Why do SME Businesses Over-borrow ?

There are different reasons for over-borrowing by SMEs: over- optimism, availability of finance, stage of the business cycle in addition to simple business reasons such as misguided business decision or new market development. In general, these factors can be shown to be both on the supply side and demand side:

Supply Side
Availability of financing: there are many programs offering access to finance for SMEs, aiming at reducing the barriers to access to finance. Many of such programs are not able to distinguish between the credit constrained business and an opportunistic borrower who may be induced to take on unnecessary debt only because it is available at a favorable rate.
Unfair lending practices: similarly to households, SME businesses may face unscrupulous lenders selling too much debt or inappropriate toxic products which may cause the borrowers to experience financial difficulties.

Demand Side
Over-confidence: many entrepreneurs exhibit overconfidence and will borrow beyond their needs only because they believe that they will be successful. While optimism plays an important role in entrepreneurial success, it may also lead to over-indebtedness.

Myopic decision-making: as already mentioned, small business owners may not always act rationally and in their best interest, they may accumulate too much debt based on their biased assessment of the market potential or become a victim of a herding behavior of other businesses which are borrowing money. Financial skills of borrowers may play an important role as well.
Innovation and growth: many SMEs borrow funds to finance growth and expansion of their operations, and borrowing is highly correlated with high growth if the expected growth is realized. If not, the excessive borrowing based on faulty expectations may lead to over-indebtedness of the business. The interplay between the supply and demand factors determines the actual borrowing behavior of businesses, and its potential for indebtedness.

Therefore, it is critical to analyze both types of reasons for indebtedness.


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