Credit Use by Small Businesses

This section examines the composition and borrowing behavior of small firms to identify characteristics that are associated with important patterns of credit use. It also discusses the special role that small business plays in the U.S. economy and the unique challenges small firms face in obtaining credit.

Small Business: Definition and Background

Defining what is meant by "small business" is the difficult first step in conducting a policy-relevant analysis of the financing needs of small business. The financing needs are very different for a "mom and pop" grocery store, a microenterprise in the inner city, a start-up high-tech firm, a business that is ready to expand from early-stage growth to the next higher level, or a business that has neared the point of issuing public debt or equity. Yet the term "small business" encompasses all of these entities. According to a broad guideline used by the U.S. Small Business Administration (SBA), a small business is a firm or enterprise with fewer than 500 employees. This definition encompasses nearly all businesses in the United States.

The U.S. Census Bureau's County Business Patterns data indicate that there were over 7.4 million active employer establishments in March 2009.¹⁴ The vast majority of these establishments were modest in size, with more than one-half of them employing fewer than 5 employees and nearly an additional one-third employing between 5 and 19 employees. In total, small employer establishments with fewer than 500 employees constituted 99.8 percent of all employer businesses, a fraction that is consistent with previous years (table 2).

More than one-third of small employer establishments were organized as S corporations (37.7 percent), and just under an additional one-third as C corporations (31.1 percent). The primary difference between the two types of corporations is that C corporations are subject to corporate income tax, while S corporations are not. However, S corporations are legally constrained to have no more than 75 shareholders; are restricted to one class of stock; and, to avoid income tax liability, must pass all income to the owners at the end of each fiscal year. The remaining small employer establishments were organized as sole proprietorships (13.3 percent), partnerships (10.1 percent), and nonprofits (7.5 percent).

Small businesses operate in every major segment of the U.S. economy. The most common industry for small employer establishments in 2009 was retail trade, which accounted for 1 out of 7 small firms. About one-half of establishments were in construction, health care and social assistance, professional and technical services, accommodation and food services, and other services, each of which accounted for roughly one-tenth of small employer establishments. The remaining small establishments were principally involved in finance and insurance (6.6 percent), wholesale trade (5.7 percent), administrative support (5.1 percent), real estate and leasing (4.7 percent), manufacturing (4.1 percent), and transportation and warehousing (2.8 percent).

Geographically, small establishments were widely dispersed throughout the nation, with 19.3 percent operating in the Northeast, 21.9 percent in the Midwest, 23.7 percent in the West, and the remaining 35.1 percent in the South. This distribution roughly reflects the 2009 population distribution, with 18.0 percent of the population living in the Northeast, 21.8 percent in the Midwest, 23.3 percent in the West, and the remaining 36.9 percent in the South (U.S. Census Bureau, Population Division, 2009).

Small businesses contribute significantly to the strength and vigor of the U.S. economy. Establishments with fewer than 500 employees accounted for nearly 80 percent of total covered sector employment and over 70 percent of first-quarter payroll.¹⁵ In addition, most large and successful companies begin as smaller firms that prosper and grow.

The concerns of the Congress and other policymaking bodies about small business financing largely stem from the perception that small firms have more difficulty gaining access to credit sources than do large businesses or other types of borrowers. The source of this difficulty may be the greater riskiness of small firms and the associated high costs of evaluating and monitoring credit risks, or it may be inefficiencies in markets that hinder pricing of risk or impede the effective pooling of risks. To the extent that private-market impediments or inefficiencies are the source of any difficulties for small business financing, policymakers may focus on measures that address these factors. In this case, no one policy prescription would likely work for all, and no one definition of small business would be appropriate. As discussed in this report, credit needs and borrowing sources differ widely among small businesses.

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Risks of Lending to Small Businesses

Lending to small businesses is generally considered riskier and more costly than lending to larger firms. Business Employment Dynamics data, compiled by the Bureau of Labor Statistics, provide insights into some of the risks.Figure 7 depicts the survival and conditional survival rates as well as the average employment for a cohort of employer firms that were born in 1994.¹⁶ Because a cohort is restricted to the fixed group of firms initially included, the survival rate--the share of all firms that began in 1994 and are still in business in each subsequent year--must decline over time as firms go out of business. In contrast, the conditional survival rate--the share of firms that were in business in the previous year and continue operations in the current year--may rise or fall each year. The average employment is calculated among firms in business in each year. It, too, may rise or fall over time.

