What is an MSME Loan & how does it work?

During the past few years, micro, small, and medium-sized enterprises (MSMEs) have contributed enormously to India's rapid economic growth. Their role in creating jobs in the country has been crucial.

While they play a vital role in India's sustainable development, they also face enormous risks and challenges to survive and grow. Lack of sufficient financing is one of their significant challenges. Due to this, MSME loans have gained popularity in recent times. This article provides an overview of MSME loans.

What Is MSME Loan?

From 02.10.2006 to 30.06.2020, MSMEs were defined by the amount of investment in plant and machinery for manufacturing and equipment for services separately. However, on 26.06.2020, the Government of India issued Notification No. S.O. 2119(E) with new MSME definitions effective from 01.07.2020. As per the latest definitions, the criteria now include turnover limits and investment in plant and machinery or equipment, applying uniformly to manufacturing and service enterprises. In simple words, the simplified criteria for MSME are-

Classification Of MSMEs

The Indian government classifies businesses into Micro, Small, and Medium Enterprises (MSMEs) based on their machinery and equipment investment and annual turnover (sales). This applies to both manufacturing and service businesses w.e.f. June 2020. Here's a simplified breakdown:

Types of MSME Loans:

MSME business loans are different from regular business loans. They are more affordable and have relaxed terms regarding interest rates, tenure, MSME loan eligibility, and repayment. Here are the different types of MSME loan schemes available for your business in India:

Working Capital Loan

A working capital loan helps businesses manage daily operational expenses like purchasing raw materials, inventory management, and paying salaries and creditors. These short-term loans ensure smooth operations by maintaining a smooth cash flow in your business. The different types of working capital loans include:

• Cash Credit: It offers a credit limit based on creditworthiness. Interest is charged only on the amount used.
• Overdraft: It allows businesses to withdraw more than their account balance, charging interest on overdrawn amounts.
• Trade Credit: It helps suppliers or vendors extend deferred payments for goods or services purchased.
• Invoice Financing: Businesses sell outstanding invoices to financial institutions at discounted rates for immediate funds.
• Bank Guarantee: A bank guarantees payment to a third party on behalf of the borrower.
• Letter of Credit: A bank guarantees payment to a beneficiary against specified documents.
• Point of sale finance: These types of loans are generally used by retail businesses. The financing is based on the business’s future debit or credit card sales. 

Before providing working capital loans, lenders may ask for collateral like land, property, shares, or gold. However, after reviewing the company's financial statements, some lenders offer MSME loans without collateral.

Term Loan

Term loans provide funds for long-term capital expenditure, such as buying machinery, setting up or expanding a unit, and other capital-intensive projects. You need to repay these loans in fixed installments over a predetermined period. The interest rate can either be fixed or floating, that is, a rate that traces a benchmark rate and keeps changing over time. Types of term loans include:

• Capital Expenditure Loans: These are generally used for purchasing machinery, equipment, or infrastructure.

• Project Term Loan: Such loans help set up new manufacturing units or real estate development.

Vehicle Loan: You can use this loan to purchase commercial vehicles.

Other MSME Loans

The demand for MSME loans is increasing with the rise in opportunities for MSMEs. They are now offering flexibility to restructure the loan when needed. As a result, other specialized loan categories have also emerged; they include:

• Equipment/Machinery Loan: These are primarily for buying machinery or equipment to upgrade technological capabilities and operational efficiency of the business.
• Government-Sponsored MSME Loans: The government offers loans at concessional interest rates and favorable terms through schemes like Prime Minister's Employment Generation Programme (PMEGP), Credit Guarantee Funds Trust for Micro and Small Enterprises (CGTMSE), Stand-Up India, and Mudra Yojana.

Business Loans for Women Entrepreneurs: These specialized MSME loan schemes are designed to support women-owned MSMEs. The MSME loan interest rate here is lower than the rest, and the loan terms are preferential under the scheme.

Usage Of MSME Loans

Small businesses can use MSME business loans for many purposes, including

• To meet the requirements for working capital

• Boost the company's performance

• Expansion of new and innovative businesses

• Managing the cash flow of a business

• Investing in new equipment and machinery

• Purchasing tools, vehicles, and other fixed assets for the business

• Developing raw materials or stock inventories.

Significant Benefits Of MSME Loans

Taking out an MSME loan has many advantages. These include:

1. Accessibility

Funding a startup, sustaining an existing business, or expanding your business can be challenging as a business owner. Thankfully, the process of obtaining MSME loans is simple and hassle-free. Loan amounts are disbursed quickly with minimal documentation, especially if you need them urgently.

2. Complete Control

Finance is a crucial part of a small business's operations, but obtaining it is not always easy. While angel investors and venture capitalists are other sources of loans, they tend to seek control of part of the company in return. MSME loans are the best option for small business owners unwilling to lose control of their businesses.

3. Reduced Interest Rates

Business owners who wish to obtain a loan must consider the interest rate when calculating a loan's overall cost and monthly installment. Monthly installments are calculated based on principal and interest. For affordable EMIs, take a loan at a lower interest rate. Small businesses usually benefit from these loans as they have competitive interest rates.

4. No Collateral Needed

MSME loans require no collateral from business owners. Since small businesses may not have many assets, they cannot keep their equipment as collateral. Putting their valuable resources at risk by taking secured loans could negatively impact their productivity.

5. Short-Term Commitment

Most small businesses use MSME loans for short-term needs. Due to the lack of long-term commitment, this arrangement offers some flexibility for the borrower. Additionally, short-term commitments help management handle cash flow and allocate resources more effectively.

6. Flexible Tenure To Ease The Repayment

A comfortable repayment tenure allows borrowers to manage their debt obligations more effectively without defaulting. Business owners can plan their finances better with MSME loans since they offer flexible repayment terms.

Eligibility Criteria For MSME Loans

To qualify for an MSME loan, you must meet the following criteria:

• Have a credit score higher than 750

• The business must be at least one-year-old

• Banks vary in their business turnover requirements for existing businesses, but the minimum is Rs.12 lakh

• Financial stability and good repayment history

• No previous loan defaults

Documents Required For MSME Loan

The following documents are required for MSME loans:

• Government-approved KYC documents such as Aadhaar cards, PAN cards, voter IDs, driving licenses, etc.

• Passport, electricity bill, or rental agreement as proof of address

• Business Financial Statements such as GST Returns, bank account statements, and profit and loss statements from the last six months.

• Business registration documents as proof of ownership

Take Advantage Of IIFL Finance Small Business Loans

Small and medium enterprises can lean on IIFL Finance small business loans to meet their capital requirements. Specifically designed to assist small businesses, MSME business loans provide quick funding for essential infrastructure, operations, machinery, advertising, marketing, and more. These business loans have affordable interest rates so you don't have to cut down on essential expenses.

Frequently Asked Questions:

Q1. What is the interest rate on MSME loans?

Ans. The interest rate on MSME loans usually ranges from 8% to 15%.

Q2. Are MSME loans flexible in terms of repayment terms?

Ans. Yes. The repayment period for MSME loans is flexible, ranging from 12 to 60 months.

Q3. Are MSME loans different from business loans?

Ans. Although both loans are available to businesses and enterprises, the amounts and interest rates might differ slightly. The MSME loan is specifically tailored to meet the needs of MSME businesses.