Blog post -
Cash flow-based loans are now an option for Indian MSMEs, but will banks lend?
The central bank of India recently permitted financial institutions to lend to micro, small and medium enterprises (MSMEs) on a cash flow basis, in addition to existing asset-based lending.
In cash flow-based lending, the repayment is based on the business-projected cash flows. Lenders determine the risk and repaying capacity of a borrower by his cash flows.
But rising non-performing loan accounts in the MSME sector could dampen the boost this new move could give to these businesses.
There are nearly 70 million MSMEs in India and many of them are not able to get swift loans from banks because they don’t have much collateral to offer. Hence, they mostly remain underfinanced or not financed at all.
Cash flow lending could thus make a big difference to these businesses, and this kind of lending is not new to banks. They have been funding many infrastructure projects for established companies in India in the same way.
But banks may still hesitate to lend all small businesses on a cash flow basis. Firstly, according to a report by credit bureau CRIF High Mark, loans to MSMEs in India, which represent a major share in the overall commercial loans by volume, have risen by 52%, i.e., from 16.2% in FY17 to 24.6% in FY21. In fact, MSME loan volume, with loans up to Rs 500 million, had a share of 85% of commercial loans in March 2021. That’s a big jump in lending exposure to the MSME sector, and banks could be wary of increasing this exposure even more.
Secondly, RBI, the central bank of India, recently issued a clarification on asset classification norms that will increase the number of non-performing assets (NPAs) —loans that are in default or in arrears.
Currently, some lending institutions upgrade accounts from NPAs to the standard asset category upon the payment of certain overdues. But the new RBI rules state that loan accounts can be revised from NPA to standard assets only if all the outstanding interest and principal are paid by the borrower. As a result, financial institutions are likely to see a higher number of NPAs in the future and may want to limit their lending to risky businesses.
So, while the central bank has provided support to the MSME sector by allowing cash flow-based lending, it has also put new restrictions on lenders through these rules about NPAs. That means the overall impact on MSMEs could turn out to be neutral.
What lessons can MSMEs learn from these developments? Raising capital is often required to grow a business, and the possibility of accessing financing based on healthy cash flow reinforces the importance of managing cash flows. The ability to repay these loans punctually is also closely linked to effective cash flow management. That means managing receivables from your customers and getting paid on time is critical to the sustainability of MSMEs.