Two facets of small business dynamics can be observed in figure 7. First, the increasing average size among the surviving businesses indicates that small businesses are more apt to fail in any given year of existence than larger or growing ones. Second, the failure rate in the early years--when the firm is likely to be the smallest--is quite high relative to later years. For example, 20 percent of establishments born in 1994 failed in the first year (by 1995), but only 11 percent failed in the second. Conditional on having survived the first three years in business, more than 90 percent of establishments will continue to be in business the following year. Historically, and particularly in the early life of a business, lenders have had difficulty determining the creditworthiness of applicants for small business loans. The heterogeneity across small firms, together with widely varying uses of borrowed funds, has impeded the development of general standards for assessing applications for small business loans and has made evaluating such loans relatively expensive.

Lending to small businesses is further complicated by the "informational opacity" of many such firms. Obtaining reliable information on the creditworthiness of a small business is often difficult because little, if any, public information exists about the performance of most small businesses. Small businesses rarely have publicly traded equity or debt securities, and public information on such firms is typically sparse. Many small businesses also lack detailed balance sheets and other financial information often used by lenders in making underwriting decisions.

The cost to the lender does not end with the decision to grant a loan. Small business lenders typically have had to monitor the credit arrangement with individual borrowers. For very small firms, a close association between the finances of the business and those of the owner may increase loan-monitoring costs.

Historically, the relatively elevated costs of evaluating small business applications and the ongoing costs of monitoring firm performance have made loans to small businesses less attractive for some lenders, especially because, when expressed as a percentage of the (small) dollar amount of the proposed loan, these noninterest costs are often quite high compared with loans to middle-market or large corporate borrowers. Financial institutions, especially commercial banks, are believed to have an advantage in dealing with information problems. Through interactions with a firm that uses its financial services, the lending institution can obtain additional information about the firm's activities, ownership, financial characteristics, and prospects that are important in deciding whether to extend credit.¹⁷ Lenders can use information gathered over time through longterm relationships with business owners and other members of the local community to monitor the health of the business and to build appropriate incentives into loan agreements.¹⁸ The role of relationship lending will likely continue to be significant, even as developments such as automated banking, credit scoring, and bank consolidation influence the competitive structure of the banking industry.¹⁹

Insights on the risks of lending to small businesses may be gained by examining delinquency rates at banks that primarily do small business lending, small-business-lending-intensive (SBLI) banks. During the recent financial crisis and ensuing recession, these risks became much more obvious as small businesses struggled to keep current on their outstanding debt.Figure 8 shows the delinquency rates for C&I and commercial real estate (CRE) loans for SBLI banks compared with other banks.²⁰ In the early part of the decade, delinquency rates at these SBLI banks were similar to such rates at other banks for C&I loans. However, in 2007, delinquency rates at SBLI banks began to rise for C&I loans faster than delinquency rates at other banks. The rate peaked at nearly 7 percent in 2009 at SBLI banks, compared with about 4 percent at other banks. Since then, the rate has come down but remains elevated and above the rate at other banks. For CRE loans, the story was slightly different. Until 2009, the delinquency rate at SBLI banks was slightly above the delinquency rate at other banks. In 2011, the delinquency rate at SBLI banks peaked slightly below the rate at other banks but continues to be considerably higher than pre-recession levels.

Credit Use

Up-to-date and comprehensive information about the universe of small businesses is sparse, and most evidence about financing needs and sources is derived from surveys. In light of this reality, the NFIB sponsored surveys in 2009, 2010, and 2011 to gauge the credit access of small firms during the financial crisis and ensuing economic turmoil.

Each of the three NFIB samples was drawn from the Dun & Bradstreet Market Identifier File and included between 750 and 850 small employer firms. For the surveys, small employer firms were defined as firms with between 1 and 250 employees in addition to the owner(s). The samples were stratified by employment size, and weighted responses are representative of the Dun & Bradstreet population of small employer firms in the United States in 2009, 2010, and 2011.²¹

These three surveys quantify the use of and access to credit by small employer firms in the 12 months prior to each survey.²² Respondents were asked to provide information about their applications for and current use of four distinct types of credit: new credit lines, renewal of existing credit lines, business loans from financial institutions, and credit cards (including personal cards used for business purposes). Small business owners were also asked about their real estate holdings and whether those properties are used by the business as collateral for business borrowing.

