A guide to Working Capital Financing for MSME exporters in India
Did you know that Working Capital Financing is the biggest challenge that Indian MSME exporters face? Now that the pandemic has receded and the demand in the international markets is picking up, demand for Working Capital Financing from MSME exporters is also rising. Working capital is even more important for MSME exporters as they play a critical role in the balance of payments for the country. What is Working Capital Financing, and why is it so crucial for MSME exporters, who are one of the critical engines of growth in our economy? Let us understand the need for Working Capital Financing in MSME exporters by looking at the challenges of an MSME footwear exporter from Tamil Nadu.
In Ambur, a town near Chennai, India’s leather industry’s hub, footwear manufacturers are getting ready for orders from Europe for the ‘Fall’ season. There, a first-generation entrepreneur, Rahul, proprietor of M/s. VJ Shoes has just got his first order of shoes from Italy against a Letter of Credit (LC). The payment terms are that the buyer will make full payment 60 days after receiving the shipping documents as per the terms of the LC.
Now, Rahul has a problem: he has to buy leather, pay his employees to manufacture the shoes for the order, then ship them to the buyer. Once the consignment is loaded on the ship, he will submit the documents to his bank, which will forward them to the buyer’s bank. The buyer’s bank will then ask the buyer to accept to pay in 90 days.
The manufacturing process will take 45 days, and then the documents will take another 15 days to reach the buyer. Then the buyer gets another 60 days to make the payment for the shipment. In total, Rahul will get paid 150 days after getting the order.
In the interim, Rahul has to buy raw materials for the footwear, pay salaries, rents, utility bills, etc., to keep the factory running until the buyer pays for the order. The funds that will allow Rahul to do all these activities are known as Working Capital funds. Now, Rahul’s challenge is that he does not have the funds to execute this order. And he cannot afford to reject the order as this is his first sizable order after the onset of the pandemic. So, the way out for him is to seek Working Capital Financing from banks and financial institutions.
Types of Working Capital Financing:
Working Capital Financing can be classified based on whether collateral in the form of immovable property is required.
1. Secured Working Capital (WC) Financing:
Most Working Capital Financing facilities come under this category. In this type, the bank requires collateral in the form of immovable property in addition to prime security, which is stock (in the form of raw materials, work-in-progress and finished goods) and book debts (aka Accounts Receivables). For Secured WC Financing, the interest rates are typically Repo Rate + 500 bps or thereabouts. The facility tenor is for 12 months when the limit is enhanced or reduced according to the borrower’s requirements and is usually renewed for another year. The amounts given under these loans are typically more significant and range from Rs. 25 lakhs upwards.
2. Unsecured Working Capital (WC) Financing:
This type of financing is not secured by collateral in the form of immovable property, hence the name. Since the credit risk is much higher than secured loans, the interest rate is also higher, ranging from 15% to 22% per annum. These are usually called business loans with a tenor of 1-3 years. Borrowers repay these loans in monthly installments. The amounts given under these loans are typically small and range from Rs. 20 lakhs to Rs. 50 lakhs.
3. Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE) Scheme:
Most MSMEs don’t have sufficient collateral as immovable property, especially in the early stages. To overcome this challenge, the Government of India has sponsored a scheme to give collateral-free loans to MSMEs at interest rates similar to secured loans but with a maximum limit of Rs. 2 crores. Under this scheme, the lender insures the loan against default risk, and the borrower pays the insurance premium annually.
In the case of VJ Shoes, they could avail of a secured loan if they can provide collateral. Otherwise, they are better off availing of working capital financing under the CGTMSE scheme. Since VJ shoes has an export order backed by a Letter of Credit, they can also avail of funding in foreign currency.
Another challenge VJ Shoes faces is that even after they ship the goods, they still have to wait for another 60 days to get paid as the customer has a credit period. So this borrower needs money to manufacture, pack and ship the goods (pre-shipment) and keep going until the payment is received (post-shipment).
Let us now look at the classification of Working Capital Financing, i.e., Pre-Shipment Financing and Post-Shipment Financing.
Pre-Shipment Financing, aka. Packing Credit (PC):
This form of Working Capital Financing is given to manufacturers holding confirmed orders to manufacture and ship the goods. PC can be provided in foreign currency as Packing Credit in Foreign Currency (PCFC), or Export Packing credit (EPC) in INR. PCFC limits are meant to help exporters compete effectively with international competitors who may be availing funds at a lower cost than Indian exporters. Packing Credit limits are usually secured by collateral.
There are two advantages of borrowing in foreign currency: First, the borrowing acts are a natural hedge against foreign currency risk (read more about foreign currency risk here and hedging here). Secondly, borrowing in foreign currency is way cheaper as the interest rates for foreign currency are significantly lower than for domestic currency.
PCFC is a form of Working Capital Financing available to exporters like VJ Shoes in which funds are released in foreign currency against confirmed export orders. Once the goods are shipped, PC and PCFC limits get converted to Post Shipment Working Capital Financing Limits.
Post-Shipment Financing:
As the name implies, Post Shipment limits are meant to finance borrowers until the buyer’s payment is received. Since the goods have already been shipped, the credit risk involved is lesser as long as there is an LC or the buyer has sound finances. Due to this reason, Post Shipment limits may be offered on an unsecured basis as an invoice/bill/LC discounting facility.
In the case of VJ Shoes, they would do well to avail of Working Capital Financing in the form of PCFC in Euros (as their Italian buyer will pay them in Euros). Once the goods have been shipped, the PCFC limit will become a Post Shipment facility. This Post Shipment limit will be repaid once the buyer makes the payment.
In the specific instance of VJ Shoes, they should apply for a pre-shipment working capital line (PCFC) in Euros as their Italian buyer would prefer to make all payments in Euros. This PCFC line will convert to a post-shipment line once VJ Shoes submits the shipping documents to the bank.
Once the payment is received, the bank will credit the proceeds after deducting interest and outstanding principal. Since the working capital financing facility was in Euros, as was the payment received, VJ Shoes has a natural hedge against the possibility of making a loss due to fluctuations in foreign exchange rates, i.e., foreign exchange risk.
Thus, we see that VJ Shoes will be able to execute the export order using Working Capital Financing. This example of VJ Shoes illustrates the critical role that Working Capital Financing plays in supporting MSME exporters. This blog does not cover many other types of Working Capital Financing as we are only discussing MSME exporters considering their critical role in our economy.
In the major cities in India, the availability of Working Capital Financing is not a challenge due to several banks competing to provide services to MSME exporters. However, in the smaller towns, the availability of Working Capital Financing is challenging due to fewer banks having a presence there.
If you are an MSME exporter based in Karnataka, Kerala, or Tamil Nadu and need additional working capital financing, please contact us at joe@tjconsulting.in or +91-9008557845.
Frequently Asked Questions:
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I have just incorporated my company, and I have export orders. For what kinds of Working Capital Financing am I eligible?
Unfortunately, banks do not fund businesses until they have completed at least 3 years in operation and have shown Net Profits for at least the last two years.
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Can I avail of PCFC/EPC without collateral?
Banks generally require collateral for pre-shipment limits. However, post-shipment financing can be availed on an unsecured basis if the order is backed by an LC and the documents are compliant with the terms of the LC.
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Which bank is best for Working Capital Financing for MSME exporters?
All banks aggressively compete for exporters’ business and generally offer the same products. However, they also have different USPs to differentiate themselves from the competition. Therefore, you will have to reach out to the banks, see their products and then choose a bank which is a good fit for your unique circumstances.