Credit rating – An invaluable tool to build a sustainable organisation
Many MSMEs treat credit rating as a ritual to satisfy the bank. In reality, it has the potential to enable building stronger and sustainable entities.
We recently came across a case in which an MSME enterprise’s credit rating was below investment grade. As a result, the bank’s loan exposure to the firm was priced slightly higher. The entrepreneur was clearly upset, and he blamed the credit rating system, which he believes is more of a burden than a virtue. He was chastising his bank for ignoring his long-term relationship.
We took up the case and analysed the inputs given to the rating agency, and we made our own assessment of the firm’s financial and business standing. We found that his grievances are not entirely out of place. The firm standing is much better than many others in that industry.
The obvious question is why the firm did not get the credit rating it deserves
The notable reason for the lower credit rating, we observed, was the poor level of accounting practice. The principles of corporate accounting are not adhered to despite having a large turnover. It is further compounded by the low level of engagement with the representatives from rating agencies while they were doing their work.
The company religiously handed over documents that were needed by the rating agency. There was no attempt from the company side to interact and provide deeper insight into the operational, managerial, financial, and industrial factors which are benign to the company and how the future would look like for the company.
This disinterested approach is emanated from the perception that the rating just a ritual to satisfy the bank that extended the loans.
Its true value was not appreciated by the company promoters. Simply they were not aware that interaction with rating agencies during the process would enable them to have better insight into their own business which the representatives of rating agencies normally discuss. Secondly, they were not aware of the multiple benefits the credit rating exercise will bring.
The benefits of Credit Rating:
- Diversify the funding base and lower the interest cost: A good rating can help you gain faster and cheaper credit for your venture. The firm’s rating visible to the general public online may prompt structured debt providers to approach directly with better structures at competitive rates. A good rating can trigger an appetite for investors to join hands.
- Expanded business opportunities: The independent risk evaluation of SMEs by an unbiased third party lends credibility to them and opens doors for them while dealing with MNCs and corporates. They can submit credit ratings for tenders and make you more credible to get bigger orders. It is a fact that better ratings have helped the SMEs retain customers and suppliers, and negotiate better terms with them.
- Risk Mitigation and self-improvement: Credit rating is a third-party assignment and the work needs to adhere to certain regulations. They normally do their job in an unbiased way. Further having been in this exercise, they do advise on improving the internal controls, better adherence to accounting standards, and suggest ways to improve the governance. It emphasises the strengths and weaknesses act as triggers for self-correction. Regular renewal of ratings not only helps improve a firm’s performance but also internal control.
- Better-rated entities will enjoy a higher reputation: Another advantage is a higher reputation. It has the potential to embellish the reputation in the market. Disclosure of the rating of the firm by credit rating agencies is mandatory and being published in the press briefing and rating agencies website. This is easily amenable to the general public to view. Having been rated well means positive vibes will spread about the company. A firm that received a better rating has an obvious chance of receiving good review and enhanced confidence for those who would like to engage in the business with it.
Sustainable Organisation and rating:
Every entrepreneur aspires to make his organisation lasting longer. They strive hard, sacrifice a lot of privileges, passionately pursue their mission, and put at risk everything they possess.
However, no organisation can claim stability in the face of a fast-changing business environment and disruptions imposed by multiple factors.
The rating can help the organizations in two ways:
- It will help to eliminate the risks by exposing bad practices in the annual rating exercise.
- The organisation’s which aspire for better rating will obviously improve its governance, compliance and control mechanism and thereby build encumbrance.
Credit rating is a statutory obligation for those who have availed a significant amount of debt from the bank. In reality, it is a potential tool to elevate the standing in the minds of customers, suppliers, potential employees, potential investors & debt providers, and other stakeholders including larger society.
Every organisation- small or big, having a bank loan or not- should take credit rating like a serious exercise and strive to secure a superior rating. Those who are rated lower must strive to improve the rating by working in the weak areas.
Author: Anil Kumar Shetty, Founder SME Advisors
Adherence to the Regulations by Lenders – Enforcement is needed
The pandemic is still raging and many entrepreneurs are living under the shadow of uncertainty with regard to restructuring.
