The Credit Guarantee Scheme & its Impact on SMEs -
Case of working capital management for Auto Dealers


Vivek Joshi
Director - Creative Head Consultants Jaipur
Corporate Consultant & Trainer
Professor of Finance & Entrepreneurship

Abstract –

The research work focuses upon Credit Guarantee Schemes (CGS) as they are operational in India. The impact of these CGS on Micro, Small and Medium enterprises (MSMEs). Are CGS making real differences are they really beneficial in attaining objectives for which they were started. To bring out the desired study in proper perspective, the case of auto dealers has been brought under scanner. The Auto sector is booming and the industry even in the midst of severe recession registered growth. Auto Industry is capital intensive industry with high working capital requirements. Therefore the Auto Dealers have been selected as favourite and most apt segment to study as they are SME and they need huge funds for working capital, CGS provides working capital support to SMEs, so as to check the efficiency and effectiveness of CGS the case of working capital requirements of auto dealers has opted for the study.

Introduction –

Following economic liberalization in India in 1991, the Indian automotive industry has demonstrated sustained growth as a result of increased competitiveness and fewer restrictions. India in last 5 years became the second fastest growing automobile market in the world. The automobile industry in India is the ninth largest in the world with an annual production of over 14,049,830 units in 2009-10. In 2009, India - Asia's fourth largest exporter of automobiles, behind Japan, South Korea and Thailand. The growth felt in auto sector is supported by easy access to finances and facilitated by huge demand base of India's population.

Table I

Reasons for Growth –

Major reasons for the growth of auto sector are as follows:

• The government sponsored stimulus package

• Low interest rates

• The aggressive competitiveness to launch newer models

• Accessibility of Funds by Auto Dealers

• Easy availability of funds to customers

The trend of high demand and expanding production base is expected to continue for another 3-5 years. The first quarter of financial year 2011 has kept up with the momentum from fourth quarter of financial year 2010, thereby setting the tone for rest of this fiscal, on a Quarter on Quarter basis the industry volumes have grown by 4.3% and a resounding 32.5%on a Year on Year basis. The numbers are also a break from the seasonal trend of a weaker first quarter reflective of potential strong year ahead with the advent of festive season from September and the start of the base rate regime (expect to lower retail financing costs). The major concern would be the raw material prices and capacity constraints which have been instrumental in reducing margins. With the new capacities getting operational from softening of input costs would see significant improvement in profitability of the players.

Understanding Financing Need for Auto Dealers –

Most car dealerships display their inventory in a showroom and on a car lot. Profit margins on automobile sales are low. A new car dealer may mark up a car by less than two percent over the manufacturer's invoice cost, and typically the car dealer borrows from the manufacturer for inventory and pays interest (called flooring or floor planning). On the other hand, some manufacturers pay "hold-back" to improve the fiscal stability of dealers. Typically this is around 1% to 2% of the vehicles' wholesale price to the dealer. Hold-back is usually not a negotiable part of the price a consumer would pay for the vehicle. Hold back is designed to offset the cost the new car dealer has for paying interest on the money being borrowing to keep the car in inventory.

As it is a common knowledge that sales of car in India are a seasonal affair, usually more demand comes at the time of Diwali, Eid and Christmas. The festive season and growth in demand for vehicles is initiated from Mid-September every year as festivities onsets from that time. The seasonality of demand and higher value of stock including high costs associated with maintenance as well as management of inventory creates lot of problems and throw significant challenges to auto dealers in India.

Working Capital Requirements for an Auto Dealer are –

Working capital consists of the short term financial requirements of business enterprises (Gitman, Joehnk, & Pinches, 1985).

Working capital for auto dealer's is the capital needed to resolve short-term financial difficulties arising from payment of employees salary, rental expenses of venue of operation, running charges i.e. electricity & other utilities, maintenance and upkeep of stock etc., are all integrated components of working capital to be borne and meet every month by an auto dealer so as to keep his business running.

