Under-financing: A menace among SMEs in India
Non-availability of sufficient funding or under- financing of businesses has abruptly ended the entrepreneurial journey of many in India. Meticulous preparation of DPR, Financial closure and executing the same accordingly will eliminate this risk to
I recollect an incident happened many years ago. A businessman had approached the bank seeking term loan for the new project and concomitant working capital for the same. The project has a gestation period of one year and bank found its wisdom to postpone sanctioning of working capital till the completion of the project. Upon receipt of sanction, the businessman sought a meeting with the senior official. He requested the bank to sanction working capital along with term loan. His contention is that in the event bank goes back on its promise to fund working capital, his project will be rendered non-viable and hence he did not find it is worthwhile to pursue the project without full working capital facility being sanctioned. He is not well educated and he cannot speak in any language other than his mother tongue. All his viewpoints were translated into English by his financial advisor. But he carried an amazing level of wisdom which has touched the right nail. The executive appreciated his concerns and immediately asked the officials to process and sanction working capital limits.
What are the key lessons one should learn from him:
He fully understands the need for having financial closure before embarking on the groundbreaking, a commendable action not found among many entrepreneurs who plan growth. Rather it is not uncommon to find entrepreneurs hurrying for starting the new project without tying up the fund.
Why is Under-Financing relevant?
Under-financing renders many entrepreneurs immobilised, unable to move anywhere. Underfinanced projects will not see commercial production thereby causing severe liquidity strain and may make existing business suffer irreparably. Under-financing leads to distress situation which in turn motivate entrepreneurs to borrow at an unsustainably high rate of interest or he may opt to mortgage all his assets elsewhere to raise the funds thus increasing debt load or leverage. In such circumstances, banks will not be enthusiastic rather more likely turn indecisive to support further. Delayed completion of the project may force project unviable. The technology may become obsolete. Reputation will suffer and creditworthiness will go for the toss.
Causes of Under-Financing
It is a common refrain among SMEs in India experiencing the impact of under-financing in their business that Banks have not funded the full amount and had they given sufficient finance, my business would not have suffered the distress. But a closer look at the situation reveals a completely different picture. If you diagnose the reasons for distress, one of the following two will be more likely seen among such cases:
- Lack of financial closure before starting project
- Change of project size and scope during implementation
1. Obtain Financial closure before setting on execution: Financial closure is an important step in eliminating the risk of under-financing. However, it is the culmination of an entire process which begins with project conceptualisation. Entrepreneurs should undertake preparation of Detailed Project Report ( DPR) with or without the support of financial advisors and technical consultants depending upon the need. All these will lead to developing the financial planning. A well-crafted financial plan makes one feel confident about the project and so is lenders and investors. Thereafter secure funding for the project to the full extent. All these exercises have to be completed before starting the execution. Please ensure that you will not be lured by machinery suppliers and pay advance to buy machineries. That will trigger temptation to go far shortcuts and thereby financing a mess.
Also read: Why SMEs need professional Financial Advisor
Your readiness to launch project is complete only after securing the financial closure. I strongly suggest including tying up full working capital facilities as well. Many times entrepreneurs and banks think that working capital can be sought post completion of the project. It is not a wise decision. There is a risk that bank may not sanction required working capital at that point in time. Here are many instances of new units running at underutilised capacity for want of enough working capital facilities. However, bank may insist for commitment fee for sanctioning working capital limits upfront as the bank will have to set aside capital for such commitments as per RBI norms. Still is worthwhile to have sanction for working capital beforehand.
2. Change of Project size and scope while implementing: It is another source of risk of under-financing. It is common for entrepreneurs to get suggestions from many sources to increase capacity, change technology or add another products line while executing projects. Though there are inherent advantages, we suggest avoiding any such temptation. The DPR prepared is sacrosanct and should not be deviated in execution. The deviations and non-review afresh may become catastrophic for the viability of project and prospects of all of your businesses. In the event there are compelling reasons for doing so, then review the project thoroughly, take the bank into confidence or tie up other sources of fund. Ensure that financial closure is achieved before setting on alteration of scope and size.
What are the way out?
A very simple solution to avoid the risk of under-financing is to have DPR before embarking on the execution of the project. Treat DPR is sacrosanct and ensure that timeline, cost and scope of the project have scrupulously complied. This ensures that project will sail through without any hurdles.
In the event you are experiencing under-financing, it is better to seek fresh financial support from banks or source from other sources such as leasing to meet the needs. If the situation is turning into distress, seek to restructure under extant guidelines.
In order to get any support, Keep the financial records update and keep your bankers in the loop.
Under-financing may defeat the purpose of the project and may even threaten the survival of rest of the businesses. Entrepreneurs should not ignore the need to approach the new project with full preparation and having DPR beforehand