Understanding the real cost of MSME financing

Micro, Small, and Medium Enterprises (MSMEs) play a crucial role in the Indian economy, contributing significantly to employment generation, industrial production, and exports. Despite their importance, MSMEs face challenges in accessing finance, impacting their expansion and operational efficiency.

Key components of MSME financing costs

The actual cost of borrowing for MSMEs in India extends beyond the commonly focused costs such as interest rates and processing fees. Here’s a breakdown of the key components contributing to the real cost of MSME financing:

• Interest rates: This is the primary cost of borrowing and is typically expressed as an annual percentage rate (APR).
• Processing fees and charges: Fees charged by lenders for processing the loan application, including documentation and administrative costs.
• Prepayment Penalties: Charges imposed on the borrower if they repay the loan before the scheduled term.
• Collateral Requirements: Some loans may require collateral, such as property or inventory, that can add to the overall cost of the loan if the collateral has significant value.
• Loan Insurance: This is optional but is sometimes recommended - Loan insurance protects the lender against specified risks, adding to the overall cost of the loan.
• Late Payment Fees: Penalties for missed or late payments, which can increase the total cost of borrowing.
• Other Hidden Charges: Any additional fees or charges not explicitly mentioned in the loan agreement but can impact the overall cost.

Understanding these components is crucial for MSMEs to accurately assess the total cost of borrowing and make informed financial decisions. To bring in further clarity for borrowers, the RBI has mandated all lenders to declare the fully loaded Annual Percentage Rate (APR) in the Key Facts Statement which MSME borrowers must review.

Impact of loan structure and tenure

The structure and cost of loan products, specifically its tenure, plays a significant role in determining its suitability for MSMEs. Banks and NBFCs often push for longer tenure term loans to align with their own debt cycles. Additionally, there will also be prepayment penalties for early closures. Long tenure business loans with repayment periods extending up to 5 years are suited for long-term ROI-linked expenditures such as significant capital expenditure expansion. However, they may not always meet the short-term financial needs of MSMEs.

In many cases, MSMEs require funds for short-term purposes such as inventory scale up, marketing initiatives, and boosting sales. Existing short-term loan products like Overdrafts (OD) or Cash Credit (CC) limits often fall short of meeting these needs as they typically require collateral or security, thus limiting their access to those MSMEs that are capable of offering such assets. 

Additionally, the credit limits offered are often insufficient to address the actual requirements of MSMEs. 

Many MSMEs end up taking long-term loans for short tenure use cases and continue servicing the loan even after they have recovered the money. Therefore, it is important for MSMEs to evaluate their requirements carefully and choose between short-term and long-term funding options accordingly. 

To effectively compare long-term loans vs short-term loans, businesses should consider the absolute cost of the loan, which is determined by the total amount payable over a period of time. This absolute cost impacts the P&L, and is offset against the firm’s margins.

For example, an MSME with a 50% gross margin could obtain a Rs 25 lakh loan from a technology-driven lender for inventory expansion, incurring a one-time fee of 6% spread over six months. This arrangement would provide an additional Rs 23.5 lakh in cash at an absolute cost of just Rs 1.5 lakh, significantly cheaper than a 24-month loan.

Opportunity cost

Raising debt and equity financing can be a very time-consuming process, requiring significant investment of time away from business operations. In case of debt financing via traditional lenders such as banks and NBFCs, it can take anywhere between 30-90 days to raise debt. 

Additionally, it necessitates the compilation of extensive data, including profitability records for three years, and the provision of collateral. The exhaustive process of securing debt financing can divert resources and attention away from core business operations. Despite these efforts, the amount raised through debt financing may often fall short of the desired level.

Equity financing is suitable for early-stage companies that are yet to achieve product-market fit (PMF). It can take anywhere from six months to a year and multiple investor presentations to raise equity from investors. 

Venture capitalists typically invest in high growth companies that promise significant returns on investment (ROI). However, not every MSME aligns with venture capital criteria for rapid growth. Equity financing is also not suitable for scaling up ROI-linked expenditures or meeting the business growth timelines of MSMEs. Additionally, opting for equity financing may lead to the dilution of ownership stakes, thereby affecting the financial returns for founders and early stakeholders.

Therefore, MSMEs must carefully evaluate the pros and cons of both debt and equity financing options to determine the best funding solution that aligns with their business objectives and the amount of time they can invest in the fundraising process.

Founders’ time is the most valuable asset that a business has and therefore speed of execution should be a primary consideration factor while raising funds.

Transformation in MSME lending

The MSME lending space in India is at an inflection point and has been transformed by the advent of new age technology-driven lending platforms. These loans are designed to make the borrowing process seamless for MSMEs and come with specific features to cater to the company’s unique requirements and move fast with readily available data. 

Understanding the real cost of MSME financing is crucial for informed decision-making. MSMEs should evaluate time costs, loan structures, and new lending options to optimise financial resources and drive growth.

(Abhiroop Medhekar is the Co-founder and CEO of Velocity, a cash-flow based financing platform)