We have been assisting the couple to deal with financial distress emanated from COVID 19 pandemic and consequent lockdown in the early last year. The flourishing restaurant business nosedived to a complete standstill. Thanks to their spirited reworking of the strategy and increasing online orders, the business remains afloat. Though the profitability is still a far cry, there is a glimmer of hope and optimism that the days ahead will be better. They have few loans from NBFCs and banks as well. We all know that when the going is good, the enterprises tend to borrow a business loan that comes without any collateral security and it is quick in delivery of the loans. Unfortunately, the Covid 19 made things go very bad. NBFC which had been recovering the regular instalments till the pandemic did not show any remorse at the situation rather insisted on payment though there is not enough cash flow. The borrower made repeated requests for restructuring the loan and a softer repayment schedule for the balance outstanding which they ignore.
What is astonishing is- the approach of the NBFC to ignore RBI’s guidelines on One Time Restructuring (OTR). The subject party is eligible to seek OTR as per RBI norms. Despite repeated requests to consider under the RBI Scheme of OTR, they ignored the request.
The question is- what is the sanctity of the regulations which is not adhered to by the NBFC
In the midst of the COVID 19 pandemic and post lockdown, the Reserve Bank of India came out with series of regulatory guidelines to banks and Non-Banking Finance Companies(NBFCs) to extend relief to customers to overcome the financial distress and smoothen the process of recovery of loans in an orderly fashion. Also, Govt of India came out with many guidelines to help the MSMEs to overcome the stress.
RBI issued two comprehensive guidelines on August 6 2020. They are: Resolution Framework for COVID-19-related Stress (for personal loans and corporate exposures) and Micro, Small and Medium Enterprises (MSME) sector – Restructuring of Advances.
The circulars were very clear and unambiguous in their intent. It has given enough flexibility to enable banks and NBFCs to restructure loans with liberal terms and addressed the key concern by waiving the condition to downgrade the loan to non-performing status.
In the first reading, it sounded as if it is a panacea for avoiding conflicts between banks and borrowers. There was a great sigh of relief among MSMEs that there will not any harassment for recovery rather the process to recover from the COVID 10 pandemic will be smoothened.
Many MSMEs have given a request for restructuring in view of the delay in the onset of business recovery.
This particular couple also made a request way back in September 2020 to restructure the loan to NBFC. However, it was very agonizing to see that the lender neither took serious note of the request nor shown any inclination to implement RBI guidelines. They were absolutely cold to the proposal. In fact, there was no one to discuss the proposal.
It is not an isolated case rather than a system-wide practice. Despite the standard conditions set by RBI for identifying the eligible entities to undertake a restructuring, the banks and NBFCs are not enthusiastically taking up and do not see any obligation to act under the regulations. Their action is very patchy.
The obvious question is- what is the sanctity of the regulations issued by the RBI. Who will have to oversee the implementation?
The regulations are announced as a response to demand from industry bodies and citizens. If it is ignored by the lenders and if they focus on recovery, it will not serve any purpose.
Bank/NBFC is a party for the transaction. It is prudent to leave it to their wisdom to decide on the restructuring proposal? Is there any department or a statutory body which is having the supervisory responsibility to enforce the regulation promulgated by RBI? Indeed it is needed.
Regulations and policies are meant to remove personal prejudices, individual discretions and notably, it will facilitate the contract between two parties conflict-free. Having regulations on OTR is indeed positive for the MSMEs to overcome the covid induced stress. However, its significance is lost when there is no appetite among the lenders to implement.
An agency from Govt/Regulators will have to look at the efficacy of implementation of schemes. This is needed to eliminate the uncertainty and enable effective implementation. It requires setting up a mechanism to help the borrowers to notify their desire to seek restructuring in an independent platform and such request should be referred to Bank /NBFC headquarters for further action.
Setting up such a mechanism with the online channel is quite easy and requires minimal investment. The benefit will be multifold. Having provided the platform, the process will become more transparent and the banks & NBFCs will be compelled to take an objective view of the proposal. It will take away the uncertainty. Brining more stressed business assets into productive use will result in a more economic capacity to grow.
