MSME Loans – Importance of reliable credit analysis
MSMEs have a significant impact on the overall growth of the world economy and its various milestones. According to a world bank report published in 2020, MSMEs represent close to 90% of all business establishments around the world and account for more than 50% of the net employment, and this figure only increases as we account for the informal sector.
As MSMEs continue to strive towards growth, the International Finance Corporation predicts that they will require an additional financing of $5.2 trillion to facilitate this growth. When lending to MSMEs, one of the most critical factors we need to consider is how they carry out their commercial credit analysis.
Why Is Credit Assessment Important?
The fundamental purpose of commercial credit assessment is to determine the risk associated with the entity and appraise a risk rating. At its core, commercial credit analysis helps lenders calculate the Probability of Default (PD), Exposure at Default (EAD), Loss Given Default (LGD) & other parameters to calculate the Risk-Weighted Assets (RWA) of the credit being extended.
Accurately estimating the RWA further equips the lender to determine the net CAR or Capital Adequacy Ratio, such that they are well prepared to absorb a certain amount of loss, while complying with statutory and capital compliances.
Along with this, lenders can also use a variety of tools, such as cash flow analysis, ratio analysis, and trend analysis, to calculate the risk involved as well as the chances of default involved in the loan to determine the DSCR or the Debt Service Coverage Ratio, which is a significant component of the risk report being subsequently generated.
The risk report generated because of commercial credit analysis serves as a great yardstick to determine if a particular borrower is creditworthy or not, thus benchmarking its importance in disbursal of MSME loans and in maintaining a healthy loan portfolio.
What Is Credit Assessment: The 5 C’s of Commercial Credit Analysis
In simple words, commercial credit analysis can be understood as a process to understand the company’s ability of meeting its financial obligations and to capture the risk associated with lending to a particular entity.
Various financial institutions around the world follow their own set of parameters to undertake this process, and mentioned below are the integral 5 C’s of every commercial credit assessment process:
Character is one of the most important factors you need to take into consideration while undertaking a commercial credit assessment process. Some of the aspects you can consider assessing the character of the borrower include their credentials, reputation in the industry, and past credit report.
The second C you need to take into account is the capacity of the borrower, by taking into consideration their present cash flow, payment of expenses, current debts, and also their credit score.
Capital is the amount of own investment the owner or the management of the business has made into the business. A high capital investment indicates that the owners are serious about their business activities, thus reducing the rate of default moving forward.
Collateral is the security against which the borrower takes the loan, and it acts as an insurance in case there is a default. If the borrower is willing to put forward an asset or collateral of equal or higher net worth than the credit line being extended, the risk factor involved in the loan decreases by a great amount.
Last but not least are the conditions of the loan, which determine both the avenues where the loan amount will be spent along with the terms and conditions of repayment. Having pre-decided conditions helps lenders better establish customer categorization and simultaneously conduct risk profiling.
How Is Commercial Credit Assessment Different?
Commercial credit analysis starkly differs from consumer credit analysis across the following main parameters:
- Minimum Net Profit
In a commercial credit assessment process, you need to take into consideration the minimum net profit of the business as opposed to the total income of the individual as practised in consumer credit analysis. In a business setup, the minimum net profit value indicates the repayment capacity of the business after all its bills have been paid, and dues have been cleared.
- Assets & Collaterals
In a consumer credit analysis process, lenders generally take into account the fixed assets of the borrower before determining their creditworthiness. However, in a business setup, we might often need to include floating assets, such as employee strength, current clients, machinery available and much more to better understand the level of security that can be pledged by the business.
When undertaking a commercial credit assessment process, rather than evaluating the individual creditworthiness of the business owner, we need to take into account the key stakeholders and management of the business, as these are the decision-makers who establish the way forward for the business. As opposed to putting the onus on an individual in consumer credit analysis, commercial credit assessment puts the onus on the business entity as a whole and not just the business owner.
- Unstructured Data
Most MSMEs around the world often suffer from unstructured data, and it is immensely important that we take this into account in the commercial credit assessment process. Unstructured data, once categorized with the help of modern fintech technology, can prove to be a goldmine to properly assess the true creditworthiness of the business entity.
- Cash Reserves
As most MSMEs transact with a cash-intensive consumer base, more often than not they have cash reserves, which are undocumented and thus taking this reserve into account will glorify the commercial credit assessment process and help you properly calculate the creditworthiness of the business entity.
Conclusion: How Will Technology Impact Credit Assessment Processes of MSMEs?
With the increase in capability of modern fintech technologies, lenders are more equipped than ever before to take advantage of the various tools available to them.
For example, a majority of MSMEs around the world and especially those in the informal sector operate on a lot of unstructured data. Proper implementation of modern technology can transform this into structured data, which can be further used by lenders to acquire a holistic view of the MSME in its entirety such that they can better assess their capacity to meet financial obligations.
Along the same lines, lenders can make use of this technology to acquire a universal view of their entire MSME loan portfolio and equip themselves to make better decisions. Another example of this can be found in instances where if a micro enterprise claims that 50% of their transactions are through digital channels, lenders can use this technology to extrapolate the remaining half on the available data. The potential for modern fintech technology and its subsequent impact in the MSME Lending sector is immense and is only set to grow moving forward.
AllCloud’s lending software enables financial institutions to streamline their lending processes and make reliable credit decisions. AllCloud offers.
- Business Rules Engine for automated credit decisions
- Configurable Scorecard mapping multiple parameters for efficient decision making in lending process
- More than 80 pre-defined templates for credit scoring at customers disposal.
- Integration with credit bureau API's across multiple data sources, Bank, Credit Bureau, Tax agencies etc. to collate data in single place.