By Andrea Silvello
In 2008, the ‘Big Crisis’ hit the global economy hard. In the USA, the Gross National Product decreased by approximately 1.2% in 2008, but then bounced back. (delta GNP 2008-2015: +24%). However, in Europe, and especially in Italy, things went very differently: in 2008, Europe lost some 5.5% of GNP, while Italy lost around 9.9%. In Italy, unlike in the USA, the GNP continued to decrease and stabilised only in 2014. (delta GNP 2008-2015: -14%) This has resulted in a critical situation for the Italian and European economies, based on the reaction of small and medium enterprises. In the Eurozone, SMEs account for some 99%[1] of the total number of enterprises. This segment includes the majority of existing companies and a significant proportion of employees. In Italy, the share of SMEs is overwhelming. More than 99% of industrial companies have less than 250 employees, and among them more than 80% are microenterprises with less than 10 employees[2].
How Italian SMEs Compare With Other SMEs
Italy is known to be a relationship-based country, more or less like all the civil law countries in Europe. On the other hand, we have ‘arm’s length’ countries, like the USA and the UK, which are common law countries.
Although Italy has a relationship-based system, it has a peculiar characteristic its industrial fabric. Indeed, Italy, more than other countries, has based its economy on SMEs, and for this reason three aspects are key to understanding the Italian economic specificities:
The relationship of SMEs and banks
The relationship of SMEs and suppliers
The SMEs’ financial structure
The Italian economy is going through a recessive cycle, just as the economies of other European countries are, but Italian SMEs are unique in the international scenario for reasons that make them seem weaker than their international competitors. These reasons have to do with their financial structure:
More than 90% of financial indebtedness held by banks
High delays in suppliers’ payments
Low equity levels
Looking at a sample of some 11,000 European SMEs, the framework outlined in a study published by the European Central Bank[3] is clear. The majority of SMEs’ debt, including factoring and leasing, is held by banks due to SMEs’ limited access to capital markets and historical approach to facing financial needs, which involves accessing new debt facilities.
Other forms of financing and issuing of equity are almost nil. New forms of debt financing have been developed over the last few years, but up until now their effect has been almost negligible.
[su_pullquote]The Italian economy is going through a recessive cycle, just as the economies of other European countries are, but Italian SMEs are unique in the international scenario for reasons that make them seem weaker than their international competitors. These reasons have to do with their financial structure:
More than 90% of financial indebtedness held by banks
High delays in suppliers’ payments
Low equity levels[/su_pullquote]
Private Debt Funds are developing in order to support SMEs with financing investments and long-term development strategies. It would be realistic to imagine a trend in which banks will focus on working capital financing, which would let Private Debt Funds acquire market shares on medium and long term structural financing. Of course, in the wake of this trend, some commercial banks may strategically decide to find new forms of agreement with Private Debt Funds for medium and long term operations.
It is unsurprising that Italian SMEs have, as compared to European SMEs, resorted more to bank debt as a financing tool, even if banks increasingly tend to cut down on debts granted to SMEs due to the enterprises’ structural weakness.
Based on a study published by the Euler Hermes Group a world-leading provider of financial solutions Italy is amongst the fifteen most developed countries of the world in which companies delay payments to suppliers. Compared to the rest of the world, in the majority of business sectors, Italian firms have an average of approximately 100 DSO (days sales outstanding). This is higher than any of the major economies of the world.[4]
A study by Cribis D&B a worldwide network of business and economic information reveals that in the first quarter of 2015 only some 37% of Italian SMEs payed at maturity, around 17% payed suppliers over 30 days (often synonymous with financial weakness or, even worse, an incapacity to respect obligations), while the majority of the SMEs payed with up to 30 days of delay. In Italy, this delay is historically considered something physiological and is overall accepted.
Reduced Profits Lead to Increased Loan Rates
Now, the economic and financial crises have caused a double effect on enterprises: a great reduction in profits and an increase of non-performing loan rates for banks, with the necessary intervention of the ECB to adjust the minimum capital requirements.
Many poor economic and credit performances have to do with the unfamiliarity of SMEs’ entrepreneurs with the basic rules of corporate finance. In fact, the use of leverage should be appropriate only when businesses earn a lot and get a return on capital higher than the net cost of borrowing principles which are not known or are disregarded or ignored in the years of fat profits and ‘easy’ credit.
