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AFrameworkforCreditAnalysisI. RiskAssessmentII. TheClient’sFunding NeedsIII. LoanStructuringIV. LoanManagement1I. RiskAssessmentMonitoringtheEconomicEnvironmentAnalyzingIndustryConditionsAssessingaClient’sMarketingManagementAppraisingtheClient’sOperationsManagementEvaluatingManagementCapabilitiesandCharacterAnalyzingtheBorrower’sFinancialManagement2MonitoringtheEconomicEnvironmentMuchoftheriskassociatedwithaloanisduetobroadeconomicforcesasshownonthenextslideLendermustmanageitsexposuretocertaintypesofbusinessesLendermayhavetocurtaillending,eventobusinesseswithagoodtrackrecord,inperiodsofeconomicadversityNecessarytomonitorthecurrentandforecastedeconomicenvironment3TheEconomicEnvironment-Cont.KeyelementsoftheeconomyEconomicgrowth-thebusinesscycleInflationratesInterestrates-thelevel,termstructureandriskstructureGovernment-politicaltrendsandcurrentfiscalandmonetarypoliciesInternationalrelationships-balanceofpayments,currencyvalue,internationalmarkets4TheEconomicEnvironment-Cont.Itisimportantforthelendingofficertokeepontopofbroadeconomicconditionsbecauseoftheirpotentialimpactonthebank’sclientsandthequalityoftheofficer’sloanportfolio5AnalyzingIndustryConditionsAborrower’sfinancialperformancedependson:

CurrentconditionsandprospectsforitsindustryHowwellthecompanyispositionedrelativetothecompetition?Itisnecessarytounderstandboththerisksandopportunitiesforthemajorindustrysectorsinthebank’smarketDeterminetwofactors:Aretheindustry’sprospectsattractive?Whichtypesoffirmsaremostlikelytosucceedintheindustry?6AnalyzingIndustryConditionsBanksnowcreateportfoliomanagementgroupsMonitorindustryconcentrationsinthebank’sloanportfolioDeterminefutureprospectsforkeyindustriesSetlimitsonthemaximumexposurethebankwillpermitforanindustryorspecificborrowerRiskclassificationsystems-usedtoassignanumericriskratingtoallborrowersorloanrequests.Industryconditionsformpartofthisriskrating.7FactorsaffectingIndustryConditionsMichaelPorter’sModelEaseofEntryAvailabilityofSubstituteProductsBargainingpowerofbuyersandsuppliersCompetitiverivalry.Rivalrytendstobegreatestwhentherearenumerouscompaniesproducinglargelyundifferentiatedproductsorservices.Dependenceonotherindustries8AssessingaClient’sMarketingMarketingisacriticalfactorformostborrowers,especially“start-ups”,thoseenteringanewbusinessorfacingtoughcompetitionFirmshouldhaveaplanwhichcovers:ProductPoliciesPricePoliciesPromotionPersonalSellingActivitiesDistributionPolicies9AppraisingtheClient’sOperationsManagementOperationsmanagement-thesetofactivitiesrequiredtotransforminputssuchasrawmaterialandlabourintothefinalproduct.Majorcomponentsofoperationsinclude:Quality-valueformoneyProcessDesign-technology,plantlayoutFacilitiesPlanningandSchedulingInventoryManagement-howmuchisnecessarytocarry?Employeemanagement10EvaluatingManagementCapabilitiesandCharacterDeterminetheexperienceandskillsofkeyprincipalsThisincludestechnicalknowledge,contacts,resourcesinmarketing,operationsandfinanceplusskillinmanagingandmotivatingothersAssessmanagement’’scharacter:integrity,financialconservatismandrespectforcreditors11AnalyzingtheBorrower’’sFinancialManagementStrongfinancialmanagementisanessentialingredientforsuccessFinancialcapacityisthecompositeofmanagementpoliciesandpracticesinseveralareas:Isthereadequateliquidity?Thefirm’’srelationshipswithtradecreditors,lendersandinvestorsTheequitycapitalcontributedbytheownersTheextentoftheowner’’swithdrawals12Borrower’’sFinancialManagementcont’’dCalculatekeyfinancialratios1.Profitabilityratios2.Assetutilizationratios3.FinancialcapacitytestsWhichratiostocalculatewillvarywiththetheindustryandtypeofbusiness(example-serviceormanufacturing)13ProfitabilityRatiosProfitMargin:Netprofitaftertax/netsales.GrossProfitmargin:Theportionofrevenuesremainingafterthecostofsales.