SMEs play an important role in the economy, employing over half of the workforce in the UK. Higher interest rates, larger cost increases and a more subdued macroeconomic environment can put pressure on SMEs. While the relatively small scale of major UK banks’ exposures to these businesses means that they are less likely to pose direct risks to lender resilience, pressure in this sector has the potential to pose a risk to economic growth if it results in SMEs reducing employment and investment.
We can use debt-servicing ratios (DSRs) to measure SME vulnerability. DSRs measure a business’ available cash flow to pay current debt obligations and are typically taken as total payments (both interest and principal) over earnings. This measure is more appropriate for our sample than interest coverage ratios, as unlike most larger firms, our sample of SMEs tend to repay their principal over the duration of the loan rather than as a lump sum at maturity. A high DSR indicates that a business is more likely to have difficulty paying their debt and may be at a higher risk of default.
We calculate proxy DSRs using Experian data, which comprises of a sample of approximately 2 million SMEs and provides company-level information on loans and current account flows. This data set does not contain company earnings, so we use current account inflows as a proxy. This is imperfect as inflows do not include any revenue made in cash, nor additional current accounts not captured in Experian.
Many SMEs used the government-backed Bounce Back Loan Scheme (BBLS) during the pandemic. That lending was fixed rate and so will be insulated from higher interest rates until it matures. But over 80% of commercial loans to SMEs are floating rate, meaning the higher interest rates have passed through already on a large proportion of these loans. For that reason, we separate out the accounts with BBLS loans from the ones with commercial loans in our analysis of the debt-servicing pressure on SMEs.
Over the past year, DSRs for the median SME for both commercial and BBLS loans are broadly unchanged with rising interest payments offset by rising earnings in our proxy measure. But we find that there is a tail of vulnerable companies who have seen rising debt-servicing pressures (Chart 1).
For commercial loans, SMEs with DSRs in the top 25% have seen a rise in their average DSRs, with the 75th percentile SME experiencing a 1.6 percentage point rise in their DSR since October 2022. This increase has been driven by higher floating-rate debt payments. The 95th percentile DSR has increased by around 6.8 percentage points over the same period but appears to have been on an upward trend since 2019.
For BBLS loans, we would expect interest payments to have stayed broadly flat as these loans are fixed rate. At the 75th percentile, DSRs have shown little change, but at the 95th, earnings have fallen, pushing up DSRs.
Taking BBLS and commercial loans together, at the 95th percentile, there has been a pronounced pick up in DSRs in the accommodation and food, construction, retail, transport and professional services industries over the past two years. These industries are historically sensitive to the business cycle.
Reflecting the recent increases in DSRs, the proportion of SMEs in arrears on their loan repayments has risen moderately from a low of 0.9% in February 2023 to 1.2% for commercial loans and remains high at around 5% for BBLS loans according to November 2023 data. Total corporate insolvencies have also risen to their highest annual number since 1993, largely driven by micro and small businesses. Conversely, the insolvency rate is low compared to historical levels: this is explained by an increase in the number of registered companies.
Chart 1: SMEs’ debt-servicing pressures have increased (a)
This post was prepared with the help of Sarah Burkinshaw and Malhar Patel.
This analysis was presented to the Financial Policy Committee in 2024 Q1.
Share your thoughts with us at BankOverground@bankofengland.co.uk
