Embedded Finance
MSME Credit

What is Cash Flow Based Lending and how it will ease the MSME Credit Gap?

Devashish Mulye   /    Product Manager    /    2021-05-12


Cash Flow Based Lending enables tailored, short-term, small-sized credit products and risk assessment of MSMEs, based not on their balance sheet or assets, but on real-time cash flow data. As per a 2019 report submitted to the RBI (by then SEBI Chairman UK Sinha), all banks should focus on cash flow-based lending models to ease the $280 billion credit gap in the Indian MSME sector. This form of lending is only possible when digital lenders leverage Embedded Finance and would be a departure from the current MSME lending model used by banks. 

This article explores this new method of lending and how embedded finance powers it.

What is cash flow-based lending?

Cash flow-based lending enables lenders to leverage real-time cashflow data to reimagine the end-to-end lending process. This includes underwriting, credit product configuration, and repayment. It removes the dependency on using collateral to assess the users. Real-time visibility of cash flow enables the creation of new credit products that have a short tenure, small ticket size, faster approval turnaround time (TAT), and flexible repayment periods.   One such example of a credit product is where the end-use of the funds can be locked. For example, in the case of a retailer who is purchasing stock from an FMCG brand, the money can be directly disbursed to the brand. This essentially secures the loan just as an asset-backed loan would have.

CFBL vs Asset Based Lending

In CFBL, the repaying capacity of a borrower is determined by his cash flows. In asset-based lending, the capacity to repay is decided by the value of the collateralized asset.  In contrast, CFBL loans need no collateral.

CFBL vs Balance Sheet Lending

In balance sheet-based underwriting, lenders holistically assess the borrower’s financial position based on assets, liabilities, and shareholders’ equity. However, balance sheet-based underwriting isn’t optimal for short-term loans. Assessment of the overall financial position of the MSME may not be required as long as cash flow is guaranteed for a short loan tenure.

Why cash flow-based lending?

The process of asset-based or balance sheet-based lending is designed for long-term, large-size loans. However, CFBL enables ‘sachetization’ of loans, i.e. short-term, small ticket-size loans (likened to shampoo sachets) tailored to the needs of the MSME. It empowers MSMEs to manage their working capital and invest in growth. Here is how CFBL helps MSMEs:

Provides flexible loan terms: Cash flow data is used to conceive of the loan amount, tenure, and repayment timelines to serve the needs of MSMEs. 

Take as an example, a small tourism company. Its business flourishes in the summer and sees no activity in the 3 winter months. So while it pays its EMIs on time for 9 months, it defaults on its payments in winter. CFBL facilitates repayment schedules that are based on the borrower’s actual cash flows.

Helps manage cash flows: MSMEs often face a working capital crunch due to factors such as:

  1. Fluctuating demand

  2. Inefficient supply chains

  3. Lack of plug-and-play facilities to expand real estate

  4. Low cash-flow buffers

  5. Delayed payments from customers

  6. Variable inventory turnover

Availability of schemes and discounts that help them increase their margins

As per the RBI report, the average delay in payments for MSMEs is well over 90 days.

As per the RBI report, the average delay in payments for MSMEs is well over 90 days.

An example of how CFBL eases the working capital crunch - a small business that has its cash flow locked in accounts receivable needs to pay salaries. This is where CFBL comes in as a solution. It enables lending against such accounts receivables. In addition, quicker TAT and the tailored repayment terms help MSME continue to operate.

MSMEs without collateral can access credit: Small businesses such as kirana stores and small retail trade shops often don’t own assets to submit as collateral. CFBL enables such small businesses to get access to credit.

Types of CFBL lending products

Working capital loans: Short-term, small ticket size loans that cover a company’s everyday operational needs such as payroll, rent, utility bills, paying GST.

Buy-Now-Pay-Later: BNPL is a payment option available at checkout for B2B E-Commerce platforms. It enables users to purchase on credit and repay in installments or bullet repayments.

Merchant Cash Advance:  MCA is a small-ticket size loan given against accounts receivables. It is meant to provide immediate relief in terms of tied-up cash flow to MSMEs.

Overdrafts: An overdraft allows a borrower to overdraw their account up to a specified limit. It enables access to short-term funding to fill a temporary cash shortfall — and it can be paid off at any time, with the interest only payable on the amount outstanding each day.

Trip finance for logistics companies: Fleet owners or truck drivers need financing for their trips as they might not have the capital up-front. This could be used for fuel, vehicle maintenance, insurance payments, and other expenses. Alternate data such as load transported, kilometers traveled, and repayment history can be leveraged to underwrite these borrowers.

Turnover-based loans: GST and Point of Sale data enable lenders to assess the turnover of MSMEs. Similarly, Anchor Platforms have data about the MSME’s transaction history, ordering history, sales, accounts which can be used to determine turnover. Lenders can use this turnover information to determine loan amount and tenure for MSMEs.

Supply chain finance: This refers to a working capital system where a lender pays suppliers while offering credit to the buyer for an extended period at various points in a supply chain. It is an unsecured arrangement that allows both the selling of goods and the maintenance of a healthy cash flow.

How does embedded finance power cash flow-based lending?

Embedded finance enables customer-facing digital businesses to offer financial services to customers within their platform. Further, embedded finance leverages a deep understanding of the (heterogeneous) MSME sector to provide tailored MSME lending products. Embedded Finance enables CFBL by enabling continuous monitoring of cash flow, reducing operational costs, solving for information asymmetry, and bringing a wide network of lenders. 

Here’s a detailed explanation of its benefits: 

Lowers acquisition cost for lenders: Customer Acquisition Costs are brought down by leveraging existing online and offline networks. Anchor platforms (the customer-facing digital platforms) can be tapped to distribute credit products, customize credit products, simplify the application process, and as a result, lower acquisition costs.

Improves underwriting: Anchor platforms have data such as the financial position, cash flows, ordering history, sales or accounts data of MSMEs. This is used to underwrite sachetized loans and approve new-to-credit customers. It enables continuous monitoring. Metrics such as a change in seller rating or velocity of sales can be used to underwrite borrowers or create early warnings.

Tailors the repayment process: Continuous monitoring helps in designing a tailored repayment process. A borrower can be excused from repaying in certain months if the projected cash flow in those months is low.

The Anchor Platform facilitates a smooth repayment process. It sends tailored messages and reminders. It can set event-based triggers such as initiating a repayment when a borrower is paid by its customers. They can also set time-based triggers such as reminders of automated debit on a certain date.

 A smooth repayment process is especially important because MSMEs have recurring credit needs at high frequency and are managing multiple loans.

 Control of the end-use of funds: Anchor platforms such as marketplaces that facilitate transactions between MSMEs and their suppliers can enable the remittance of the loan amount directly to suppliers. That locks in the amount and essentially secures the loan.

Credit product customization - Embedded Finance leverages the understanding of the Anchor Platform to tailor the credit product.

CFBL, powered by embedded finance, represents a paradigm shift in the MSME credit space. MSMEs that do not have large balance sheets can access credit on terms that serve their purpose. If you are lending to MSMEs, it is important to embrace embedded finance and offer tailored cash flow-based credit products to your specific target segment.