What is a Credit Crunch, and How Can it Impact Your Small Business? 6 Things to Know

May 9, 2023

The lending environment is changing quickly. Between rising interest rates, the recent banking turmoil, and general economic uncertainty, small businesses are now facing a credit crunch. How can you cope with this difficult situation?

This article will help answer that question. We'll look at what a credit crunch is and the forces that have brought it into being now. At the same time, we'll outline how your small business or startup can handle this decline in lending activity and what you can do to set yourself up for continued success.

What is a credit crunch?

You need cash for your small business. A fresh opportunity or the need for further funding has made you seek out a loan. How likely is it that you'll find a lender willing to give you money?

When the chances of finding a loan start to shrink dramatically, the economy has entered a credit crunch. This situation is characterized by a more restrictive policy towards potential borrowers.

In a credit crunch, the tightening comes on suddenly, often leaving companies scrambling for capital. Funding opportunities that seemed abundant just months before have dried up. This can represent an enormous setback for your growth plans – especially if you aren’t sufficiently prepared.

In a credit crunch, the tightening comes on suddenly, often leaving companies scrambling for capital. Funding opportunities that seemed abundant just months before have dried up.

Why is there a credit crunch right now?

The economic conditions of the past year have caused banks to tighten their credit requirements, leading to the current credit crunch. This began with a sharp rise in inflation coming out of the pandemic, which has forced the Federal Reserve to dramatically raise its interest rates. This in itself has changed the dynamics of the lending market.

Meanwhile, the steep rise in rates has had dramatic side effects. Some banks have been caught in difficult situations, leading to a string of failures in recent months. Silicon Valley Bank started the process back in March. However, the outlook remains murky as evidenced by the recent collapse of First Republic Bank.

Higher rates and worries about overall industry stability has (understandably) made many lenders more cautious about their risk profiles. As a result, companies have faced declining approval rates, making it more difficult (or even impossible, in some cases) to secure financing.

To get an idea of the impact on the lending market, let’s look at the Biz2Credit Small Business Lending Index. This data set is meant to track the credit situation for small businesses.

The figure declined in March, amid the aftermath of the SVB failure. The numbers showed that big banks approved just 13.8% of loans in March. At the same time, the approval rate for small banks slipped to 19.1%.

This marked the lowest pace of approvals at big banks since July 2021. Meanwhile, the figures had dropped dramatically from pre-COVID levels. In February 2020, just before the pandemic took hold, the Biz2Credit index showed an approval rate among big banks of 28.3%. For smaller players, the pace stood at around half of applications.

Tips for handling a credit crunch

What does the credit crunch mean for you? It's likely that you've already started to feel the impact. Conditions have changed significantly in recent months &#151 a fact which should cause an alteration in your funding strategy.

Here are a few of the effects the recent credit crunch could have on your ability to raise funds for your small business:

  1. Loans will get tougher to get. As we noted with the Biz2Credit data provided earlier, approval rates have dropped significantly over the past three years. Now, only around one out every seven applications submitted to a big bank leads to new additional resources.

  2. The loans you get will come with stricter terms. This includes higher rates, increased credit requirements and additional restrictions. As a result, even if you score an additional loan, that money will come at a higher cost.

  3. The process to receive a loan will get longer and more intricate. You might remain an excellent candidate for additional borrowing, even under the current conditions. However, banks will likely enact a more thorough process of approval. Given these circumstances, expect the procedures to take more time and involve additional steps.

As the environment surrounding the lending industry gets cloudier, you'll need to take this reality into account. In other words, you'll need to alter your playbook. Your funding possibilities have narrowed and any loans will now likely come with additional strings attached. Here are some steps you can take to better prepare your small business for tighter credit conditions:

Review your current borrowings

Take stock of your current balance sheet. Understand your liabilities and see if there are ways to launch a healthy restructuring. At the same time, see what you can do to get the most out of your immediate situation. For instance, if you have loans near the end of their term, consider refinancing them or rolling them over.

Maximize your cash flow

Reduce your need for additional funding by tightening your operations. Lower costs, prioritize productivity improvements, and focus your investments on the most profitable prospects. This will let you reduce your cash burn or maximize your incoming cash, depending on where you are in the development cycle.

Make yourself the best lending candidate possible

As part of your review, do your best to match your operations with current expectations. Make yourself an attractive borrower. This might take a little time. The key is to put a process into effect that lets you maximize your long-term prospects.

Build an emergency fund

As much as possible, hold on to the cash as you have. With the credit crunch, getting a further injection of funds through a loan could become difficult. That puts increased value on the resources you already have available. Try to set some of this aside in an emergency fund, giving you some cushion in case of an economic downturn or unexpected stumbling block.

Reorient your goals to the new reality

Less available cash should mean a restructuring of your growth plans. Given that capital might become harder to access, you should reassess your goals and outstanding projects. You might need to curtail some of your more speculative investments and concentrate your efforts on fewer expansion opportunities that offer the best chances for near-term profitable growth.

[During a credit crunch], you might need to curtail some of your more speculative investments and concentrate your efforts on fewer expansion opportunities that offer the best chances for near-term profitable growth.

Consider other funding options

As loans become more difficult to obtain, you might need to look elsewhere for your funding needs. To respond to the new reality, become familiar with other forms of raising capital. This might include seeking out investors or turning to alternative lenders outside of traditional banks.

Surviving (and even thriving) during a credit crunch

Yes, a credit crunch can pose many challenges to your small business or startup. However, that doesn't mean you can't sustain exciting growth. You just need to know how to navigate the current conditions and operate in an environment that will be significantly different from the one that existed just a few years ago.

To do this, it's important to understand the causes and effects of a credit crunch. From there, you can prepare your business to the best of your ability. Use the information provided here to do so, getting the most out of your current resources and finding the best way possible to take advantage of the opportunities ahead of you.