Auto Dealers also have intermediate to long term working capital requirements to effectively carry out their day to day operations which include the high cost of local marketing and payroll and maintenance of facilities etc. 

Managing Working Capital –

Working capital needs of an auto dealer are quite high and funds are needed to meet diverse needs, therefore a single source of working capital financing will not be sufficient to fulfill all needs, what is needed, a wide assortment of options to be used as per need or may be combination of more than one or two sources as per requirements. Few of the important sources are as follows:-

• Typically loans are provided by banks and occasionally also some non-bank lenders.

• Banks tend to view a working capital auto dealer business loan from the point of view of the entire relationship where as non-bank lenders will approach this from a traditional lenders point of view requiring adequate debt service coverage. 

• Inventory financing where in the Auto Dealer borrows money against his existing inventory is another way to achieve financing goals.

• Many times the car company itself will provide the Auto Dealership with these financing alternatives – many dealers however like to arrange their own financing

Financing Needs and the Working Capital Management –

• Fixed assets and the non-seasonal portion of current assets are financed with long-term debt and equity (long-term profitability of assets to cover the long-term financing costs of the firm).

• Seasonal needs are financed with short-term loans (under normal operations sufficient cash flow is expected to cover the short-term financing cost).

Self-Liquidating Nature of Short-Term Loans (Working Capital Financing) -

• Seasonal orders [Seasonality of Demand] require the purchase of number of vehicles beyond current levels {Stocking}.

• Increased inventory is used to meet the increased demand for the product/Vehicle.

• Sales become receivables in case of 'financing'.

• (Installments) Receivables are collected and become cash.

• The resulting cash funds can be used to pay off the seasonal short-term loan and cover associated long-term financing costs.

The availability of working capital can also minimize financial shortcomings in the future. Sufficient working capital is the result of proper financial planning and consistent earnings of the business.

Credit Guarantee – WHY?

Given financial market imperfections and institutional weaknesses, Governments in general resort to various industrial policy tools to improve credit allocation to the advantage of SMEs. One of them is credit guarantees

Credit Guarantee Schemes (CGS) in India – Introduction

It can be considered as an instrument to expand access of small & mid-size enterprises (SMEs) to loans from financial institutions. The Credit Guarantee Scheme is to help the new and existing industrial units in SME classification also units in Information Technology and Software Industry to access credit without the hassles of collateral security from the eligible institutions. The loan limit under the scheme, which was Rs.10 lakh per borrower, has been enhanced to Rs.25 lakh per borrower in terms of special policy package (2000-02; amendment) and recently it has been increased to INR 1 crore.

Objective of CGS –

Major objectives of credit guarantee scheme in India are:

• The objective was to create an institutional mechanism to support banks and financial institutions to ensure availability of credit facility and easy access to institutional funds to the SME sector.

• Provides Funds or Finance to institution to whom Banks and other financial institutions shy away from extending credit as the perceived risk is high.

Small & Medium Enterprise/Micro & Small Enterprise –

As the above diagram presents Micro is the smallest venture, than comes small enterprises and last is Medium enterprise. These have been distinguished from each other on the basis of capital employed and number of people employed. A company with fewer than 10 employees is termed as "micro". A small business is one that has fewer than 100 employees (goods-producing business) or fewer than 50 employees (a service-based business). A firm that has more employees than these cut-offs but fewer than 500 employees is classified as a medium-sized business. Small and Medium Enterprises play a vital role for the growth of Indian economy by contributing 45% of Industrial output, and produce more than 8000 quality products for the Indian and international markets. As a result, Micro Small Medium Enterprises (MSME) are today exposed to greater opportunities for expansion and diversification across the sectors.

