The SME Lending Puzzle: Why Banks Fall Short

Let us consider the following hypothetical scenario:

ABC & Co., a small services firm, began operations in mid-2011. It reported a 40% jump in annual turnover from Rs. 5 Cr in FY 2012 to Rs. 7 Cr in FY 2013. As a startup, the company has not yet broken even and reported losses for consecutive years. The promoter is well educated, previously worked in organizations of repute for over a decade before deciding to float this venture. The short-term finance requirement of ABC & Co is about Rs. 40 lac for 90 days, but does not have any physical collateral to offer as security. At this stage, the promoter of ABC & Co. decides to approach banks and NBFCs in the market to fund this debt gap.

What would this promoter’s experience be in today’s scenario? Would he be successful in securing the necessary funds?

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According to a recent statistic, 33% of companies operating in the Micro, Small and Medium Enterprises sector have access to banks and financial institutions, while the rest remain excluded and are compelled to raise money through informal channels.

This debt gap is alarming especially in the backdrop of the fact that SME segment contributes nearly 10 percent of the country’s gross domestic product and 45% of all industrial output.

Till date, banks and NBFCs have not been able to finance this debt gap effectively. What has prevented or restricted them from profitably penetrating this sector? Is it due to inherent credit risk in the segment, lack of collateral, government regulation and laws, or simply because there are greener pastures elsewhere to lend money?

Lets us understand the debt requirement of the SME segment (both early-stage as well as mature entities) before we try to further dissect this issue. In our example, ABC & Co. could require financing for primarily two reasons:

1) Capex, i.e. medium to long-term finance for business expansion, product diversification, renovation of business premises, or purchase of machinery.

2) Working Capital i.e. to cover short-term immediate cash flow needs arising from day-to-day business operations.

To cater to this demand, banks and financial institutions already have specific products (both fund and non-fund based) that can be broadly categorized into two categories for the sake of simplicity:

1) Simple lending products, which would typically cater to the first requirement of SMEs for Capex. These are medium to long-term financing products in the form of equipment and machinery loans, high yield unsecured business loans, Loan against Property etc.

2) Specialised lending products, which typically include factoring, trade finance, cash management services, project finance, bank guarantee, or letters of credit, which typically cater to the second requirement of working capital finance.

As is evident from the above, it is not the lack of “products” that explains the under-penetration of finance flowing to the SME sector. Rather, it is in the design, applicability and administration of these products to the SME sector that banks have fallen short.

In an effort to go deeper, we can identify four key reasons among others, for this shortfall:

1)  Sole Focus on Financials: The current approach to SME lending in most institutions is still heavily dependent on business financials- i.e. looking at historical data to predict future creditworthiness. Typically this involves a lot of paper work and many visits to the applicant.

This approach has not been very successful in the SME sector to-date due to the fact that the financials provided by the applicant are often opaque given the cash nature of business transactions and incentives to under report income to save on taxes. ABC & Co., on this parameter alone (aside from business vintage) would be filtered out as the current financial position reflecting business losses would not be very appealing to most financiers.

2)  Bureau Reporting: There are two kinds of credit bureau reports that can be generated by member banks and NBFCs – Individual and Corporate. While individual records are provided by most bureaus, only CIBIL currently provides reports for corporate entities in India. Valid records for SME entities are still not very evolved in the country. And while the bureaus can provide data on credit worthiness of the individuals involved in any given company, they cannot give relevant insights about an applicant who is a first time borrower.

Since ABC & Co. is newly established, there would not be any bureau record on the company. The application would then have to be judged on the strength of the individual records for the promoter as well as the business viability of ABC & Co.

3)  Selective Segmentation: The implication of the above two factors is that only the “upper layer” of the medium to large enterprise segment is able to pass through banks’ and NBFCs’ credit assessment parameters, leaving aside the major chunk of “small” entrepreneurs and entities whose need for adequate finance is more pronounced. These small entities could be major links in the supply chains of large players, and their inability to access finance could have the ripple effects across the value chain.

4)  Lack of Collateral Security: Lending in India traditionally has relied on taking adequate collateral as a “risk mitigant” to cover the credit risks associated with SME lending and the ambiguity around appraising this segment. The Loan to Value ratio (LTV) becomes the yardstick to segregate and approve or reject cases based on risk. This ratio is inversely proportional to the risk perception of the applicant.

Since ABC & Co. does not have any physical collateral such as property or machinery to offer and the promoter has pitched in whatever money he had in the form of initial capital into the business, his application would be rejected by most banks and NBFCs in the market today.

