MSEs are adapting to a brave new world

The unorganised ones are feeling the heat of GST, but long-term gains outweigh transitory pain

CRISIL’s discussions over the past few days with organised micro and small enterprises (MSE), especially those dealing with medium-to-large enterprises and government entities, show they have taken to the goods and services tax (GST) regime fairly well.

On the other hand, unorganised MSEs — mostly small units with low compliance levels and high dependence on cash transactions — are struggling to cope, and are seeing clients shifting to GST-compliant rivals. Compounding the problem is a stretch in working capital because clients are holding back payments for want of clarity on applicable rates and invoice-matching process.

The refrain is that demand hasn’t slackened, but lack of understanding about the compliance process is a frequent cause of business disruption.

Given that July was the first month of GST implementation, most MSEs are yet to begin uploading invoices to claim input tax credit. Therefore, teething issues would continue in the near term.

Once that’s sorted, we believe GST will fundamentally alter the dynamics of the MSE sector.

We see organised players doing better than before because of administrative ease and greater reach that a unified market — that’s more competitive and efficient — spawns.

In the manufacturing sector, profitability will improve for MSEs that hold on to their pricelines despite lower tax incidence now. But things could go the other way in the services sector, where a 300 basis points (bps) increase in tax to 18 per cent would mean those unable to pass on would be impacted.

Digital revolution underway

Because it’s a digital ecosystem, GST will improve the availability of business data by an order of magnitude. For instance, many MSEs believe monthly uploading of invoices will improve record-keeping — data that will come in handy when seeking a bank loan or wooing prospective clients.

The fourth census of the micro, small and medium-size enterprises sector, showed just 5.18 per cent of MSEs (both registered and unregistered) had availed of finance through institutional sources, and an even smaller, 2.05 per cent, from non-institutional sources, in 2009.

Put another way, 92.77 per cent did not have access to institutional credit, or depended on self-financing.

Illustration: Binay Sinha

But now that MSEs are leaving digital — and quite granular — footprints, lenders can capture more of — and more reliable — information.

Such transaction trails — or “digital exhaust” — can now be proxy for creditworthiness analysis matrices such as cash flows, and trends in receivables realisation and payment delays to suppliers. That would improve the comfort of institutions when lending to MSEs.

Small city players to gain

A unified market will also improve the competitiveness of organised players and open up new markets for their products.

MSEs based in Tier II or smaller cities are expected to gain more from greater logistical efficiencies. Those in small cities spend relatively more on materials and less on manpower compared with peers in metros and Tier I cities.

In smaller cities, raw materials constitute nearly 73 per cent of the overall costs for an MSE, according to CRISIL’s analysis — or a good 500 bps more than in larger cities. That’s because large manufacturers are located closer to centres of economic activity, which offer twin benefits — greater bargaining power with suppliers and cheaper logistics.

While large cities will continue to offer these, the advantage will erode with GST. Enhanced systemic efficiencies will reduce input and logistics costs, making it faster and cheaper for raw materials to reach smaller towns and for finished goods to reach lucrative markets.

Employee costs will remain lower in small cities, allowing MSEs there to improve margins or compete better on prices by passing on the benefits to customers. Additionally, given relatively lower land prices in such places, capacity expansions will be cheaper.

Unorganised lot faces existential crisis

Profit margins will come under pressure for those that thrived on the edges of the mainstream. Before GST, unorganised MSEs had lower cost structures because of exemptions from paying social security benefits to employees  and excise duty. This allowed them to offer lower prices and yet maintain 10-11 per cent operating margin — nearly the same as organised MSEs.

Since the threshold limit for GST exemption has been reduced drastically to Rs 20 lakh from Rs 1.5 crore, promoters who had set up multiple outfits, or were understating revenues or employees to duck thresholds, will come into the tax net. Many others will, too, which could turn their businesses less profitable, if not unviable. 

Organised MSEs will become more competitive in industries where the GST rate is lower than what was the effective indirect tax rate earlier because input costs will reduce. Consequently, unorganised ones will face pressure and given their limited ability to increase prices, will have to reduce margins.

Lessons from those who sailed well

As with paradigm shifts, there are lessons in change-management here, too. Our discussions show that some business owners have been attending seminars and training to enhance their transition experience. Others have hired consultants referred by suppliers and customers. Hiring common consultants is helping some MSEs address issues faster.

We find MSEs adapting to the big change better than expected. Nimbleness and constant exchange of information within their networks are affording quick alterations to business processes.

To be sure, competition from larger rivals is set to intensify because they will also gain from economies of scale and an end to price distortions (no more varying taxes across states).

The upshot? Some transitory pain, and a lot of long-term gains.

The author is senior director, CRISIL Ratings-SME