A recent Crisil study on the funding patterns of small and medium enterprises (SMEs) in India reveals that there is scope for banks to increase their lending to SMEs by Rs 500 billion. Against the acceptable banking practice of financing 75% of an SME?s incremental working capital requirement, on an average, only about 60% was funded between 2006-07 and 2008-09. The SMEs met the bulk of their residual funding needs from their own funds.

This study of SMEs? working capital funding patterns also debunks the long-held perception that these enterprises are over-leveraged. Moreover, the study indicates that bank branches in the urban areas have greater scope than those in the semi-urban and rural areas to increase funding support to SMEs; the headroom for lending to small SMEs is greater than that of large SMEs.

A state-wise analysis reveals SMEs in states such as Gujarat, Delhi, and West Bengal have the highest incremental funding opportunities (IFOs). These states have the highest potential for incremental SME funding. In comparison, SMEs in states such as Tamil Nadu, Rajasthan, and Punjab have low IFOs, and appear to be better funded.

The analysis of funding patterns based on other parameters do not reveal any prominent trend. Banks have the opportunity to increase funding support to SMEs across industry sectors and there are no specific sector-related trends with respect to IFOs. Also, most SMEs included in the Crisil study have long track records, which rules out the possibility that working capital financing was affected by concerns of management pedigree or quality.

The study is based on a large sample of enterprises rated by Crisil under NSIC?s performance and the credit rating scheme for micro and small enterprises. As part of its study, Crisil first analysed changes in the composition of SME balance sheets over the past two years. Of the 15,000 and more SMEs that Crisil has rated so far, a large sample of more than 2,000 SMEs rated in 2009 was considered for this study. The sample ensured adequate representation by region, industry sector, and other parameters.

As per accepted banking practice, banks are permitted to fund up to 75% of the incremental working capital requirements (increase in current assets less increase in current liabilities) of borrowers. Banks can fund 75% increase in current assets (74%) less increase in current liabilities (21%); in other words, while banks can fund up to 40% of SMEs? incremental working capital requirements, the actual funding provided by banks was only 25%. This reveals a significant incremental funding opportunity of 15% of SMEs? incremental working capital requirements.

Another way of estimating the size of this opportunity is to evaluate its proportion over the existing stock of banking sector advances to SMEs. Crisils analysis indicates that the size of this opportunity may be as large as about a fifth of advances to the SME sector. This not only reflects the size of the opportunity but also underscores the impact it can have on the SME sector as a whole. For further analysis and ease of reference, the difference between the actual bank funding and the maximum permissible levels as explained above has been defined as the incremental funding opportunity.

The smaller the SME?s scale of operations, the greater the IFO. SMEs with low turnover (less than Rs 50 million) have a much larger IFO than those with a larger turnover, indicating that the opportunity in financing smaller enterprises is much larger than that of financing larger enterprises. Increased support will help boost the growth of smaller SMEs and enhance the effectiveness of various government initiatives to support SMEs.

The trends, as revealed by the Crisil study, however, raise certain questions. Was this large funding mismatch a temporary phenomenon? More importantly, was it a result of the SMEs? efforts to reduce gearing during the period of the study? To answer these questions, Crisil analysed the data for the period between 2006-07 and 2007-08. The analysis revealed similar trends?the funding mismatch is certainly no temporary phenomenon, and has existed for the past three years. The financing pattern for the SMEs? incremental working capital requirements in 2007-08 (over the previous year) was similar to that in 2008-09. Moreover, de-leveraging by SMEs is unlikely to have caused the funding mismatch?SME balance sheets have remained moderately geared between 2006-07 and 2008-09.

The SME sector will continue to an engine of growth for the economy, and it presents a significant business opportunity for banks.