Based upon capital requirements, in India MSMEs can be defined as, a micro enterprise is an enterprise where investment in plant and machinery [original cost excluding land and building and the items specified by the Ministry of Small Scale Industries vide its notification No. S.O. 1722(E) dated October 5, 2006 does not exceed Rs. 25 lakh;

ii) A small enterprise is an enterprise where the investment in plant and machinery (original cost excluding land and building and the items specified by the Ministry of Small Scale Industries vide its notification No. S.O. 1722(E) dated October 5, 2006) is more than Rs. 25 lakh but does not exceed Rs. 5 crore; and

iii) A medium enterprise is an enterprise where the investment in plant and machinery

(Original cost excluding land and building and the items specified by the Ministry of Small Scale Industries vide its notification No. S.O. 1722(E) dated October 5, 2006) is more than Rs.5 crore but does not exceed Rs.10 crore.

Table II

Table III

Auto Dealers as SMEs –

Auto Dealers are micro and small enterprises, reference to World Bank Groups, organizations with up to 50 employees and sales of up to US$3 million per annum (INR150, 000,000). Few Key examples are: - Hindustan Hyundai, Speed line Toyota, Western Motors.

The status of Auto Dealers as SMEs makes them eligible for loan from CGS Fund. Under the mentioned conditions an Auto Dealer can finance its Working Capital Requirements under Credit Guarantee Scheme.

Putting blocks together –

The above diagram explains the relationship that exists between SMEs and Credit Guarantee Schemes. To help in explaining the relationship and to highlight how it functions an example of auto dealers has been brought under consideration.

In the given diagram Auto Dealers are indicated as representatives of SME and they need working capital so as to keep them functional as well operational. On the other side of the diagram we have CGS, which provides finances to SMEs. Auto Dealer approaches CGS for meeting their working capital need and for the purpose a loan application along with proposed plan and necessary documents is forwarded to CGS Fund. On appraisal of documents if everything is found suitable the working capital loan within specific guideline will be granted to an auto dealer. Three circles at the bottom represent different functions that CGS Fund performs for SMEs. These functions are categorized fundamentally into Working Capital Financing, Capital Adequacy Services and last but not the least the Support services and Provisions i.e. providing export production support, leasing of equipments, logistical support and technical know-how support.

SME Financing –

Accessing finance is a challenging task for firms. However, these financing constraints tend to be more difficult for SMEs to overcome than for larger firms. On an average 23.9 percent of small enterprises have identified access to finance as a major constraint compared to only 18.2 percent of large firms. This limited access is mainly associated with the high administrative costs of small-scale lending, the underdeveloped financial system, the high risk perception attributed to small enterprises, asymmetric information and small firms' lack of collateral.

Focus of this research work is to understand the intricacies and important elements of working capital financing of SMEs under CGS.

• Quantum fixed at minimum 20%-25% of the unit's projected annual turnover for both new as well as existing units.

Table IV

Table V

Features of Working Capital Financing of SMEs under CGS ––

• Easy Access
• Low Rate of Interest
• Quick Processing & Servicing
• Timely Availability

Working Capital for Auto Dealers via CGS –

* Unsecured cash loan packages, which comes in a form of Over Draft or Term Loan or a combination of both to be offered to eligible new automobile dealers for their working capital requirements.

* 'Project Vikas' – Government initiative to support the Auto Industry & Formation of Auto Clusters.

Tools to Measure Success of Credit Guarantee Scheme –

Three Parameters – These parameters are as follows:-

1. Financial Additionality – Refers to availability of funds to an SME that would not have been available in the absence of the scheme.

2. Economic Additionality – Economic spillovers that accrue both at the beneficiary firm level and sector, because of increased access & availability of capital.

3. Sustainability of Scheme – The net cost of the administration of the scheme and the levels of EA & FA achieved indicate whether a credit guarantee scheme is economically sustainable.

Impact of Credit Guarantee Schemes on SMEs –

• The Amount of claims settled cumulatively is very low

• Cautious approach in providing finances

• Needy Entrepreneurs could not access credit as their business plans fell short of the traditional lending norms.

• Low awareness about the program

• Lack of incubation and technical-support facilities

• Only 5% of the loans are disbursed to start-ups (majority to existing clients)

• Recently the limit of finance raised to INR 1 crore from INR 25 Lakh

• Lack of proper scoring model across business life cycle or for different industrial sectors

Recommendations –

• Current Coverage of Credit Guarantee should be raised by at least 200% (INR 1 crore to 3 crore)

• More Awareness Creation campaigns

• Association with IIMs and IITs

• Generation of incubation and technical facilities

• Change in risk appetite of financing institutions so as to facilitate SME growth

• Emphasis on sound project and product idea.

