Small, Micro and Medium enterprises (SME) sectors in India have played a substantial role in the growth and development of the Indian economy. The SME industry has been the foundation stone for the economy offering employment to millions and making a sizable contribution to the national exports as well as the GDP of the country.
Despite this, the expansion of MSMEs has been hindered by their exclusion from traditional lending sources. SME loans could help to secure long term growth for the businesses through faster and easy access to capital. In the upcoming years, the Government of India aims to reach SME contribution to 50% of the country’s GDP and 75% of the country’s exports. Such SME loans could be an excellent source for SMEs to get necessary support for their business operations and achieve long term growth objectives.
SME Loans- Meaning and Purpose
SME loans are financial products issued by lending institutions to small or medium-sized businesses to fulfil its business growth objectives. Such loans could be either secured and unsecured in nature requiring collateral for certain sums, whereas others do not require any collateral. Such SME loans are an excellent source for fulfilling immediate fund requirements for a business to encourage smooth operations and implementation of their growth-related objectives.
Due to the considerable risk involved accessing business loans from traditional lending institutions has been difficult. However, the rise of non-banking financial institutions (NBFCs) and numerous government policies and initiatives have expanded access to credit, relaxed eligibility norms and encouraged growth of SMEs in India.
SME Funding Challenges
Why do lending institutions show reluctance to lend funds to SMEs in India? The very first thing that comes to mind is that they lack authority and long term records to showcase their ability to repay the loans. Lets have a quick look at the challenges faced to avail SME loans in India.
- Lack of Credit History- SMEs with little or no credit history makes it challenging to evaluate their loan repayment capacity.
- Higher risk of failure- Since SMEs face higher chances of failure compared to larger businesses, thus lending institutions are reluctant in offering SME loans.
- Low Capitalization- SMEs generally have restricted capital reserves that make it difficult for the business to sustain financial distress and repay the SME loans.
- Lack of documentation- Since SMEs have little reporting and compliance requirements, lenders find it challenging to assess their financial health and monitor their performance which is a crucial part in sanctioning SME loans.
- Limited Assets for Collateral- Generally, SMEs lack adequate assets that could be pledged with the financial institution as collaterals, to reduce the risk of default of SME loan.
- Lengthy process of application- Compared to larger and established corporate entities, loan application processes for SMEs require in depth due diligence to reduce loan default possibilities. Again, lack of knowledge and expertise to manage these processes on the part of SMEs could discourage lending institutions from offering business loans.
SME Loans and Lender Readiness
Common Challenges Faced by SMEs to Raise Capital
Various SME entities have faced numerous challenges to gain access to capital to meet their business needs. Such hindrances might have deterred them from achieving their business goals, but they must employ strategies to realise their entrepreneurial dreams and drive economic growth. Hence, provided below are some common challenges faced by SME businesses and the solutions to overcome the same-
Limited Credit Access
Regardless of whether the business has a brilliant idea or innovative product, several small and medium enterprises lack access to funds. Most of the SME business owners consider traditional lending institutions as their first choice to raise capital for their business needs. In light of their smaller size, limited track record, extensive collateral requirement, rigid payment terms, higher rate of interest, etc. they are perceived as higher risk by traditional financial institutions.
However, to resolve the issue of enabling capital access the Government of India has launched several programmes which support SMEs through partial collateral/collateral free or guaranteed loans. These programs provide loans through banks, cooperative banks, NBFCs, rural banks up to a predetermined sum. It included schemes such as-
- Avail Collateral-free MUDRA loans- The Pradhan Mantri Mudra Yojana (PMMY) is a flagship programme that offers micro, small and non-corporate businesses with loans up to Rs.10L known as MUDRA loans (Micro Units Development and Refinance Agency Limited). MFIs, NBFCs, Commercial banks, and Small Finance Banks offer MUDRA loans via applications received through the Udyami Mitra portal.
- Government Guaranteed loans under CGTMSE loans– The Credit Guarantee Trust Fund for Micro and Small Enterprises allows SMEs to apply business loans with guarantee up to (50%/75%/80%/85%) of the sanctioned amount mitigating the default risk for lending institutions. The permissible loan amount along with guarantee cover has been provided below-
| SME entities availing loan up to Rs. 5L | 85% guarantee cover |
| SME entities availing loan between Rs. 10L-1Cr. | guarantee covers up to 50% authorised credit amount for retail-trade activities. |
| In the event of loan default by SME borrower | The trust covers up to credit facility defaults for loans up to Rs.2 Cr granted by lending institutions. |
- Avail business loans for implementing latest technologies/purchase machinery/equipment – SMEs who wish to increase their manufacturing efficiency by adoption of latest technologies could benefit from this scheme. This scheme aims to encourage technological upgradation of SME businesses by offering up to 15% capital subsidy through institutional credit up to Rs. 1 crore for eligible industries or technologies. However, if the businesses replacing machinery or equipment with the same machinery/equipment or replacing technology/equipment with used equipment will render them ineligible to avail the scheme.
