Give 'credit' where due...why SMEs deserve a lot more
Owners of start-ups and humble businesses usually have a common backstory. At some point in their lives, they refused to pretend that their jobs were more interesting than they appeared to be.
Two friends in Surat experienced this restlessness for quite a while. What could they do to break free, adopt a larger world? They didn’t have business capital, but toyed with a concept. If something as basic as water can be repackaged and sold, why not tea? Today, they sell 100-plus varieties of tea in Gujarat, their own version of ‘chai pe charcha’.
This is the essence of India’s entrepreneurial dynamos, the agents of economic change and often the unsung heroes called Small and Medium-sized enterprises (SMEs) and Micro, Small and Medium Enterprises (MSMEs). Indian economy has reams of stories on such business aspirants that can be consumed through a lifetime.
Yet it’s ironic that SMEs and MSMEs frequently deal with jammed arteries of credit. Like blood flow to the heart, credit is essentially for the health of these sectors. Since most borrowers in this segment hail from different towns, their authenticity is not established. Consequently, they struggle to avail of loans from financial institutions.
They start with limited working capital, insufficient collaterals, and inadequate credit scores that further distances them from lenders.
According to a report published by the International Finance Corporation (IFC) a few years ago, the potential demand for India’s MSME finance is about US$ 370 billion as against the credit supply of US$ 139 billion, resulting in a finance gap of US$ 230 billion.
Even if accounting records and financial statements are available, they face difficulties accessing institutional finance. Risk and volatility levels are deemed higher in this sector than among large corporates.
External variables impact their business in a major way. To cite an example, when an Indian automotive manufacturer endured crises a few years ago, it had a negative bearing on this sector. Several MSMEs dependent on this automotive giant defaulted on payments owing to liquidity crunch and were classified as NPLs (Non-Performing Loans) by banks.
A survey by Dun & Bradstreet in April this year revealed that the pandemic has impacted 82% of small businesses. Given that the Indian SME sector acts as a defence against economic shocks and adversities, it shouldn’t be languishing in the dark. First, let’s acknowledge what they stand for.
SMEs and MSMEs account for a third of India’s GDP, 45% of manufacturing output, 48% of exports, and contribute approximately 50% of the country’s industrial output. The Indian MSME sector employs over 26 million women and has produced around 8 million women entrepreneurs.
Analysts believe SMEs could absorb a significant proportion of the 600 million entrants to the labour market by 2030. In this regard, a business daily has highlighted: “…SMEs are relatively evenly distributed in comparison to larger organisations. Rural areas account for 45%, while the remaining are in urban areas.
“Hence, SMEs are well-poised to address poverty in both the cities and villages. Although the proportion of urban poverty has declined over the years, it has increased in absolute terms. In 2018, Kolkata, Delhi, and Mumbai had anywhere between 42-55% of their population living in slums.
“This number is certain to have increased in the pandemic. By providing employment and income, SMEs can raise income, living standards and consumer spending.”
Despite the significance, the industry faces various challenges like limited access to finance, less competitive borrowing rates, timely payments from buyers, lack of verified information and so on. Additionally, they are often compared with large corporates in their industry thereby creating an unfair play. SME Ratings addresses all these challenges.
What is SME credit rating? Why is credit rating important?
The prevailing information asymmetry within the sector impedes supply of adequate quantum of finance. The banking and financial service institutions struggle to make lending decisions owing to lack of structured and analysed information on them. Consequently, some SMEs approach informal channels owing to easy accessibility and availability of credit without mortgages and documentation hassles even though the rate of interest may be high. While these offer credit without much of paper formalities, they pull SMEs into a whirlpool.
Given this scenario, credit rating for MSMEs and SMEs is crucial to keep these business entities in fine fettle.
What does a SME rating agency do?
An SME rating agency assesses the ability of SMEs to repay its debt from banks or NBFCs, meet service commitments made to the buyers, pay the dues of suppliers and so on.
Broadly, SME credit rating assesses the financial viability of SMEs and MSMEs and their capability to deliver on business obligations. Besides providing insights into their sales, operational and financial composition from a risk perspective, rating highlights the overall health of these enterprises.
