SWARNIMA TIWARI

RESEARCH SCHOLAR, DEPARTMENT OF MANAGEMENT

NEHU, TURA

FINANCING OF MSME- A CRITICAL ANALYSIS

Abstract
Micro, medium and small scale enterprises (MSME) sector, has crucial role and place in the Indian
economy in terms of employment generation, exports and economic empowerment of a vast section of
the population. MSMEs not only play crucial role in providing large employment opportunities at
relatively lower capital cost than large industries but also help in industrialization of rural & backward
areas, thereby, dropping regional imbalances, assuring more rational distribution of national income
and wealth. MSMEs are complementary to large industries as ancillary units and this sector
contributes a great deal to the socioeconomic development of the country As per available statistics
(4th Census of MSME Sector), this sector employs an estimated 59.7 million persons spread over 26.1
million enterprises. It is estimated that in terms of value, MSME sector accounts for about 45% of the
manufacturing output and around 40% of the total export of the country which is next only to the
agricultural sector.
This study aims to provide an assessment of the Micro, Small and Medium Enterprise sector (MSME)
finance in India. The chapters in the study highlight the key characteristics of the MSME sector, and
assess the demand for, and the flow of finance into the sector. The study also evaluates the consequent
gap in the financing needs of MSMEs
Keywords: MSME, Credit Flow, financial institutions.

INTRODUCTION
The Micro, Small and Medium Enterprise sector is crucial to Indias economy. There are 29.8 million
enterprises in various industries, employing 69 million people. The sector includes 2.2 million
women-led enterprises (~7.4 percent) and ~15.4 million rural enterprises (51.8 percent). In all, the
MSME sector accounts for 45 percent of Indian industrial output and 40 percent of exports. Although
94 percent of MSMEs are unregistered, the contribution of the sector to Indias GDP has been
growing consistently at 11.5 percent a year, which is higher than the overall GDP growth of 8 percent
%.( Source: MSME Census, IFC Intellecap Analysis). According to MSMEs Act 2006 the
enterprises are broadly classified in terms of activity such as enterprises engaged in manufacturing,
production and enterprises engaged in services. The below chart shows New Nomenclature of
MSMEs.

CLASSIFICATIONS OF MSME

Enterprise

Manufacturing

Service

Micro

Upto Rs 25.00 lacs

Upto Rs 10.00 lacs

Small

Above Rs 25.00 lacs to Rs

500.00 lacs

Above Rs 10.00 lacs to Rs

200.00 lacs

Medium

Above Rs 500.00 laces to Rs

1000.00 lacs

Above Rs 200.00 lacs to Rs

500.00 lacs

Source: (As per Micro, Small and Medium Enterprises Development Act, 2006)
MSMEs consider challenges in access to finance as one of the biggest constraints in growth. A study
on the MSME sector also suggests that the multiple growth constraints can be largely linked to
inadequate access to finance. The Report of Working Group on Rehabilitation of Sick MSMEs by
RBI also finds lack of adequate and timely access to working capital finance is one of the key reasons
for sickness in the sector.

REVIEW OF LITERATURE

A comprehensive review of literature on MSME is reviewed with reference to their financial

aspect is made gives an idea about the work done in the past and assists in description of the
problem area but also provides a basis for interpretation of findings. An attempt is made
along the following lines to review some of such studies.
Smith and Smith, 2000, studied the major sources of funds for MSMEs are his personal savings,
credit cards, loans from friends and family and loans against property.

Tagoe et al. (2005) examined the impact of financial sector liberalization (FSL) policies on
the financial management of micro, small and medium-sized enterprises (MSMEs) in Ghana,
using six case studies. Findings, confirm and extend the conclusions of previous studies; are
integrated into a framework that explains the impact of FSL and the factors at work. The
main financial challenge faced by MSMEs is access to affordable credit over a reasonable
period. This is determined by the financial needs of MSMEs and the action of investors.
MSME financing needs reflect their operational requirements, while the action of investors
depends on their risk perception and the attractiveness of alternative investment (which
affects their willingness to invest). Government borrowing, the general economic climate,
availability of collateral, quality of MSME record keeping, and MSME investor relations
skills affect the way in which this challenge is managed.
Berger and Udell (2006) suggested a more complete conceptual framework for analysis of
MSME credit availability issues. This framework shows that the key conduit through which
government policies and national financial structures affect credit availability is leading
technologies. The feasibility and profitability of different lending technologies are affected by
the casual chain from policy to financial structures. These technologies, in turn, have
important effects on MSME credit availability. Financial structures include the presence of
different financial institution types and the conditions under which they operate. Lending
technologies include several transactions technologies plus relationship lending. The frequent

misleading conclusion is that large institutions are disadvantaged in lending to opaque

