Credit risk

How MSMEs can improve their credit risk scores

Credit and financing for MSMEs: Credit risk assessment models for SMEs are generally based on the 3 Cs approach: capital, character and capacity.

By Dr Vishnu Ramachandran

Credit and financing for MSMEs: Small and medium enterprises (SMEs), the backbone of India’s economy, are wedged between the corporate and retail segments in terms of loan ticket size and have the least credit penetration. This is because unincorporated SMEs are subject to relatively relaxed financial disclosure standards to avoid imposing too much compliance on them. This results in inadequate and unreliable information on SMEs, which makes it difficult to assess their creditworthiness. This, combined with the inability of traditional models to assess their credit risk, hampers credit penetration to SMEs.

Digital lending fintech companies are trying to solve this problem with innovative data aggregation to collect unstructured data on SMEs. Additionally, the global information infrastructure now generates a large amount of transaction data from the use of digital wallets, digital payments, B2B e-commerce and point-of-sale (POS) terminals. According to McKinsey & Co, real-time payments grew by 41% in 2020, and India recorded $25.6 billion worth of such transactions. This provides a wealth of near real-time data for new era credit risk assessment models to assess the creditworthiness of SMEs.

Credit risk assessment models for SMEs are generally based on the 3 Cs approach: capital, personality and capacity. Capital refers to the assets held by the SME which indicate its financial strength and which can be used as collateral. Character is best represented by the payment history of the SME. Capacity is the current and future ability of the SME to meet its financial obligations from the cash flows generated by the business. With that in mind, here are some steps SMEs can take to improve their credit risk rating.

Payment deadline

Ensure that bank and NBFC loans are repaid on time and that credit card payments are made before the due date to help maintain a high credit rating with various credit bureaus. As a landlord, also keep your personal credit history clean; lenders monitor the credit ratings of the SME and its owner(s).

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Always pay employee contributions, including salaries and statutory payments such as the provident fund, on time. Do not delay relevant filings and disclosures to regulatory authorities such as the Registrar of Companies. Stay up to date with tax payments and tax returns. File GST returns on time, as banks and NBFCs verify GST returns before approving SME loans. Make timely trade payments to avoid unnecessary disputes. Having lawsuits filed against you for issues such as bad checks under Section 138 of the Negotiable Instruments Act sets off red flags and sends your credit score plummeting.

Accuracy and Transparency

Maintain the correct legal identity and contact details of your business in all legal databases. Have a strong social media presence and disclose adequate information in a timely manner. If your business has earned quality accreditations or won awards, highlight them. Handle customer or employee complaints on any social media platform quickly and professionally.

Adopt digital channels for payments to ensure transparency in your transactions, as modern credit risk models use near real-time data from various digital payment platforms to assess risk. It can also significantly reduce your transaction costs.

Make sure your small business owner(s) and directors comply with legal requirements and have a good record. When evaluating creditworthiness, lenders perform background checks on owners to validate identity (KYC) and check for criminal records, political ties (PEP) and involvement in money laundering. Any negative data on the owner(s) will have a negative impact on the credit rating of the SME.

Stay within industry benchmarks

Ensure that key ratios (debt to equity, interest coverage ratio, current ratio and quick ratio) are in line with industry standards. The business must be appropriately capitalized with adequate equity from the owner(s). Optimize working capital management and avoid large customer or supplier accounts that exceed industry standards. Inventory should be consistent with the size of your business – a bloated inventory inflates your need for working capital.

Taking the above steps, while not always easy, will help you as a small business improve your creditworthiness and improve your credit score. This will not only help you borrow at lower interest rates, but will also build your credibility with big business and commerce.

Dr. Vishnu Ramachandran is co-founder and chief technology and product officer at Rubix Data Sciences. The opinions expressed are those of the author.

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