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This problem of access to finance for SMEs in India is even more accentuated for early-stage companies or startups such as ABC & Co. In their case, past financial performance would be not a correct indicator of the future potential of the enterprise. After initial round of equity funding from family and friends or seed investors, working capital requirements or ad-hoc needs for short term finance would inevitably kick in and must be dealt with in a timely manner to keep the firm operational.

To conclude, traditional lending to the SME sector in India can best be described as a “One Size Fits All Approach.” The risk management techniques used by banks and other financial institutions today are invariably more suitable for medium and large corporate entities. The same set of rules when inadvertently applied to small and early-stage enterprises result in a faulty output, i.e. the systemic rejection of most SME loan applications like ABC & Co. Given the intense nature of competition in the lending industry today, the consequence is that too many banks and financial institutions end up chasing the same set of “good” customers, leaving aside a much larger untapped segment of SMEs in the process.

Watch this space for more articles on the subject as well as suggested ways to underwrite “small” and
“early-stage” entities in the SME sector.

(Image credit: http://blog.directcapital.com/misc/small-business-loan-video/) 

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Top Reasons Why Unsecured Business Loans Are Becoming Popular

During the lifecycle of a business, there are times when the inadequacy of working capital threatens the flow of operations and hinders growth. Traditional lending institutions in India such as banks rarely provide assistance in such situations, as they generally demand collateral, which small business and young entrepreneurs may not possess. An unsecured business loan can take care of routine business expenditure such as maintenance of machinery, making payments to suppliers and purchasing raw material. It can also be useful for business expansion activities such as purchasing new machinery or expanding premises.

Moreover, all small and medium enterprises need funds to seize new opportunities for growth, and the window for such opportunities is usually small. In such a scenario, there is a need for quick access to funds. The loan repayment schedule also needs to be synchronous with the expected revenue flow from a business venture. Hence, an unsecured business loan taken from a FinTech company works best for them, as it is disbursed much faster than a loan from a bank. Further, these FinTech companies ensure that an SME is always at ease while paying the loan instalments.

Unsecured loans are turning extremely popular amongst small businesses communities. These are a few reasons why.

They help strengthen the business finances

A suitable business growth opportunity can present itself at any time, and therefore a small business needs to have access to adequate resources at all times. In case the cash flow situation is imperfect or there is a working capital requirement to meet routine business expenses, it helps to take an unsecured loan for a short period until the situation improves. This ensures that a small business will never find itself at a disadvantage when a new opportunity presents itself. Such loans from FinTech companies do not come with any prepayment penalty, and their tenure can vary from a few months to a couple of years.

Faster approval and quick access to funds

The digital revolution and the subsequent development of IT systems and processes have led to the rise of new age FinTech companies over the past five years. FinTech companies in India follow a completely different approach to the unsecured business loan market, as they use innovative technologies to profile, design and disburse loan products for small businesses. Even the application for an unsecured loan can be made online or through the mobile app, and all supporting documents such as bank statements, tax statements, previous loan statements, KYC documents, business receivables and other relevant documents can be uploaded in digital format. The use of advanced analytic techniques allows these companies to process a loan application within minutes. Upon approval, the loan amount is transferred to the borrower’s bank account within a few working days.

An unsecured loan product for every business

Extensive use of technology enables FinTech companies such as Capital Float to design new loan products that are meant to fulfil varying business needs. The loan product, Term Finance, is meant for small businesses that have been in operation for more than two years and have been doing good during that period. Such businesses can take business loans from ₹1 lakh to ₹1 crore for a duration of a few months to three years.

Supply chain finance is meant for small businesses that have blue-chip companies as customers. Such businesses can take up to 80% of the pending invoice value as an unsecured loan. The loan can be repaid either as monthly instalments or at one go upon receiving payments from the customer.

Unsecured loan products designed to support digital economy

Online Seller Finance is another loan product from Capital Float that is designed for businesses that generate revenue through e-commerce marketplaces. It provides up to 200% of the monthly sales volume as advance to such businesses. This money can be used to accelerate business growth online.

Similarly, merchants that receive the bulk of their payments through PoS terminals can avail up to 200% of their monthly card settlement value as advance through a customized finance product called Merchant Cash Advance. The loan amount can be repaid through the deduction of a fixed percentage from card settlements in the subsequent months.

Get loans on the most favourable terms

Capital Float offers loans at the most competitive rates. These unsecured loan costs can be brought further down by choosing the right loan product. Capital Float charges a flat 2% processing fee for all their loan products, and there are no other hidden charges. Another great benefit is the flexibility offered in loan repayment, which is linked to the business receivables.

