Cash Flow-Based Lending: A Game Changer for MSMEs

Posted On
May 08, 2023

India's economy is known for its diversity, with micro, small, and medium-sized enterprises (MSMEs) playing a critical role in driving economic growth and job creation. However, obtaining credit remains a significant challenge for these businesses, particularly in the aftermath of the COVID-19 pandemic. This credit gap is impeding their ability to grow and expand, leading to a negative impact on job creation and economic development.

The credit gap is particularly severe for micro-businesses as they face a tough time obtaining traditional forms of credit. The lending market in India offers several options for companies seeking credit, including secured lending, unsecured lending, asset-based lending, and invoice financing. Although secured lending typically offers lower interest rates and longer repayment terms, it requires borrowers to pledge an asset as collateral, which can be challenging for small businesses. On the other hand, unsecured lending does not require collateral but may have higher interest rates and stringent eligibility requirements. Asset-based lending enables companies to borrow money against their assets, but its setup can take time and effort. Invoice finance provides fast cash access, but it may come with increased costs and interest rates. Despite their benefits, these lending options can be challenging for MSMEs to access due to their eligibility criteria and collateral requirements.

While the pandemic caused significant disruptions in supply chains, reduced demand for goods and services, and a decrease in cash flows, many MSMEs struggled to meet their financial obligations. To overcome these challenges, alternative lending methods have become a viable option in India to close the credit gap and support the expansion of MSMEs.

One such alternative lending method that has gained popularity is cash-flow-based lending

Understanding Cash Flow-Based Creditworthiness

Cash flow-based creditworthiness is a newer approach to lending that has gained popularity in recent years, especially in the MSME sector. Traditional lending institutions often rely on collateral and credit score to evaluate a borrower's creditworthiness, making it difficult for many small businesses to access credit. However, cash flow-based lending offers an alternative method of evaluating a borrower's creditworthiness.

In cash flow-based lending, the lender evaluates a borrower's ability to repay the loan based on their cash flow history, which includes their revenue, expenses, and other financial metrics. This approach offers lenders a more accurate picture of a borrower's financial health, which in turn enables them to make more informed underwriting decisions. Cash flow-based lending can also help reduce the risk of default for lenders, as they are able to evaluate the borrower's ability to repay the loan more accurately.

Benefits of Cash Flow-Based Lending for MSMEs

The traditional lending models are not very effective in serving this segment, especially when it comes to assessing their creditworthiness. Many MSMEs are thin-file customers with sparse bureau footprints, which makes it challenging to evaluate their creditworthiness accurately. Additionally, traditional lending models rely on historical data, which may not reflect the current or future financial health of a business.

Moreover, many MSMEs have not taken loans from formal sources and are not part of mainstream financial services. This absence of credit history makes it challenging for them to access credit through traditional lending models. Lastly, bank statements do not yield much information as the majority of sales still occur via cash, which means these businesses do not have a digital trail of transactions.

In contrast, cash flow-based lending models address these challenges by providing a more flexible, inclusive, and reliable approach to assessing creditworthiness. This type of working capital financing allows businesses to borrow money based on their monthly cash flow, rather than their credit score or collateral. As a result, cash flow-based lending models can be a more accessible financing option for MSMEs, even those with poor credit histories or limited assets.

Empowering MSMEs with Cash Flow-Based Lending

  1. Access to credit despite limited credit history - MSMEs without a significant credit history can still obtain loans with cash flow-based lending. As cash flow-based lenders focus on the business's cash flow history, they can determine if the business can repay the loan based on its historical cash flow.
  2. Greater flexibility in loan amounts - Cash flow-based lenders may provide MSMEs with more flexibility in loan amounts based on their monthly cash flow. This approach allows businesses to borrow the amount of money they need without taking on unnecessary debt.
  3. Improved cash flow management - Cash flow-based lending helps MSMEs to manage their cash flow better as they can borrow funds to meet their immediate cash flow needs, which enables them to focus on growing their business rather than managing cash flow problems.
  4. Faster approval times - Because the approval process does not require credit checks (which may take weeks), merchants can receive funds within days rather than weeks or months like with traditional lenders who rely heavily on your credit score when making decisions about whether or not they should lend money out at all.

The Importance of Accurate Cash Flow Analysis

Accurate cash flow analysis is crucial for any loan application. This analysis provides lenders with insight into how a business is performing financially and the ability of the business to repay the loan. However, many challenges can arise when collecting and sharing cash flow data with underwriters.