MSMEs
Thampy (2010) give a brief description about the major bottleneck to the growth of the vital
Indian small and medium enterprises (MSME) sector is its lack of adequate access to finance.
The major issues in the financing of MSMEs in the Indian context are examined under this
paper. These include the information asymmetry facing banks and the efficacy of measures
such as credit scoring for SMEs, whether transaction lending would be adequate to address
the information issues or would lending have to be based on a relationship with the SME.
Whether the size and origin of the bank affect the availability of credit to SMEs. The author
also gives an importance of the credit appraisal and risk assessment processes in todays
banking landscape and the role that banks can play in developing the MSME sector in India
OBJECTIVES OF THE STUDY:
1. To know about the recent trends in financing of MSMEs.
2. To know about the contributions of different sources in financing of MSMEs.
3. To know about role played by financial institutions in financing MSMEs.
4. To identify the various barriers faced by MSMEs in raising finance.
SOURCES OF FINANCING FOR MSMES:
The MSMEs in India largely depend on self-finance. As per the recent census of MSME sector 92.8%
of all enterprises were found in the category of taking self-finance/No finance. (Source: MSME
Census, 2007).This high percentage of units depending on self-finance/No finance can be a result of
high proportions of units falling in Micro enterprises category. Micro enterprises comprise 95% of
all the MSME units in India, whereas the share of small enterprises is 4.7% and that of medium
enterprises is only 0.17 %.( Source: MSME Census, IFC Intellecap Analysis)
This study shows that of the overall finance demand of INR 32.5 trillion, 78 percent, or INR 25.5
trillion either self-financed or from informal sources. Formal sources cater to only 22 percent or INR
7 trillion of the total MSME debt financing.
Within the formal financial sector, banks account for nearly 85 percent of debt supply to the MSME
sector, with Scheduled Commercial Banks comprising INR 5.9 Trillion. Non-Banking Finance
Companies and smaller banks such as Regional Rural Banks (RRBs), Urban Cooperative Banks
(UCBs) and government financial institutions (including State Financial Corporation and State
Industrial Development Corporations) constitute the rest of the formal MSME debt flow.
Within the informal financial sector non-institutional sources include family, friends, and family
business, while institutional sources comprise moneylenders and chit funds.

PERCENTAGE SPLIT OF MSMES BY SOURCES OF FINANCE

Percentage of enterprises by sources of finance rough Institutional Sources
Through
PERCENTAGE OF ENTERPRISE BY SOURCES OF FIANACE
No finance/self finance
Percentage
of
enterprises
92.8%
Source: MSME Census, 2007

Through
institutional source

Through
noninstitutional sources

5.2%

2.1%

The MSMEs which fall in unorganised sector continue to take credit heavily from the informal
financial sector. The active participation of informal financial entities in lending is a result of several
advantages that these firms consider as significant. The informal financial sector has access to
information through the social and personal networks. It helps to develop a relationship of trust and
confidence which is important in the absence of adequate amount of collateral.
MSMEs perceive that the least usage of paper work and absence of administrative sluggishness and
rigidities make the availability of loans from informal sources quicker as compared to formal banking
system. The timeliness, convenience and simpler process of informal financial entities attract the
borrowers of MSMEs. The banking sector has also been an important source of finance for MSMEs,
especially, for those which are in organised sector. The following table indicates the outstanding bank
credit to micro and small enterprises.

OVERALL FLOW OF FINANCE TO THE MSME SECTOR

Working with the assumption that all finance demand by the MSME sector is met by either formal or
informal sources, the estimate for overall supply of finance to the MSME sector is also INR 32.5
trillion. This comprises informal finance, self-finance and finance from the formal financial sector.
However, the characteristic of the finance flow is that informal sources and self-finance together make
up most of the finance channelled into the sector. An estimated INR 25.5 trillion, or nearly 78 percent
of the sectors debt demand, is fed by these two sources, while formal sources cater to just over 22
percent of the demand at INR 7 trillion.

Formal sources of finance, i.e. banks and non-banking institutions, account for 6.97 trillion of
the overall formal finance supply, and commercial banks are the largest formal sources of
finance, primarily providing debt capital to the MSMEs

The study estimates that the supply of formal equity to the sector is INR 0.03 trillion.

The study estimates that informal sources account for an estimated INR 24.4 trillion in
finance to the sector. Informal sources include both institutional sources such as
moneylenders and chit funds, and non-institutional sources such as family, friends, and family
business

In addition, entrepreneurs also leverage personal resources and contribute equity to the
enterprise. Self-equity contributions are estimated to account for INR 1.1 trillion of finance
flow into the sector.

The overall demand for finance in the MSME sector is estimated to be INR 32.5 trillion. The majority
of finance demand from these enterprises is in the form of debt, estimated at approximately INR 26
trillion. Total demand for equity in the MSME sector is INR 6.5 trillion, which makes up 20 percent
of the overall demand.
FLOW OF MSME DEBT FINANCE FROM THE INFORMAL SECTOR
Informal finance dominates the sector and 95 percent of it comes from non-institutional sources. The
study estimates that these source such as family, friends, and family business together account for INR
23.2 trillion of the informal finance to the MSME sector.

Financial transactions with non-institutional informal sources are typically in the form of
debt; these transactions are not bound by any contractual agreement, and the repayment terms
are mutually agreed. Typical repayment terms include bullet payment of principal and regular
interest payments. Due to the non-contractual nature of transactions, many micro enterprises
prefer informal sources over formal sources despite the relative higher rates of interest.

