MSMEs need cash-flow based financing

B Yerram Raju | Updated on March 11, 2020

Small units shouldn’t be credit starved

As opposed to asset-backed credit, a loan can be based on expected cash flows. But lenders should adopt a hands-on approach

Access to finance is the Achilles heel of micro, small and medium enterprises (MSMEs). The UK Sinha Committee has recommended cash-flow based finance as the best possible way of resolving the working capital issues of the sector.

This is a form of financing in which a loan is backed by a firm’s existing and expected cash-flow. It is very different from asset-backed loans, where the collateral of the loan is based on business assets. The repayments are based on business-projected cash-flows. The debt covenants of these kinds of loans are focussed on manageable levels of interest rates.

Charting the cash flow helps in entering the fixed costs, operating costs, accounts receivables and existing accounts payable into the future weeks/months realistically.

It is important to understand that financing the cash flow is somewhat unique for each business — depending on, among other factors, the industry, business size, stage of business, model size, and owner’s resources. It is, therefore, important for each enterprise to assess its resources for financing cash flow: owner investment or equity; government incentives and remittances; inventory financing; trade financing; deposits on sale; receivable discounts; factoring; purchase order finance, etc.

Flow not uniform

Several MSMEs do not have uniform cash-flow throughout the year. If they want to buy the raw material when it is available at a low price, they need storage space and the lender must be okay with having high stocks. Unmoved stock is always viewed with suspicion. Whenever the turnover is low, the firm faces stress because it cannot afford the luxury of unloading the excess raw material.

Whenever finished goods are not rolled out, it could be for a variety of reasons: the buyer is not satisfied with the quality; the buyer is starved of resource at the time of receipt of goods; or has shifted his line of activity and, therefore, trying to escape the obligation to buy. There are also a number of cases where the payments are delayed even after acceptance of goods.

If the contractual relationship between the buyer and seller that is invariably conditioned by the provisions of the Indian Contract Act comes into dispute, the amount gets stuck under litigation. The MSMED Act has provisions to tackle delayed payments under MSME Facilitation Council, but these have been ineffective. Therefore, at the tail-end of production, where the sale occurs, the cash gets stuck.

E-commerce and e-invoicing (GEMS and TReDS) are yet to significantly have an impact on manufacturing MSMEs.

In the pre-GST period, several MSMEs were buying raw material and selling finished product in cash. This simply meant they were bypassing the lenders’ books. This unorganised way of doing business is gradually being transformed with the introduction of GST. It is expedient for an enterprise to have a revenue-based financing programme to ensure that cash flows are not hurt for want of a loan from banks/financial instituttions.

It is easy to lend based on cash-flows to flower/vegetable vendors, traders dealing in gas cylinders/furniture, etc. But funding manufacturing enterprises based on cash flow isn’t that easy. The entities in this segment can also afford higher interest for their loans as they can invariably pass on the interest cost to the buyer through higher sale price. If they want to offer competitive price, they indulge in discounts.

Mindset change required

In other words, there are many aspects of the cash conversion cycle (CCC) of MSMEs that the lenders need to understand. And, this would require: a change in mindset of the field staff and managers of banks; and continuous follow up of the cash flows systemically with a consent-based ERP architecture.

The MSME Ministry offers Zoho ERP book free of cost to enterprises with turnover of ₹1.5 crore. This threshold could be raised to ₹5 crore. The could transform 55-60 per cent of micro and small enterprises, and get them into organised finances when cash-flow based lending becomes reliable and data driven. Data itself will be the security. Credit rating and collateral are either not required or based on movable short-term assets such as inventory, floating debentures (for limited companies), debtors, etc.

Cash is king. It is cash that repays the loan and not collateral as the latter takes enormous time, cost and effort to liquidate. Documentation is also simple: in the form of invoices issued by the enterprise; sales records; supplier and customer references in addition to a thorough interview of the enterprise owner.

It may be necessary to cross-check with the suppliers the invoices provided. All this simply means that in a cash-flow based model, banks should spend more time with the entrepreneur and they don’t have the wherewithal to do this now. While the RBI has been working on a Public Credit Registry, the way it captures the data, the veracity and verifiability of the data, and the ease with which it becomes accessible would make data itself collateral for banks and FIs.

The writer is author of ‘The Story of Indian MSMEs’. The views are personal.

Published on March 12, 2020

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