Finance is quite rightly called the ‘Lifeblood of Business’.Short-term or long-term; managing working capital or capital finance; completing an order or strategic business expansion…. nothing works without business finance. When this criticality is seen alongside the poor state of SME financing, it is no surprise that the SME economic growth engine is often found sputtering.
Firstly, let’s consider how a business funds itself. The three primary sources of financing for a business are: a) accruals from the business, or profits; b) owner’s equity; and c) external borrowings or business loans. While all sources are vital, the importance of loans, especially for small businesses, cannot be overstated – accruals/profits can be seasonal and equity funding is expensive as well as scarce. Availability of loans, thus, helps a business tide over short-term funding constraints and helps in planning a long-term capital structure that can help maximize returns for the business owner.
SME funding scenario
Given that the 36 odd million SMEs employ over 80 million people in India, represent 8% of GDP, and contribute towards 40% of total exports from India, it would be fair to think that SME financing should be a priority for banks and NBFCs. The statistics do not bear this out. As per Rajya Sabha discussion records, "RBI had informed that gross outstanding credit for top ten corporate groups is INR 5,73,682 crore as on March 2016".
Compare this with total credit to the MSME segment of INR 11,10,000 crores spread across 2.06 crore loan accounts as on March 2016 ! This disparity in credit availability is due to multiple factors but two reasons stand out as most important: banks find SME exposures cost ineffective and too risky. The former is due to the fact that a large part of the fixed administrative cost incurred per exposure – such as paperwork, site visits, document verification, etc. - is the same whether the borrower has a relationship of INR 5 lacs or INR 5 crs. So, a bank officer would much prefer to complete his targets with a couple of large clients rather than service dozens of smaller businesses. The latter is part perception and part reality. Smaller businesses tend to depend more on cash dealings and many habitually are poor record keepers. This makes accurate credit scoring difficult. Unfortunately, all small business borrowers then get painted with the same brush.
After the flood of deposits that followed the demonetisation move, banks were expected to expand lending and lower interest rates on business loans. Also, borrowers expected RBI to get aggressive with rate cuts as an offset to the growth shock that demonetisation caused. So far, both expectations have not been met. Banks have chosen to lower deposit rates to a far greater extent than lending rates and RBI has chosen to hold off on rate cuts in its last two policy meetings following the resurgence of inflation and uncertainty over global macro factors.
Besides these two factors, the other dampener for expectations of more funding at lower cost comes from badly stretched bank balance sheets, with no relief in sight. Unsustainable levels of debt in large problem exposures combined with low operating profits that in some cases do not even cover interest payments means that there is no quick solution around the corner. Though these problems mainly relate to big corporates, even viable MSMEs will end up suffering due to adverse selection.
In this situation, small businesses often need to depend on informal sources of credit, such as private moneylenders, which charge high rates of interest. According to a recent report by International Finance Corporation, 78% of the MSME debt demand is either met by self-financing or through sources like moneylenders, whereas a mere 22% comes through formal lending sources.
Addressing the gap
We have only begun to acknowledge the extent of the financing problem for MSMEs. This problem extends beyond the just low availability of finance or high-interest rates. Small businesses also need the right advice on what form of financing and which source of borrowing is best suited for their requirement. Most traditional lenders are not able to fulfill this critical role, which can help small businesses in a big way. Digital lending firms regularly work with its clients to improve the odds of getting the right loan using a three-fold approach – improving the risk profile of the borrower, engaging with relevant lenders, and convincing them of the soundness of the borrower and the business. This has helped many of the clients with credit scores that do not fully reflect their repayment capacity. They help a borrower to get a business loan for a large, upfront capital investment in his start up despite the absence of a track record. What these cases show is that good advice should precede the drafting of a loan application.
Given the reluctance of banks and the adverse business scenario they are operating in, Indian MSMEs sorely need alternatives. In this, they have made a slow but sure move towards alternative lending channels, which include online NBFCs, Loan Marketplaces, P2P platforms, besides other formats. These channels offer a much wider choice of borrowing options, thus offering loans that are tailored towards a specific purpose as against the off-the-shelf collateralised loans or loans against property that banks typically offer to MSMEs. This could include E-commerce Merchant Cash Advances, Unsecured Business Loans, Seasonal Working Capital Financing, various forms of Short-Term Funding, Equipment Loans and Business Line of Credit.
Moreover, in many cases, these channels also offer advisory services in guiding business owners towards the right options. When a loan product is tailored for a specific need, not only does it improve the odds of obtaining the loan, but it also minimizes the cost of borrowing.
Convenience and efficiency levels are also shooting up because of alternative platforms. Borrowers can view options online, ask for advice on which one suits their needs best, upload necessary documentation, and receive approvals…. all in a matter of minutes thanks to technology. Even borrowers who do not have a credit score are becoming bankable with multiple off-beat sources of information being used to triangulate repayment capacity.
With GST expected to increase formalisation of the economy, it is vital that small businesses have continued and adequate access to their lifeblood, finance, in order to compete effectively. It would be disappointing to see a business fail merely due to a market failing, and that is the need fintech firms aims to serve.