Assessing Risk the Right Way: The Promise of Cash Flow-Based Lending for MSMEs
The lending landscape is evolving, and cash flow-based lending (CFBL) is gaining traction over the traditional asset or balance sheet-based financing models for Micro, Small, and Medium Enterprises (MSMEs) in India. This lending model assesses a business's ability to generate cash flow and repay debt based on its cash inflows and outflows. The adoption of CFBL has the potential to address the enormous credit gap for MSMEs in India, which was estimated to be Rs. 20-25 lakh crore in 2019 by the UK Sinha Committee constituted by the Reserve Bank of India (RBI).
Why the Shift?
Assessing credit risk for MSMEs is a significant challenge due to the lack of financial data and credit history. Most of these businesses may never have taken a loan before or maybe new with no substantial data history.?
Lenders are realizing that although MSME finance is a good opportunity, the lack of tangible assets makes it difficult for them to secure asset-based financing. While there is some data available in financial statements and yearly filings its not a holistic way to assess the risk of an MSME.?
Therefore, the better approach is to look at alternate data sources such as bank statements, assets, UPI transactions, GST returns, income tax returns, social media activity, and other digital footprints. By leveraging alternate data, lenders can assess the creditworthiness of MSMEs more accurately.
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What is CFBL and Who is it Suitable for?
CFBL allows businesses to borrow money based on the projected future cash flows of a company. CFBL loans are short-term working capital loans used to manage operational expenses such as raw material purchases, supplier payments, electricity bills, rent, salaries, administrative fees, business travel, and more in a business.?
An ultra short-term loan of 120-180 days helps the business see through the period of cash crunch. By the end of the loan period the customers will start paying back and the business can fulfil its obligations towards the vendors in time. Another advantage is that CFBL is not shown as long term borrowing in the books. It may have higher interest rates associated with it but that’s because the loans that can be availed just in time. CFBL allows businesses to obtain financing much faster, as an appraisal of collateral is not required.
A few collateral-free credit options include invoice financing, purchase financing, B2B Buy Now Pay Later, and supply chain finance. The push for cash flow-based lending for MSMEs, the launch of the TReDs platform as a trade receivable discounting mechanism, and the thrust for digital infrastructure in the form of an account aggregator framework are all driving forces behind this new lending model.
With a more accurate assessment of a business's ability to repay loans, CFBL is a more accessible and flexible financing option for MSMEs. This lending model is suitable for businesses: in trading, engineering services,? ones that see seasonal fluctuations in cash flows, face a working capital crunch and do not have access to collateral.
Adopting cash flow-based lending models will benefit MSMEs and have network effects on the economy. As banks evolve their monitoring frameworks and meet customer requirements on an ongoing basis, this lending model will likely lead to new data formats, use cases, and product innovation, strengthening the banking sector and propelling the country's growth.