IMT Finance for the SMEs and Credit Rating Agencies D S Solanky,

Small Exercise  As an entrepreneur think of a viable business idea  Who according to you is an SME  Do you think SME are important for the country  If you are an SME what problems you might encounter

SMEs are… THE MICRO, SMALL & MEDIUM ENTERPRISES DEVELOPMENT ACT, 2006  Micro Enterprises - investment in plant & machinery upto Rs. 2.5 mn  Small Enterprises - investment in plant & machinery upto Rs. 50 mn  Medium Enterprises - investment in plant & machinery upto Rs. 100 mn Services Sector  Micro Enterprises - investment in equipment upto Rs. 1 mn  Small Enterprises - investment in equipment upto Rs. 20 mn  Medium Enterprises - investment in equipment upto Rs. 50 mn

Are SMEs are like this common man…

Importance of SME sector  Economic Development Balanced Regional Development Better Resource utilisation Generation of Employment Entrepreneurship Development  Industrial Growth Contribution to Industrial Output Supply of intermediates to Large Enterprises Exports Ability to adapt to changing environment  SMEs propelled the growth of leading Asian economies. SMEs in Asian economies account for around 40-60% of capital investment, 60% of employment and 50% of output and 35% exports.

Contd…  Plays a pivotal role in the overall industrial economy  Estimated contribution – 34% of Indian Exports  Constitutes – 39% of the manufacturing output  Provides employment to over 31 mn people over 12.8 mn enterprises, labour intensity 4 times higher than large enterprises  Exhibiting growth rates higher than the overall industrial sector  Many important sectors of Indian Economy – Textiles, Bio- tech, IT, ITES, Auto ancillaries and other services.

SMES IN INDIA : AN OVERVIEW  Production, employment, exports of SSIs in India have all shown a consistent rising trend  Production has increased from Rs.1844 bn to Rs.4188 bn during the period FY2001 – FY2006.  The contribution would be even better if medium enterprises are taken into consideration (definition of SMEs has come into effect only since October 2006). Playing an increasingly important role Source: Ministry of Micro, Small and Medium Industries, Govt. of India Note: * Exchange rate : US$ 1.00 ~ RS

Increasing importance of SMEs-- Globalisation  Globalisation of the world economy has increasingly drawn the Small and Medium Enterprises (SMEs) into global value chains.  Globalisation facilitates access to global markets – now an important part of business strategy for many outward-looking SMEs  Access to global markets for SMEs can offer a host of business opportunities Access to larger and new niche markets; Help prospective high growth firms realize their potential Possibilities to exploit economies of scale and technological advantages; Upgrading of technological capability; Lowering and sharing cost including R&D costs.  Globalisation can also pose challenges and threats to SMEs - exposure to international competition from foreign firms, and may result in the loss of traditional markets to lower-priced competition from abroad.

SMEs in India  Small Scale sector accounts for over 30% of India’s aggregate exports.  Certain vibrant export sectors in India are dominated by SME Sector. e.g. Agro & Processed foods, Marine Products Information Technology Garments Gems & Jewellery Leather Products  Growth of industries in the SME sector in India has contributed to the overall growth or the Gross Domestic Product as also in terms of employment generation and exports.

SMEs in India..contd  Steady increase in no. of micro & small enterprise, production, employment and exports over the years.  Number of units increased from around 2.0 million units in to 12.8 million units in , employing more than 3.12 million persons, next only to agriculture.  Policy support for promoting small scale industries – incl. reservation of economically viable and technically feasible items for exclusive manufacture in the small scale sector.  Performance of the small scale sector, forming part of total industrial sector - has direct impact on the growth of the national economy.

Issues and Challenges Facing SMEs Lack of skilled and knowledgeable labors Inconsistency of labor supply Lack of technology Constrained managerial capabilities Limited managerial bandwidth Low productivity Low brand value. Mainly in the lower end of value chain Access to adequate financing R & D –

If corporates don’t get finance they seriously need to re- examine the way out

SMES : ACCESS TO FINANCE  Credit to SSIs increased in absolute terms from Rs. 528 bn in 2000 to Rs. 902 bn in  Trends:  Graduation of SSIs to large Corporations  Banks have tended to lend more to larger corporates  Increasing role of Exim Banks to help SMEs in globalisation Credit to SMEs has been increasing in absolute terms Source: Report of the Trend & Progress of Banking in India, RBI

SME Sector: Funding Institutions  Commercial Banks/ Cooperative Bank  Small Industries Development Bank of India(SIDBI)  National Small Industries Corporation(NSIC)  Exim Bank  State Finance Corporations/ State Level Agencies  Non Banking Finance Companies (NBFCs)  Credit Guarantee Fund Trust for Small Industries(CGTSI)  ECGC – ECA for export insurance.

Lending to SMEs in India: Challenges  Promoters have limited managerial and financial resources.  In general financial statements of a typical SME do not reveal its correct financial position. Asymmetry of information, non-standardized financial statements.  Most of them are partnership or proprietorship firms. Legal problems for these forms of constitution.  Lack of collaterals.  Individual oriented. Lacks professionalism.  No concrete business plan.  Difficult to obtain quarterly information. Loan monitoring is difficult.  High percentage of related party transaction.  Lack of innovation. Vulnerable to competition.  Banks charge higher rates to factor in the risks.

The Answer is very obvious…

Credit Rating ? What is that ?  It is an evaluation of Credit Worthiness of a person or company or instrument.  It indicates the capability/willingness to pay the obligation, and  the risk perception of the client in the eyes of the lenders 17 Bipin Bhardwaj, DGM SME, SBI, LHO, New Delhi

Concept of Credit Rating rating is, essentially, an independent, unbiased and objective opinion on the relative ability and willingness of the issuer of a debt instrument “Credit to meet the debt service obligations as and when they arise.”

