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Access to finance at the right time is one of the major obstacles to MSME growth. Banks, NBFCs, and other lending institutions often need to check and validate the creditworthiness of the borrower to reduce the risks associated with lending. And this is where credit risk comes into the picture – the probability that a borrower will default on his/her payments resulting in losses for the lender. Today, let’s navigate into the world of borrowings and understand what is credit risk, how lenders evaluate the risks associated with lending to a particular borrower, how credit risk is evaluated for MSMEs, and how MSMEs can improve their CIBIL score (credit score) to enhance creditworthiness and reduce risks .

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What is credit risk?

For a lender and borrower, understanding what is credit risk and the extent to which there’s potential for gain or loss, is important.

Credit risk therefore can be defined as the potential risks associated with lending funds to a borrower. For lenders, it means to evaluate the financial health of a borrower and assess how likely it is that they will be able to repay the loan in time.

And to assess the financial health of a borrower, the credit score or CIBIL score plays a pivotal role as it provides a snapshot of the borrower’s earning, spending and loan repayment pattern, guiding lenders in their decision-making.

What is the importance of credit risk for MSMEs?

You may be wondering why credit risk is important?

Importance of credit risk for lenders:

Assessing the credit risks associated with lending is important for maintaining the financial stability of the economy and the financial system in the country. By evaluating if a borrower has the potential to borrow and repay, lenders can mitigates losses, secure investments, and avoid taking uncalculated risks.

Importance of credit risk for MSMEs:

  • Increase access to finance:

For an MSME, understanding the nuances of credit risks is critical for increasing their access to finance. The lower the risks, the higher the chances of securing finance for business growth and expansion.

  • Negotiate loan offers

It also enables MSMEs to negotiate business loan offers. By assessing their financial health, MSMEs can calculate their loan repayment potential and apply for the right amount of loan.

  • Avoid debt

Timely loan repayment can prevent MSMEs from being in debt. This is vital for stability and business continuity.

By understanding their borrowing potentials and the risks associated with it, MSMEs can avoid borrowing excess funds that they will not be able to repay in time (defaulter). This will further risk their chances of securing funding in the future when they need it.

How is credit risk measured?

When you visit a bank/NBFC, you will need to submit some documents for availing business loans – mainly bank statements, P/L sheet and balance sheet, previous loan records, income statement (to validate stability), and other financial records. These documents are required for the lender to measure your financial health and evaluate your repaying capacity.

It must be noted that these documents are tools that enable lenders to assess a borrower’s creditworthiness. It will differ based on whether it’s a personal, professional or business loan, or an overdraft, or advance, or invoice finance.

The borrower’s financial stability, assets and collaterals, guarantors, credit history etc. will also determine the credit risks associated.

Points to consider:

Some general points that lenders will consider for measuring the credit risk associated with a borrower are:

  • The business’s potential, future financial projections, and financial behaviour
  • Business credit score for historical data on the business’s loan repayment capacity, credit utilisation, credit mix, duration of credit history etc.
  • Business viability and market position
  • Industry of operation, market trends, and overall business ecosystem

In general, a minimum credit score for business loans is required, based on qualitative and quantitative factors:

  • For business loans with collateral: 600+ based on the nature of the collateral being pledged
  • For business loans without collateral: 700+

What are the different types of credit risk?

Credit risks can be present in different forms. For lenders and businesses to be able to manage and mitigate losses, it’s important to understand them.

Here are some of the types of credit risks and strategies to avoid making them:

  • Defaulter risk: This is the most common form of risk – borrower being unable to repay the loan in time. As a lender, the easiest way to avoid this situation is to conduct a thorough credit history check and previous loan repayment data on the borrower. Risks can be reduced by limiting the loan amount or guiding the borrower to avail credit through a proper mix (e.g., overdrafts, business loans, etc.)
  • Interest rate risk: When banks offer loans, interest rates are charged. Interest rates can be flexible or fixed. A common risk in this case comes with flexible/floating interest rates, where any change in interest rates impact the borrower’s ability to repay. A simple solution in such cases is to opt for fixed interest rates, where the borrower has to repay EMIs on scheduled dates and avoid the consequences on non-repayment of loan EMIs.
  • Diversification risk: MSMEs require finance for multiple purposes – buying raw materials and machinery, expanding business operations, managing daily cash crunches, etc. As a lender, it is advisable to have a wide range of products available for borrowers. Diversification will enable to mitigate risks, as borrowers can borrow finance based on their requirements specifically. For instance, as a MSME owner, if you want to buy a vehicle, you can avail a commercial vehicle loan. Here, the vehicle is the collateral, which lessens the interest-rate and reduces the lender’s risks.

What are some credit risk examples?

We have understood what is credit risk, what is credit risk for MSMEs, why it’s important and some of the types of credit risks. Based on these factors, let’s take a look at some examples of credit risks and why it’s important for strategic risk management.

  • Lack of proper credit mix: This refers to the different forms of credit that a borrower has availed. A mix of fixed and revolving credit is preferred. As such, if a MSME borrows only business loans, it’s not a very healthy credit mix. It also increases the credit risks as it does not demonstrate the business’s ability to manage different repayment obligations simultaneously.
  • Availability of collateral: Credit risks are higher when it’s provided without collateral security or a guarantor. For credit beyond a certain threshold, most lenders usually request for collaterals as it reduces the risk in case of default. This more for emerging businesses that often don’t have a strong financial history and records. (Also read: Why collateral is required for SME loans)
  • Changes at portfolio level: To minimise credit risks, lenders often diversify at the portfolio level. That is, a fair mix of different types of lending. As a MSME borrower, chances are higher that you will be able to avail a specific loan type if the lender is focusing on promoting the loan. For instance, considering the government’s focus on the manufacturing sector, lenders are likely to prioritise this type of loan. You can avail a machinery loan for MSME growth to buy equipment for your business. This will be easier to avail since lenders will be focusing on this type of loan.

How can MSMEs mitigate credit risks for their business?

As a MSME borrower, if you are looking for credit, you can take the following steps to lessen credit risks associated with your business:

  • Ensure you have a high credit score making your business more creditworthy (Also read: Benefits of having a high CIBIL score)
  • Repay all previous loans (for ongoing loans, ensure you are making timely payments)
  • Have a healthy credit mix, for example, overdraft, invoice finance, business loans, equipment loans, loans against property etc. to establish yourself as a credible borrower
  • Take corrective action to remove your name from CIBIL’s defaulter’s list
  • For LLPs, partnerships, or private limited companies, ensure your founders and co-founders are reliable and have a strong personal credit score and credit history
  • Build a comprehensive business plan to showcase how you plan to use the funds and outline the returns expected (this builds confidence in your repayment capabilities)
  • Try to arrange for collateral as it reduces the credit risk (Note: For business borrowings, avoid pledging personal properties/assets)

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Sohini Banerjee

Sohini is a seasoned content writer with 12 years’ experience in developing marketing and business content across multiple formats. At Tata nexarc, she leverages her skills in crafting curated content on the Indian MSME sector, steel procurement, and logistics. In her personal time, she enjoys reading fiction and being up-to-date on trends in digital marketing and the Indian business ecosystem.