(NetSales-CostofSales)/NetSalesSalesGrowth:Measuredovertime.Usuallyexpressedasa%growthperyear.ReturnonAssets:NetProfit/TotalAssets.Thismaybedistortedduetotheageofthefirm’’sassets.14ProfitabilityRatiosReturnonEquity=NetProfit/TotalEquityThismeasurestherateofreturnonthecapitalprovidedbyequityinvestors.Equityincludescommonstock,retainedearnings,andminorityshareholders’’interestBanksnormallyrequireanagreementfromtheownersthatequityfundswillnotbewithdrawnwithoutthebank’’spriorpermission15AssetManagementRatiosTurnoverofCurrentAssets.Daysofinventory=Inventory/(CostofSales÷365days).Thisshowshowcarefullymanagementiscontrollingit’sinvestmentininventory.Costofsalesisusedtoensurethatbothgoodssoldandinventoriesarecomparedonthesamebasis,namelyatthecostofpurchaseorproduction.16AssetManagementRatiosCollectionperiodforReceivables=AccountsReceivable/(NetCreditsales÷365)TellsushowquicklyAccountsReceivablesarecollectedInaddition,thelendershouldobtainanagingschedulewhichclassifiesAccountsReceivablebyhowlongtheyhavebeenoutstandingForexample,ifthebusinesssellsonnet30daysthenmostreceivablesshouldbenolongerthan30days17TypicalAgedAccountsReceivableSchedule0-30days31-6061-9090+GradeACompanyInc12,000AGoodBet&Associates23,000NotSoBadCo.4,500APoorDealInc.6,000FlybyNightLtd.99918AssetManagementratio-cont’dIfalargenumberofcustomershavenotpaidfor40or50daysorlonger,thenthecompanymaybelaxincollectingoverdueaccountsorhasextendedcredittocustomerswhohavedifficultypaying.Olderreceivablesmayindicatethatthequalityofthereceivablesissuspect.Thismeansthatthebankmaynotbeabletocollectallofitsreceivablesiftheborrower’’sassetsneededtobeliquidated.19FinancialCapacityRatiosThefirmmustbesufficientlyliquidtomeetitsrecurringcommitmentsandhaveadebtstructurethatcanbeservicedfrombothitsprofitsanditscashflowsLiquidityMeasures:CurrentRatio=CurrentAssets/CurrentLiabilitiesIsagoodmeasureofsolvencyasitindicatestheextenttowhichclaimsofshort-termcreditorscanbecoveredbyliquidassets20FinancialCapacityRatiosQuickratio=(Cash+ShortTermsecurities+receivables)/CurrentLiabilitiesShowsthemostliquidassetswhichcanbeliquidatedtomeetshort-termobligations21FinancialCapacityRatiosDebtRatiostellushowmuchfinancialleveragethefirmhas.Higherleverageincreasestheriskoftheloanandwhetherthefirmwillbeabletoserviceitsinterestandprincipalpayments.Theamountofequityinvestedsignalsthecommitmentofthemajorshareholderstothebusiness.22FinancialCapacityRatiosContinuedDebttoAssets=(CurrentLiabilities+Long-termdebt)Assets*Measurestheproportionofassetsfinancedbyotherpeople’’smoneyincludingthebank.DebttoEquity=(CurrentLiabilities+long-termdebt)(Totalequitycapital+postponedshareholder’’sloans)*Measuresthedebtrelativetotheinvestmentoftheowners.InterestCoverageRatio=(Earningsbeforeinterestandtaxes)/interest.