The Growing Credit Gap for MSMEs
Medium and Small Enterprises (MSMEs) play a vital role as the key driver of global growth, innovation and employment. MSMEs are crucial in shaping the economy, especially in emerging markets where they contribute up to 40% of the GDP and employ 7 out of 10 workers (The World Bank, 2022). Despite being an essential driver of economic growth, MSMEs are constrained by the lack of access to finances, receiving a disproportionate share of credit across the formal lending system. These firms tend to rely on traditional bank financing to meet their funding needs, but this is also limited by the bank’s risk appetite and capital adequacy measures. The International Finance Corporation has estimated that 65 million MSMEs in the formal sectors have unfulfilled financing needs amounting to $5.2 trillion a year, which is approximately 1.4x the current global MSME lending (The World Bank, 2022). Things get worse when looking at emerging markets like India, where most of these firms remain informal and lack access to bank credit due to limited credit history & lack of awareness. Against this backdrop, equipment leasing has emerged as a clear alternative to bridge the gap.
Understanding Equipment Leasing
Every organisation needs cutting-edge equipment to boost productivity and efficiency and drive organisational success. However, it is an increasing challenge for businesses to make purchasing decisions about expensive equipment. With technology changing so rapidly, they tend to become outdated quickly. Furthermore, MSMEs are particularly averse to buying equipment upfront, as it may result in additional strain on the company’s cash flows. Equipment leasing may well be the NEW NORMAL for companies with limited capital and inaccessibility to standing lending options. Equipment leasing is essentially a form of asset financing, which involves the lessor (lender) lending the equipment to the lessee (borrower) for a specific period in exchange for lease rentals (monthly payments). Equipment leases are issued by Leasing Companies, Banks & other financial institutions and Equipment Vendors/Distributors issue. Items for lease include all the standalone machineries (for all manufacturing industries), IT Equipment, vehicles & heavy machinery is, usually financed through leasing. There are two types of leases based on who owns the asset at the end of the term –
Operating Lease – An Operating Lease is a short to long term contract (12 months –5 years) where the lessee returns the equipment to a lessor when the duration of the contract ends (Tardi, 2021).
- Operating Lease agreements are generally preferred by larger organisations as they tend to deliver more savings in running costs (registration, insurance, etc.).
- Operating leases are also beneficial for businesses that constantly need to upgrade their machinery due to technological advances (such as Office Equipment, Machinery).
- In an operational lease, lease rental payments can be claimed back as business expenses & reduce the tax liability.
Capital/Financial Lease – Finance Leases are generally long term contracts (3-7 years) where the lessee has the option to attain ownership of the equipment at the end of the period.
- While the lessee bears the risk associated with the equipment (in the form of insurance/taxes), they also benefit from claiming depreciation & interest expenses and the maintenance expenses, which reduces the tax burden.
- Financial Leases are beneficial for businesses where ownership is critical, such as core manufacturing/agricultural equipment.
Entering into an Equipment Lease Agreement
Businesses that decide to lease equipment need to enter into a lease agreement with the lessor. The lessor drafts a contract stating the lease duration, financial terms, payments due, the market value of the equipment, renewal options and cancellation provisions (if available). Businesses can use the equipment during the lease term until the contract expires. Once the lease agreement expires, enterprises can purchase the asset or extend the lease for another term, depending on the type of lease. The rates paid to lease the equipment vary based on the lender and the business’s credit score.
Advantages of Opting for a Lease
The basis of the concept of leasing is the assumption that it is the use of assets rather than the ownership that yields profits. Leasing differs from traditional lending, where loan repayment focuses on the company’s cash flow generation and collateral (if part of the contract). Leasing enables borrowers with limited credit histories and/or no collateral to use capital equipment when they do not qualify for traditional lending from financial institutions/banks. An often-cited situation in the agricultural sector, where access to credit is limited due to the risk perceived by the lenders (Paul Newall, 2020). Leasing also helps businesses gain access to a broader range of equipment. It makes it financially possible to use the said equipment that would have otherwise been too expensive to purchase.
While traditional financial sources require borrowers to have a collateral, lease lending can finance the price of the equipment upfront with no collateral. Borrowing through a lease is also typically cheaper than traditional lending due to lower security deposits required and fixed payments structure (as opposed to business loans which have fluctuating rates). Furthermore, leasing frees up an MSME/Startup’s cash balance to fuel high-growth opportunities rather than have it stuck in expensive capital equipment.
Bottom Line
MSMEs and Startups in the formal sector have traditionally seen their growth limited due to the lack of funding options available. A lack of credit history, higher capital requirements from financial institutions, and general risk aversion to lending to the sector have resulted in very few firms accessing credit at competitive rates. With the scaling of businesses becoming more expensive, lease lending has emerged as a bridge to solve the funding gap which currently resides with firms in the sector. Lease financing gives companies the flexibility to rent/purchase an asset that they could not previously, at fixed rates, without the need for additional collateral. Furthermore, the cash flows from the equipment/asset tend to pay for the lease liability, enabling the company to use its liquidity for higher-growth projects to generate superior returns. With attractive prospects for MSMEs &young companies, Lease lending could become the new normal moving forward.
(The author Shrikant Goyal, Co-Founding Member & Managing Partner, GetFive and the views expressed in this article are his own)