Restructuring is beneficial to all the stakeholders:
Restructuring of loan is one important step in the broader agenda of the revival of stressed business. Unfortunately, there is an element of restlessness among the bankers and NBFCs to undertake this. Rather many are willing to call the customers for One time Settlement of the loan; a sort of inducement. It is not correct. A business of an individual member of the society constitutes an economic asset of the whole country.
Secondly, it is in the interest of banks and NBFCs to hold a dialogue with stressed customers and create a viable path for turnaround. After all pestering, the borrower in the hour of the crisis engulfing the whole society will only lead to self-inflicted injury to these institutions than bringing meaningful recovery.
The fact is in the long run the restructuring is indeed beneficial to the banks and NBFCs though they have to endure short term mismatches in the asset-liability management.
COVID19 Pandemic is causing havoc in the economy. Small business owners are bearing with brunt. The OTR scheme is very much important for stabilising their business and finance. RBI and Govt should make its implementation very effective and facilitate fixing the stressed relationship with lenders so that they will move to revive their business. That will facilitate faster economic recovery.
A weak resolution environment is negative to promote entrepreneurship
COVID 19 exposes the vulnerability of MSMEs in the face of uncertain events. This shows a need for a robust resolution mechanism to deal with creditors and find a viable path forward.
I met with a group of partners of a restaurant business who had been doing extremely good till the COVID 19 pandemic started. The format was very unique in the industry and has the potential to be replicated elsewhere. In fact, the promoters had drawn an ambitious plan to expand the footprint through the franchisee route to take it is to different parts of the city as well as pan India. Pandemic and consequent sudden lockdown had made the calculations go haywire.
The business just slipped out of control. They could not salvage the business. The creditors and suppliers demand was too much to bear with. The bank loan which was well within the normal level till the lockdown suddenly became too much to digest as there was no income flow. The leased property, wherein they invested more than Rs 1 crore to create a unique theme, had to be demolished as the rent payment becomes burdensome. With the removal of the store from the place which was part of their brand, there was no chance to return to the normal business. The condition deteriorated to the level beyond their imagination in the wildest of dream and all happened in just a matter of a few months.
Now the partners are helplessly watching the unfolding of recovery actions from the multiple lenders who have extended business loan at a high rate of interest with a short maturity.
The absence of policy support to deal with uncertain times is the central issue
The pandemic was unanticipated rather an uncertain event. Equally the lockdown was sudden and there was no time to think of alternative options. None of these was under their control.
Today we are in a situation wherein there is no regulatory or legal framework to enable entrepreneurs troubled by uncertain events to carve out a viable path to return to normalcy. The uncertain events affect all in equal measure. However, what is missing is a legal framework that will distribute the pain without letting anyone in the contract to be benefitted or remain unaffected whereas another the party will remain in an advantageous position at the previous level or better. For instances when the lender is a party to the contract, the borrower undergoing the uncertain event will remain indebted to the fullest extent because there is no statutory binding for the bank to sacrifice a fraction of the loan to make the business viable or allow to service the debt with a haircut and a longer schedule.
This unequal position in fact deteriorates the situation further as it will bring in too much uncertainty in the minds of entrepreneurs who will have to deal with the enlarged ego of the other party. This will divert the focus away from resurrecting the troubled business and end in the destruction of the enterprise. Destruction of an economic enterprise brings agony to not only the entrepreneurs & his family but also but the larger society as it will also suffer loss in many ways.
This unequal position is not a stand-alone event affecting a few. It is visible very widely. The entrepreneur will have to answer the same question from many others such as suppliers, unsecured creditors, tax authorities etc. They in turn will have to face a similar situation with others. In all, it is a challenge for the whole society.
Thus there is a need for a standing mechanism to support those victims of uncertain events. The mechanism should be able to help them to withstand the immediate pressure on cash flow and stabilise the business. Once the business returns to normalcy they should be compelled to make the payment to obligors be it bank, creditors suppliers alike.
In the face of uncertainty, the most important support an entrepreneur require is to stand firmly against the wind flow and thus preventing the run on the business. This will create breathing space and allow the firm to review its business and find a viable path forward.
