Proper classification of entries in the annual accounts- An essential task for SMEs

Accurate classification of entries in the book of account is a basic requirement for proper representation of financial standing before lenders and other stakeholders.

Recently we were approached by one construction company having many projects in its fold for advice on the difficulty in securing the bank loan despite having a good amount of own investment and healthy growth over a few years and he was willing to extend good collateral security to the comfort of the bank.

He said that the bank is not in favour because the financial ratio is not favourable. As per the initial assessment the current ratio, key ratio to decide on the working capital limit was below one. Something the banks consider not acceptable.

We started analysing the financial records of the year 2019-20. We found that the reason for the low current ratio was the wrong classification of the unsecured loan. To our dismay, we found that the unsecured loan was clubbed with sundry creditors. On the hand the firm has acquired fixed assets to that extent..  Of course in the first reading, anybody will get an impression the firm has diverted the short term creditors’  money to acquire long term assets.

Apparently the bank had drawn a conclusion that the party does not have financial discipline and has diverted the short term money for long term use.

Party indeed invested the money into the business in the form of an unsecured loan and he has no plan to get back that loan in the near future. Rather this amount was invested keeping in view the requirement of long term funding needs for the growth of the business.

Here the wrong conclusion on the part of the bank originated in the wrong classification of the loan from the promoters into the short term liability that too clubbed with sundry creditors.

Annual Accounts –an important document to represent our business:

Maintaining books of the account is the process of recording and maintaining financial transactions and information relating to a business, on a day-to-day basis. It ensures that records of the individual transactions are correct, comprehensive and updated with accuracy.

Some of the entrepreneurs treat book keeping as a low priority one and hardly look at it for its veracity and integrity. Further, they treat annual auditing of accounts is just a ritual for compliance and tax assessment. They do not see any significant relevance to their business plan. Still worse many boldly state that the books of accounts do not reflect the true picture of the business.

In fact, some SMEs failed in financial management due to weak or no accounting records. On the contrary, financial management is very crucial to the success of a small business. Many repent this when they hit the distress.

These opinions and  perceptions won’t help the entrepreneurs. The books of accounts are important for many reasons. Annual accounts are only documents that address the concerns of stakeholders – bank, suppliers, buyers, potential  investors, tax authorities etc.

Why SMEs should maintain proper books of account

To prepare Financial Statement: Balance sheet, profit and loss account, cash flow statement are the key elements for reporting to investors/ financiers/bankers on crucial information about the financial status of the enterprises, and books of account are a precursor for it.

To fulfil tax obligations: Paying tax is an obligation by law; beitincome tax, customs and other taxes and duties. To know the correct amount of obligation and to resolve any disputes, one needs adequate and accurate books of account

Legal requirement: There is a certain stipulation in the IT Act to file the returns and this requires to be backed by the books and account. Further Companies Act 2013 also requires every company to maintain their books of account.

Better financial management: At present, better financial management provides a better picture of the health of a company. To make forecasting of financial requirement, acquiring necessary capital and to analyse investment decisions, you should have adequate records of business transactions. Also, the review of the operating performance in relation to time periods or peer comparison can be effective only with proper accounting practice.

Long term sustainability: A thoroughly studied and prepared annual accounts throw many facts and expose the inefficiencies in managing the finances.  Thus it will eliminate scope for the surprise appearance of liabilities and financial stress.

Interacting with Accountant especially Auditor is important  task:

Proper preparation of our books of accounts is our primary responsibility and getting it thoroughly audited by a Chartered Accountant is an equally important job.

No accountant is interested to make a wrong representation of entries. However, for want of clarity or lack of evidence in the books about the nature of the transaction or by oversight, they may also err in the grouping of the data.

Further, the Auditor having gone through your books of accounts during the course of the audit may have observed deficiencies. Such observations are vital to improving our internal control and risk mitigation. Thus entrepreneurs should interact closely with their Auditor during the annual audit process. Their wisdom drawn from multiple engagements will help you to improve internal control. Also, it will eliminate the scope for errors.

Conclusion:

Accurate classification of the entries in the books of account is in the interest of the entrepreneurs. A growing business requires support from multiple sources including banks. Hence accurate representation of the annual accounts is important for winning the confidence of finance providers such as bankers and investors. 