Non-institutional lenders typically do not insist on any immovable collateral. Instead such
sources tend rely on personal reputation or social collateral to hedge repayment risk, making
it easier for enterprises to access informal finance.

Costs of funds from such sources tend to vary from 1 percent per month to 5 percent per
month.

INSTITUTIONAL INFORMAL SOURCES

family business; 22%

own savings; 31%

family/friends; 47%

Source: Report on Entrepreneurship in India, National Knowledge Commission

FLOW OF MSME DEBT FINANCE FROM THE FORMAL FINANCIAL SECTOR

The MSME sector receives INR 6.97 trillion debts from banking and non banking institutions. Banks
and government financing agencies constitute the largest share of formal debt to the MSME sector,
and are estimated to provide INR 6.4 trillion to these enterprises. The balance INR 0.57 trillion of
formal debt is Supplied by non-banking finance companies (NBFCs). Unlike in many developing
countries in Latin America where large banks are down-scaling to serve the Small and Medium
Enterprise (SME) market, in India large banks have been the largest formal source of finance to
MSMEs for decades.
OUTSTANDING CREDIT TO THE MSME SECTOR BY SCBS

Year

Public
Banks

2008
2009
2010
2011
2012

151137
191408
278398
376625
3963.0

Sector

Private
Banks

Sector

46912
46656
64534
87857

Foreign
Banks

All Scheduled Commercial

Banks

15489
18063
21069
21461

213538
256127
364011
485943
5276.84

Source: MSME Annual Report 2011-12.

As of March 2012, total credit outstanding of all scheduled commercial banks to the MSE sector stood
at ` 5,276.84 bn compared to ` 4,785.27 bn as of March 2011, registering a growth of 10.27% over
March 2011. Credit outstanding to the MSE sector as of March 2011 was 32.08% higher compared
with March 2010. Growth in lending towards the MSE segment witnessed a slowdown in FY12
mainly due to the impact of global economic crisis affecting the demand for goods and services and
thus, reducing the overall industrial production activity.
Banks are introducing loan products catering MSMEs exclusively. Indias commercial banks are now
launching loan products which are covered by Credit Guarantee Trust Fund for Micro and Small
Enterprises (CGTMSE). This Scheme is an initiative of Government of India to strengthen credit
delivery system and

MICRO FINANCE INSTITUTIONS (MFIS)

Microfinance institutions are often incorporated as NBFC-MFIs, and are mostly active in the
unregistered and unorganized microenterprise segment. MFIs are gradually scaling up from providing
individual loans to providing business loans for micro enterprises. The average size of credit
disbursed by MFIs ranges from INR 0.015 million to INR 1 million per enterprise. Primary research
suggest that MFIs accept immovable property such as land, building and/or hypothecated assets as
collateral.
The study estimates that MFIs supply INR 0.02 trillion ($0.4 billion) of debt to the micro enterprise
segment. In line with broad sector financing trends, short-term working capital accounts for a larger

share of the portfolio. Despite the huge market potential, the current activity of MFIs is limited due to
constraints in accessing capital and other stringent regulatory requirements.

CONCLUSIONS:
From the study it can be concluded that MSME sector in India relays heavily on informal sources of
finance which include no financing/self financing, funds from friends relatives, and family business
and majority of the enterprises are funded by the owners own capital. Enterprises in India also avail
finance from community institutions such as chit funds. The size of the organized chit funds market in
India is estimated to be INR 0.3 trillion. Since Chit funds offer flexible repayment options and ondemand finance with limited or no collateral.
In case of financial institutions Public sector banks continue to be the most preferred source of finance
for SMEs with 68.4% of the SMEs choosing to use services of public sector banks. Micro-finance
also plays a considerable role in financing of MSMEs its activity in micro enterprise financing is
limited or less, due to recent changes in the regulation. Despite of government initiatives, only 5.18%
of the MSME units (both registered and unregistered) availed finance through institutional sources,
2.05% had availed finance from non-institutional sources, and 92.77% of the units had no access to
finance or depended on self-finance, (according to the Fourth Census of MSME sector conducted in
2009). These figures clearly highlight the extent of financial exclusion in the MSME sector.
BIBLIOGRAPHY
1. A. N. Berger and G. F. Udell, The economics of small business finance: The roles of private equity and debt
markets in the Financial Growth Cycle, Journal of Banking and Finance, vol. 22, pp. 873-897, 1998.
2. N. Tagoe, E. Nyarko and E. A. Amarh, Financial Challenges Facing Urban SMEs Under Financial Sector
Liberalization in Ghana, Journal of Small Business Management, vol. 43, no.3, pp. 331343, 2005.

3. Smith R. L.; Smith, J. K. (2000): Entrepreneurial Finance, New York, Wiley.

4. A. Thampy, Financing of SME firms in India, IIMB Management Review, vol. 22, pp. 93-101, 2010.

5. Annual Report, (2012-13). Ministry of Micro, Small and Medium Enterprise, Government of India.

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