Limited/Lack of Investor Awareness
Another challenging aspect for difficulty to raise capital for SMEs could be due to their lack of investor awareness which affects their ability to connect with investors and secure funds for growth and expansion purposes. It could happen due to following reasons-
- Primarily, investors like Venture Capitalists, Angel Investors and other investment firms tend to focus towards more established entities with scalable businesses or may hold little knowledge regarding the growth opportunities presented by SMEs.
- Poor Networking skills could make it tough for SMEs to reach the right people who might be interested in offering investment for the business. Thus, start-ups and SME owners with limited networks may take it longer to build relationships with potential investors.
- Inability to communicate their value proposition and demonstrate their potential for growth to investors could further cause investors to overlook promising investment opportunities due to information shortage.
Therefore, it is imperative for SMEs to build their skills and expand their network through various programmes and events conducted for investor meet ups or connect through professional networking platforms. Building strong relationships with investors could significantly improve their chances of raising capital to achieve their business goals.
Other than this, the Government has launched the scheme Fund of Funds to address the financing and networking requirements for SMEs. The scheme encourages SMEs to meet their equity funding requirements through the Investor Funds and register themselves with the proposed Fund of Funds. The scheme offers equity financing to sustainable and fast-growing SMEs through infusion of different kinds of funds (Venture Capital, Private Equity, etc.) into underserved MSMEs.
Limited or Inconsistent Cash Flow
The issue of irregular business cash flows while attempting to raise capital for their operations is arguably one of the most common challenges faced by SMEs in India. In order to seize business growth opportunities, a business must have a good cash flow for instance, leasing a large business space, purchasing equipment, hiring manpower or building a new website, etc.
However, SMEs could resolve this issue through using alternative financing options like Supply Chain Financing. Supply chain financing (SCF) entails the issue of working capital by lenders to borrow businesses by leveraging their existing commercial relationships in a cost-effective and efficient manner.
It includes a number of methods designed to finance suppliers using trade receivables and invoices as an intermittent collateral for loans. SCF financing solutions could help SME distributors and suppliers to boost their working capital making them globally more competitive.
Poor Credit Score Management
Needless to say, lending institutions determine the creditworthiness of the borrower businesses on the basis of their credit score and repayment history. Since, most of the SMEs face financial distress to run and manage their operations, they have a low credit score implying higher risk of default for the lender and loans at relatively higher interest rates for the borrower SME.
Hence, SMEs unable to avail business loans could consider the following-
- Consider including a trustworthy co-signer or guarantor for the loan application, specifically the one with better creditworthiness.
- Provide Collateral or Additional Collateral such as equipment, machinery, immoveable property, etc. to assure repayment within time to the lender
- Seek loans from NBFCs who have flexible norms for the borrower’s credit score.
- Look for alternative lenders (like those in the fintech industry) who would be open to lend funds to businesses with lower credit scores.
Identifying, Securing and Managing Fund Needs
Another issue faced by SME owners is to identify their fund requirements and securing funds from investors. It is to be noted that traditional lending sources necessitate three resources- data, assets for collateral and time. Thus, SMEs lacking these three elements should consider alternative financing sources including but not limited to-
- Angel investors
- Venture Capital or Private Equity
- Crowdfunding
- Peer to Peer Lending
- Invoice Financing
- Business Incubators and Accelerators
Apart from identifying the right solution for financing, it is also difficult for SMEs to decide the right amount for fulfilling their business requirements which is a tricky part. Seeking less than required funds may increase chances of loan approval but will sacrifice the true business potential whereas asking more than required funds might be rejected outrightly.
Similarly, SMEs also struggle to raise capital due to their inability to clearly demarcate funds for short-term as well as long term usage, lack of transparency for funds distribution required for managing day to day operations, etc. Thus, here are some useful tips to identify SME fund requirements-
- Set Clear Financial Goals- Set clear financial goals by assessing your current financial situation. Track cash flow to create financial plans enabling the identification of immediate objectives and build growth strategies for coming years.
- Create Budget- Create a budget to identify business goals, allocate resources and avoid overspending. Estimate incomes and expenses periodically apart from those required for growth and expansion requirements. Finally, compare budget to actual results to find gaps and adjust accordingly.
- Make Financial projections- Next, create a financial report on the basis of estimated costs and expenses on the basis of in-depth market research backed with historical data. An effective financial projection could help SMEs to showcase their ability to generate revenue and manage expenses will garner interest among investors to raise funds.
