What is cash flow-based lending for MSMEs to cover operating costs?

Credit and financing for MSMEs: The credit gap in the MSME sector is massive, around 20 to 25 lakhcrore rupees, according to a report by the UK’s Sinha Committee, formed by the Reserve Bank of India (RBI). That is at least equal to Pakistan’s gross domestic product (GDP) of 20.08 lakh (US$262.61 billion) in 2020, according to World Bank data. The reason for the huge credit gap is twofold: First, MSMEs lack of assets such as land and buildings, etc. to secure asset-based financing or secured lending, and second, challenges faced by financial institutions in assessing credit risk Lack of financial data and credit history among small businesses.

As a result, in recent years lenders have begun to embrace the cash flow-based approach to disbursing loans to MSMEs via alternative data sources such as UPI transactions, income tax returns, GST returns, bank statements, CIBIL score, point-of-sale data and more. The loan amount generally ranges from Rs 20,000 or less to Rs 2-3 crore.

Cash flow-based loans are generally working capital loans that are needed in the short term to manage operating expenses in a business such as rent, salaries, administrative expenses, business travel, raw material purchases and more. Buy now, pay later, invoice-based financing, supply chain financing, co-lending, etc. are some of the collateral-free lending options available to small borrowers based on their needs and based on their companies’ cash flow data.

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Lenders’ growing focus on cash flow-based lending has emerged amid RBI’s proposal to introduce cash flow-based lending in place of balance sheet-based lending. “To improve the credit-to-GDP ratio, access to credit and the cost of credit must be addressed through reduced reliance on collateral and more cash flow-based lending,” RBI Governor Shakktanta Das said in a webinar on Investor Education organized by the National Council of Applied Economic Research (NCAER) in December 2020.

However, the share of cash flow lending in total lending that both banks and NBFCs jointly originate is currently very small as it “requires much more discipline on the part of the lender, while requiring even closer monitoring of the lending unit cash flows ,” Ajay Srinivasan, director of Crisil Research, had said at the SME Artha event organized by Financial Express last November. This accordingly means that operating expenses (OpEx) remain on the higher side, at least initially when the company is formed, Srinivasan had said.