Synopsis: As opposed to asset-backed credit, MSMEs can avail of loans based on expected cash flows. In today’s blog, we will untangle what cash flow-based lending is and why it is gaining traction among lenders and MSMEs.

Years of mandated MSME lending have not been able to stave off the burgeoning credit constraints faced by MSMEs. As per RBI, the demand for external credit approximates Rs. 37 trillion, but only Rs. 14.5 trillion is met through formal sources. This has, in turn, resulted in a massive credit gap of Rs 20-25 trillion.

Against this backdrop, the UK Sinha Committee recommended following a cash flow-based lending (CFL) model to solve the credit crisis currently clogging the growth veins of MSMEs. But why do we need a CFL model at all? Let’s find out.

Current MSME Lending Scenario

As micro, small, and medium enterprises (MSMEs) are considered high-risk — a fact quantified by their higher NPA ratio — lenders prefer sanctioning MSME loans backed by collateral. And the problem with asset-backed credit products is the requirement of collateral itself.

To illustrate, if a business wins a contract to supply goods and wants capital to buy machinery for production, what collateral can it offer for a loan sanction? Furthermore, such businesses may even need to provide goods on credit, which further delays their payment cycles, thereby affecting loan repayments.

Another issue that lenders grapple with is assessing MSMEs’ creditworthiness. Since small businesses have little to no credit history, poor financial recordkeeping, and sizable information asymmetries related to their cash flow trends, the traditional credit appraisal system results in high turnaround times (TATs). Indeed, banks can take up to 29-31 days to process an MSME’s loan application.

Finally, the loan operating costs (LOC), i.e., the cost of processing MSME loans, disbursement, and pursuing repayments, are generally very high for MSMEs. Due to the fixed nature of some of these costs, loaning amounts under Rs. 10 lakhs result in considerably lower profits for conventional lenders.

The cash flow-based lending (CFL) models can break these structural barriers faced by MSMEs, thus ensuring adequate credit flow to grow their businesses successfully. 

But what is cash flow-based lending (CFL)? Let’s understand.

What is Cash Flow-Based Lending (CFL)?

Cash flow-based MSME lending envisions a transition in the lender’s appraisal system from a conventional balance sheet-based funding model to an objective assessment framework based on the future cash flows of an MSME. 

To simplify, lending institutions will focus on the MSME’s actual revenue generation in real-time and plan the repayment schedule around its cash inflows while extending MSME loans. This, thus, discounts the need for collateral. 

Therefore, banks track an MSME’s turnover based on its GST data, sales registered on POS machines, e-commerce transactions, or the number of trips made (by a logistics company). This data collection has further been eased with the Account Aggregators (AA) system becoming operational, which allows for consented data sharing.

5 Elements of Cash Flow-Based Lending (CFL)

In contrast to other MSME lending products, including credit lines, project finance, and MFI microcredit, CFL is possible only in a digital lending and payments value chain. Some of the features of cash flow-based lending are:

1. Sachet Loans

The real-time visibility of cash flows allows lenders to create small-sized/sachet loans with progressive tenures, which are especially useful for New-to-Credit businesses.

2. Shorter Loan Processing Times

The shorter tenures result in faster TATs as lenders are mostly concerned with short-term cash inflows.

3. Customized Terms

CFL models allow for flexible repayment schedules and terms tailored to an MSME’s needs.

4. Reduced Credit Risk

Lenders also have the option to make instant MSME lending and disbursement decisions based on changing scenarios, such as changing sales velocity or poor customer reviews.

5. Automated Cash Flow Controls

CFL loans assure lenders of repayment by creating a lien on future cash flows, which has been made possible by E-liens, a digital public infrastructure.

How Does Cash Flow-Based Lending Assist MSMEs- 3 Reasons to Know

Due to their short-term, sachet-sized, customizable nature, CFL loans embolden MSMEs to access adequate capital for meeting their working capital and growth requirements. Below, we elaborate on how CFL augments the growth of MSMEs.

1. Collateral-Free MSME Lending

Since CFL-based MSME loans are tied to expected future cash flows, lenders have no requirement for any pledged security. This is crucial for small businesses, including small-time retail stores and Kirana shops, that have no way of meeting a lender’s collateral and thick credit file requirements. 

Additionally, it does away with the need to carry out extensive borrower assessments and credit score evaluations. Consequently, cash flow-based MSME lending has opened doors to the formalization of credit. Furthermore, it is touted that with the Public Credit Registry becoming operational, cash flow data itself will become the new collateral.

2. Improves Cash Flow Management

Since CFL-based MSME lending involves tracking cash flows, it helps in realistically charting future cash flow trends, particularly the fixed costs, operating costs, accounts payable, and accounts receivables—all the reasons that can cause a working capital crunch. This way, MSMEs are in a better position to maintain financial stability while benefiting from easier MSME loan terms.

For instance, consider a scenario where a small business is unable to pay salaries to its employees, as its cash is currently locked in accounts receivable. In this case, the MSME can get a CFL-based loan against its receivables at a shorter processing time and more amenable repayment terms. 

3. Flexible Loan Terms

It is critical to note that financing cash flow is distinct for each firm, as it is based on several parameters, including industry, business size, stage of business, and owner’s resources. As a result, an MSME may require terms and conditions that are customized to its model — a need met by CFL. Moreover, the debt covenants of these MSME loans are centered on affordable interest rates.

For example, assume a small tourism firm that is largely flourishing throughout the year except for the three winter months of sluggish activity. As a result, the said business is unlikely to meet its repayment obligations due to slow tourism. A cash flow-based loan strategy can help such a firm by structuring repayments on the company’s real cash inflows.

The Final Takeaway

The advent of cash flow-based lending complemented by the AA framework has propelled the rise of a new breed of fintech companies that are offering tailored loan products to MSMEs. Additionally, banks have moved beyond traditional asset-backed MSME loans to CFL models to recapture the MSME market. This can be gleaned from the soaring popularity of invoice-based financing and post-shipment finance products among MSMEs.

Most of all, faster adoption of CFL can be a panacea for all the credit woes faced by MSMEs. Armed with adequate and timely credit, they are sure to grow and succeed while generating massive network effects for the economy.