Revenue is vanity, profit is sanity, but cash is king. A business may find it extremely hard to take their eyes off cash, as cash flows are the life blood of a business. Irrespective of the size, scale or nature of a business, it’s critical to maintain a fine balance between cash inflow and outflow. And deficits, if any, must be met, or else the survival of the business is under threat.
Ensuring a steady supply of cash is not easy, and for small businesses, this problem is even more acute. Insufficient cash translates into delays in delivering current orders and the inability to take on new ones. To add to it, uncertainties like covid can cause payment delays which have devastating effects for SMEs.
We undertook a survey across 800 SMEs to understand how severe the cash problem really is. The survey revealed that small and medium businesses need at least 15 lakh crores of invoice funding annually but only a negligible portion of it actually gets financed.
To find out why this happens, let’s break down the gaps in current supply chain financing and understand how modern age instruments like invoice discounting can give SMEs the infusion of cash that they badly need.
How small and medium businesses have been managing cash traditionally
Cash credit, also known as an overdraft, has continued to be a predominant credit option to fund working capital for many businesses and constitutes about 70% of the total bank credit in the Indian banking system. In fact, in India, asset-based loans, or collateral loans have been popular as a funding option. However, there is inherent bias in the manner these loans are offered. These loans are designed to favour the rich, or rather asset-rich businesses, and are far from being customer-friendly.
The big problem with traditional financing options
The heavy dependence on collateral for bank loans and cumbersome application processes hurts many small and medium businesses. This, in turn, forces them to take credit from unorganised sources at very high interest rates that could ultimately jeopardise their own business profits.
Traditional financing models are largely asset-based financing; they are inherently biased towards the rich, forcing small businesses to adopt unfair practices to get cash for survival. A better approach would be to do a revenue and cash-flow based evaluation which is more appropriate than an asset-based evaluation. Without doubt, Good people deserve good capital. Which means businesses that display growing revenues and their metrics are positive deserve to receive cash to meet their current needs and fuel their future growth. Financial institutions want the security and sanctity of their loan books, they have focussed on assets since assets are easily verifiable. However, India’s recent foray into massive digitisation and formalisation have made it possible to verify and trust the quality of a business. With the coming of GST and deep penetration of e-invoicing, Indian businesses are set to see the most impressive digitisation since independence.
This trend is also reflected in how countries like the US and China have benefited from supporting SMEs. Not only are small businesses the backbone of the US economy, these businesses have generated nearly two-thirds of the new private sector jobs in recent decades. In China, SMEs have grown 10% year on year fuelling China’s explosive growth and making it amongst the top economies of the world.
The flip side of the cash problem
Interestingly, cash-rich businesses are on the other side of the problem. There has been a steady reduction in benchmark rates (repo rate) from 6.25% in June 2018 to 4% in March 2022. As interest rates continue to fall, large businesses find it difficult to deploy cash effectively and their returns have been dwindling.Invoicing discounting has been around yet there are struggles
Invoice discounting is an alternative credit form where suppliers are paid early by corporate customers at a slightly reduced value. The good part about invoice discounting is that there are no collaterals required, which have often been a blocker for small businesses to receive credit. Unfortunately, only top-tier suppliers have had access to invoice discounting. As per our research, the long tail of vendors of roughly 75%, who account for 30-40% of spends are generally excluded from any invoice discounting program.
Besides exclusion, the other difficulty SMEs have been dealing with is long payment cycles. Clear’s survey revealed payments continue to be pushed to somewhere between 60-120 days, despite the implementation of the MSME Act, 2006. This Act requires all MSME payments to be released within 45 days. The processing of the invoice itself is a time consuming process; usually it takes 5-20 days before which the payment is finally released. This compounds the cash flow problem for the suppliers is a foregone conclusion.
Due to the problems listed above, small-scale suppliers of large Indian enterprises have unserviced need of credit which is estimated to be over $200B (INR 15 lakh crores) annually. This problem can be a barrier to India’s growth and can stall the massive opportunity that lies ahead of us, especially the creation of jobs in the next few decades.
How tech-led approach boosts access to Invoice Discounting
Accelerated digital adoption, a highly digitised supply chain, significant e-invoicing adoption, and improvements in automation and self-service capabilities along with integration with Enterprise Resource Planning (ERP) systems is the perfect recipe for Invoice Discounting to take off in a big way.
India’s digitisation efforts have led to the creation of an ecosystem that is conducive towards developing platforms that calculate discounts dynamically. This is done on a sliding scale and is driven by days paid early. Which means that technology allows variable discounts to be offered based on payable days which are reduced on the invoice payment date instead of a flat discount which does not take into account the number of payable days reduced.
Invoice discounting for the win
We have already understood how invoice discounting is a superior and flexible alternative to traditional discounting. Large enterprises can deploy their excess funds to good use and earn 2-5 times higher returns on their treasury cash. This can maximise their EBITDA returns. For suppliers, it provides them with easy visibility on receivables, the timely infusion of cash, collateral-free funds which are at minimal cost and therefore it helps them continue their operations. Banks and financial institutions will also be able to deepen their penetration in supply chain credit in a cost efficient manner in a relatively low default instrument (and high risk adjusted yield).
It’s not difficult to see how tech-led invoice discounting in its new avatar, which we can call 2.0, is a win-win-win for many reasons.
Views expressed above are the author’s own.
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