The sales and profit margins of many micro, small, and medium-sized enterprises (MSMEs) are highly vulnerable to seasonality, input and labor costs, late payments, natural calamities, unexpected expenses, and myriad other factors that result in lumpy cash flows. Without collateral or sufficient credit information, banks are often reluctant to lend them money, so these MSMEs face the additional risk of non-performing assets.
But thanks to new technology, the mindset of financial institutions is changing in ways that are enabling MSMEs to access loans. There is a growing trend of cash flow-based financing backed by current and projected future cash flows.
These loans are entirely different from traditional asset-backed loans, where the valuation of collaterals offered to the lender decides the loan amount and tenor. The reticence of conventional banks to lend to MSMEs hinges on the fact that they do not possess fixed assets as collateral.
Emerging financial technology (fintech) players around the world are reshaping how MSMEs can access working capital and cash flow finance. Having acknowledged that MSMEs lack the capacity to produce financial reports to enable financial institutions to assess their repayment capacity and default risk, they are deploying nimble and agile technologies to get an accurate understanding of their cash conversion cycle.
The cash conversion cycle is the time MSMEs need to convert investments in inventory and resource inputs into cash through sales of goods and services that can help establish the cash generation terms of the business and thereby help to determine their repayment capacity and enhance price transparency. After all, cash is the only factor that can repay a loan; collateral is only the second way out if money cannot be generated.
A good example is Kenyan merchant cash advance service Grow, which helps MSMEs access capital by factoring their cash flow cycles while simultaneously encouraging them to start moving away from cash to electronic payments account via the Kopo Kopo transaction platform.
A percentage of the digital transactions that merchants receive is set aside to repay their advances. This arrangement keeps repayments fluid, bite-sized, and in line with cash flow.
In India, Capital Float, a non-bank finance company, provides instant decisions on collateral-free loans for small entrepreneurs. A risk profile assessment is carried out in real time by analyzing MSMEs’ cash flows using data from PayTM, an e-commerce payment system and digital wallet company, mobile financial services firm PayWorld, and smartphones.
Capital Float customers carry out electronic know-your-customer (KYC) authentication, receive the loan offer, confirm acceptance, and sign the loan agreement on a mobile app. The loan amount is credited to their account on the same day, with nil paperwork.
Cash flow loans help MSMEs seize opportunities when they arise, and are an excellent example of the targeted, niche innovation that enables fintech to compete with more prominent—but slower—traditional banks. They are well suited to businesses that maintain very high margins, but lack enough hard assets to offer as collateral.
These loans typically cater to MSMEs in retailing and marketing, where managing and generating better cash flow is crucial given their higher cost of debt and lower return on capital compared to large corporations.
Rural lending is also shifting toward cash flow-based lending, which would lower costs and attract big banks and financial institutions. Fintech solution providers like India’s CropIn Technology are bringing data, artificial intelligence, and machine learning to banks to help them better assess credit risk.
Farmer data on KYC, geo-coordinates of farms, history of crops they have sown, crop size, yield and potential earnings factor into the partner bank's digital platform. This information is collated with remote-sensing data to predict a farmer's productivity, estimates of the yield, and selling price.
The last step is plotting risk scores for farmers using a machine-learning algorithm. By assessing the cost of input/output, positive cash flow and profitability, instant credit disbursal can be made in rural areas.
After the loan has been issued, satellite imagery helps the bank conduct remote monitoring and evaluation by providing periodic data on whether the farmer has used the disbursed loan for the intended purpose. When the crop approaches the harvest stage, the bank is alerted to get in touch with the farmer to initiate the repayment process.
Insurance companies looking to offer crop protection to smallholder farmers can also leverage such technology for underwriting and claims administration. In the dairy sector, insurance firms are now able to finance cash flows by determining the amount of compensation payable to a farmer based on both quantity and quality of milk produced.
More frequent repayments align with the nature of cash flow lending and the risk policies of fintech lenders. It involves real-time cash flow-based underwriting and monitoring of highly leveraged balance sheets, using current account and merchant settlement data on large volumes of small payments. The loan size and pricing are based on the level and stability of cash flows.
Since MSMEs typically have a single bank account, using highly automated pricing and decision engines provides a clear electronic footprint for tracing the history of the cash flows. By analyzing the net cash flows, an accurate and real-time risk assessment of the short-term financial health of MSMEs can be made on their repayment capacity and liquidity position.
Access to real-time information helps to manage risk, as it allows the lender to identify the defaulting MSME quickly and ring-fence the cash flows or suspend payments before overdue fees accrue. This leaves no room for manipulation of funds –a root problem of asset-backed lending strategies that suffer diversion of cash flows through multiple bank accounts.
With a new generation of digital-savvy MSME owners emerging in developing Asia, traditional players may soon find themselves playing second fiddle to fintech. The only way to survive is to innovate in the MSME finance space and accelerate investment in technology to future-proof their platforms and retain and grow their non-traditional customers.