GST + Demo = Shortage of Working Capital

More than 140 countries in the world had GST (Goods & Services Tax), before India adopted it. The tax was created after abolishing more than 14-40 different type of Tax levies. It created a cross-state single market and broke barriers like Chungi’s (Tax plazas) on inter-state borders. It is truly a far reaching structural reform which would have a profound effect in the way Indian MSME’s (Medium Small & Micro Enterprises) manage their Finances.

Why GST?

Before GST came into effect, the country suffered from exception-based governance, but post its implementation, a rule-based order came into existence which would break unorganized businesses and force them to be a part of the Tax-compliant organized sector.

Prior to GST, the tax-compliant firms faced a massive and grossly unfair competition from huge number of tax-evading companies. The Tax-evading companies competed better on price, which is the single biggest business determinant in a highly price-elastic market like India. On the other hand, Tax-compliant firms had worries in the form of high requirement of Working Capital.

Working Capital

Working Capital

Working Capital – Lifeline of MSME

It is nothing new for an Indian MSME businessman to get a 60 day credit on the raw material purchased, then spend a lot of capital on production, make the shipment, see the shipment reach the end-customer taking its own time and after the shipment reaches the customer, then have to face the ignominy of being at the mercy of the client for payment of invoices.

Not only did the Tax-evading companies offer a better price, but also allowed end-customers to pay in 3-6 months and even beyond. This was a nightmare for the Tax-compliant companies since it meant that their receivables payout would be long and this would necessitate greater requirement of Working Capital.

The worst part is that agreements are mandated by the Government to build in a maximum duration of 45 days for invoices to be paid. But Indian Judiciary being in a perpetual limbo, has meant no recourse under the Contract Law for the seller with Buyers making merry at the cost of the Seller.

How GST tries to correct long receivables timelines

GST corrects this to a large extent, because if the payment doesn’t happen by 6 months, the facility of availing input credit, itself lapses. However, differential GST needs to be paid within 45 days by the Sellers, whereas Buyers are still paying much later than that, thereby increasing the Working Capital requirement of Sellers.

Unsecured Funding

In the case of small firms with no collateral and the promoters not holding any real estate for collateral, the only option is to go for unsecured funding. Such unsecured funding comes at a ROI (Rate of Interest) of 14-18% per annum (p.a) from Banks, the caveat being that each Bank lends only upto INR 40 lacs per client, to lower risk. Even for availing this Funding from the formalized Banking system, the cash flows on the Books of the company should have capacity to repay the loan. This means that the company should be Tax-compliant and report its business properly.

MSME’s work on thin margins, mostly 8-10%, but being fully compliant means paying GST/ Corporate Tax and other levies and yet competing on price. This has been the Achilles heel of MSME’s in India.

Tax-evading companies, on the other hand, don’t pay any direct or indirect taxes. For their Working Capital needs, they resort to taking loans in cash from the market, paying usurious ROI of 12-24% p.a! In case of real estate players, the ROI is even 30-40% p.a! Taking these cash debt itself means the company has no interest in paying any taxes.

What has happened since last one year

GST meant that unorganized players and Tax-evading companies need to be a part of GST chain, to avail input credit or to search for cash-based companies, which are disappearing fast every day. With each passing day, companies are choosing to be a part of GST chain, which means these Tax-evading companies, will have to either take the plunge or simply shut down.

Now, the whole fuss with GST is not only increasing Tax compliance in a hugely Price-elastic market, but another step of the Government which effectively settled the question of how long Tax-evading companies will be able to operate. And that was – Demonetization (Demo).

Demonetization – crunch creator in Working Capital

Demo meant that excess cash in the system got reduced from 12% to 9% and it got deposited with the Banks. Hence, Cash Lenders charging usurious ROI, which formed the backbone of Working Capital needs of Tax-evading companies, exited to a large extent. The few available such Lenders started charging ROI of 24-30%. The backbone of the Tax-evading company got truly crushed and therein lies the tale of the hues & cries from crony quarters.

It is GST PLUS Demo, which has affected the system, and for the right long-term reason. Critics be damned!

GST – Part of larger Structural Reforms

GST is part of large structural reforms carried out by this Government – Others being RERA, Bankruptcy Code, notifying Benami property Bill and so on. Other structural initiatives of the Government were Market pricing of Fuels, enhancement in Cooking Gas connections, the JAM trinity and Aadhar.

These are all intended to correct the massively inverted Indian economy, which threw up rewards for being unorganized and outside the formal system.

The Government knew that the pain felt by the public would be upfront and the rewards would come later.

Flaws with GST

The GST architecture itself suffers from many flaws, but they are being gradually corrected.

High GST rates are a big hassle – It was to happen because GST Council worked on the principal of Revenue Neutrality i.e The initial Tax slabs should be such that from Day 1, Central & State Governments don’t lose out on any revenue. But this was a faulty way to think, because low Tax rates means faster Tax compliance and formalizing of the economy. With increasing formalization, Government revenues would only have risen hugely with time. But the GST Council, instead kept high rates of 18% and 28% for a large number of middle class items, thereby slowing compliance. Now, it is being corrected.

With steps being taken to correct the situation, like increased limit of composition scheme, exemption from monthly filing returns for MSME’s with less than Rs. 1.5 cr turnover etc, some sense has come in the system. One important pending point is that companies in the middle of the chain, bear Tax because of differential GST rates. So if your product retails on 28% tax item but your raw material is on 18%, the company would need to bear the differential of 10%

GST has meant that lending capacity of Banks increased and the Logistics sector got an uplift post abolition of inter-state Tax Plazas. Now, Real Estate and Petroleum is proposed to be brought under GST, thereby most of the Indian economy will be under the levy of GST.

The main problem – Working Capital – is also being corrected by infusion of money in PSU Banks.

Author: Tushar Kansal

Tushar has been associated with the Project Assessment, Fund-raising & Financial Advisory realm in India for 2 decades. He has straddled multiple roles in Financial Advisory in Deloitte Touche Tohmatsu, PE Deal-maker in Times of India’s Brand Capital, in Corporate Finance roles in Aircel, as an Entrepreneur in Education field and as a CFO (Chief Financial Officer) till 2014. Prior to that, he was the Head of Debt for MTS India, where he was instrumental in raising $2.5 billion structured debt. Tushar has been involved in $6 Billion of transactions in Debt/ PE/ M&A across all asset classes. He has major experience in Education domain – From 2001 to 2006, Tushar led his Education entrepreneurship venture which provided Entrance examination training for Engineering colleges in India. The venture grew to 800 students and then was bought out by a marquee pan-India player in this space, as a strategic sale. Tushar is a panel member at CNN-News18. He is also a Columnist @ Business World, Indian Defence News, Business & Economy, Indian Economist, Digital Market Asia, OpIndia & Growing India.

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