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.
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.