●Rating reflects Credit Risk ●Ratings indicate Probability of Default ●Does not cover market risk, reinvestment risk, pricing etc ●Rating is applicable for the entire tenure of the instrument ●Not a one time evaluation ●Not formula-based ●Credit Rating is essentially an outcome of Overall Risk Assessment of the issuing entity ●Rating is not a recommendation to the investors to deal in the rated security ●Does not imply rating agency performs an audit function Concept of Credit Rating

Credit Rating of Bank Loans :  Reserve Bank of India, has mandated that Banks in India shall observe the BASEL-II norms.  These Basel -II norms mandate a Higher Credit Risk for the Unrated Loans, and Low Credit Risk for AA or AAA rated Loans 20 Bipin Bhardwaj, DGM SME, SBI, LHO, New Delhi

Basel-II: A perspective RBI requirement under new Basel II framework Banks are required to arrive at their capital requirements for loan/facility exposures to various entities using stipulated risk weights These risk weights are linked to the credit ratings of loans/facility assigned by RBI/SEBI recognized rating agencies such as CARE An unrated loan/facility exposure by the Bank gets a higher risk weight whereas a rated exposure gets lower risk rate

Credit rating under Basel-II -Implications Large number of entities will have a credit rating enabling better profiling w.r.t. credit risk Credit risk management in banks linked to independent risk opinions Banks have to set aside lower capital for higher rated entities and vice versa, enabling appropriate benefits to borrowers in terms of pricing of credit Rated entities can access debt markets easily Entities can assess their own financial flexibility by comparing ratings across companies and across industries

Trusting banks can be hazardous for their health….

If you want to have a loan of Rs. 50 Crore from a Bank and you are unrated, the bank will have to cover your risk by 150% of normal, and If you get yourself rated, your risk may come down to just 20%(in case of AAA). Credit Rating of Bank Loans 24 Bipin Bhardwaj, DGM SME, SBI, LHO, New Delhi

Credit Risk Industry Risk Industry Risk Business Risk Business Risk Mgmt. EvalnMgmt. Evaln. Mgmt. Evaln Financial Risk Financial Risk Industry Characteristics Industry Financials Market Position Operating Efficiency Track Record Credibility Strategic initiatives Others Existing Fin. Position Cash flow adequacy Financial Flexibility Accounting Quality External Risk Internal Risk For Companies with Capex, Project Risk is also considered Project Risk Project Risk Risk Assessment in Credit Rating

Rating Scale Investment GradeSpeculative Grade Long Term Short Term AA A AAABBB PR4PR5 BBBCD PR1+PR1PR2PR3

Ratings options for SME  SME Ratings Assessing overall debt management capability One time assessment  Basel II – Bank Loan Rating Required by banks for Capital Adequacy purpose  IPO Grading Mandatory for maiden public issue Relative assessment of the fundamentals of the issuer

Key Demand Drivers for Credit Rating Rapidly developing Financial Markets Broad Spectrum of Issuers accessing capital markets New & Complex Investment vehicles and Financial securities Broader investor participation Tightening Regulatory requirements Growing need for Independent and Objective assessment of new type of Risks Evolution on New Rating/Grading Products

Benefits of Credit Rating Investors / lenders An independent, unbiased and objective opinion on risk To draw their credit risk policies and assess the risk premium offered by the market on the basis of credit ratings To effectively monitor and manage investments in debt instruments Issuers For wide access to funds For pricing and timing of issues correctly For financial flexibility

Financial Intermediaries Useful in lending and investments Business counterparties For establishing business relationships For opening letters of credit, awarding contracts For entering into collaboration agreements Regulators To determine eligibility criteria and entry barriers for different types of securities To monitor financial soundness of organisations and promote efficiency in the debt market Benefits of Credit Rating

Issues in Rating of SMEs ● Asymmetry of information – absence of well documented credit history ● Sectoral and sub-sectoral classification of entities for adequate industry comparison ● Existence of Clusters ● Changing Economic and industry dynamics – Globalization ● Strong linkages with the bigger corporates ● Financial transparency versus Business model strength ● Unavailability of authentic data ● Large number of unregistered units

Information requirement  Background, brief profile of the company, promoters and other group companies  Last five years’ annual reports/ audited accounts  Copy of latest data submitted to the bank and loan repayment schedule  Details of capex plans for the next 3 years or project/ feasibility report  Product category-wise sales (volume & value), for last five years.  Current order book position (Client/ Order Value/ Product Wise), if applicable  Top 10 customers (in Value terms) for the last 3 years  Background and brief profile of the company and its promoters and other group companies  Capital History and Shareholding pattern as on date

Process Flow CARE Request for Rating Submits information and detailed schedules Interacts with team, responds to queries and provides additional data necessary for the analysis. Assigns rating team The team analyses the information Team interacts with client, undertakes site visits and analyses data submitted by client RATING COMMITTEE awards rating. Rating Letter & rationale issued to client Press Release, published in website, CAREVIEW and Rating Reckoner Accepts Rating? CLIENT Appeal for Review of rating (once) Rating Kept Under Periodic Surveillance No Yes

CREDIT RATING COMPANIES IN INDIA 1.CRISIL 2.CARE 3.ICRA 4.FITCH 34 Bipin Bhardwaj, DGM SME, SBI, LHO, New Delhi

 THANK YOU