Low income households engage in a range of economic activities, being both producers and consumers. Nevertheless, because of the variation in their purchasing power, level of economic and geographic integration including access to finance and risk-taking ability, their consumption and productive patterns are often visibly different. At the same time, bringing BoP-produced goods to market is not easy in spite of efforts to improve the competitiveness of rural enterprises. Rural producers and SMEs often lack information, infrastructure, access to finance, and risk-taking ability to commercialize their products without the intervention of fee extracting intermediaries.
This post highlights the work of an entity - Crafts, Apparels, and Furnishings Network Enterprise (CAFNE), that is quietly pioneering a financing innovation to address the working capital challenges faced by such rural producers and small businesses in India. Let us look at the problem before introducing the innovation: With over 11 million SMEs, India's SME sector is the second largest employer. It is second only to agriculture and contributes more than one third of the national exports. Moreover, there are ca. 40 million rural artisans in India, and almost forty percent of India's workforce comprises of small farmers, craftsmen, and producers who work as entrepreneurs.
Since most of these producers work on a small scale, several innovations in organizing and aggregating such producers have been attempted in the past, like cooperatives and producers group, but with very limited success in designing an economically viable and replicable model of reaching out to the bulk of such small producers. One of the greatest challenges faced by most of these innovations for scaling up has been the lack of access to an affordable line of credit from banks for meeting working capital needs.
Last year, Katie Hill authored a great article that talked about the working capital challenge faced by small businesses in India. Katie highlighted two major points: a) the reluctance of banks to lend to SMEs in the absence of collateral; and, b) the working capital challenge as a barrier to SME growth. When we look at the situation from a banker's perspective, the most critical input for decision making is access to relevant and accurate information about the SME. In most access, an information asymmetry exist, which means that banks increase lending margins beyond SME's capacity, thus resulting in over-pricing of good risks and under-pricing of bad risks. As Katie mentions in her article, even in cases when enterprises have pledged 100% collateral, banks have been reluctant to lend to SMEs.
Given this, along with the fact that the invoice cycle of majority of these producers is over 60 days, is there, then, a debt-free alternative of financing their invoices and thus opening for them a credit line to address their working capital needs? To learn more, I recently spoke to Madhukar Choudhary, who at CAFNE is leading this financial engineered innovation on the ground.
Madhukar says that "Buyer-backed Supply Chain Financing (BSCF) is a financial product designed to help producers and SMEs receive funding against their account receivables. Under a typical arrangement, a company like CAFNEfirst effects payments to the producers when goods are delivered to the buyers and bill documents are presented for financing. Subsequently, CAFNE collects the payment from the buyers on due dates while assuming the credit risks (directly or through a third party) associated with the collection of the accounts i.e. defaults in payments."
When a business delivers products and / or services to its customers, and an invoice is created, the invoice then becomes an asset that can be traded. The business can draw money against the invoice, by discounting the bill, before the money owing on the invoice is actually collected from the buyer. What CAFNE does is act as a third-party that manages these receivables until it has been paid, and advances money - after holding back a portion of the invoice that in part acts as a collateral or "holdback" and in part pays to service the lenders financing and other administration fees - to the producers group. So, the producers group receives an amount that is equal to a reduced value of the receivables pledged. And, once the client (the buyer of the products / services of the producers group) owing on the invoice pays, then CAFNE remits to the producers group the remainder amount of the invoice.
With a tool like BSCF on offer, producers groups with less than perfect credit are eligible for funding due to the credit worthiness of their clients - usually big businesses or government with very good credit rating. In other words, enablers like CAFNE count on the credit worthiness of the big companies buying the products and services rather than the producers groups needing to have invoices financed. Although, on one hand, BSCF helps small businesses unlock capital that is invested in receivables, but on the other it also transfers, in part, the default risk associated with the receivables to the financing company such as CAFNE. Since CAFNE accepts major portion of this credit risk, it employs critical risk-reduction techniques such as subordination by asking the buyer company to offer first loss default guarantee.
Some of the producers groups usually have a line of credit but it is usually not large enough even when combined with the realization of accounts receivable to meet the operational needs of their businesses. So, when a producer group company is growing and needs cash to meet operational needs and to fill new orders, and is unable to obtain necessary cash through conventional loans, the company should truly consider BSCF since it shortens the gap between the time an invoice is submitted and when it is actually paid. Additionally, BSCF is not entered on the balance sheet as a debt because it is not a debt but rather the sale of an asset, thereby achieving substantive improved balance sheet metrics such as Return on Assets, Return on Capital, etc. In sum, BSCF is an excellent short-term solution to help the business return to profitability by assisting in immediate cash infusion derived from discounting the invoices that provide businesses with significant financial leverage.
Finally, by using some of the cash to reduce debt, the producers group increases its credit-rating and strengthens its ability to be bankable with a bigger line of credit and lower interest rates. At the same time, with such increased capitalization, these producers group not only achieve increased sales, but also realize deep discounts from their vendors; reduce costs by upgrading their operations and pass on these savings onto their customers, there by achieving competitive pricing innovations.