India is home to about 26 million small enterprises (with investments less than 50 million) that account for about 20 per cent of the country’s GDP . While small enterprises drive economic growth with their ability to innovate and employ in large numbers, the biggest challenge faced by them is access to finance.
Small enterprises, such as brick-kilns, grocery stores and small restaurants, need finance to purchase raw materials, procure stock, pay wages, meet other working capital requirements and support expansion plans.
Despite the efforts of Ministry of Small and Medium Enterprises, SIDBI and support from the RBI by inclusion under priority sector, there continues to be a huge demand-supply mismatch in small enterprise financing.
One of the major reasons for banks/financial institutions (FIs) being unable to bridge this gap is the perceived credit risk involved in financing small enterprises. This is primarily on account of non-availability of valid bills, proper accounting systems and lack of known buyers.
To mitigate such credit risk, banks typically look for enhanced collateral or traditional equity, both of which cannot be brought in by most entrepreneurs. Further, due to their small size and local presence, the transaction costs involved in financing them are very high.
ASSESSING LENDING RISKS
In the face of banks’/FIs’ reluctance to lend, these enterprises are compelled to resort to high cost, non-continuous financing from money lenders and other informal sources, or continue to operate at sub-scale. Banks charge an interest rate of 10-20 per cent, compared with 36-70 per cent from informal sources like money lenders. Risks faced by any business can be broadly classified as idiosyncratic or systemic. Idiosyncratic risks are specific to an enterprise, like location of business or skill of the entrepreneur.
Systemic risks, on the other hand, are beyond the control of any enterprise. Such risks make up the environment in which a business operates. Risks due to change in preference of customers, a catastrophic event, and changes in economy are all examples of systemic risks.
The key to financing any enterprise lies in the ability of the financier to evaluate and manage such business risks. High quality origination can help evaluate idiosyncratic risks well. Traditional equity acts as a cushion for such risks. A high quality local originator with geography and business specific information about such enterprises in the operational area will be able to evaluate and manage this risk well and will demand lesser traditional equity to be brought in by entrepreneurs.
Systemic risks, however, are a different ball game. No amount of traditional equity is sufficient when the financier is uncertain about an enterprise selling anything at all in an environment where demand patterns and economic situations can change very quickly.
A financier searches for cues to establish that the business has a current and future ability to service loans, even in an uncertain business environment. For small enterprises that have large number of cash transactions, poor record of sales, produce undifferentiated goods and lack known clients, assessment of systemic risk becomes very difficult.
Such challenges can be addressed through structures that allow financiers to trap cash flows, or by resorting to a stronger and well established sales pattern in a supply chain.
FINANCING METHODS
Some ways of financing small enterprises are as follows: Supply-chain financing, where a supplier and a buyer with known balance sheets can be financed.
For example, small enterprises that manufacture and supply jam to large players can be financed if their cash flows are trapped through bills, or by obtaining a collateral/guarantee/comfort letter from the company to which it supplies.
This can be adopted by many financial intermediaries, even large banks. The method has its limits because it requires careful mapping of supply chains. Lending through a local financial intermediary who can verify cash flows and income of the enterprise and finance them through relationship-based approach is another option.
A local financial intermediary who understands the working capital cycle, seasonality, procurement place and mode, point of sales, and demand for the product or service, can finance small enterprises based on an understanding of the geography in general and various aspects of the business in particular.
A local intermediary can ascertain turnover, income and other key financial information required to arrive at a credit decision about the enterprise.
Business-specific templates can be developed for each small enterprise and a master limit can be fixed taking into consideration the scale of business, projected sales turnover and surplus they would generate.
Depending on business requirements, FIs can provide working capital loans, term loans or both. Also, long-term, relationship-based lending helps mitigate credit risk by creating dynamic incentives for the enterprise to maintain a relationship with FIs.
PRODUCT INNOVATIONS
Innovation in product structuring is as important in addressing gaps in small enterprise financing as the channel itself. Innovative products such as equipment lease finance can help address the need for term debt, and products such as receivable financing, bills discounting and factoring could substitute requirements of working capital finance, addressing the unique needs of small enterprises.
Local originators are best placed to do this given their monitoring capability and knowledge of small enterprises, allowing structuring of products like working capital finance, channel finance and cash credits that meet needs of the enterprise, enabling scale.
This article first appeared in The Hindu Business Line