Leverage & Uncertainty- Double Whammy for MSMEs

The MSMEs which are leveraged will find going will be very challenging in the present circumstances. This should enhance the appreciation for prudent financial management.

Recently I had a call from one entrepreneur who has been into a movie screening business. The unit is leased to an operator for a monthly fixed rental payment. The same is discounted with a bank to get into another business. Unfortunately, that new business suffered a huge loss as they were new into it and they did not make a proper financial strategy before entering.

Despite the loss in the new venture, the debt servicing remains intact due to regular rental income from the tenant. However, the global pandemic of COVID 19 has changed all the calculations. The movie screening is stopped and so is the cash inflow.

The industry is not sure how long the situation will persist. The entrepreneur and his family are very tensely watching the evolving scenario.

COVID 19- Not a risk rather an uncertain event

Many are cribbing that they are not prepared for intense liquidity stress due to the economic impact of COVID 19 and resultant difficulty in debt servicing. The fact is that COVID 19 is not a risk to anticipate. The risk is one which can appear and reappear on the horizon and a positive probability can be assigned to it. Such that we may take some preventive measures,  avoid its happening and /or at least we can mitigate its impact. In case of uncertainty based events, nothing can be predicted- neither its arrival nor its impact.

Today the whole world is experiencing an uncertain event and its longevity is unpredictable. So is its impact on the individual business.

Leverage is a prudent strategy in the period of high economic growth. But timing high growth is a challenge:

The leveraged business model is good so long as the economy keeps an upward trend in growth because the cost of debt is lower than equity. The challenge is to predict how long it will last. It is difficult to predict. Growth prediction is becoming a challenge due to the globalised trade regime and newer disruptions from evolving regulations, technological advancement and changing business process driven by the internet.

If the economy hits a downward spiral or industry in which you are operating is slowing down, the debt will be a serious challenge. Once trapped into a vicious debt trap, many entrepreneurs borrow more to meet the repayment obligations. As they borrow more and more, the cost of borrowing will go up and eventually the credit record will suffer. More borrowing coupled with slowing business is sure toxic combination for any business to survive.

In India, we have been witnessing a steady decline in the growth in the last two to three years. That has affected the business of many well-run entities. We have witnessed the collapse of many large companies and being sold under bankruptcy code in the last two years. The common denominator was a high debt load.

COVID 19 has aggravated this. Many long-standing businesses are facing a serious crisis of survival in the wake of pandemic and coupled with borrowing. The borrowing now appears excessive due to lowering sales and they are facing a double whammy situation.

Policy Response to COVID 19: Govt/RBI initiatives and their impact

Many debt-laden firms are staring at the imminent collapse. Govt & RBI came to their support by offering fresh loan under ECLGS, Moratorium and MSME Debt restructuring Scheme.

Fresh loan under ECLGS has helped many to postpone their immediate repayable to four-years spread. Moratorium gave temporary respite from cashflow burden for stalled businesses. Whereas the restructuring extended a window of opportunity to take a fresh look at the business scenario and revise the debt servicing.

The measures are lead to rearranging the payables with reference to timing; whereas interest burden pertaining to moratorium remains and business sentiment remains weak. Otherwise, a normal level of leverage in the orderly economic scenario is now crystallizing to distress due to lower than expected cash flow.  Burden from the period of the moratorium will have a compounding effect.   A realistic solution could be allowing reduction or sacrifice of the interest burden. In the absence of such a step, the viability of many businesses will remain doubtful.

MSMEs are more vulnerable and affect the personal life of an entrepreneur

The long term prediction of the prospects with excessive reliance on debt is becoming a risky proposition for businesses –big or small. The impact will be more severe for small businesses because they normally mortgage their assets like living home to secure credit for the business. Any impact on the business will directly affect their family life. This is not the case with large corporates.

Many of the entrepreneurs do not think about derisking their business model while seeking more growth. They continue to pursue the growth through loans from banks and NBFCs and thus retaining 100% risk for themselves. All their assets and cash flow(business as well as personal)  are intensely leveraged to meet the financing needs.

COVID should be an eye-opener. It is the high time for MSMEs to explore ways and means of de-risking the business model and take it as a precursor for pursing the growth ambition. At least explore ways of minimising the risks to the family through smart structuring.

