By Tarek Kamal, Managing Partner
When an MSME reaches out to financial institutions for a loan to grow their business, the financial institution only finances a part of the project cost. Before approving the loans, financial institutions assess project proposal to ensure that the MSMEs can generate sufficient cash flow to service the debt. However, they usually seek to secure the loans further with personal guarantees and collateral.
Two of the biggest challenges to financing MSMEs cited by financial institutions are that:
- MSMEs cannot provide financial statements that are needed to assess the cash flow of the business and therefore cannot provide the comfort needed for lending to them.
- MSMEs do not have sufficient collateral to support the loan that is being requested.
The first challenge can be resolved easily enough through training for MSMEs. Capacity building of MSMEs need to include more than just training to enhance their skills in running a business (selling, marketing, planning, production and operations management, etc.). Among the most critical functions that MSMEs are often the weakest is in keeping track of their financial transactions, preparing financial statements and presenting their business plans and propositions in line with the lenders’ requirements. In fact, the transactions need to be recorded appropriately and represented in financial statements for their own use and for financial institutions. Another very important criteria that needs addressed is that MSMEs ensure that their business transactions are independently verifiable.
With regard to the second challenge, when financial institutions state that MSMEs don’t have sufficient collateral, they are usually referring to hard collateral such as land and/or buildings. And this is after the MSME loan application has been assessed to be viable, i.e. the MSME will be able to repay the loan from the business cash flow. It is true that most MSMEs do lack hard collateral. However, the MSME’s receivables, inventories, plant and equipment and other assets are available to be pledged. Additionally, entrepreneurs and their spouses effectively pledge everything that they own by signing off on personal guarantees against the loan.
The collateral issue needs to be looked at from the perspective of the MSME entrepreneurs. A paradigm shift is needed among bankers to recognize that however little the MSMEs have invested in the businesses that they run, it is everything that they have. They run their business for their livelihood, i.e. their business income provides food, shelter, clothing and education for their families. Defaulting on a loan would result in bankruptcy and loss in their ability to support their families. The entrepreneur’s dependence on the business to support their families actually serves as a far more potent form of collateral than a mortgage charge over hard collateral that can take years to liquidate. Therefore sensitivity training for financial institutions is needed to bring about this kind of realization can go a long way in building a business case for lending to MSMEs.
Most financial institutions expend a significant amount of their resources in training the staff to manage corporate lending. However, if MSMEs are to be targeted meaningfully, financial institutions need to be trained on techniques for reconstruction of financial statements from the sales information that the MSMEs keep for their own records and to be able to interview MSMEs to gain a deeper understanding of their businesses. Capacity building in financial institutions also need to be focused on their ability to assess and manage the MSME risk.