The two effects are linked because when businesses decrease their EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortisation) and profit margins, banks will deteriorate their credit ratings. At the same time, those same businesses seek new financing from the same banks, but the banks will not be willing to grant the financing (in light of the increase of default rates on their credit portfolios and the strict rules introduced by the central bank), or, in a better scenario, will grant the financing with an increased interest rate.
This chain of events has simple consequences. First, companies will run on a low amount of liquidity. Second, they will not generate enough cash flow to repay banks and suppliers, further worsening the overall economic framework.
All of this crates a dangerous ‘loop’ that in many cases will act as the ‘kiss of death’ to SMEs’ business. As reported in the Cerved-ABI analysis, the rate of Italian businesses in financial distress has on an average increased from 1.5% to 2.5% from 2007 to 2015. This is a result consistent with the findings linking SMEs’ probability to default on their bank debt. This probability has, in the same 2007 to 2015 time period, increased on an average from 1.7% to 3.5%.[5]
[su_pullquote align=”right”]Many poor economic and credit performances have to do with the unfamiliarity of SMEs’ entrepreneurs with the basic rules of corporate finance. In fact, the use of leverage should be appropriate only when businesses earn a lot and get a return on capital higher than the net cost of borrowing principles which are not known or are disregarded or ignored in the years of fat profits and ‘easy’ credit.[/su_pullquote]
This has obviously been reflected in SMEs’ risk profiles; the percentage of risky and vulnerable enterprises has increased by roughly 4% in the 2007-2015 time period.
SMEs’ LOW EQUITY
As Simon Lewis, Chief Executive of the Association of Financial Markets in Europe, said in his article published in The Telegraph in February 2015, there in more than one reason why Europe’s economic recovery has lagged so far being the recovery of the US. But, ‘at the heart of the European malaise is a shortage of equity capital’ for SMEs.[6]
This is a crucial difference between European and American SMEs. The latter has on an average more equity than debt, and does not depend so much on banks.
This over-reliance on debt is a peculiarity of the European economy and is reflected in the structure of its financial system.
In Italy, many enterprises should increase their equity levels because this would benefit their relationships with banks. It’s a basic concept: if an entrepreneur does not believe in his business and is not willing to invest more equity, why should banks do so?
The low equity level of Italian SMEs complicates their relationship with those who have to decide whether or not to grant them lines of credit. According to Il Sole 24 Ore, a leading Italian finance and business newspaper, using criteria equivalent to those of Basel II (an international business standard that requires financial institutions to maintain enough cash reserves to cover risks incurred in operations) Italian SMEs have on average a BB credit rating, and with equity levels around 10% of all financing services and financial leverage of approximately 90%.
To improve the credit rating to just BB- grade, it would be necessary to raise equity levels to at least 25% of total invested capital (2.5 times the current level) and stabilise financial leverage between 60% and 75%.
If Italian companies would increase their equity levels, consequently decreasing their bank debt and strengthening their financial position, they would finally benefit from better credit ratings and a lower cost of financing, creating a new virtuous circle between banks and businesses. This would make the latter fit enough to face the current adverse economic environment, and, in the end, provide them with stronger competitive weapons for the coming years.
[su_divider style=”double”]So Marcos Rojo might have some explaining to do when wife Eugenia Lusardo asks why he quite is so excited in this Instagram post.[/su_divider]
The author is the Founder and Managing Director of Business Support Spa, a strategy consulting and financial advisory ’boutique’ which focuses on SMEs in Italy.
References
1 http://ec.europa.eu/enterprise/policies/sme/facts-figures-analysis/
2 http://ec.europa.eu/enterprise/policies/sme/facts-figures-analysis/performance-review/files/countries-sheets/2014/italy_en.pdf
3 https://www.ecb.europa.eu/pub/pdf/other/SAFE_website_report_2014H2.en.pdf?0b8b95ddc52c86145f91c8d2a566e3f8
4 http://www.eulerhermes.com/mediacenter/Lists/mediacenter-documents/Economic-Insight-Payment-Behavior-DSO-Jun15.pdf
5 https://www.abi.it/DOC_Info/Press-releases/Outlook_sofferenze_Abi-Cerved_2apr2015_English.pdf
6 http://www.telegraph.co.uk/finance/economics/11432834/Europes-SMEs-need-more-equity-capital-and-courage-to-take-arisk.html