By Deepak Ghadge
Credit and Finance for MSMEs: There is a fundamental problem with how many MSMEs and SMEs manage the finances of their company and it essentially comes down to not maintaining financial discipline. If the founder cannot read the balance sheet or does not understand finance, they need to do a short-term course at the earliest rather than depend on the accountant. The accountant is only loyal to the job he or she has to perform and works with the data they get to prepare the balance sheet. However, they are not responsible for signing the balance sheet. It is the owner who signs and hence it is their responsibility to know how to interpret the data and figure out trends related to the firm’s financial health. This helps them in negotiations for loans, capital raise, and also having shorter credit cycles.
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Let’s look at two companies A and B.
- Procures raw materials and keeps the inventory for three months
- Uses these raw materials to convert into finished goods in one month
- Keeps finished goods inventory for another one month
- Sells the product within three months of the credit payment terms
The entire working capital cycle in the case of company A takes eight months, that is, from procuring raw materials to receiving payment of the finished goods which means that the firm receives income 1.5 times in a year.
- Procures raw materials and keeps the inventory for one month
- Converts raw material into finished goods in 15 days
- Keeps finished goods inventory for another 15 days
- Sells the product with 1-month credit payment terms
The total working capital process in this case is three months, which means the cash or income cycle is four times in a year.
It is important for entrepreneurs to understand that they need to work with customers who agree with 30-45 days credit terms and work with the ecosystem to drive this change.
This is where technologies like blockchain can help in recovering outstanding payments via smart contracts. Implementing certain softwares and driving others to be part of the digital ecosystem can help in securing transactions, and receiving timely payments.
Also, according to the MSMED Act, 2006, the government specifies that MSMEs should receive their payments from their buyers in 45 days for the recipient of any goods or services.
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However, to avail this facility, it is important that the entity is registered as an MSME.
To summarise, there are two rules of good financial management:
- Never invest your money without ensuring that the assets you acquire can generate a return which is at least equal to the cost of your capital
- Invest your money in such a way that the assets will generate an inflow of funds before the liabilities demand an outflow
Founders should recognise that all sources of funds are liabilities and not gifts. The money raised today will have to be repaid tomorrow.
If the entity is taking a loan and is meeting one of the two rules, it should refuse the loan, because the assets may not generate enough revenue by the time the liabilities are due (Source: Romancing the balance sheet by Dr Anil Lamba).
This rule applies not just to manufacturing companies, but is true for every company. Software companies too have raised capital and have mismanaged their finances due to which they are not able to repay their investors. For instance, offering payment credit for more than three months have led companies to chase their vendors for payments. The payment may not happen in 90 days despite follow-ups and the to-and-fro communication might take the credit period from 120 days to 150 days. If this cycle continues, there will be no investors willing to invest in the company’s future funding rounds. Investors are interested in short-term credit cycles so that there is sufficient working capital to meet the operational capital requirements of the firm. So, for the company’s success, great entrepreneurs invest in financial management and discipline.
Deepak Ghadge is the author of the book ‘Dhool Dhoop Dhakka: Entrepreneurship by Design’. Views expressed are the author’s own.
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