MSMEs, as we all know, is the backbone of Indian economy (or for that matter any economy, globally) that, on an average, accounts for 37% of the GDP, 45% of the Manufacturing Output, 42% of the country’s exports, and is the largest job creator by providing employment to over 110 million people spanning over 50 million enterprises. Despite such noteworthy contributions to a nation’s economy, this sector stays the most neglected in terms of funding, and the humungous challenges in accessing credit continues unabated. In my previous article “The Future of Fintech Lies in Being a Solutions Architect” published in April 2023, I highlighted the consequences of the issues in funding to MSMEs because of which this sector, today, accounts for close to 95% of the overall credit gap, and despite the Fintech coming a long way, the credit gap in MSMEs is almost at one-half of the sector’s addressable credit demand, which is alarming.

Despite having project viability, confirmed orders, EPC projects in hand, and a robust business plan, the challenges in the MSME funding is only intensifying by the day, and is further widening the credit gap. This was widely discussed in my article “MSME Funding Gap Despite Project Viability: Field Observations” published in December 2018. The key reasons – or the pain points – for this continuing funding challenges in MSMEs are quite a few: 1) lack of (or insufficient) hard assets for collateral based funding; 2) lack of proper documentation and books of accounts; 3) poor or low historical financial track records, including balance sheet; 4) relatively low credit scores; and/or 5) credit default or delayed payment / one-time-settlement (OTS) in the past due to being victim of economic circumstances (which was not a willful default).

Therefore, no matter how viable the forward-looking business is with realistically commendable steady cash flow projections, the above-mentioned five point’s i.e, the business history, balance sheet strength, and insignificant asset base will always come in the way for MSMEs to access funding. Hence, migrating to cash flow-based financing based on realistic cash flow projections will neutralize the hurdles coming from the above-mentioned show-stoppers, and will pave the way to revolutionize the funding ecosystem for the MSMEs. This will be a paradigm shift from the traditional collateral/securitized way of lending to a more realistic framework for lending based on fundamental business prospects.

The cash flow-based funding, which will be purely based on the realistic cash generation of an enterprise in the immediate/near future, will most certainly revolutionize the MSME growth trajectory leading to an inclusive economic growth – as a positive fallout.

However, it has its own risks and challenges, and, therefore, before digging deeper into the mechanism of cash flow-based funding, it is imperative that we first discuss the associated risks and the due diligence strategy that will work as risk mitigant followed by carrot (reward) and stick (penalties) approach for the MSME borrowers based on the risk evaluation.

Risks Associated with Cash Flow Based Funding

While the premise to advocate cash flow-based funding is undisputable, and the holistic approach to adopt and implement it would be noble, there are valid lending risks associated with it that cannot be ignored from a lender’s perspective. These risks, which can make a lender shy away from adopting cash flow-based funding, are:

• Lack of Transparency and Professional Approach in Maintaining Books and Financial Records – When it comes to impeccable transparency and professional approach in conducting business in terms of maintaining books and financial & other records, micro and small businesses lack the sophistication and acumen of mid-large and large businesses. While this may be due to lack of adequate training and resources, and not on purpose, this goes a long way in building a perception whether the prospective borrower is safe/credible or not among the lenders’ fraternity.
• Cooking of Books (Window Dressing) – Lack of integrity and corporate governance issues leads to overstatement of revenues, understatement of costs, and inflated assets and shareholders’ equity. This leads to not only rejection of the funding proposal by the lender, but also may end up getting blacklisted for future funding.
• Stock Adjustments – While stock adjustments (i.e., change in closing stock) are legal and allowed under accounting standards, a lender would eliminate it to assess the real cash flow. While higher stocks would lead to higher reported operating income, it would equally dent the operating cash flow i.e., cash generated from operations. That is exactly what a lender would analyze while evaluating cash flow, and a higher stock would be a possible red flag while considering the funding proposal.
• Accounts Receivable / Provision for Bad Debts – A business reporting higher revenues, but also has higher provision for bad debts / accounts receivable is a concern. Higher revenues that lead to higher income may not lead to proportionate cash flow (cash generation) if the accounts receivable is higher (or if the provision for bad debts is higher). A lender would, for sure, normalize the income by making adjustments for accounts receivable/provision for bad debts while evaluating the cash flow for funding proposal. This is because a higher accounts receivable would negatively impact the cash flow i.e., cash generated from operations.
• Higher Cash Conversion Cycle – If the operating asset (current assets) days are significantly higher than the operating liability (current liabilities) days, it would prolong the realization of cash into the business, ultimately impacting the future cash flows. This, too, would be seen as a concern, if not a red flag, by the lender while evaluating the cash flow-based funding proposal.
• Existing Leverage – If the business is already highly levered, not only the debt servicing costs goes up (thereby impacting the cash flow), but also the relative enterprise risk. The operating cash flow, in such a situation, will be minutely scrutinized by the lenders to assess if the future cash flows would have enough cushions to pay for debt servicing.
• Unrealistic Cash Flow Projections – Cash flow forecasts that cannot be corroborated with concrete rationale (including verifiable supporting documents) is a significant red flag when it comes to cash flow-based funding. If the projections are questionable and / or have fundamental flaws, it would be a deal-breaker.

The above are the key risks that will likely be factored if cash flow-based financing were to be considered.

Lenders’ Due Diligence for Risk Assessment and Evaluation

The only way to have a holistic adoption of cash flow-based funding is to develop an unshaken confidence and faith in the system so that it becomes easy to override the hurdles mentioned earlier in this article i.e., the key reasons because of which MSMEs continue to face challenges in accessing credit.

In order to build an unquestionable faith in this system, the lenders should conduct a detailed due diligence, which should focus on each parameter/factor that drives or impacts the cash flow (including the future cash flow). The following can be evaluated and cross-verified for complete authenticity:

1. Proper legal vetting of the commercial contracts/order books/EPC project work orders, etc.;
2. Legal vetting of the borrowers regarding civil/criminal lawsuit or any court order(s) already issued in any of the matters, if any;
3. Legal vetting of the borrowers’ clientele (customers) regarding civil/criminal lawsuit or any court order(s) already issued in any of the matters, if any;
4. Talking in person to the borrowers’ clientele who gave such above orders;
5. Facility visits of the borrowers and their clientele who gave the above orders;
6. In-person meetings with the borrowers’ clientele that gave the above orders to understand – a) the rationale behind awarding the contracts to the lenders’ prospective borrowers; b) performance guarantee, if any; c) penalty to the borrowers if the timeline to deliver the service / complete the project/orders are breached; d) payment terms until the last milestone of the project/order; and e) customer guarantee of honoring payment invoices raised by the borrowers, if any;
7. In a back-to-back contract, the steps (a to e) mentioned in the above point should also be repeated with the end client (i.e., the client of the borrower’s client) who gave such orders / awarded such contracts;
8. Assessing the financial health of the end client (including the intermediary client, if any, in a back-to-back), their performance track record, credit history, credibility in honoring payment invoices, etc.;
9. Verifying the purchase orders issued by the prospective borrowers to their vendors/suppliers for procurement of materials to execute the contract;
10. Talking in person to the borrowers’ vendors/suppliers to assess their capability and credibility in timely supplying the materials based on the purchase order issued;
11. Assessing the financial health and past track records of the vendors/suppliers; and
12. Financial due diligence of the prospective borrowers’ expense accounts/heads, and assets and liabilities

The above due diligence will reveal the risk status of the borrowers and whether it could be considered as safe/credible for cash flow-based funding. Further, the above due diligence can be used as Risk-Reward for the prospective borrowers. For example, if a borrower has a relatively lower risk based on the probability of the future cash flows being good, the lender may offer attractive interest rates than the industry standard, and vice-versa to borrowers having moderate to high risk. In addition to the cost of funds, flexible tenures can also be worked out based on the probability-risk of the cash flow projections. In other words, the more probable future cash flows are, the more attractive would be the interest rates and tenures, and vice-versa.