Data from the NFIB surveys describe patterns of credit use by small businesses. Although credit use is ultimately the intersection of demand and supply factors, it is nonetheless very useful in developing a picture of the demand for credit by small businesses. The data reveal patterns at both the aggregate and firm levels. It is important to keep in mind that the surveys are not following the same firms in each year, so it is not possible to say what happened to the credit demand and use of a particular firm over time, but it is possible to say what happened to the credit demand and use of a representative sample of small firms over time.²³

Types of Credit Used

Small businesses use a variety of types of credit to fulfill their financial needs, including loans taken down under lines of credit, other term loans, trade credit, and credit cards. Patterns for each product are discussed here.

Credit Lines

Credit lines were more commonly used than term loans by small businesses in each year, with just under one-half of firms reporting having such a line (table 3). Between 2009 and 2011, the fraction of firms with lines of credit varied little. Among firms with at least one line of credit, the median firm had a single line. The average number of lines per firm steadily increased from 1.4 in 2009 to 1.7 in 2011.

Substantial variation exists in the use of credit lines by size of firm. Roughly one-third of the firms with fewer than two employees reported using a line of credit in each year, compared with two-thirds of firms with at least 50 employees. The usage pattern by size holds up over time, but usage rates are a bit higher in 2010 than in either 2009 or 2011.

The usage pattern by age of firm is less clear. In general, usage seems to increase until the firm reaches 10 to 20 years old, and then holds steady or drops off slightly. Between 2009 and 2011, an increasing fraction of older firms had lines of credit. For example, 48.4 percent of firms 30 or more years old had a line of credit in 2009, while 64.6 percent of them did so in 2011. The same is not true of the youngest firms, whose usage peaked in 2010. For all but the oldest firms, the average number of lines was highest in 2011 among firms with at least one line of credit.

Credit line usage by industry over this period reveals no obvious pattern. In 2009, firms in "other" industries were most likely to use lines of credit, with nearly 6 out of 10 such firms reporting having at least one line of credit. This fraction falls over time to 4 out of 10 in 2011. The next most frequent users in 2009 were construction and manufacturing firms, with one-half of firms in both industries reporting having lines of credit. However, their paths go in opposite directions over time. While an increasing fraction of manufacturing firms report lines of credit in 2010 and 2011, the opposite is true of construction firms. This divergence is likely partially attributable to difficulties in the housing market, which employs a fair share of small construction firms. Five out of 10 firms in professional services and 4 out of 10 firms in nonprofessional services report having lines of credit in 2009. Over time, increasing fractions of firms in professional services and decreasing fractions of firms in nonprofessional services report having lines of credit. Over two-fifths of firms in wholesale and retail trade and one-third of firms in finance and real estate have lines of credit in 2009; in 2011, one-half of firms in wholesale and retail trade and two-fifths of firms in finance and real estate have them.

The surveys do not provide information on either the size of the line of credit or the amount by which the line has been taken down.

Business Loans

Business loan usage trended down between 2009 and 2011. In 2009, nearly 36 percent of small employer firms reported that they had at least one business loan; in 2011, less than 30 percent of such firms so reported (table 4). This overall trend is not consistent when looking at firms according to size, age, and industry.

The more employees a firm has, the more likely it is to have at least one business loan. For example, in 2009, roughly 1 in 5 of the smallest firms reported having a business loan, compared with nearly 1 in 2 of the largest firms. The number of loans also varied substantially, with the number generally increasing with the size of the firm. Over the recent period, business loans generally became less common among the smallest firms and more common among the largest firms.

By age, there is roughly an inverted-U-shaped pattern, with use being lowest among the youngest firms, increasing as firms age, and dropping off among the oldest firms. As firms age and grow, the need for business loans may increase, which may reflect a life-cycle growth pattern; once firms get to a certain age, most have reached their optimal size and have less need for loans to grow and expand. Over the recent period, usage rates fluctuated significantly by age of firm. For example, 20.4 percent of the youngest firms reported having a business loan in 2009; this proportion increased to 36.2 percent in 2010 and then fell to 14.5 percent in 2011. In contrast, 32.1 percent of firms aged 15 to 19 reported having a business loan in 2009; this proportion increased to 41.5 percent in 2010 and then fell back some to 37.7 percent in 2011.

Business loan usage varies substantially by industry. In 2009, business loan usage was lowest among firms in professional services (26.7 percent) and highest among firms in manufacturing (55.4 percent). While usage remained fairly constant for firms in professional services, the share of manufacturing firms using business loans decreased markedly from 2009 to 2011, with only 29.2 percent of manufacturing firms reporting having a business loan in 2011. Although not as large as the decline among manufacturing firms, a decrease in the share of firms in construction and nonprofessional services that reported having business loans between 2009 and 2011 was also observed.

