The most effective alternative financing model to support business growth
Income is vanity, profit is sane, but money is king. A company may find it extremely difficult to take their eyes off cash, as cash flow is the lifeblood of a business. Regardless of the size, scale or nature of a business, maintaining the right balance between cash inflows and cash outflows is essential. And the deficits, if there are any, must be made up, otherwise the survival of the company is threatened.
Securing a steady supply of cash is not easy, and for small businesses this problem is even more acute. Insufficient cash translates into delays in the delivery of open orders and the inability to accept new ones. In addition, uncertainties like covid can lead to late payments which have devastating effects for SMEs.
We conducted a survey of 800 SMEs to understand the real seriousness of the cash flow problem. The survey revealed that small and medium enterprises need at least 15 lakh crores of invoice financing per year, but only a negligible part of it is actually financed.
To find out why this is happening, let’s break down the gaps in current supply chain finance and understand how modern age instruments like invoice discounting can give SMEs the infusion of cash they sorely need. .
How small and medium-sized businesses traditionally manage their cash
Cash credit, also known as overdraft, has remained a predominant credit option for financing the working capital of many businesses and constitutes around 70% of total bank credit in the Indian banking system. In fact, in India, asset based loans or secured loans have been popular as a financing option. However, there is an inherent bias in the way these loans are offered. These loans are designed to favor the wealthy, or rather asset-rich businesses, and are far from client-friendly.
The big problem with traditional financing options
Heavy reliance on collateral for bank loans and cumbersome application processes are hurting many small and medium-sized businesses. This, in turn, forces them to take credit from unorganized sources at very high interest rates which could ultimately jeopardize their own business profits.
Traditional financing models are largely asset-based financing; they are inherently biased in favor of the wealthy, forcing small businesses to engage in unfair practices to get money to survive. A better approach would be to do a valuation based on revenue and cash flow, which is more appropriate than an asset-based valuation. Without a doubt, good people deserve good capital. This means that businesses with growing revenues and positive metrics deserve to receive cash to meet their current needs and fuel future growth. Financial institutions want security and sanctity in their loan books, they have focused on assets since assets are easily verifiable. However, India’s recent foray into massive digitalization and formalization has made it possible to verify and trust the quality of a business. With the advent of GST and the deep penetration of e-invoicing, Indian businesses are expected to experience the most impressive digitization since independence.
This trend is also reflected in the way countries like the United States and China have benefited from SME support. Not only are small businesses the backbone of the US economy, but these businesses have generated nearly two-thirds of new private sector jobs in recent decades. In China, SMEs grew by 10% year-on-year, fueling China’s explosive growth and making it one of the best economies in the world.
The flip side of the cash flow problem
Interestingly, cash-rich companies are on the other side of the issue. There has been a steady reduction in benchmark rates (repo rates) from 6.25% in June 2018 to 4% in March 2022. As interest rates continue to fall, large companies are struggling to effectively deploy their cash flow and returns have declined. Billing the rebate has been around but there are struggles
Invoice discounting is an alternative form of credit in which suppliers are prepaid by corporate customers at a slightly reduced value. The advantage of invoice discounting is that no collateral is required, which has often prevented small businesses from receiving credit. Unfortunately, only top-tier suppliers had access to the invoice discount. According to our research, the supplier long tail of around 75%, which accounts for 30-40% of spend, is typically excluded from any bill discounting program.
Besides exclusion, the other difficulty that SMEs face is the length of payment cycles. Clear’s survey found that payments continue to be pushed to between 60 and 120 days, despite the implementation of the MSME Act 2006. This law requires that all MSME payments be released within 45 days. Processing the invoice itself is a time-consuming process; usually it takes 5-20 days before the payment is finally released. This exacerbates the cash flow problem for suppliers is a foregone conclusion.
Due to the problems listed above, small suppliers to large Indian companies have an unmet need for credit which is estimated at over $200 billion (INR 15 lakh crore) per year. This problem can act as an obstacle to India’s growth and block the huge opportunity before us, especially job creation in the coming decades.
How a technology-driven approach improves access to bill discounting
Accelerated digital adoption, a highly digitized supply chain, significant adoption of e-invoicing, and improvements in automation and self-service capabilities as well as integration with enterprise resource planning systems (ERP) are the perfect recipe for invoice discounting to take off. .
India’s digitization efforts have led to the creation of an ecosystem conducive to the development of platforms that calculate discounts dynamically. This is done on a sliding scale and is driven by paid days in advance. This means that the technology makes it possible to offer variable discounts according to the days payable which are reduced on the date of payment of the invoice instead of a fixed discount which does not take into account the number of days payable reduced.
Bill discount for gain
We have already understood how invoice discounting is a superior and flexible alternative to traditional discounting. Large corporations can put their excess funds to good use and get 2-5x higher returns on their cash. This can maximize their EBITDA returns. For suppliers, it gives them easy visibility into receivables, quick cash injection, unsecured funds at minimal cost and therefore helps them to continue their operations. Banks and financial institutions will also be able to deepen their penetration into supply chain credit profitably in a relatively low default instrument (and high risk-adjusted return).
It’s not hard to see how the tech-driven bill reduction in its new avatar, which we can call 2.0, is a win-win for many reasons.
The opinions expressed above are those of the author.
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