Conclusion

A leveraged business model is a good option in a high growth period. However, it can be toxic if there is a decline in the business that may arise due to internal and external factors. Creating excessive leverage on the cash flow anticipating the same economic scenario into the future for years is quite a dangerous phenomenon. No business can be stable in the long term in the new trade regime.

The learning from the present crisis is- Restrain from unbridled borrowing to fund the business plans. Rather derisking oneself while pursuing the growth should be the preferred option.

SMEs in Distress- Beware of ‘Soldiers of Fortune’

When in distress, many SMEs chase new money and normally end in traps of mischievous elements who make tall promises and swindle money.

I recently met one entrepreneur after a gap of two years. Once he had a flourishing business in excess of Rs 50 crores. He had built the business by himself brick by brick. Having come from a middle-class family, despite the success, he stuck himself to the higher values-Extremely affable, god-fearing, and committed to meet promises.

The back to back the introduction of policy measures – Demonetisation and GST-pushed him to the slippery position. Before he could make the required changes in the business process and financial management, the situation went out of control. The liquidity stress started appearing and he started defaulting on the payments resulting in personal insinuations from the providers of loan and suppliers which he never experienced in his life. On the other hand, the trade cycle got disrupted and order flow dried up as his principals started realigning their business to adjust to the new reality.

While he was battling in multiple fronts he started getting offers for a comprehensive bailout. Obviously these offers attract him as he was already exhausted to deal with demand from various people.

They offered to arrange a very large sum and consolidate the borrowings into a single source along with a very attractive rate of interest much below the RoI applicable to well-rated borrowers despite being highly stressed.

The waiting is still on…

Unfortunately, he is still hoping for the new money ever after two years. In the meantime bank and NBFCs have initiated recovery action against his properties and have been establishing their rights.  The business is closed and the family is living with agonising pain and praying for better days.

It is commonly observed among the entrepreneurs in distress:

Most of the entrepreneurs in financial difficulty look for quick solution fearing that continued distress may affect the business and their reputation.  Having pledged every asset to lenders they fear the impact of distress much more than what it really is. That in turn, prompts them to seek an instant solution. They tend to react to any proposal with much more intensity and avoid confronting those mercenaries to understand their credentials.

Fortune soldiers- Mercenaries who boast  about exclusive access to money:

These agents claim that they have an exclusive arrangement to secure money at very soft terms. They show a lot of empathy and promise to work for clients with all the sincerity.  If we analyse the experience of interaction with these fortune soldiers there are commonalities in their approach. Some of them are :

• They present as if they enjoy a high degree of confidence of the financiers.
• They seek very small fraction as advisory fee and a still smaller fraction as advance
• Terms are so compelling to justify taking risk of giving advance
• The advance will be packaged as a commitment fee or insurance premium to bring the money from abroad etc
• They do not reveal much about the financier.
• They prop up the  names of people in higher offices
• They set the meeting in very premium places

Eventually, their target is to extract advance as much as possible, keep giving excuses to frustrate and eventually make one go away.

Entrepreneurs are more vulnerable in India for financial distress than in any other country:

The options for turnaround are limited in India. The general perception of the stressed enterprise is highly prejudiced. Many see them with suspicion of laundering money from the firm. Being in stressed and struggling lonely, entrepreneurs are obviously vulnerable.

Many take risk of giving the advance in the hope of getting a large sum. Unfortunately, many entrepreneurs have lost a huge sum of money in their hunt for fortune.

The greater damage will be when an entrepreneur diverts his attention to chase this route and keep away from immediate tasks.  Lack of credible proposal may prompt recovery action leading to the collapse of the business and destruction of enterprise value.

How to deal with this situation?

If anyone offers a deal which is cheaper than a bank loan, it is to be examined thoroughly before committing. We have not still come across a charity extending helping hand to distressed businesses.

Entrepreneurs should desist from the temptation to seek quick money and allow them to be drifted away from reality. It is nothing but a distraction to find a viable solution within their reach and exacerbating the distress.

Keep your attention to immediate tasks such as talking to creditors and suppliers.

Many a time we falsely blame the absence of money for our distress. However, the fact is that most of the reasons for distress lie elsewhere and pumping more money won’t solve the problem.

Review the business strategy with the support of professional advisors. With professional assistance, you can build a new roadmap and lower the risk to sustainability.  When an outsider is roped in, fresh scrutiny will open the mind to explore alternatives.