In the process, it may require the creditors have to make a sacrifice in the immediate future with or without a clawback option to recover the loss in the medium to long term depending upon the circumstances and viability.
Resolution support in India:
There were few attempts to create a window of opportunity for distressed firms to review and rework a path forward. The very comprehensive support mechanism was enshrined in the 2015 circular of the Govt of India (Framework for Revival and Rehabilitation of MSMEs). It indeed addressed the concerns. Unfortunately, it suffered from the lack of enforceability of the guidelines. Rather it remained a wishful policy framework and its adoption is purely voluntary.
However, enactment of the Bankruptcy Code in 2016 had raised hope for many. Though Insolvency and Bankruptcy Code (IBC) has the power and scope for stressed business firms to seek relief as in many advanced countries, it is not fully implemented covering all types of the constitution rather limited to LLC(Limited Liability Companies) and LLPs(Limited Liability Partnerships). For the rest, though the law provides for, Govt has not notified yet.
It is time for Govt makes IBC law accessible to all forms of businesses uniformly. There were apprehensions that bankruptcy tribunals will be overwhelmed with litigations. It is not the correct position. Because having an option in the hand will facilitate dialogue among the creditors with the firms and will help to find a viable solution voluntarily. If you look at the history of litigations in Bankruptcy Tribunals(NCLTs), the voluntary understanding that arrived among the stakeholders forms a significant proportion of resolutions than otherwise.
MSME Prepack- A welcome step
There are discussions in various fora that the Govt will bring in a Prepackaged resolution solution under IBC to simplify the process and expedite the resolution for the benefit of MSMEs. The process under the pre-pack insolvency envisages formulation of a resolution plan before the initiation of a formal court process. It is a welcome step and it should be made available to all forms of the business including proprietorship firms and partnership firms along with LLCs and LLPs.
Resolution support de-risks the operating environment and hence promotes entrepreneurship:
A populous country like India needs to encourage entrepreneurship to create employment opportunity and improve the competitiveness of the economy. However the journey of entrepreneurship is filled with experiments, adventurism, and itself is a learning curve for many. It is unlikely to be smooth and cannot be predicted to proceed as planned.
Having a support mechanism for those who may suffer along the path of the entrepreneurship journey to revisit the journey will create a great enabling environment for many to take entrepreneurship. In the long run, the country will win.
A law like IBC is much needed for businesses at this point in time than ever in the history of organized business because the uncertainty in the operating environment is at an elevated level. The entrepreneurs require a sense of assurance through the legal framework to seek a solution if the business proposition fails to yield the desired result. This way the resolution support can promote entrepreneurship.
CGSSD Scheme: New lease of life for stressed MSMEs in India
The new scheme is a well-conceived framework to enable stressed potentially viable MSMEs to secure a new lease of life and a much needed bridge to facilitate constructive engagement with the bank.
Recently an entrepreneur sought our assistance to revive his business units, one in South and the other one in North. Both are in the same activity and are incorporated in the year 2016. Both together consumed the investment in excess of Rs 30 crores with little than 50% of the bank loan. The business was new to the family although they are in the higher reach of the value chain of the industry for more than four decades.
Both businesses faced quite the same problem. They failed to gather a robust team. The capacity utilisation was lower than the minimum viable level. . The key risks were not in control. Since the family members were at the helm of affairs, there was lax internal control and governance. No one took the burden of running the business professionally.
Despite the most modern production facility and promoted by the family of successful entrepreneurs, the business failed to reach the expected revenue targets and started incurring huge losses resulting in the account becoming NPA in the books of the bank. Having no option left with, Banks in both the places initiated recovery action under SARFAESI Act.
The family repeatedly sought assistance from the banks to restructure the loan and revive the business by infusing additional capital. However, banks were very adamant insisting for the recovery of the loan.
Latest Development: Revival is underway
Thanks to the Govt’s initiative of helping the stressed MSMEs through a new scheme “Credit Guarantee for subordinated Debt (CGSSD)”, the businesses of both these units are seeing a revival.
