potential risks does not mean that you need to stop working on an application in hand and refuse the client. Identifying a particular risk means that when making a loan decision, you should consider the potential impact of this risk on the client's solvency and business, including overall future of the business. Additionally it means, that it should be evaluated the optimal financing format given the identified risks and the possible ways to mitigate these risks, including taking additional loan security. In some cases, risks may be such that – even if additional loan security would be available – it is advisable to refrain from lending.

Considering the business, its potential and existing risks you can arrive at a sound lending decision. To build a long-term relationship, we also recommend to discuss the situation with the client, highlight the identified problematic aspects and, if the client asks for it, provide him/her with suggestions on possible solutions.

What is important to consider when conducting a qualitative analysis?

Further recommendations for conducting a quality analysis

 

The main objectives of a quality analysis:

• cross-check the provided financial results based on an understanding of the client's business organization and its main business processes;
• assess financial sustainability and factors that can affect the performance of the potential borrower’s business, including the ability to adapt to a changing environment, plan business updates in accordance with sector trends;
• analyse the situation in the sector, key economic indicators and trends;
• assess how critical the identified qualitative risks are and how they can affect the repayment of the requested loan;
• analyse the arguments for accepting these risks and formulating additional conditions for mitigating them;
• formulate your conclusions for decision-makers.

We recommend to include space in the analytical forms for the description of main findings regarding identified qualitative risks, foreseeing a different area for each of the qualitative analysis aspects.

For successful implementation of the analysis of qualitative factors in the process of decision making, it is important to pay close attention to the risks identified and to the findings/conclusions drawn as a result of such an analysis.

We recommend to make the qualitative analysis part of the methodology, to structure the approach, and determine the method of documenting the findings of the analysis. Qualitative factors serve as basis for understanding quantitative indicators as well as basis for their correct interpretation and cross-checking, and are critical for sound risk assessment and decision making. The inclusion of qualitative factors in the analysis, along with quantitative indicators, will allow your financial institution to conduct a comprehensive analysis of borrowers and make informed and sound lending decisions.

^[1] This topic requires special attention, and a separate online course has been devoted to it on this online platform – “OL2001 Online Course: Data consolidation and relationship between financial statements in SME finance”.

^[2] In view of the negative consequences of Covid-19 for economies, additional factors should be considered in analyses, such as, for example, decision-making flexibility and speed with which steps aimed at business optimization can be implemented. These are described in detail in the publication “ANALYZING BUSINESSES IN TIMES OF CRISIS”.