Alternatives to Traditional Credit

Small business owners may turn to alternative forms of credit if they find themselves unable to obtain traditional forms or if they find the terms of these other products more favorable. Two such alternatives--credit cards and trade credit--can be examined using data from the 2009-11 NFIB surveys. These widely used alternative forms of credit may be important both in financing small businesses and, as substitute products, in influencing the demand for traditional credit by small firms. According to the NFIB surveys, just under 60 percent of small firms used a credit line or business loan in each year, but just under 90 percent used a credit card or trade credit.

Credit Cards

Credit cards can serve as a convenient alternative to paying expenses by cash or check if a business pays balances on time and in full each month. They can also be a substitute for traditional forms of credit when balances are carried month to month. Survey evidence from earlier periods suggests that credit cards are used primarily for convenience.²⁴

Credit cards used for business purposes can be issued to the firm itself (business cards) or to the owners of the firm (personal cards).Table 5 shows the percentage of small businesses that used personal credit cards, business credit cards, or either personal or business credit cards to pay for business expenses in 2009, 2010, and 2011.²⁵ The fraction of firms that use either a personal or business card declined somewhat over this period but remained near 80 percent in 2011. There seems to be a slight decline in the fraction using business cards and a slight increase in the fraction using personal cards. This decline in business card usage follows a period of rapid growth in business credit cards between 1998 and 2003.²⁶ In 2009, roughly one-fourth of personal credit card users and one-fifth of business credit card users actually used their cards as a source of credit. By 2011, nearly one-third of firms that used personal credit cards reported normally carrying a balance, while the share of firms using business credit cards and carrying a balance had not risen greatly.

The use of personal and business credit cards differed by size of firm. Business use of personal credit cards generally decreased as firm size increased, whereas the use of business credit cards increased with firm size. In 2009, only the smallest businesses used personal credit cards as often as business credit cards. This difference may indicate that small firms have more difficulty than larger firms in obtaining business credit cards and therefore use personal cards as a substitute.²⁷

The use of either a personal or business credit card generally increased with the age of the firm. However, unlike with firm size, the distribution between personal and business card use does not show a clear pattern of tradeoffs. At every age, personal card usage is less common than business card usage; however, the usage rate is not highest among the youngest firms.

Credit card usage also varies a great deal by industry. Credit card usage is highest among manufacturing firms, with more than 85 percent of such firms using some type of credit card. In addition, business cards are far more prevalent than personal cards. In 2010, close to 85 percent of finance and real estate businesses and professional services businesses used a personal or business card. Both of these industries saw a decline in the share of firms using cards in 2011. Conversely, the share of construction and mining firms that reported using credit cards grew between 2010 and 2011, from 78.2 percent to 87.5 percent. This increase reflects growth in the share of firms with both personal and business credit cards.

Trade Credit

Trade credit arises when a business purchases goods or services for which payment is deferred. Like credit cards, firms can use trade credit either as a form of credit or as a convenient alternative to paying cash each time a purchase is made. In 2010, 57.8 percent of small businesses used trade credit, about the same proportion that used credit lines or business loans but much smaller than the proportion that used credit cards (table 6).²⁸ In 2011, this fraction had fallen to 47.1 percent.

Trade credit is generally extended for an intermediate period (30 to 60 days), at which point payment is due. When payment is not made by the due date, financing charges are applied, and trade credit becomes an alternative method of financing business expenses. Trade credit can be a very costly form of credit for firms that do not make timely payment.

As shown in table 6, trade credit was used more extensively by larger firms (around 70 percent of small businesses with 10 or more employees used trade credit in 2010, compared with 41.6 percent of the smallest firms) and more well-established firms (around 60 percent of small businesses that had been in business 10 or more years used trade credit in 2010, compared with 42.8 percent of the youngest firms). For nearly every size and age category, trade credit was used less in 2011 than it had been in 2010.

Substantial variation in trade credit usage is apparent by industry, with construction and mining firms the most likely to have used trade credit in 2010 but far less likely to have done so in 2011 (83.7 percent in 2010 versus 54.2 percent in 2011). Other industries experienced declines in trade credit usage, although the decreases were not as dramatic. The only industries in which trade credit was more commonly used in 2011 than it had been in 2010 were manufacturing (55.9 percent in 2010 versus 70.9 percent in 2011) and wholesale and retail trade (64.5 percent in 2010 versus 67.1 percent in 2011).

