Credit Evaluation ecosystem and MSME

It is understandable that Micro, Small and Medium Enterprises (MSMEs) often find themselves disoriented and lost in the credit evaluation ecosystem. When we talk to entrepreneurs and owners of MSMEs, we often get requests to elaborate the various concepts of credit rating, credit score, credit information companies, credit rating agencies, etc. This post attempts to throw some light on these various concepts in a simple and lucid manner.

What is Credit Rating?

Credit rating is an assessment of the creditworthiness of a borrower – the borrower could be an individual, a business, a company or a government. It is an evaluation of the possibility of a loss resulting from a borrower’s failure to repay a loan or meet contractual obligations.

What is A Credit Score?

Credit score is the numerical representation of creditworthiness of an individual. It measures the individual’s ability to pay back the borrowed amount. In India, the credit score is a number typically between 300-900. A higher credit score increases an individual’s chances of getting a good deal on borrowings.

Credit Rating vs. Credit Score: the Difference

Generally speaking, credit ratings are alphabetical grades (like AAA, AA, BBB, etc.) and used for large corporates and countries. Credit scores are plain numbers, used for individuals and some small businesses.

Credit rating agencies are responsible for rating corporations and their debt instruments. Ratings allow investors to determine how risky a corporation and its debt are, before making an investment purchase. In effect, what is the likelihood the corporation will default on its debt obligation? Leading credit rating agencies in India are CRISIL, ICRA, CARE, etc.

Credit information companies or credit bureaus are agencies that provide information relating to the creditworthiness of an individual. They provide credit reports and credit scores, which helps lenders determine how risky an individual is to lend to. The higher the credit score, the better a person’s credit profile is. There are 4 credit information companies in India, namely CIBIL, Equifax, Experian and CRIF Highmark

MSME financing landscape

The MSME sector has emerged as one of the key sectors within the Indian economy contributing to growth, exports, and job creation. MSME lending is shifting more towards lower vintage borrowers especially in the Micro segment. This has necessitated an objective model to identify high-risk customers. The MSME sector is largely unorganized and significant information asymmetry challenges exist i.e., one party in the transaction is in possession of more information than the other. In order to understand the historical credit behaviour of the borrower, it becomes important to assess the credit risk ranking of MSMEs. In the next few sections, we will talk about how CIBIL MSME Rank will be handy for MSMEs to have quick access to finance.

According to the Ministry of Micro, Small & Medium Enterprises of the Government of India, credit rating is not mandatory. However, it is in the interest of the MSME borrowers to get their credit rating/ranking done, as it would help in getting better credit pricing. Which means that MSMEs with a good score will have a higher ability to negotiate better terms & conditions (interest and other charges, etc.) on their borrowings.

In India, the Reserve Bank of India (RBI) licenses organizations to function as credit information companies. The Credit Information Bureau (India) Limited (CIBIL) is the most popular of the four credit information companies licensed by the RBI. CIBIL CCR is a record of your company’s credit payment history. This is created from data submitted to CIBIL by several lending institutions across India. The past payment behaviour of a company is a strong indication of its future behaviour. It is therefore important to understand that the CCR is heavily relied on by lenders to evaluate and approve lending applications.

CIBIL MSME Rank (CMR) is a risk grade assigned to the MSME. CMR summarizes your CCR as a number. The rank is similar to the CIBIL Score provided for individuals. On a scale of 1 to 10, CMR-1 is the least risky. CMR is now available for companies with current credit exposure of up to Rs. 50 crores. It is widely adopted by banks and other financial institutions to create a rule-based lending framework, risk-based pricing of loans, automating renewals and effective portfolio monitoring and management.

CMR helps lenders take better informed decisions and provides faster and cheaper credit to the deserving MSMEs based on their risk profiles. It enables:

a. Evaluation of credit risk in an objective manner

b. Reduction in Turn-Around-Time (TAT) of the approval process

c. Adoption of rule-based process for limit setting/renewal/enhancement of borrowing

d. Early warning system for portfolio monitoring

e. Pre-screening of borrowers and making pre-approved financing offers

f. Risk-based pricing

Key parameters used in CMR to measure credit risk

1. Profile of liquidity: The liquidity profile of a MSME borrower is judged by taking a look at the patterns of use of funds over the past 2 years.

2. Firmographics-based observations: Firmographics are essentially descriptive attributes pertaining to an enterprise such as the maturity of the entity, type of ownership, the industry, and the location.

3. Repayment behaviour: This is ascertained by making a month-on-month analysis of the payments that were made along with the classification of assets. These metrics are taken into consideration while determining the track record of the borrower.