Open accounting and open banking: a marriage made in heaven
SME accounting packages have become aggregated data platforms indicating the creditworthiness of small businesses
How Open Banking paved the way for data powered lending
SME lending was built without envisaging the internet. This is evident in the fact that the industry relies on static, incomplete and out-of-date information to make key decisions around the creditworthiness of small to medium-sized businesses.
The Opening Banking directive successfully got the ball rolling towards an open data ecosystem and has drastically increased the information available to lenders when assessing the risk level of an SME.
This can only be seen as positive as, historically, lenders have relied heavily on Companies House data (which can be 18 months out-of-date) and manually submitted management accounts.
Continuing to depend on redundant information in an 11-year bull market would almost definitely lead to some dangerous and miscalculated lending decisions.
Open Banking data has immense value as one of many immutable data sources a small business uses to run their business. These data sources are amalgamated and reported through online accounting platforms such as Xero, QuickBooks and Sage.
The automation of bookkeeping via incontrovertible data sources feeding directly into the small businesses accounting platforms has meant business owners and managers are using these packages as a single source of truth to report on the financial performance of their company.
This also means data available on SMEs has never been more accurate, timely and free available.
But surely banking data is all that matters?
Accounting 101: The accrual concept is the most fundamental principle of accounting which requires recording transactions when they are earned and not when they are received in cash.
Banking data only recognises transactions as and when there has been a cash movement. For example, a small business may have signed a new 10-year lease on a brand new office building months before applying for a loan. Due to a rent-free period of 6 months, there will have been no cash movement in the business bank account.
As per the accrual concept for accounting, this rent-free period will be split over the life-time of the lease and the rental payments will be recognised immediately from when the lease starts, offering a far more representative indication of the business’s financial performance.
One key indicator of an SME in distress is their inability to pay their suppliers on time. If an SME stops paying their suppliers their cash balance can remain fairly positive but they could be days from a winding-up order and have no ability to pay back the loan they are applying for to stay afloat. On the contrary, having on-going access to current and historic aged payables reports can give an early indication of a riskier borrower who is slowly increasing their time to pay their expenses and a lender can make a more accurate assessment of whether the business is likely to be able to repay the loan.
Businesses usually have numerous bank accounts, if a lender relies solely upon banking data, this leaves room for an applicant to window-dress their financial health by using a bank account that is primarily used for income (and exclude large purchases through a separate bank account) when applying for a loan. Accounting platforms act as an aggregated platform for all business transactions.
Accounts are designed to give more context to a small business’s financial position than can be gained from just bank transactions. In a world of Open Accounting, there is no justification for a small business lender not gathering this rich, additional data.
Isn’t accounting data modifiable?
As an SME ourselves, Codat uses Xero on a daily basis to assess and report on the financial performance of the business.
Codat uses the following tools to run the business (to name a few) each of which has a direct integration into the Xero system we use and automates double-entry bookkeeping on our behalf:
Pleo — Business expense cards to record and administer staff spending
Barclays Bank — Main business account which feeds transactional data directly into Xero
GoCardless — To administer the collection of recurring payments
ReceiptBank — To manage the receipts and invoices
Fluidly — To forecast future cash flows to make key decisions about Codat’s next steps
Therefore by establishing an ongoing link to an applicant or customer’s Xero, Quickbooks or Sage the lender will have access to literally every transaction that has ever occurred within that business allowing the formation of a real-time data-powered underwriting model.