Summary of Credit Use

The use of credit products exhibited several clear patterns. Among small businesses, larger firms were more likely than smaller firms to use each of the traditional credit types. Declines in usage between 2009 and 2011 were also strongest for the smallest firms. However, whether this pattern reflects a greater need for credit at larger firms or whether lenders are simply more willing to extend credit to larger firms is unclear.

The relationship between firm age and credit use is similar to the relationship between size and use, but not as linear. Again, the declines in usage between 2009 and 2011 are most apparent for the youngest firms. Several factors may explain the similarities and differences in the relationships between size and credit use and between firm age and credit use. The similarities are likely due to a correlation between firm size and age--most new firms are also quite small. The differences are likely related to the greater informational opacity of younger firms and the different credit needs of firms over their life cycle. The opacity might make evaluating creditworthiness more difficult for lenders, which could reduce the supply of some types of credit available to young firms, while well-established firms may have less need for credit.

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Credit Application Experience

In some cases, small businesses may have wanted to use more credit than was reflected in the survey, but were unable to obtain it. The analysis in this section looks at the experience of firms that sought to obtain credit but had their applications denied.

As shown in table 7, one-half of the firms applied for some type of credit in 2009.²⁹ Just over one-half of these applicants were successful in obtaining all or most of the credit for which they applied. Application rates in 2010 were similar to those in 2009, with nearly two-thirds of firms obtaining all or most of the credit for which they applied. In 2011, the portion of firms applying for credit increased. However, success rates were similar to those observed in 2009, with 46.9 percent of applicants receiving only some or none of the credit for which they applied.

In each year, the larger the firm, the more likely it was to apply for credit. With the exception of the smallest firms, denial rates declined with the number of employees; larger firms' applications were more likely to have been approved.³⁰ While this is true in each year, both application and denial rates were higher in 2011 than they were in 2009 and 2010.

Application rates and denial rates by firm age do not exhibit a clear pattern. The youngest firms applied more frequently than firms in any other age group in each year except 2011, when they had the same application rate as the oldest firms. The denial rate is generally greatest for firms four to six years old. Between 2009 and 2011, application rates increased for most age groups.

In addition to self-reported application experiences, the NFIB obtained PAYDEX credit scores for surveyed businesses from Dun & Bradstreet. The PAYDEX score is a measure of the timeliness with which a business pays its bills; it ranges from 1 to 100, with higher scores indicating more timely payment performance. Some of the apparent differences in application and denial rates can be explained by closer examination of the PAYDEX scores (table 8). The most striking difference is the overall decline in scores between 2010 and 2011. In 2009 and 2010, the average PAYDEX score was 63; in 2011, the average score was less than 45.³¹ The PAYDEX scores do provide some support for the notion that younger and smaller firms present more of a risky proposition for potential lenders. Scores generally increase with the age and size of the firm. Thus, the evidence regarding loan application experiences of small businesses and the finding that smaller and younger firms have their loan applications approved less frequently are consistent with the conventional wisdom that these firms are riskier, have shorter credit histories or less collateral to pledge as security, and are more informationally opaque.

Unfortunately, one cannot tell from the survey data whether the firms that had credit applications denied were able to obtain financing from other sources. Even so, unless all denied credit applications were approved elsewhere, the data on the application experience of firms indicate that the demand for credit by some small businesses may have been higher than suggested by the credit-utilization data. Because smaller and younger firms have their applications denied more frequently than their larger and older peers, the difference between credit demand and ultimate use should be greater at smaller firms.

Besides the firms that were denied credit, some firms that may have wanted additional credit may not have applied because they expected that their applications would be denied. The NFIB surveys asked respondents whether they had forgone applying for needed credit because of the expectation of denial.³² The data indicate that there may have been a large number of "discouraged borrowers" over this period; in 2009, more than one-third of the sample reported having forgone applying for credit (table 7). While this fraction has declined a bit over time, slightly less than one-third of firms reported having done so in 2011, a share that seems elevated.³³ It is important to keep in mind that not all credit applications should be approved. It is clear from table 8 that the firms that did not apply for credit because they felt the application would be turned down were less creditworthy, with credit scores 7 to 15 points below those of the average firm.

Overall, credit use by small business has declined in recent years. This decline is likely a combination of several supply and demand factors. First, as noted earlier in this report, the demand for credit started to decrease around 2006 and plummeted in 2008, recovering only partially at present. Second, also as discussed previously, credit generally became less available as banks tightened their standards. Finally, small businesses' financial health and their ability to pay their bills in a timely fashion have generally deteriorated over this time, making it more difficult to borrow even if the firms desired to do so.

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References

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