Why MSME and SME loans turn into NPAs?

How often have we heard of a Start up or SME with a very promising business model and a great start to their business, but only to find them in a huge debt trap few years down the line? Promoters end up staring at a business deadlock and face the prospect of poor ratings/scores due to impending NPAs.

Many SME/ MSMEs go through phases where they are not able to service their loans and that loan becomes NPA to the bank.

Our experience and analyses of various SMEs has revealed that SMEs/MSMEs take term loan for a specific purpose, which may generate enough profit to service the interest of loan - however they fail to generate adequate returns to pay off the principal amount and eventually they go for further borrowings and end up getting into the debt trap.

This can be further analyzed from below mentioned example.

SME is in service business generating 2 crores of turnover with 10 % net margin, at very low rate of depreciation as the SME is into the service industry. It also borrows 1 crore which are to be utilized for purchase of vehicle and computers hardware & software at the rate of 12.5 % for the of 5 years. SME will pay Rs.2,25,000 as monthly EMI and the outflow for the year is 27 Lacs, whereas the income of the SME will be 20 Lacs, hence there is a short fall of 7 lacs for the first year and by that time there is no return on the investment, eventually there is no optimal way other than borrowing Rs.7 lacs from market to pay the EMI of first year, Further, if the business has seasonal impact then there will be high chances of delay or default for the payment of further installments, which will be paid after bearing the interest and penalty likewise.

Another hazard faced by SME is the CIBIL Scores. The impact of NPA to the SME is very severe as most of the banks take personal guarantee and assets of the promoter/director/family members as collateral – thus a delay in one or two instalment results in the reduction of the credit scores of all the Guarantors under CIBIL scores. This further reduces the probabilities of them getting additional or new loans, whereby they have to depend on private lenders outside the banking system for any new loans. This affects the growth of the SME, as the promoter struggles to get funds and the business expansion plans fail drastically.

Many of the SMEs may agree with the above example as they must have faced the similar issues. One solution to the above problem is to reduce the EMI outflow to the extent of the current earning of the business. For this to materialse, there should be a reduction in interest rate or the extended repayment timeline - authorizing bank manager to recover only interest on the request of the promoters in case of financial stress in business and increase the loan tenure.