- Manage Cash Flows- It is also important to monitor the income and expenses of the SME business. SME businesses should ensure adequate incomes to meet their short-term obligations with the help of cash flows statements. Further, in order to avoid liquidity issues and seize growth opportunities businesses should review and adjust their financial strategies.
Innovative strategies to increase SME finance
Meeting Credit Needs Via Alternate Routes
When it comes to lending to SME businesses, traditional lending systems have adopted a more cautious approach to mitigate non-performing loans and similar liabilities. Now, MSMEs could approach structured finance entities who offer services such as corporate restructuring, legal and off-balance sheet accounting or use of financial instruments to seek credit for working capital as well as term loans. It is especially helpful for SMEs lacking documentation to establish their creditworthiness rather than to look out for unsecured loans at high interest rates to advance their business growth.
Planning Insurance Support
Certain SMEs also suffer from lack of distribution channels which could connect them to relevant insurers. Given the rapid pace of technological adoption and digitization, as well as constant presence of cyber threats, the first step in addressing such issues is to insure SMEs against any operational risks. From agro to pharma industry, holding adequate insurance could act as a facilitator to help SMEs against ill effects of any impending disaster.
Adopting Latest Technologies
Cutting costs to achieve maximum profitability is a major concern for most SMEs in India. In order to reduce reliance on additional resources and save expenses, MSMEs could implement the latest and reliable technologies. For instance, SMEs could benefit from employing software that makes accounting and bookkeeping easier. Instead of relying on several stakeholders for essential functions like maintaining sales records, it will enable them to strategically structure their company and create a transparent accounting system.
Automating Operations
SMEs adopting robust technologies for automating their manual tasks could bring efficiency and reduce operational costs. For instance, using online catalogue for product and service details, employing tech platforms to list pending orders, or creating automated bills and payment slips, etc. or more could also improve efficiency and precision as well as encourage transparency in business processes.
Collaborating for Technical Support-
Collaboration between businesses for technical support for SMEs to expand their network and get peer support. For instance, listing SME business for online business and accepting digital orders through another business acts as a facilitator is an ideal example for collaboration for technical support.
Cash Flow–Based Lending-
SMEs could seek funds based on their anticipated future cash inflows through cash flow-based lending which does not rely on conventional collateral or creditworthiness of the business. The predicted income streams and cash flow cycles are used by lenders to determine its ability to repay loans. Revenue based financing, Merchant cash advances and Invoice financing are some of the examples of cash flow-based lending.
This strategy could be especially relevant for financially distressed businesses as it could allow them access to capital even if they lack solid track record or substantial assets to pledge with the lender.
RBI Mandates to Banks Pertaining SME Lending
In regard to lending to the MSME sector, the Reserve Bank of India issues various guidelines to lending institutions from time to time. Lately, the RBI has issued a master circular which sets out current criteria pertaining to SME loans to be followed by lending institutions in India-
- Banks have been encouraged to target 20% Year-on-Year (YoY) growth in SME loans along with up to 10% growth in the number of SME business accounts each year.
- In order to ensure optimum availability of SME credit, banks shall make sure that not less than 60% of the SME loans are provided to SME enterprises. Such lending targets for the SME sector shall be evaluated on the basis of outstanding credit to SME as on the prior March 31st.
- Banks shall accept all SME business loan applications either submitted physically or digitally through SME borrowers in a transparent manner. The lending bank shall also make sure that the serial number has been documented in the application as well as the acknowledgement receipt.
- Banks have been discouraged to seek any collateral for business SME loans up to Rs.10L provided to SME borrowers. It is to be noted that the limit of Rs.10L for collateral requirement could be extended up to a loan sum of Rs.25L where the SME business has a good track record for loan repayments.
- SME business owners shall be allowed to avail a composite SME loan (mixed ratio of working capital as well as term loan) for up to a sum of Rs.1 Cr via a single application.
- Lastly, public sector banks shall ensure at least one specific branch for meeting SME borrowing needs in every district across the nation.
Conclusion
The SME sector in India has played a key role to support the Indian economy through employment generation as well as contributing to its GDP. Although, it cannot also be denied that most of the smaller enterprises meet failure within 5-10 years of its incorporation due to financial distress. Such issues are of serious concern but could be resolved through better monitoring of SME loans so that these borrowers get credit at the crucial stages of the business cycle. BankKeeping can help SMEs and MSME businesses in their banking journey to avail better credit facilities and effective loan management, helping them to reduce their borrowing costs at various levels.
Developing a deeper understanding of such challenges, comprehending solutions and putting focused solutions in place could help the SME sector immensely. Apart from this, close cooperation between the Government, Lending institutions and the Investors to address access to capital related concerns could bring a bright future for the SME sector and consequently build a prosperous nation.