Challenges in Working Capital Management for SMEs

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Image Source: Freepik

Author: Harshvardhan Lunia, CEO & Co-Founder, Lendingkart

Working capital in its simplest form refers to the liquidity available to a company. In large organizations, there are experts spending hours dedicated only to working capital management. However, in smaller organizations, start-ups or SMEs, handling this vital business metric can often get quite tricky. What puts SMEs at a clear disadvantage is the fact that often, even with very smooth and lean working capital management, they may not be able to raise sufficient funds to match growth.

Snapshot of problems faced by SMBs in getting credit:

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Some factors are detailed below:

Small Ticket size & High Transaction Cost:  According to an industry analysis, Non Corporate Small Businesses (SME business) in the country have an unmet finance need of approximately INR 9 lac crores. Low revenue per client, high distribution, man power and product (design/marketing) costs, and high risk of credit losses deter a traditional financial institution from investing in the typical ticket size of loans for Indian SMEs, leading to unexplored revenue opportunities for lenders in this sector.

First-time Entrepreneurs: Many SME owners are first-time entrepreneurs or sole proprietors trying to manage a variety of functions themselves and may not always have the financial expertise to adopt the best financial practices. Often, an SME owner finds it hard to manage payment lifecycles or gets easily carried away and ends up overshooting the pre-defined budget in the hope of marketing the business better. A tight-fisted control, therefore, is imperative for efficient management of working capital needs of the business. If one is unable to pay salaries and buy inventory, there will be little left to market at the end of the day!

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Additionally, many SMEs may be managing their existing working capital well but may still face the need to raise more funds when they are in the growth stage. As mentioned above, the SME proprietor may not always be in a position to find the best available means to raise funds. They may also be at a disadvantage compared to bigger players whose brand names or owners’ clout in the industry commands funds at competitive prices easily.

Information Asymmetry – Lack of proper books of accounts and financial records: One of the root causes why SMEs are unable to raise funds when needed is information asymmetry. On account of non-availability of bills, credit history, established accounting systems, client base and lack of standard business process, the perceived credit risk for financing SME’s increases drastically.  Additionally SMEs in India are unable to present a totally transparent and detailed picture of their financial situation to banks and lenders.

Limited Access to Finance due to high levels of perceived risk: The restricted and often inadequate access that SMEs have to finance has been recognized as a global economic concern.  Because of Low or no credit rating, high rate of diversion/siphoning off the funds, Banks typically demand enhanced collaterals(Equity/ Infrastructure/ Inventory) which despite the high performance and proven efficiency of their business models, many  SMEs are unable to provide. This results in a limited working capital to meet the needs of their growing enterprise. This trend has become more prevalent since the credit crunch of 2008-2009 when institutional lenders and banks became increasingly reluctant to offer finance to emerging businesses and start-ups.

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While some alternate sources of funds like Friends and Family, Co-operative/ Rural Banks, Credit Societies have constraints in terms of amounts they can finance, other like Money Lenders typically charge exorbitant rates of interest.

In the age of internet, many small businesses operate on extremely lean models where they eliminate the need for large logistical spaces and stored inventory altogether. These factors make them more credit-worthy as they result in greater profitability. However, conventional banking organizations are unwilling to take this approach towards the potential of SMEs. Consequently, banks tend to cut down on the loan amount that the SME may otherwise have been able to raise. In fact, most large financial institutions would prefer to cut down on the loan amount and the interest rate for the sake of security rather than offer a higher working capital loan and earn more money on it. Clearly, their risk appetite nosedives in situations where information asymmetry exists. This phenomenon is popularly referred to as ‘Credit Rationing’ and is not always healthy for the SME sector and for the economy as a whole.

Weak & Inadequate marketing and globally in- competitive due to lack of product branding: Lack of funds often limits SMEs to operate only in local markets leading to shortage of working capital, inadequate marketing/product branding and stagnation in growth. Given the small scale of operations in contrast to their buyers and suppliers, one of the biggest challenges SMEs face is to command competitive procurement, distribution and selling prices. In addition, the absence of market linkages for this unorganized sector makes them prone to any demand disruption in the supply chain which can severely impact operations as the working capital of these businesses is locked away in illiquid inventory and receivables.

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There is a dire need of financial institutions that can understand the strengths of smaller organizations and provide them with the necessary guidance to build on these capabilities and attract more funds to hit the next level of growth. There is also a pressing requirement for agencies that understand the potential of SMEs and fulfill their working capital needs in the absence of conventional assurances against default.

SMEs are the driving force of any economy and start-ups breathe new life into the business landscape of a nation. This sector is also one of the most vital when it comes to job creation. Small and Medium Enterprises, therefore, need to be fuelled appropriately with easier and more productive access to financial information so that they can better manage their resources. There is also a very apparent need to provide more funding options to SMEs so that they can grow their business rapidly and contribute more actively to the economy.

Disclaimer: This is a guest post. The statements, opinions and data contained in these publications are solely those of the individual authors and contributors and not of iamWire and the editor(s).

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