Many factors hinder the growth of MSMEs in India. Among the many risks faced by these enterprises, which are largely unorganised, a major one is the default of payment by the counter-party.
Counter-party risk, otherwise known as default risk, is the risk that an organisation does not pay out on its receivables to the supplying firm when it is due. Default risk influences the credit worthiness of a source firm. This further gives rise to credit risk. Buyer default risks are a constant factor affecting the growth of Indian MSMEs. A failure to receive payment or slow payment cycles can severely curtail the cash flows of a business, as this limits its ability to access funds. This affects the overall performance of the company. The counter-party risk further affects the working capital requirements and the planned expansion plans of the firm. Counter-party default also creates a demand-supply mismatch.
A prime reason MSMEs have to suffer from counter-party risk is information asymmetries. Inadequate information available to MSMEs about the financial capability of the counter-party increases the default risk.
Several tools and techniques can help mitigate counter-party risks for MSMEs. One commonly used counter-party risk management technique is buyer-backed supply chain financing, or BSCF. This is a financial product designed to help producers and MSMEs receive funding against their account receivables. Under a typical arrangement, an organisation will make payment to the producer when goods are delivered to the buyer and bill documents are presented for financing. Subsequently, the organisation collects the payment from the buyer on the due date while assuming the credit risks (directly or through a third party) associated with the collection i.e. defaults in payments. The invoice created becomes an asset that can be traded. The business can draw money against the invoice, by discounting the bill, before the money owing on the invoice is collected from the buyer.
Credit assessment of the client is another technique used to eradicate counter-party default risk. This gives the client an edge in making business decisions. Thus, procuring information regarding counter-parties before dealing with them could protect MSMEs from such risks.
The risk assessment is usually done through credit rating or credit scoring. The risk assessment is done by credit rating agencies. These agencies, through their various products, assist MSMEs to know their counter-party risk. Some of the products generally used are listed below:
Report on business information will provide details of overall business operations of the counter-party, including its profile, financial information, payment history, ownership details and operational information.
Customerised report on the counter-party is also used for credit analysis, depending on the requirement of the MSME. These reports are based on an in-depth evaluation of the counter-party’s stability, financial status, industry benchmarking, SWOT analysis and forecast of the potential to repay their future debt. These reports are usually used for large transactions and for making critical business decisions.
Receivable management solutions are provided to mitigate the payment risk which could arise from global factors and a volatile currency. This product is specially designed for exporting MSMEs. Any increase in default risk impacts the cash flow and profitability of exporters. This solution helps exporting MSMEs to recover outstanding payments from their counter-party.
Trade analysis is done on the counter-party. This analysis is based on the trade experiences of industry players, which are then compared with other existing data to determine the business trend of the counter-party in the past, present and future. It is believed that most bankrupt companies exhibited delayed, fluctuating or below industry-average payment behaviour.
Moreover, under non-recourse factoring services, the service provider gives working capital finance and bears the credit risk if the buyer does not pay up. However, there is generally limited recourse in a trade dispute between the buyer and the seller on the quality and supply of goods. Under factoring services, the service provider offers a range of financial services like receivables financing, sales ledger administration, accounts receivables collection and management, credit protection and advisory services.
Depending on the nature of risk, companies could adopt any of the above means to mitigate counter-party risk. Moreover, MSMEs could approach credit rating agencies for a credit assessment.
The author is a senior economist at Dun & Bradstreet India