Cash flow-based lending leading the way for financial inclusion

Lending today has transformed leaps and bounds in the last few decades. However, there’s still a lot more wiggle room for improvement when it comes to financial inclusion.  

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Traditionally, lenders extend loans basis an asset-based model that considers the past performance of the company and collateral assets as a security. But with today’s fast-paced, dynamic world and changing business landscape, the past is no longer a good enough yardstick to measure future possibilities, which is where flow-based lending comes into the picture.

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A cash flow-based lending model allows a company or an individual to borrow money based on its projected future cash flows. Here, lenders analyse the risk more on future projections and assess the repayment ability and creditworthiness of borrowers.

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Data is the game changer.

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While flow-based lending is not a new concept, it was never feasible until now, as banks and financial institutions could never verify the income or validate small businesses’ projections. However, with the advent of technology, lenders can now trace income, credit history, repayment history at the click of a button. Additionally, the Government is investing in setting up public digital infrastructure through its initiatives starting from the GST to UPI, Aadhar Enabled Payment Systems (AePS), and Trade Receivables Electronic Discounting System (TReDS), lenders access to data is improving.

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The Reserve Bank of India’s nod towards setting up of Account Aggregator or licensed intermediaries is a positive step in enhancing financial inclusion through flow-based lending. AA will be the custodian of the borrower’s data from various financial institutions. On consent of the borrower can provide new-age Fintech companies or NBFCs access to the borrower’s credit history in a matter of seconds.  

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Moreover, the talks of launching a Public Credit Registry (PCR) could also help lenders gain a bird’s eye view of the customer’s financial profile on a real-time basis. All these measures can help financiers make informed data-backed decisions to widen credit reach while also reducing the default risk.

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Applications and Advantages

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With technology transforming the scalability of businesses within no time, adopting a cashflow based underwriting have quite a few advantages:

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• Financial inclusion: Cash-flow based lending tends to increase access to working capital for small and mid-sized businesses with little history but tremendous potential. Cash flow loans are based on a multiple of trailing EBITDA (earnings before interest, taxes, depreciation, and amortization) and not a multiple of the net asset value. This approach means that the borrower can qualify for a much larger loan - in some cases, up to five times the asset value that a bank following the traditional approach can provide.
• Enables loan customization: Banks generally charge EMI for all the 12 months in a year. However, cash flow lending is amenable to the concept of loan customization. For example, seasonal businesses may secure loans and service interest only in specific months in a year. This flexibility would help lenders lend to many small companies with seasonal income without risking loans become NPAs as repayments are not scheduled in the lean periods.
• Supports Growth: Several small businesses stagnate and collapse due to a lack of timely access to sufficient capital that can sustain accelerated growth in their formative years. Cash flow-based lending supports such small companies to grow rapidly by betting on their future revenue-generating opportunity regardless of their vintage.

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However, there are some risks associated with cashflow based lending too.

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While cash flow lending provides customized and quick capital injection that can be vital for businesses in dire straits, it is equally important to understand that there are higher chances of default with such loans. Given that the entire loan is based on future possibilities, if there is a miss in the projections or if an external situation similar to the pandemic were to unfold, the company may fail to earn its projected revenue and not have the ability to repay borrowed funds.

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There is also the challenge of limited penetration of the internet and technology across India. Technology provides the fundamental architecture above which the entire model is structured. Lack of organised businesses and data might make cashflow based lending harder to scale.

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A sound e-invoice infrastructure integrated into AI-based credit scoring algorithms can support better underwriting decisions to make cash flow lending scalable and sustainable for new age financiers. Combine this architecture with real-time monitoring can equip financiers to lend with confidence.

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Conclusion

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Technology is going to be the foundation of success for any financial service company soon. Cash flow-based lending will offer new-age financial services access to more credit worthy customers while making data-backed underwriting decisions.