Distressed entities require better policy support:

MSMEs need better implementation of the law to assist entrepreneurs to undertake course correction.  Unfortunately, half-hearted implementation of regulations to support distressed entities in India is preventing entrepreneurs from taking an orderly path to turnaround. This will naturally make them fall prey to unscrupulous elements.

The Insolvency and Bankruptcy code needs to be made universal.  The option of restructuring of loans should be enforced upon all the banks(public/private) and NBFCs.

In the present era of globalization, the vulnerability for risks is unlikely to recede rather likely to go up. Thus a stable policy environment is needed to support the turnaround of distressed entities. Also tagging prejudice of criminality with distress situation must end.

Conclusion:

Entrepreneurs in distress should appreciate that there are no short cuts to come out of it. Recovery from distress is an orderly process and time consuming requiring one to review in entirety and draw a new strategy.

 By

Anil Kumar Shetty, Founder, SME Advisors

Bank merger: Re-entry to the pre-1969 era for small businesses?

There is an apprehension that merger among the PSBs may lead to deprivation of opportunities for small businesses and startups to obtain a bank loan.

Govt has been pursuing the policy of consolidation of public sector banks(PSBS) into  4 to 5. Already SBI subsidiaries are merged. Last year another round of merger was implemented under the Bank of Baroda. Now again we are witnessing one more round of mergers.

We are looking at how this plays out in supporting small businesses that were one of the reasons behind bank nationalization undertaken in 1969.

Contribution of PSBs in Lending to MSMEs

It is a fact that PSBs are shouldering the responsibility of delivering credit support to the needy section of the society- be it agriculture, MSME, etc.  PSBs are always very magnanimous in supporting the MSME ventures, patronized innovations and have extended the long & short term loans. They have been wholeheartedly participating in Govt Schemes like PMEGP.  The support for financially distressed entities is commendable and they are meticulously implementing guidelines from Govt and RBI.

How the scenario may change:

With the consolidation, it is likely that the business at the branch level will also be consolidated like it is done with other mergers in the past. This will lead to lesser attention span for the extra customer load the branch will have to deal with. The attention span is important for the reason that social sector banking activities require handholding of the customers that is the hallmark of public sector banking service since 1969.

With reduced branch presence of PSBs, the access points will dwindle and invariably small businesses will have to have banking business with private peers however what they likely to miss is credit support the way they get in PSBs.

Thirdly even for PSBs, more orientation will be towards profitability since capital efficiency was the reason for consolidation. That may drive them to reorient towards large value exposures.

Private Banks show no or less keen to lend in priority sector lending:

It is a fact that private sector banks show little or no interest in priority sector lending. They prefer other via media to engage with such clients resulting in higher cost of credit for end users. Also, they are happy to compensate for the gap through alternate options extended by RBI.

They are very particular about securing their loans by taking collateral of fixed assets. Even though Govt has implemented CGTMSE scheme to extend credit guarantee for small business loans and it has been here since nearly 20 years, private banks have not shown much inclination to extend loan under this window.

They are obsessed with securing their loan more than supporting the entrepreneurship.  As a result, many budding entrepreneurs will not have access to bank credit and will be forced to seek support from predatory lenders.

If one looks at the profile of the product of many private banks, they are more keen to finance immediate needs than supporting capital investment. Support in distress is a far cry.

Role of RBI needs special mention:

Presently priority sector lending is handled by RBI. Most of the compliance with its directions are coming from only PSBs. With the reduction of their share and the increasing presence of private banks, we may see social sector lending will be reduced to islands everywhere.

Further, the RBI itself has created avenues for private banks to avoid direct participation in the priority sector lending that will further add to the declining credit flow.

Sadly RBI does not measure the flow of credit at the grassroots level rather relies on secondary data from Banks.

One can conclude that RBI action on this front is more of administrative and not accountable for the flow of credit to these needy segments.

How a merger may impact different sectors?

Mergers and consolidation of PSBs may create a huge vacuum of space of social sector lending. We believe that Micro and small enterprise will suffer more than agriculture because agriculture may get support from Coop Banks and Societies.  Also, political activism may help agriculture, that privilege is not available to MSMEs.