Once the lending rates, tenures, and other terms are discussed post risk-assessment of the prospective borrowers’ cash flow projections, the lenders can green-light the transaction negotiations for a meaningful closure and borrowers onboarding. At this stage, it is imperative now to discuss how the proposed mechanism for cash flow-based funding would work.

The Proposed Mechanism Framework for Cash Flow Based Funding

For commercial contracts that are EPCs / Project-Based / Turnkeys having a defined completion timeline, the most secure way that I could think of for lenders to get into a cash flow-based funding transaction is the ‘Escrow Route’, which is discussed in the below mentioned points:

1. Open an Escrow account between the borrower and the lender, with the first right of operation to the lender;
2. All invoices raised by the borrowers with its client should have the above escrow details, and the client should remit the payment based on the invoice to the escrow;
3. Having the first right of operation, the lender will first transfer the proportionate debt servicing amount (principal repayment “plus” interest) that is falling due based on the agreed terms of repayment to its base account upon receipt of the money in the escrow from the Borrower’s client;
4. The borrower can then transfer the balance amount from the escrow to its base account as revenue recognized upon issue of the NOC from the lender as per agreed terms of the escrow;
5. The above process (point b to d) to be followed for all subsequent milestone payments from the borrower’s client until the debt is fully paid off, and there are no further obligations/liabilities with the borrower; and
6. Once fully paid off, the lender will issue an NOC to the Escrow Agent to dissolve the escrow with all the remaining balance in the escrow to be transferred to the borrower as revenue recognized for performance/execution of its service.

While the above process is when a contract is directly awarded to the lender’s borrower from its client, it can be replicated, albeit a minor change, even for back-to-back contracts. Point a. above in the case of back-to-back will have three parties as opposed to two parties mentioned above. The escrow will be between the lender, the borrower, and the borrower’s intermediary client that awarded the back-to-back, with the first right of operation vesting with the lender. The remaining steps would be the same.

However, where the commercial contract is not in the nature of EPCs / Project-Based / Turnkeys, Escrow arrangement may not work as seamlessly as the above situation due to the lack of monitoring control on the payment coming in from various clients at different time periods. In such a situation, solutions, other than an escrow arrangement, can be worked out. The solution could be in the form of “Financing the Funding Gap” – a funding gap stems when in any given period, the cash inflows are less than the cash outflow, thereby creating a shortfall. This shortfall, also known as funding gap, can be plugged/bridged through any of the following means:

• Bill Discounting
• Supply Chain Financing
• Customer Financing i.e., lending directly to the borrower company’s clients so that the client can release prompt payments to the borrower company. However, in this case the debt-servicing liability lies with the end customers who were directly financed, and not with the borrower company
• Revenue Based Financing
• Capex Financing, where the asset being financed will be the collateral
• F&F Fund

The MSMEs Should Also Do Their Bit

The premise of cash flow-based funding for the MSMEs also demands an equal participation from the MSMEs to do their bit in terms of enhancing the professional approach of managing and conducting business. If the MSMEs are serious to access credit in the race for survival, the need of the hour is to get disciplined and follow the rigor of this process starting with hiring qualified and experienced professional advisors who can help them prepare for such funding with ease. The same was discussed and explained in my article “Challenges in MSME Funding: The Ideal Roadmap” published in October 2018.

To Summarize…

Cash flow-based funding would be a revolutionary step in putting the MSMEs on an exponential growth trajectory, and would literally be the much-needed financial Vit.B12 dose that this sector needs. A holistic approach in adopting the practice of funding based on realistic future cash flow generations may fasten the liquidity flow into the MSME system, thereby, leading to an inclusive economic growth. However, this approach will only bear fruit if the MSMEs, which is the primary stakeholder, also takes a serious step and work with other stakeholders such as advisors, bankers, among others, to inculcate a fundamental change in developing a professional outlook and image makeover, in order to be seen as a serious enterprise with growth capabilities.

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