Moreover, rating measures risk, establishes their credit worthiness, and enables creation of standardised benchmarks for financial institutions, thus enabling faster lending decisions. In addition, it helps SMEs create financial as well as non‐financial benchmarks for their units.
These services act as a guide for self-improvement, besides improving transparency and disclosure norms in a cost-effective way. The exercise paves way for building a systematic credit and information track record for SMEs and MSMEs over a period of time.
It must be added here that the rigor of rating discipline does deter SMEs-MSMEs, as they fear they will not be so highly rated and subsequently even downgraded.
However, these fears are not well-founded. An independent third-party opinion like that of SMERA’s enables such businesses to gain acceptance and credibility amongst lenders and buyers, thereby facilitating better business prospects. Hence, it’s in their interests to seek such third-party opinions which not only act as self-improvement tools but also enhance their acceptance amongst the target groups.
SME credit rating agencies in India have their own methodologies to grade companies. Broadly, they consider the rated company’s financial data, business strategy, political stability of the country the business operates in and market sensitivity. They are also based on an in-depth study of the industry, macro-economic environment and regulatory policies.
Usually there are eight grades of SME rating ranging from SME 1-8, with 1 being the highest and 8 being the lowest scale in relation to other SMEs. These ratings are valid for a year and needs to be renewed annually.
What are the benefits of SME rating?
There are three primary benefits of SME ratings viz. access to finance, enhanced credibility amongst business partners and self-improvement tools that facilitates better business practices.
Access to Finance
Any business needs finance to fuel growth and expansion. SMEs find it difficult to get loans and that too at competitive rates from banks and other financial institutions. This is largely because often they do not have a streamline finance function, their documentation may not be in desired shape, and the general perception that their practices are non-transparent doesn’t help their cause either.
SME rating acts as a third-party opinion which, in turn, comforts banks. Additionally, SME rating agencies have signed a Memorandum of Understanding (MOUs) with banks that adds another layer of comfort resulting into competitive rates for SME finance too. SMERA ratings, for example, have been facilitating banks/lending institutions in reducing the turnaround time in processing credit applications apart from acting as a self-corrective and self-assessment tool.
Moreover, SMERA has MoUs with 36 nationalised and private sector banks, with several of them extending concessional interest rates to well-rated SMEs.
Enhanced credibility amongst business partners
SMEs partners large corporates as well as companies outside India for businesses. However, many companies may not want to associate with these SMEs given the challenges of information asymmetry and perceived lack of transparency. SME rating acts as a reputation bridge in such cases.
Ratings by agencies like SMERA which enjoy high trust and reputation enhances the credibility of these players and cements the business relationship.
In India, exports remain the bulwark of the economy. Exports have been a major driver for various industries. SMERA rating enhances credibility of these units and facilitates in building trust in global trade partners.
While SMEs are key drivers of the Indian economy, many of these business entities are still evolving in order to become professional players with the best-in-class people. They want to have the right processes and be adopters of technology.
SME ratings help in identifying such gaps in companies and enable them to come up the curve. With 50,000 SME ratings, SMERA has helped SMEs of varied scales to improve their systems and processes which, in turn, enabled them to gain better acceptance amongst lenders, buyers and other business partners.
Going forward, the landscape seems to be changing for the better. Findings from the latest edition of the SIDBI claim that in FY 2021, loans worth Rs 9.5 lakh crore were disbursed to MSMEs. This amount is much higher than that in the preceding year when loans amounting to Rs 6.8 lakh crore were disbursed.
Market analysts believe government interventions like Emergency Credit Line Guarantee Scheme (ECLGS) under the Atmanirbhar Bharat programme have driven a surge in credit disbursement to these businesses.
Nonetheless, any significant change in the industry, management or financials could offer opportunities or pose challenges to these segments and subsequently impact their credit ratings.
Considering this scenario, SMERA encourages SMEs and MSMEs to adopt the discipline of not just SME rating but also re‐rating its units annually. Doing so allows better rated entities to reaffirm their might. And poor-rated units would know they have work to do. They needn’t despair knowing that rating institutions will forever provide that booster jab of confidence.