The way forward:  “Bring in a new law for creating sustainable financial architecture”:

Since consolidation exercise is underway, it seems there will not be any rethinking. However, Govt has to act to alleviate the apprehensions of a lack of access to credit from this process to small businesses.

In these circumstances, it is necessary to bring in legislation to create a sustainable financial architecture that binds regulator (RBI) and the banks to undertake lending to priority sector irrespective of ownership. They may be incentivized, extended liberal guarantees scheme coupled with provision for punitive action for not adhering to stipulations.

The notable benefits are :
a) It will make lending norms a legal mandate and ownership neutral.
b) It will universalise the access to credit in any region or activity

Conclusion:

Bank merger without implementing an alternative model to support social sector lending will leave a huge vacuum and may affect the economically weaker section resulting in further widening of inequality. This may end up at creating a pre-1969 era of lack of access to credit for small businesses and others. Legislative action is necessary to preempt this scenario. 

By: Anil Kumar Shetty, Founder SME Advisors (email: [email protected])

Non-classifying stressed MSME Loan as NPA- It is not enough

Non-classifying stressed MSME Loan as  NPA-  It is not enough

Govt’s recent decision to direct banks not to classify stressed MSME loans as NPA is just a temporary relief and it is not enough to stabilize the segment reeling in distress.

Recently Union Finance Minister announced that banks will not classify stressed loans in MSME segment as NPA till March 31, 2020, thus restraining them from initiate recovery action anticipating that this will help the stressed entities to recover themselves.

Though her concern to assist MSMEs to come out of distress is appreciable, the measure in itself is not enough to stimulate the revival of the stressed entities.

MSME segment is reeling under massive slowdown beginning from 2018 due to steep decline in the demand for their products and services. Many of the MSMEs are part of the production and marketing value chain of the large companies in sectors like automobiles. The slowdown is witnessed in the sectors like the automobile has a cascading impact on the financial viability of many MSMEs countrywide.

The ongoing slowdown is unlikely to recede in the near future.  Though the experts are having divergent views on the course of likely time period the slowdown will persist, it appears that demand recovery will take a few more quarters to gain momentum and this is expected to cause disruptions to many MSMEs.

Secondly, the segment is also experiencing the negative impact of the structural changes happening in the many industries due to changes in the way the buyer-seller interact on account of technology-driven processes and solutions.

Thirdly the segment is still experiencing the challenges from the lingering impact of economic measures such as demonetization and other policy actions either industry-specific or broader economic.

MSME Segment requires more than the standstill from the recovery:

The promise of standstill in recovery action can be a good measure provided the economy is in recovery or growth mode. That would have created more breathing space for many temporarily stressed entities and would have helped them to set right their finances in the next two quarters. However, given the present circumstances of negative sentiment about the economy prevailing in the country, this measure is of no help either to banks or entrepreneurs.

What are the most feasible solution for reviving MSME segment?

There were few measures announced by the Govt in the last few years and more recently on January 1 2019. These measures coupled with few more amendments can become a strong anchor to promote the revival of MSMEs. We discuss them as below:

Enforce  rigorously the RBI guidelines issued on January 2019 to restructure  stressed entities:

RBI had issued guidelines to support the restructuring of stressed MSME loans on January 1, 2019, without classifying the restructured loans as NPA. The guideline incentivizes the banks by allowing them to not to treat such restructured accounts as NPA  The new guidelines will be available on up to March 2020.

Effective implementation of these provisions definitely of help to stressed MSMEs. They will get breathing space and can reset the growth strategy. However, the implementation so far is far from satisfactory.

Extend resolution support to revive the stressed entities to give rebirth to them that involves writeoff/waiver of a part of dues to banks:

Many of these MSMEs are victims of the inability to adjust to expected and unexpected changes in the external environment like Demonetisation and GST implementation.

These stressed MSMEs have the potential to turnaround and can contribute significantly to the national economy as well as local communities in terms of job and earnings. However, the accumulated debt burden during the last few years of distress makes them unviable to face the competition. The level of debt (from the bank and others put together) is beyond the sustainable level.

These units require broad-based resolution support. The resolution support must have enabling provision for reassessing the debt servicing capacity and identifying the level of sustainable debt.