Indeed, new age technology driven FinTech companies have eased the pain in procuring funds from the unsecured loans market in India, and small businesses can look up to them as a partner in their business growth.

At Capital Float, we fully understand the business challenges faced by small businesses and have therefore designed the unsecured loan products in such a way that businesses can focus more on business growth rather than on worrying about getting business finance. Our customised plans ascertain that you get just the right product that suits your unique need.

To find out the product that best suits your business, click here.

Oct 24, 2018

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Considerations When Taking Short-Term Business Loans

Going the entrepreneurial route is a tough decision to take. Several people contemplate it, but only a few take that leap. Starting a business may be very challenging, but what is even tougher is running a business.

Most small businesses are faced with liquidity crunches. They are required to make payments for raw materials, overheads and staff before their receivables become due. Such businesses have not earned the confidence to ask their suppliers for a lengthy credit period. On the other hand, their customers are able to demand 30, 60 or 90 days before the invoice becomes due.

In such a scenario, small businesses find themselves at the mercy of large banks to raise short-term loans. Here are some challenges that SMEs face while applying for a short term business loan.

Estimating the Money Required: If a business underestimates the amount of money required, it would find itself unable to implement projects, execute orders, retain employees and/or realize its expansion plans. On the other hand, if a business secures a loan amount that is significantly higher than its requirements, it would be taking on an interest burden that is not justified by its bottom-line. Taking the right amount of loan can help the SME adequately address the working capital need without having a surplus or lack of funds.

Applying to Traditional Banks: Most entrepreneurs do not have the funds to invest in their businesses and keep it running for a couple of years. Borrowing from friends and family can also be tricky or simply not an option. In such scenarios, small businesses often turn to traditional financial institutions to raise short-term loans. However, these loans have a very time consuming and complex application process. There is plenty of paperwork involved. The business has to present financials in a predetermined format with supporting documents and detailed projections.

Loan Approval: The process of loan approval can be long and complicated. Banks may take several months to even reject a loan application. Mostly, loans are provided only against collateral, which the business owner may not have. Even then, lenders would conduct a thorough analysis of the financial standing of the small business. The lenders would verify all the information provided by the applicant and this takes a long time, during which the liquidity problem of the business continues to worsen. Therefore, such loans may not even be a viable option for short-term, working capital requirements.

Repayment of Loans: Most short-term business loans from traditional financial institutions have a fixed repayment schedule that is in no way linked to the cycle of receivables of the small business. Moreover, they do not allow prepayment of loans. Thus, these businesses would need to continue to bear the interest rate burden, even if it has the funds to repay the loan.

Against the backdrop of these inherent problems with securing short-term finance, technology has helped offer relief from severe liquidity crunches. FinTech companies like Capital Float rely on cutting-edge technology to offer innovative products that are aligned to the requirements and nature of small businesses. Here are some points to keep in mind while applying for a short term business loan.

Easy Application Process: The application can be sent online via a form that takes around 10 minutes to be filled. The borrower can digitally upload all the required documents.

Fast Loan Approval: The use of powerful algorithms allows Capital Float to approve or reject an application within minutes. Thus, a small business does not need to wait for several months to receive a response. Once an application has been approved, the short-term business loan is disbursed within 72 hours.

No Collateral, No Guarantor: Loans offered by Capital Float do not require small businesses to put up any collateral. Unlike traditional lenders, there is no requirement of a guarantor to validate the loan request.

Loans Designed to Suit Their Purpose: Probably the best news is that the finance products offered by Capital Float take into account the specific requirements and nature of small businesses. For instance, the Term Finance product has been designed specifically for manufacturers, traders and distributors, while the Online Seller Finance product is perfect for businesses that operate on online marketplaces. The Taxi Finance product is meant for companies that are part of the booming radio taxi business in India. Merchant Cash Advance is a loan against card receivables and Supply Chain Finance is finance against invoices from blue-chip companies.

Repayment of Loans: The repayment of loans offered by Capital Float either be in correlation to the receivables of the business or may be in the form of flexible weekly instalments. Moreover, there are no pre-closure charges, like those applied by banks and other lending institutions.

Small-term business loans are a highly effective way to finance business cash needs. However, one needs to calculate the amount carefully and then identify the right financing institute and the right product. A small business needs to opt for customized products that suit their individual requirements and offer flexible repayment options. The innovative short-term finance options available today allow small businesses to continue their daily operations without disruption and gives these enterprises confidence to grow without apprehension.

