Payment Default- A perilous risk to SMEs in India and its mitigation
SMEs are the backbone of Indian economy. Industrial ecosystem reorienting to increase the share of outsourcing to SMEs. Going forward, focus on core competency and internet have driven evolving manufacturing ecosystem will expand the opportunity for outsourcing, so is the proliferation of SMEs.
However, the business climate is filled with uncertainties and intense competition. To remain relevant amid a tough economic environment, risk management in businesses is more important now than ever. Various tips and strategies are listed under RISK TOOL KIT FOR SMEs.
One of the notable risks which SMEs are very vulnerable to is default risk(Non-Payment by Clients). For an SME, nonpayment can mean the substantial erosion of profit and in a worst case scenario, complete closure of business. If the principal company faces rough weather, it is more likely that they will delay the payment to vendors, seek extended credit period, dishonour their promise on time- all cumulatively impact the working capital management negatively. This will aggravate the SMEs’ financial condition as risk bearing ability is already at a low. Hence there is need to explore ways and means to guard against default risk by looking at ways and means to mitigate the same.
The question is – Can an SME mitigate the payment risk to business?
To a large extent, it is possible to mitigate by adopting a conscious approach to manage the cash flow of the business. There are many ways an entrepreneur can minimise default risk and navigate the challenging environment. Some of them are as follows:
1. Keep a watch the ratio of exposure to one client ( Concentration Risk):
It is not uncommon to find many SMEs are seeking solace under relationship with one large client. Though it has benefits of access to better technology and quality practice, it carries huge risk as the fortune of SME squarely depends on the client. As far as possible, it should be avoided as it is riskier going forward as uncertain global economic situation makes many large corporate vulnerable.
Please remember: The rapidity of decline or raise of any corporate in the world has gone up.
2. Diversify the revenue base:
If the relationship is very exclusive for reason like proprietary technology or exclusive partnership, then it is recommended to create a parallel source of income in a different area NOT CO-RELATED to present line of activity. Although it is very common to replicate as that is the business known to you well but risk management principle seeks you to diversify into uncorrelated vertical.
3. Keep a watch on the credit rating of OEM/Mother unit:
Nowadays large corporates or even medium enterprises invariably go through credit rating process. In India, there are six rating agencies such as CRISIL, CARE, India ratings, ICRA, SMERA and Brickworks( There are RBI approved bank loan rating agencies). They are bound to publish the rating movement in their client group on their respective website. Keep an eye on that and any decline should be taken seriously. Equally shifting of rating agencies by the client should not be ignored.
4. Keep a watch on client’s compliance and disclosures
Govt is promoting disclosures of corporates by encouraging people to visit MCA website-http://www.mca.gov.in. If your client company has not filed returns, it is the matter of concern and starts reducing the exposure.
5. Company Research:
There are many companies in private sector doing research on companies. (For example www.zaubacorp.com, www.rezorce.com, etc. )They provide commercial information and shed insight on businesses in addition to statutory disclosures. They do it for a fee. You may take recourse to that resource.
6. Take ECGC cover for exports; if you are exporting:
ECGC has a number of insurance schemes for the SME sector. The primary role of ECGC is to provide Credit Insurance Covers to exporters against credit risk (non-payment by overseas buyer) in the export of goods and services. ECGC also provides overseas investment insurance covers to protect Indian entrepreneurs investing in overseas ventures, either equity or debt, against expropriation risks.
SMEs are given special cover through Small Exporters Policy which is available to SMEs with a turnover of below Rs. 50Lakhs.
7. Opt for bill discounting with banks/NBFCs:
Bill discounting facility’s immediate gain is liquidity. There are many NBFCs have started providing discounting facilities. In addition, there are online portals to engage with you and secure bill discounting facility for exwww.kredx.com, a new platform proving this facility (previously it was mandii.com).
There is an implicit gain i.e., lenders will not discount the bills drawn on your client unless that client is of high repute/good credit rating. In that way, you will get collateral comfort of their findings. However, in case he defaults, liability will devolve you.
Factoring another facility few are offering. It works similar to above model who work on exclusive basis for bill discounting (Canbank factors). In factoring there are two types of facility- with recourse or without recourse factoring. Under without resource factoring, factor buys the book debt and relive the SME from credit risk. However it is yet to find place in India. Under with recourse factoring, in the event debtor does not pay, factor will recover from vendors(SME). Still having an endorsement from factor gives some comfort in the credit worthiness of Client/debtor.
9. Supply chain financing/Channel Financing
A new class of product is gaining currency in India. It is completely IT enabled financing model wherein client corporate trigger the transaction online through their bank to your account. It is much advanced and has the ability to help SMEs without good history to count on client-corporate’s credit strength to get credit. On other side corporates may discount the bills drawn on dealers and help dealers to work on lower working capital needs. Many banks have already started and some may develop in future.
10. Keep an eye on updates within the company:
Keep an eye on happenings within the company to have better view of the company. Accordingly you can change the strategy –increase or decrease your supply to them.
11. Build risk contingency fund:
A highly desirable thing is to create a liquid fund either recurring deposit with bank or systematic investment plan (SIP) with any mutual fund to build a corpus by earmarking a small fraction of earning as a contingency fund to beat the risk from client corporate. If everything goes well, this fund can be utilized to buy industrial unit later date.
12. Watch the competitors and peers:
Most of the SMEs operate in fragmented market wherein the market share is not dominated by few players. These SMEs , unlike multinationals and large firms, largely draw comfort from local business conditions. Hence it is important for such SMEs to always keep an eye on its competitors business model and to be open for changes.
Future looks bright for SMEs to mitigate default risk:
Two recent events have been identified as a new paradigm to help MSEs rejoice as default risk may be mitigated to very large extent and fund raising will be easier:
1. The introduction of Insolvency and Bankruptcy code:
Bankruptcy code widely feared that may harm SMEs is in fact boon to them, In the previous blog, we had discussed how it is boon. Please refer https://smeadvisors.in/insolvency-and-bankruptcy-code-is-it-beneficial-to-smes-in-india/
Now we analyse another angle, i.e., its support to improve the recovery of receivables for SMEs. Today SMEs are very vulnerable to manipulations/frauds by clients as there is no legal mechanism to enforce the demand unless seeks high court intervention which is a far cry for smaller companies. Vishwanathan committee report on bankruptcy code introduction, have mentioned that recovery is only 20% of the failed companies that too cornered by secured creditors. Trade creditors always made to suffer the loss.
Under new Insolvency and Bankruptcy code, SMEs can enforce their interest before NCLT/DRT through insolvency & resolution professionals. The process is to be concluded within 180 days of filing the case. This will help SMEs to secure their exposure to large corporates and their claim stands above the Govt dues during liquidation.
2. The introduction of the market place by NSE:
To specifically address the issue of delayed payments to the MSME sector, Trade Receivables Discounting System (TReDS) has been conceptualised as an authorised electronic platform to facilitate discounting of invoices and bills of exchange of MSMEs. NSE in association with SIDBI will be introducing shortly the trading platform for discounting the bills.
Strategy to manage default risk cannot be generalised. However, it should be an endeavour to monitor the risk of default and adopt the feasible approaches which are complimenting the business growth plans.