Taking a cue from the performance of IBC (Insolvency & Bankruptcy Code), we feel that MSMEs may be extended support through write off/waiver of dues as a measure to revive the segment. The big loan accounts are resolved with substantial haircuts under IBC route. In some cases, it is more than 50%.  A similar provision for sacrifices needs to be extended the MSME to revive the potentially viable MSME units outside IBC purview. The lenders are aware that the market for the assets of stressed units is very poor. The recovery under the regulatory mechanism is unlikely to provide any substantial gain to the lenders. The contribution of revived MSME units to the economy is expected to be more than the amount of possible sacrifice made by the lenders.

MSMEs needs structured support to tide over financial support:

Many of the stressed MSMEs have the potential to turnaround. There are many regulatory and administrative guidelines from RBI and Govt to help these stressed MSMEs to overcome the challenge. However, these MSMEs require a very comprehensive framework that addresses their financial woes and helps to find a structured approach to cover the gamut of issues, something akin to Insolvency and Bankruptcy Code 2016 without the need to through the process of Insolvency.

“Framework for Revival and Rehabilitation of MSMEs” – A better alternative:

Govt of India & RBI had implemented the above framework in the year 2016 (RBI/2015-16/338 FIDD.MSME & NFS.BC.No.21/06.02.31/2015-16 Dated March 17, 2016). The framework addresses the financial issues holistically and is capable to assist stressed MSMEs to recover the lost ground.  The framework can help the stressed MSMEs to firmly anchor themselves to come out the challenges. The framework may be amended to make it versatile and become an anchorage to stressed MSMEs. Some of the amendment can be as below:

a)      Add the provision of waivers/write-offs:  If this framework is amended to discover the sustainable debt and thereafter setting a stage for resolution, this can be a quick and supportive avenue for stressed MSMEs to seek turnaround.  

b)      Extend a fresh round of finance especially working capital: Also these MSMEs are normally at the receiving end and unlikely to generate liquidity to support. Thus the working capital facility is paramount to make restructuring and turnaround support meaning full and constructive. To make it better it is desirable that the firms may be given another avenue of support in terms of extending an additional round of working capital finance to revive the business. Though the framework allows extending additional funding, it is not implemented and thus remains a bottleneck for revival.

c)       New debt may be supported by CGTMSE: There is always an element of hesitation to extend fresh support for stressed firms. This requires explicit policy support to extend additional finance that may involve CGTSME.

d)      Simplify its administration: Present guidelines seek to involve people from outside including  Govt dept in the process of approving restructuring. Involving others may delay the process and resolution of stressed debts require timely intervention. Further having comprehensive framework backed by regulation and laws itself can create a conducive environment for enabling the arrival of a mutually understanding solution. Hence the participation may be limited to engagement between lender and borrower and/or their advisors without inviting outsiders can improve the speed of the process.

e)      Allow the advisors to assist: Bank loan restructuring alone is not sufficient. The turnaround of stressed business requires more than delaying loan repayment.  The turnaround of stressed business requires support from experts from fiancé, legal, and /or the subject matter.  It is better to involve the experts to structure a resolution plan and enable speedy implementation.  

Conclusion:

Distress in MSMEs requires a more holistic approach to assist the stressed units to come out successfully.  Instructions for standstill will not help. The present guidelines need to be reviewed and amended to support a speedy revival of the potential units and bring the buoyancy in the segment. Framework for Revival and Rehabilitation of MSMEs impended by the Govt with few amendments can be a robust platform to achieve that goal.

Equitable Access to MUDRA Loans – a need of the hour

MUDRA loans can transform the lives of many micro-enterprises at the lower end of economic strata, however, the delivery process requires to be toned up.

I have been tracking a story of a woman entrepreneur who had been running a small grocery shop with a major focus on milk vending business in our area. We have been here in this locality for more than five years. Till recently we have been buying milk from her. Unfortunately, she closed her shop recently due to non-availability of adequate finance and the inability to raise the required capital to have her own license to vend milk from KMF.

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Book Keeping and Disclosures- A need than mere compliance for MSMEs

Many MSMEs treat disclosure in the financial statements  merely a statutory compliance than an opportunity to know more deep onto their finances.

Recently I came across an instance of an entrepreneur hauled up by Income tax authorities and  issued  demand notice for an huge amount for the previous assessment year. He has been into construction business and the business had been subdued in the last two years. Obviously the profitability is very low and paid less tax compared to previous assessment year.

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