Oct 24, 2018

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Tips to Improve Your Chances of Getting a Business Loan

Lack of adequate funds is one of the main reasons why enterprising individuals with innovative business ideas often struggle in materialising their projects. Even after a venture takes off and begins to grow, it will need extra funds at some point in its growth journey to enhance its operations and pay its suppliers. A business loan in India has been typically procured from banks, but over the past decade, though the number of small and medium enterprises (SMEs) has risen sharply, most of the SMEs who had applied for business loans remain unfinanced at large.

The gap between this demand and supply for loans is gradually being closed by new age FinTech lenders. By providing quick loans without collateral, FinTech companies are helping entrepreneurs in harnessing the full potential of their business ideas. However, the competition in this field continues to be huge, and applications for business finance are still approved based on creditworthiness.

If you are grooming your entrepreneurial venture for more success and plan to apply for business loans online, here are some tips to improve your chances of approval:

1) Create a neat business plan – You must have chalked out a business plan before foraying into a field of your interest, but if there are no formal documents in its support, it is important to prepare them. A formal business plan must include the objective of the project, the way it plans to earn revenue, the development strategy and the marketing methodology. It should also have copies of financial statements and the data on cash flow projections.

If you do not have an official business plan, you may be asked to demonstrate a solid record of revenue generation with at least one year in business. To get the application for an unsecured loan approved, it is important to prove that you are capable of repaying the loan amount without default.

2) Include a documented plan on the intended use of the loan – When you need a loan for business, you must also be able to tell the lender about its exact purpose. Be it a bank or a FinTech company, the lending institution will determine the credibility of your application on the basis of the reason for which you need the loan. While all organisations have their own unique requirements, the most common grounds for loans are business expansion, raw material or inventory purchase, administrative expenses and capital investments. You can also borrow from a digital lender to refinance or pay off old debts.

3) Know what kind of loan will suit your needs – Even after you describe the purpose of your loan, you may be faced with multiple loan categories that you can apply for. It is good to know the details of each – in terms of interest, tenure, payback plans and documents necessary to procure them. Banks and digital lenders often categorise their loan products for the ease of disbursement and management. While some credit products help in quick invoice financing, others may be more beneficial to buy inventory. Consult the lender to borrow profitably.

4) Double-check your cash flow projections – When a business does not have a high credit rating or a strong history of generating revenue, it typically gets saddled with a high interest rate on unsecured loan. It is therefore important to assess your cash flow projections. You must have a good knowledge of your ability to pay back and ensure that you will soon have adequate funds to clear off your debt.

5) Be aware of the risks that lenders assess – Lending institutions in both public and private sector evaluate loan applicants on a scale of risk. If a business is considered a ‘risky borrower’, there is a high chance that its loan may not be approved. The traits that make a business look risky are as follows:

– Very small owner’s equity
– Poor credit history or defaults in payment of previous loans
– Poor revenue earnings
– Very short period in the industry
– Weak accounting system
– Questionable management

6) Leverage your personal creditworthiness – Usually a business is a different entity from its owners. Even a sole proprietorship is a separate legal entity for accounting purposes. However, when it comes to getting a business loan without collateral, even a clean personal credit history can help you in obtaining the amount you seek. The strategy is to make payments on any outstanding personal debt and credit card bills as much as you can afford. This will give your lender more faith in your business and assure them that you are not burdening yourself with unpaid debts. You can personally guarantee for your business loans by proving your ability to repay them.

7) Research extensively for lenders – If you were denied a loan for business by a bank or a traditional lending agency, do not consider it the end of your search for funds. A FinTech company offering unsecured business loans evaluates your creditworthiness using parameters different from those used by banks. If you can successfully prove your expertise in business, FinTech lenders will provide adequate financing for your immediate working capital needs. So, think beyond the conventional platforms and apply for finance online using those documents that demonstrate your ability to pay back in time. Digital lenders also grant short-term loans, the amount being disbursed in a few minutes post the approval of the loan application.

The online lending industry has shown that getting a business loan need not be a frustrating process for SMEs anymore. FinTech companies are willing to grant loans and the application process can be effortless. All you need to do is start preparing early (in lieu of the competition from other similar applicants) and collate the minimum essential documents in support of your application.

At Capital Float, the basic premise is that all applications for getting a business loan will be evaluated with speed, efficiency and favour. The products for business loan in India are custom-fit for SMEs and include Term Finance, Online Seller Finance, Pay Later Finance, Merchant Cash Finance, Supply Chain Finance and Taxi Finance.

Oct 24, 2018