Credit and finance for MSMEs: Credit risk assessment models for SMEs are generally based on the 3Cs approach: capital, character and capacity.
By Dr Vishnu Ramachandran
Credit and finance for MSMEs: Small and Medium Enterprises (SMEs), the backbone of the Indian economy, are stuck between the large business and retail segments in terms of loan ticket size and have the least credit penetration. This is because unincorporated SMEs are subject to relatively relaxed financial disclosure standards in order to avoid requiring them to be overly compliant. This results in inadequate and unreliable information on SMEs, which makes it difficult to assess their creditworthiness. This, added to the inability of traditional models to assess their credit risk, hinders the penetration of credit to SMEs.
Digital lending fintech companies are trying to solve this problem with innovative data aggregation to collect unstructured data on SMEs. Additionally, the Global Information Infrastructure is now generating a large amount of transaction data from the use of digital wallets, digital payments, B2B e-commerce, and point-of-sale (POS) terminals. According to McKinsey & Co, real-time payments increased 41% in 2020, and India recorded $ 25.6 billion in such transactions. This provides a wealth of near real-time data for new era credit risk assessment models to assess the creditworthiness of SMEs.
SME credit risk assessment models are generally based on the 3 Cs approach: capital, character and capacity. Capital refers to assets held by the SME which indicate its financial strength and which can be used as collateral. The character is best represented by the payment history of the SME. Capacity is the current and future ability of the SME to meet its financial obligations from the cash flows generated by the business. With that in mind, here are some steps small businesses can take to improve their credit risk rating.
Punctuality of payments
Make sure that bank and NBFC loans are processed on time and that credit card payments are made before the due date to help maintain a high credit rating with various credit bureaus. As a landlord, keep your personal credit history up to date as well; lenders monitor the credit scores of the small business and its owners.
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Always pay employee contributions including salaries and statutory payments such as contingency fund on time. Do not delay relevant filings and disclosures to regulatory authorities such as the Registrar of Companies. Stay up to date with tax payments and tax returns. File GST returns on time, as banks and NBFCs verify GST returns before approving SME loans. Make timely business payments to avoid unnecessary litigation. Having complaints filed against you for issues like bad checks under Section 138 of the Negotiable Instruments Act raises red flags and lowers your credit score.
Precision and transparency
Keep the legal identity and correct contact details of your company in all statutory databases. Have a strong social media presence and disclose adequate information in a timely manner. If your business has achieved quality accreditations or won awards, highlight them. Handle customer or employee complaints on any social media platform quickly and professionally.
Adopt digital channels for payments to ensure transparency in your transactions, as modern credit risk models use near real-time data from a variety of digital payment platforms to assess risk. It can also significantly reduce your transaction costs.
Make sure the owner (s) and administrators of your small business comply with legal requirements and have an impeccable track record. When assessing creditworthiness, lenders perform homeowner background checks to validate identity (KYC) and check criminal records, political connections (PEP), and involvement in money laundering. Any negative data on the owner (s) will have a negative impact on the credit rating of the SME.
Stay in the industry benchmarks
Make sure the key ratios (debt-to-equity, interest coverage ratio, current ratio, and quick ratio) are up to industry standards. The business must be properly capitalized with adequate equity from the owner (s). Optimize working capital management and avoid large accounts receivable or payable that exceed industry standards. Inventory should be consistent with the size of your business – a bloated inventory inflates your working capital requirement.
Taking the above steps, while not always easy, will help you, as a small business, improve your creditworthiness and credit score. This will not only help you borrow at lower interest rates, but will also boost your credibility with large businesses and commerce.
Dr Vishnu Ramachandran is Co-Founder and Director of Technology and Products at Rubix Data Sciences. The opinions expressed are those of the author.
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