Under the new scheme, the loan restructuring is underway at the individual bank level. A new business strategy is put in place. The operation is restarted in both the units. The capacity utilisation is steadily rising.
The new guidelines from the Govt of India made the difference:
Recently Govt brought out a new scheme to facilitate the revival of stressed but potential MSMEs. The purpose is to provide guarantee coverage for the CGSSD and provide Sub-ordinated Debt support in respect of the restructuring of MSMEs. 90% guarantee coverage would come from scheme/ Trust and the remaining 10% from the concerned promoter(s). The objective of the scheme is to provide personal loan through banks to the promoters of stressed MSMEs for infusion as equity / quasi-equity in the business eligible for restructuring.
The salient features are:
- The borrower should be the promoter of MSME unit
- The Account should be SMA 2 or NPA as on 30.4.2020
- The accounts classified as NPA after 1.4.2018 are eligible
- The loan amount will be 15% of Promoters stake in the business to the maximum of Rs 75 lakhs
- The loan will be extended to promoters.
- The loan will have guarantee cover from CGTMSE
The scheme is a game-changer:
The scheme is a source of great relief in the above instance. The promoters were sincerely looking for a way out from the messy banking relationship to revive the business. The scheme extended a framework to work with the bank and find a viable path to return to profit. Today the units are in a position to extend jobs to many unskilled and semi-skilled employees in the region. Precious public money will come back to the bank in a phased manner without going through stressful, expensive and value destructive recovery actions.
A mechanism for handholding during the stressful scenario is needed for MSMEs.
Entrepreneurship requires to be encouraged for India to become a global powerhouse and assisting entrepreneurs in the stressed scenario should be part of the policy support they need. We explain here below some of the reasons:
- Dealing with an uncertain environment is endemic to entrepreneurship: Despite the best planning, many firms may challenge to survival due to factors not in their control. Many time changes in the policy or local regulation do impact the business of the small businesses very badly.
- Internal factors and learning curve: There are chances that many a time entrepreneurs fail to get the grip on certain vital functions that may be the key success factor for the business. Every venture has its own learning curve and they need to be supported if there is any delayed onset of the business for want of understanding if its nitty-gritty.
- Bad financial planning: Many a time the decision to launch new busies is more an emotional decision than followed up with a clear financial strategy. We have seen many entities struggling to put the financial maths in place despite the best of technology, manpower, and having huge opportunities to become successful.
- Absence of professional advisors and mentors: Many first-generation entrepreneurs go through a long-struggling learning curve in the absence of access to independent and credible advisors and mentors. As a result, the process of finding the right formula for success gets longer.
Entrepreneurs do make mistakes especially in the early stage of new business. There should be an avenue for course correction. Such businesses deserve a chance to correct the course and redraw their path to success.
In the above cases the CGSSD scheme played a major role to bring in difference. In the similar instances elsewhere entrepreneurs need to be given chance for course correction. An opportunity to review and strategize their business will be of great to protect the value of enterprise they have passionately built.
Also the CGSSD scheme can create a good platform to make the engagement between the bank and entrepreneurs more constructive even when there is distress and facilitate them to find a viable path jointly to turn around the stressed business. In any case It will not take away the discretion of the bank to enforce the recovery if the attempt does not help to revive.
Further improvement required:
CGSSD scheme is a welcome step to help the stressed MSMEs. The support mechanism for stressed MSMEs may be further improved to broaden its horizon. Some of them are:
a) Make it available all across the banks and NBFCs: The borrowing of any MSME is wider than one source. This should be mandatory of all of them join in the process. Unfortunately, lenders other than Govt owned banks are not supporting the MSMEs in this regard. It should be available on a non-discriminatory basis. Govt may bring in required legal and/or regulatory actions in this regard.
b) Remove the age of NPA clause: As per the norms of the guidelines, accounts classified as NPA from April 1, 2018, onwards are eligible. This may be relaxed to cover any potentially viable unit irrespective of the date of becoming NPA.
CGSSD scheme is a welcome step to help the stressed MSMEs to find new lease of life. Also, it is a much better option for the banks instead of seeking recovery action immediately after becoming NPA.