SME Finance

Finance is generally called the ‘Lifeline of Business’. Virtually nothing works without being able to finance the business. This when criticality viewed alongside the state of SME financing, it isnt a surprise that the SME’s economic growth engine is often found crackling.

To start, let’s consider how a SME funds itself. The three main sources of financing for a business are: a) accruals from the business, or profits; b) owner’s equity; and c) external borrowings or business loans.

While all sources are equally important, the significance of loans, especially for small businesses, cannot be over-elaborated – accruals/profits have their seasonality and equity funding is expensive as well as uncommon. Availability of loans, thus, helps a SME business tide over short-term constraints and helps it in planning a long-term strategy that can help make best use of returns for the business owner.

SME funding scenario

Given that the 36 million SMEs in India employ over 80 million, this represent 8% of the GDP, and contributes towards 40% of India’s total exports. Thereby, it would be reasonable to think that SME financing should be a priority for banks and financing institutions. The statistics however do not bear this out.

The total credit to the MSME segment of Rupees Eleven Lakh crores spread across 2.06 crore loan accounts as on March 2016! This disparity in credit availability is due to numerous factors but the following two reasons stand out as most important: banks find SME Loans cost ineffective and too risky. The former is because a large part of the fixed organizational cost incurred per exposure – such as paperwork, site visits, document verification, etc. – is the same whether the borrower has a relationship of INR 5 lacs or INR 5 crs. So, a bank officer would much prefer to complete his targets with a couple of large clients rather than service dozens of smaller businesses. The latter is part perception and part reality. Smaller businesses tend to depend more on cash dealings and many usually are poor record keepers. This makes accurate credit scoring difficult. Unfortunately, all small business borrowers then get clubbed under the same perspective.

Optimism denied

After the flood of deposits that followed the demonetisation move, banks were anticipated to expand lending and lower interest rates on SME business loans. Also, borrowers expected RBI to get aggressive with its rate cuts as a measure to offset to the growth shock that demonetisation caused. So far, both hopes have not been met. Banks have chosen to lower deposit rates to a far greater extent than lending rates and RBI has chosen to hold off on rate cuts in its policy meetings following the resurgence of inflation and ambiguity over global macro factors.

If the above two factors where not enough, the other dampener for expectations of more funding at lower cost comes from badly stretched bank balance sheets. Here also there seems to be no relief in sight. Untenable levels of debt in large problem exposures combined with low operating profits that in some cases do not even cover interest payments means that there is no quick solution around the corner. Though these problems mainly relate to large corporates, even viable MSMEs will end up suffering due to adverse selection.

In this situation, small businesses often need to depend on informal sources of credit, such as private moneylenders, who charge high rates of interest. According to a recent report by International Finance Corporation, 78% of the MSME debt demand is either met by self-financing or through sources like moneylenders, whereas a mere 22% comes through formal lending sources.

Addressing the gap

In recent times, we have begun to acknowledge the extent of the financing problem for MSMEs. This problem extends beyond the just low availability of finance or high-interest rates. Small businesses also need the right advice on what form of financing and which source of borrowing is best suited for their requirement. Most traditional lenders are not able to fulfil this critical role, which can help small businesses in a big way. Digital lending firms regularly work with its clients to improve the odds of getting the right loan using a three-fold approach – improving the risk profile of the borrower, engaging with relevant lenders, and convincing them of the soundness of the borrower and the business. This has helped many of the clients with credit scores that do not fully reflect their repayment capacity.  They help a borrower to get a business loan for a large, upfront capital investment in his start up despite the absence of a track record. What these cases show is that good advice should precede the drafting of a loan application.

Way forward

Given the reluctance of banks and the adverse business scenario they are operating in, Indian MSMEs sorely need alternatives. In this, they have made a slow but sure move towards alternative lending channels, which include online NBFCs, Loan Marketplaces, P2P platforms, besides other formats. These channels offer a much wider choice of borrowing options, thus offering loans that are tailored towards a specific purpose as against the off-the-shelf collateralised loans or loans against property that banks typically offer to MSMEs. This could include E-commerce Merchant Cash Advances, Unsecured Business Loans, Seasonal Working Capital Financing, various forms of Short-Term Funding, Equipment Loans and Business Line of Credit.

Moreover, in many cases, these channels also offer advisory services in guiding business owners towards the right options. When a loan product is tailored for a specific need, not only does it improve the odds of obtaining the loan, but it also minimizes the cost of borrowing.

Convenience and efficiency levels are also shooting up because of alternative platforms. Borrowers can view options online, ask for advice on which one suits their needs best, upload necessary documentation, and receive approvals…. all in a matter of minutes thanks to technology. Even borrowers who do not have a credit score are becoming bankable with multiple off-beat sources of information being used to triangulate repayment capacity.

With GST expected to increase formalisation of the economy, it is vital that small businesses have continued and adequate access to their lifeblood, finance, in order to compete effectively. It would be disappointing to see a business fail merely due to a market failing, and that is the need fintech firms aims to serve.

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