By Avishek Gupta
Credit and Finance for MSMEs: Aiding to the tune of 8% of GDP, the Micro, Small and Medium Enterprises (MSME) sector contributes significantly to job creation, export, and innovation. Despite new policies and programs being one of the most crucial drivers in India, MSMEs face various challenges in their operations, a critical one being raising debts. The inability of MSMEs to access affordable debt to finance their expansion limits their growth potential and keeps the industry from realizing its full potential, which can have negative impacts on the overall economy.
There are 6.3 crore of MSMEs in India and over 90% of these are micro-enterprises. Many of these companies are sole proprietors and partnerships. Several of them are family-run enterprises. Another type of Micro-enterprise is a professionally managed start-up set up typically by first-generation entrepreneurs often to raise external venture capital to grow fast. MSMEs, therefore, are not a homogeneous bunch and face different challenges in accessing capital and resources as only 18% of MSMEs have access to conventional credit. Each of these categories has different sources and kinds of capital available to them.
This article focuses on professionally run MSMEs that have debt requirements in the range of INR 30 lakhs to 20 crores. The companies that require less than 20 lakhs are served by a variety of NBFCs, Fin-tech lenders and Banks directly or in partnership with other lenders. The MSMEs with greater than 20 crore debt requirements are served by traditional lenders as their high credit evaluation costs are defrayed by the higher size of the loan.
Lack of availability of mortgage requires a different approach to lending
The challenge for this category of the “missing middle” of MSMEs is that the debt requirement is too high to be addressed by personal loans or collateral-free fin-tech loans and too low for traditional lenders like banks to be interested in. These MSMEs may follow new/innovative business models and often have complex, seasonal debt requirements of varying amounts. The data and effort required to evaluate these business models are high in the loan amount because traditional financial institutions cannot fit these into their traditional credit evaluation models. Evaluating the value of mortgage collateral is easier than evaluating their complex businesses and hence it becomes an alternative to credit evaluation. However, most MSMEs do not have sufficient collateral to meet the requirement. This makes it difficult for them to secure loans and credit facilities from banks, limiting their ability to invest in new equipment, hire additional workers, and scale up their businesses.
MSMEs that can provide verifiable track record data have better chances of being financed
MSMEs generally need a financial track record of at least three years and a reasonable credit score. The loan application process for MSMEs is often complex and time-consuming, presenting yet another challenge. Financial institutions require the information to evaluate the creditworthiness of MSMEs. This makes it challenging for MSMEs to access credit, especially if they do not have dedicated staff to handle the paperwork and maintain records efficiently. The complexity of the loan application process can also limit the ability of MSMEs to access loans. The level of digitalisation among the MSMEs increased many folds during the pandemic, making it easier to provide digitally verified data; these investments need to continue. MSMEs need to continue to invest in technology to improve efficiency and adopt digital payment solutions to reduce reliance on cash. Digitalisation also leads to improvement in the capacity to collect and report data which in turn improves transparency.
A well-run MSME with appropriate internal controls and governance finds it easier to borrow
Different lending institutions have different thresholds for credit scores which are acceptable to them. Many founders or entrepreneurs are not particular with their track record of repaying their credit card bills and loans which results in reducing their score. While the company’s track record is important, the founder’s credit score also is important to secure loans from an institutional lender. No score is better than a poor credit bureau score. Many MSMEs ignore the importance of keeping up-to-date operational and financial records. They postpone investing in finance functions or build internal audit and control systems. Having a strong board with independent directors also improves their credibility and scaling potential. However, many MSMEs do not prioritise investing in building strong governance systems as they have a short-term view of reducing costs.
Also read: Unlocking operational efficiency of MSMEs: The power of increased credit access
In addition, many MSMEs are lax about paying statutory dues like GST, Income Tax, ESI and PF due to lack of awareness. This also impacts their ability to attract corporate debt. They must then manage with personal loans that come at a high cost and further limit their ability to raise debt and scale.
Blending debt and equity creates the right capital stack, but more lending institutions need to pull up their socks
MSMEs also lack awareness about suitable funding sources, many start-up founders rely only on equity and do not appreciate that different sources and different kinds of capital have different uses though money is fungible.
Even if some MSMEs can set up strong governance, have a technology backbone and meet the reporting requirements, they are not served timely and appropriate manner. The loan evaluation process could take anywhere up to 6 months, making it very difficult for MSMEs to plan their liquidity. In addition, their requirements are varied; they need loans for capital expenditure and working capital. Many businesses are affected by seasonality. They need revolving credit, short-term credit, long-term credit and different repayment options that suit their cash flows from the business. Not providing suitable loan products sets them up for failure and further restricts their ability to borrow.
Overall funding solutions available for MSMEs have increased with different kinds of entities in the fray to get a pie of a largely underserved market. Institutions and MSMEs must meet each other halfway. By developing customised products, intuitive credit evaluation processes, user-friendly application processes and responsive attitudes, financial institutions can make it easier for MSMEs to access debt funding. MSMEs on their part need to bring in transparency, strong governance, and reporting ability to access loans. By meeting each other halfway, not only will they aid each other’s growth and profitability but also help our economy.
Avishek Gupta is the CEO and MD of Caspian Debt. Views expressed are the author’s own.