• Development of separate benchmarks for different industries as well for businesses in different life-cycle stages.

• Encouragement to women entrepreneurs.

• Associating Private Institutions for training, trading & Financing.

• Reduction in upfront fee by 1%.

Conclusion –

Discussion about performance of CGS has highlighted that these schemes have facilitated growth to an extent and were successful in delivering what was expected of them still their task is not complete and lot more has to be done. Some innovative measures and big steps are to be taken to make theses schemes more fruitful for SMEs as well lot has to be done in order to make them more development oriented. Their scope of activity has to be enlarged along with a wide net of services has to be introduced so SMEs with constrained capital and resources can have a single window solution or may have one stop service provider for all their ailments.

1. SMEs continue to be the thrust area for Government policies.

2. The growing economy and the   tremendous market potential of the country augur well for the sustained growth of SMEs in the country.

3. Panacea for employment and decentralized industrial development.

4. Latest policy package for SMEs envisages 20% annual growth in credit to SME sector from FY 2005, to be doubled by 2010.

5. With the enactment of MSME Act, the sector is all set to emerge as the most   significant player in national economy.

6. Credit Guarantee Schemes are a great initiative by the Government of India.

7. With specified set of rules and guidelines plus allowances these schemes are performing reasonably well.

8.  At the given status these schemes have limited reach and growth.

9. The norms are to be fine-tuned with changing environment and business needs

The discussion above highlights the fact that most of the SMEs are unable to provide information on their creditworthiness they tend to lack appropriate accounting records and collateral. This leads to uncertainty on the project's expected rates of return and the integrity of the borrower. Gathering such information on SMEs can be challenging and costly.  The CGS has to be made more amenable towards these enterprises so as to facilitate their working and providing them with an equal opportunity for survival plus growth. With requisite changes the CGS will benefit many more (SME) entrepreneurs and will reach to larger audiences as well will facilitate expansion of business activity across a territorial and domain frontiers. Most important point that we all need to remember is that CGS are playing their role but they can never effectively substitute for financial reforms.

Reference –

Arping. S., Morrison. A., Lσrαnth. G., (2008); Public Initiatives to Support Entrepreneurs: Credit Guarantees versus Co-Funding, University of Cambridge, University of Amsterdam, University of Oxford, March 7, 2008.

Beck. T., L. Klapper, J. C. Mendoza, (2008); The Typology of Partial Credit Guarantee Funds around the World , The World Bank Development Research Group, November 2008.

Benavides. G., Huidobro. A., (2004); Are Loan Guarantees Effective? The Case of Mexican Government Banks, Direcciσn General de Investigaciσn Econσmica y Direcciσn de Intermediarios Financieros de Fomento, Banco de Mιxico December 2004.

Cowan. K., Drexler. A., Yaρez. Α., The Effect of Partial Credit Guarantees on the Credit Market for Small Businesses

Green. A., (2003); Credit Guarantee Schemes for Small Enterprises: An Effective Instrument to Promote Private Sector-Led Growth?, the United Nations Industrial Development Organization (UNIDO) Working Paper No. 10, August 2003.

Levitsky. J., (1997); SME Guarantee Schemes: A Summary; The Financier, vol. 4, NO. 1 & 2, February/May 1997,

Levitsky. J.,(1997); Credit guarantee schemes for SMEs an international review, Small Enterprise Development, No 2 June 1997.

Levitsky. J., (1997); Best Practice in Credit Guarantee Schemes; The Financier, vol. 4, No. 1 and 2, February, May 1997.

Vivek Joshi
Director - Creative Head Consultants Jaipur
Corporate Consultant & Trainer
Professor of Finance & Entrepreneurship

Source: E-mail August 5, 2010


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