One of the major obstacles is the absence of standardised reporting. Businesses may track and report their cash flow data in various ways, making it difficult to compare and analyse data across different businesses. Moreover, several businesses may not have a comprehensive record-keeping system in place, making it challenging to collect accurate and complete data.

To address these issues, companies have built platforms to help organisations track and report their cash flow data in a more standardised and reliable manner. Using digital ledgers and other record-keeping tools, businesses can provide lenders with more dependable data that accurately reflect their financial status.

However, it's important to note that not all data is created equal. There are two types of data that businesses can provide to lenders - voluntary and involuntary. Voluntary data is information that businesses provide willingly, such as income and expenditure data. In addition to this, there is a huge amount of data that gets generated by OEMs (Original Equipment Manufacturer) based on buying patterns of MSMEs which is a good proxy of their overall sales and income. Involuntary data, on the other hand, is collected without the knowledge or consent of the business, such as credit card transactions.

While digital ledgers have made it easier to collect voluntary data, it can be more challenging to gather and verify involuntary data. This is where partnerships between OEMs, technology providers, financial institutions, and other data suppliers become crucial. By working together, these entities can access more comprehensive and reliable data that can be used to assess creditworthiness.

Lender benefits of using cash-flow-based lending

Cash flow-based lending can be a game-changer for the lenders, here is how

  1. Increased transparency - Cash flow-based lending is a more transparent lending option as it enables lenders to understand how the business is using its funds. This transparency makes it easier for lenders to make informed decisions about whether or not to provide a loan.
  2. Lower risk of default - Cash flow-based lending models have lower default rates than traditional lending models. This is because lenders assess a business's ability to repay the loan based on its cash flow history, which makes it easier to identify businesses that are at higher risk of default.

A Revolutionary Credit Assessment Tool for MSMEs: Fundfina's TrueScoreTM

Fundfina focuses on offering cutting-edge solutions to small and medium-sized businesses (MSMEs). TrueScoreTM, a credit evaluation tool that helps lenders properly and thoroughly assess the creditworthiness of MSMEs, is one of our signature products. 

TrueScoreTM is a potent instrument that could revolutionise how MSMEs obtain loans. TrueScoreTM is prepared to stimulate economic growth by enabling MSMEs to thrive in the fast-paced business world of today.

How TrueScoreTM Works

TrueScoreTM is our proprietary algorithm that analyses the cash flow data of small and medium-sized businesses (MSMEs) collected over 6-18 months. The tool evaluates and predicts the cash flow volatility of the merchants based on various criteria, including revenue, demographic information, repayments data and several other parameters. Unlike traditional credit evaluation models that depend on static financial statements or collateral, TrueScoreTM offers a more accurate and comprehensive assessment of the creditworthiness of the merchants by focusing on their actual business transactions.

  1. Analysing Cash Flow: TrueScoreTM uses advanced analytics and machine learning to analyse the cash flow data of the applicant. The data is collected through Fundfina's seamless integration with OEMs, Service Providers that have a pool of merchants on their platform conducting their business to buy digital or physical goods,e that helps them perform business operations. It is this transaction data that is considered for analysing the creditworthiness. And don't worry, we don't access merchants' bank statements at any point - transparency is maintained throughout the entire process. The algorithm then applies various models and techniques to process the data, identify patterns, and predict future cash flows.

  1. Scoring: Based on the analysis of cash flow, TrueScoreTM generates a score that reflects the creditworthiness of the MSME. The credit score is designed to provide lenders with an accurate assessment of the applicant's creditworthiness. A higher score indicates a more creditworthy business.

This way Fundfina enables growth of the addressable market by increasing the pool of creditworthy MSMEs by leveraging alternate data and underwriting models. TrueScoreTM's scoring algorithms guarantee that firms get a precise and trustworthy evaluation of their creditworthiness. Unlike traditional models where the borrower evaluation is done only at the time of onboarding, TrueScoreTM continuously evaluates creditworthiness of MSMEs on a periodic basis in order to flare up early warning indicators proactively. 

Fundfina’s cash flow-based lending is an innovative approach to lending that has the potential to transform access to credit for MSMEs. Lenders can more accurately determine a merchant’s creditworthiness and provide loans that are more suitable to the needs of specific businesses by considering the actual financial performances of such businesses. Cash flow-based lending encourages companies to handle their cash flow better and offers chances for development and growth. The Reserve Bank of India (RBI) has proposed numerous guidelines and regulations to support the credit bureaus and enhance the credit culture in addition to supporting cash flow-based lending systems as a way to increase MSMEs' access to credit. Cash flow-based financing is anticipated to become more common in India with the help of the RBI, giving MSMEs the credit they need to thrive.

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