Synopsis: Read this blog to gain actionable insights on managing credit risk and optimizing their capital structure in SMEs for improved liquidity and financial health. 

If you are running an SME in India, it is exciting; managing finances can feel like walking a tightrope. There is always a risk and uncertainty of customer payments. If you’re going through a similar situation, this blog is your guide to mastering two financial superpowers: credit risk management and capital structure optimization. 

A robust credit risk management will act as your financial shield, protecting you from bad debts. We’ll show you how to assess customers wisely, set clear credit policies, and collect payments like a pro. We will also learn the secrets of capital structure, which can set the foundation of your financial health. Let’s get started.  

Best Practices for Credit Risk Management in SMEs

Credit Assessment 

As per the survey, nearly 60% of small businesses have been facing credit issues post-pandemic. However, it is crucial to make a careful decision when it comes to extending credit to a specific small business as per their credit rating. Usually, CIBIL reports and CIBIL scores influence such decisions. However, that’s not all. Here are some of the most popular techniques for checking the creditworthiness of a business.  

Character 

Analyze the character of a business from its credibility and background. In this regard, the customer’s credit report and credit score will show years of expertise, bankruptcies, history of timely payments, and more. A higher score confirms the business has a strong creditworthiness. 

Capacity 

Evaluate the ability of the business to repay the loan through its cash flow statements, business debt, and payment history. For this analysis, you can consider the Debt Service Coverage Ratio (DSCR) and Debt-to-Income ratio (DTI). The DSCR score should be a minimum of 1.25 or higher, and the DTI ratio should be 36% or lower.  

Capital 

Capital signifies the total funds and assets (both financial and non-financial) owned by a company. It is also imperative to analyze the business capital in terms of the following: 

• Total funds 
• Assets (financial + non-financial) 
• Investment in fixed assets 
• Other instruments 

The bank records and financial statements of the business can give you even more clarity on its strong capital growth. If the customer is less risky, you can comfortably assign the business a higher credit limit. 

Credit Policy and Monitoring

Credit policies indicate guidelines and procedures set by the lending company regarding the offer of credit to the SME. It contains policies regarding criteria for credit assessment, credit limit setting, payment term evaluation, and collections management. A robust policy helps the lending company manage cash flow, reduce financial crisis, and retain the strong financial health of its own company. 

Here are some tips to keep in mind for preparing comprehensive credit policies: 

Strategic Alignment:

Align credit policy with your long-term company goals and pre-defined risk management strategies. It will help you play safe in the long term.  

Risk Assessment:

Do a thorough credit risk assessment over elements like customer creditworthiness, market volatility, and industry-specific challenges. It will help your lending company identify and mitigate probable risks through targeted policy measures.  

Approval Processes:

Create a well-structured approval process for applicants as per the roles and responsibilities in departments. With a clear approval workflow, you can rest assured of transparency and accountability in your decisions for credit approval. 

Collections and Recovery:

Sometimes, certain clients may find it challenging to pay debts in a timely fashion. It could be because your client might forget your invoice while managing the rest of the invoices, or they lack the cash. That’s why you should consider implementing debt collection strategies as shared below to reduce the number of unpaid invoices you have.  

Be proactive about payment. 

Instead of waiting until the last moment, inform the client 5-6 days before the due date to remind them about the payment. Make sure to follow up over the phone apart from email, as phone calls are difficult to ignore. 

Make client payments easy.

Your invoices should clearly mention your accepted payment methods. Make sure those modes offer ease of payment to your clients. For instance, instead of mentioning just PayPal, include a clickable PayPal link to facilitate cost efficiency. 

Don’t do it yourself.

Many times, small lenders take the responsibility of handling the debt collections by themselves at the expense of other essential business tasks. Instead, it is imperative to take the help of a professional accountant, bookkeeper, or a third-party service provider to ensure maximum recovery by the due date. 

Optimizing Capital Structure and Liquidity for SMEs 

Understanding Capital Structure:

An SME’s capital structure comprises three main components: equity, debt, and working capital. Equity represents the owners’ stake in the company. Debt refers to borrowed money that must be repaid with interest. Working capital is the difference between current assets and liabilities, providing liquidity for day-to-day operations. The ideal equity, debt, and working capital mix balances risk and return. Equity comes with less risk but dilutes ownership. On the other hand, debt increases financial leverage yet adds repayment burdens. It’s imperative for SMEs to have the right capital mix to ensure sound financial health and flexibility. In this regard, efficient working capital management ensures operational liquidity without excessive investment in idle current assets. 

Matching Funding Sources to Needs: 

As a lender, you should understand that SMEs can go for diverse funding sources like loans, grants, angels, and venture capital. The ideal mode of source funding depends on the business stage, financial needs, and risk appetite. For instance, startups usually invest in angel and venture capital to fuel growth. Meanwhile, well-established SMEs go with loans or grants to avoid dilution. There are also government initiatives and schemes to facilitate SME financing and support development.  

End Thoughts

Remember, mastering credit risk and capital structure isn’t magic; it’s smart financial management. By following these practical tips, you’ve built a strong foundation for the success of your SME. Now, go forth, conquer your financial goals, and watch your business soar! But remember, the journey continues. Keep exploring resources, seek expert advice when needed, and adapt your strategies as your business grows. With continued focus on financial well-being, your SME will weather any storm and reach new heights! This guide will further help you understand how to negotiate better terms for your MSME loan.