A culmination of rising interest rates and the maturation of cheap fixed interest loans has rapidly changed the small to medium business finance sector.

Access to credit largely depends on a company’s interest coverage ratio (ICR). Reflecting a company’s ability to meet its interest payment liabilities with EBIT, an ICR of less than 1 means that a company is not earning enough to repay the interest due on its debt. According to analysis by Coolabah Capital veteran Christopher Joye, 38.6% of all ASX-listed companies had an ICR of less than 1 in FY21.

This was before one of the fastest interest rate hiking cycles in history, with the market’s forecast of the RBA’s terminal cash rate sitting at 3.72% as at January 13th 2023. At the same time, the Fed’s is 4.9% but with investors pricing in 3 rate cuts to come in by January 2024.

All companies ICR’s are now far more strained, which has had serious ramifications in both businesses borrowing power and the interest rates they are charged on loans (which are of course intertwined). The prime rate, which is the best possible rate a bank can offer and is usually only available to blue chip clients, now sits around 7%. A typical small business can expect to pay 2%-4% above prime, which can blow out significantly higher depending on the risk profile of the company.

Banks have come to be known as well capitalised, relatively risk averse financiers – characteristics that have given birth to a highly competitive non-bank lending industry. While these second tier lenders cannot compete with price, they are able to scoop up all the customers that do not meet the major banks risk parameters.

The lower the creditworthiness of a prospective borrower, the higher the risk of default. This is always the focus when investing in alternative lenders. Of course, the greater the risk taken by the lender, the greater the profit they earn. In financing, this is referred to as the net interest margin (NIM), which is the difference between the average rate a lender borrows money and the average rate they lend money out. 

There are 2.3 million small to medium enterprises in Australia that make up a $423 billion loan market reported in a small business research paper as at April 2021. 38% of them have indicated they are looking for faster, more flexible digital solutions. Online lending is becoming increasingly competitive, with many companies fine tuning their offerings while simultaneously swiftly recycling capital and maintaining a low default rate.

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Past performance is not a reliable indicator of future performance.

Sources:

• AFR, Get ready for the first rates-led collapses since 1991
• AFR, Interest rate rises could end sooner than you think
• The Guardian, For US small businesses, interest rates are next year’s key issue
• ASX announcement, FY23 Q1 Update & Appendix 4C