*Thismeasuresafirm’sdebt-worthinessanditsabilitytomeetinterestpaymentsoutofrecurringprofit.23SummaryofFinancialRatioAnalysisProfitabilityRatios:NetProfitMarginNetProfit/SalesGrossProfitMarginGrossProfit/SalesReturnonAssetsNetProfit/SalesReturnonEquityNetProfit/EquityAssetManagementRatios:TotalAssetsTurnoverNetSales/TotalAssetsFixedAssetsTurnoverNetSales/NetFixedAssetsDaysofInventoryInventory/(CostofSales÷365)24FinancialRatiosContinuedAccountsReceivableCollectionPeriodAccountsReceivable(AverageDailySales)FinancialCapacityRatios:CurrentratioCurrentAssets/CurrentLiabilitiesQuickratio(CurrentAssetslessinventorylessprepaidexpenses)/Currentliabilities25FinancialRatiosContinuedFinancialCapacityRatios(Continued):Accountspayablepaymentperiod=Accountspayable/AveragedailypurchasesDebttoassetsratio=TotalDebt/TotalAssetsInterestCoverage=(Earningsbeforeinterestandtaxes)Interest26CashFlowAnalysisThepurposeofariskassessmentistojudgethecompany’sabilitytoserviceitsobligationstothebank.Aborrower’srepaymentcapacityisprimarilydeterminedbythecashflowsthatthebusinessgeneratesThemajorsourcesandusesofcashinthebusinessmustbeidentifiedtopredictfuturecashflowsStatementofchangesinfinancialpositionareprovidedaspartofthecashflowstatementsTellswherethecashiscomingfromandwhereitisbeingused:operating,investingandfinancingactivities27II.TheClient’sFundingNeedsEstimatingTotalFinancingNeedsIdentifyingNon-BankSourcesofFinancing28EstimatingTotalFinancingNeedsAbankerhastoidentifythetotalfundingthatthecompanyrequirestosupportitscurrentoperationsandtocarryoutitsplansforexpansion.Themajormethodsofforecastingafirm’sfinancialneedsCashFlowbudgetsProformafinancialstatementsTheloanfacilitymustbesetatalevelthatisbothrealisticforthecompany’sneedsbutisnotexcessiverelativetotheavailablecashflows29FinancingNeedsFinancialforecastsmustbepreparedbymanagementoranoutsideaccountantandthebankercanonlyassessthereasonablenessoftheforecasts.Providesboththeamountandtimingofthefirm’sneedsHelpsthebankerbetteranalyzetherisksassociatedwithaloanrequest.Sensitivityanalysisshouldbedonewheretheforecastsarepreparedusingdifferentassumptionsaboutfutureevents30FinancingNeedsBankerstoooftenseeloanapplicationsonlyafterfinancialneedshavebecomeimmediateandurgent.Financialforecastsprovidethebankwithcheckpointsformonitoringaborrower’sprogressandperformance.Anunanticipatedneedisnotnecessarilybad.Itcouldalsoindicatethatthefirmhasfoundanewbusinessopportunitytopursue.31CashFlowForecastsCashflowforecastestimateswhenandinwhatamountscashwillflowinandoutofthebusinessCashbudgetsareusefulforshorttermforecastsandforthosecompanieswithseasonalsalesandproductioncyclesPrepareCashReceiptsbasedonprojectedsalesandthenpreparecashoutlayswhicharecloselylinkedtothesalesforecast.32SampleCashBudget33ProjectedFinancialStatementsApproximateforecastscanbedevelopedbyapplyingthecompany’sexistingbalancesheetandincomestatementratiostoestimatesoffuturesalesvolumes.ExtendforecastsseveralyearsintothefutureForecastedIncomeStatementsAreusuallythestartingpointindevelopingaproformastatementManyvariablessuchasinventories&accountsreceivablesmovecloselywithsales34ProjectedFinancialStatementsStartwithforecastingtheestimatedsalesgrowthrate.Rawmaterialcosts,labourexpensesandproductionsuppliesasapercentageofsalesareforecastedtoremainatcurrentlevels.UsuallythebalancesheetismoredifficulttoforecastthananincomestatementEstimatesarerequiredandmaynotberelatedtoasinglekeyvariablesuchasthesalesfigure35ProjectedFinancialStatementsAccountsreceivableandinventoryaretiedtosalesEstimatetheaccountsreceivablebalancebasedonthepastcollectionexperienceEstimateinventoriesbasedonthetypicalinventorylevels.EstimatetheplannedpurchaseofnewplantandequipmentlessdepreciationAccountspayableforecastshouldincorporatethecompany’splannedpurchasesofrawmaterialsanditspaymentpractices36ProjectedFinancialStatementsCashandNotespayableshouldbeadjustedtobalancebothsidesofthebalancesheet.Cashaccountissetatanamountthatthecompanybelievestobeareasonableworkingbalance.Oncethecashaccountisforecasted,thebankloanpayablecanbecalculatedtofindtheamountthatmakesthebalancesheetbalance.Thisisknownasthe“plug””figure.Thisbalancingfigurerepresentstheclient’sfundingrequirementtosupporttheforecastedlevelofassets.37ProjectedFinancialStatementsForecastsshouldbeconstructedwithdifferentbasicassumptions.Sensitivityanalysiscouldtestthefollowing:1.Slowdowninthecollectionofaccountsreceivable2.Declineininventoryturnoverrate3.Unanticipatedexpansionoffixedassets4.Higherexpensesthanplanned5.Lowersaleslevelsthanpredicted6.Tradecreditorsdemandingfasterpayment38IdentifyingNon-BankSourcesofFinancingThreebroadsourcesoffundsareavailabletothefirm:1.Fundsgeneratedbythefirmbyincreasingtheworkingcapita.lA.Shortencredittermsandincreasethequalityofcustomersreceivingcredit(usebetterscreening).B.Reducecompanyinventorylevelsandslowpaymentofaccountpayables(wherepossible)C.Improvefinancialplanning-cashflowbudgeting39IdentifyingNon-BankSourcesofFinancing2.Externalbusinesssources-PersonalAssetsFriends,familyandemployees-“l(fā)ovemoney”InformalInvestors-privateindividualsFactoring-afirmthatactsasthecreditandcollectionsdepartmentLeasingFranchisingorVentureCapitalOthertermlenders-eg.GECapitalPublicEquityMarkets40IdentifyingNon-BankSourcesofFinancing3.ExternalgovernmentSourcesGrantsForgivableLoansDirectloansGovernmentGuaranteesTaxbreaksDirectequityinvestmentsinthefirm41PartIII.LoanStructuring1.IdentifyingtheAmountandFormofBankFinancing2.LendingandtheLegalEnvironment3.SecuringtheLoan4.LendingandEnvironmentalLaw5.PricingtheLoan6.Designingtheloanagreementandloancovenants42TheAmountandFormofBankFinancingTheInitialScreen-Isthedeal“bankable?”.Doesithaveacceptablerisksrelativetothereturn?Isthereturnadequatetocompensatefortherisksaccumulatedandthecostofservicingtheaccount.Banksareinthebusinessofgrantingloansthattheyconsidertoberelativelylowrisk.PreparealistofprosandconsTurningdowntheloanshouldincludeafrankdiscussionofthecompany’sproblemsandoptions43TheAmountandFormofBankFinancingSettingtheloanlimitDeterminetheclient’sabilitytopayCashflowsarederivedfrominternallygeneratedfunds.Long-termloanscanonlyberepaidfromprofitsifthebusinessistoremainaviableentity.Enforcedliquidationofthecompany’sassetsisa“fall-back””position,shouldcashflowsfromoperationsfallshortofrequirementsInjectionofowner’’scapital-isitavailableifneeded?Collateralsecurity-determinethelendingvalueofaccountsreceivableandinventoryorthevalueofthefixedassets44TheAmountandFormofBankFinancingBanksnormallyfinance75to80percentofthecostoffixedassets100%financingmaybewarrantediftheassetscouldbereadilysoldattheirpurchasepriceorifthecustomerhasadditionalcollateraltosupporttheloanTheamountoftheloanshouldbesufficienttomeetthecustomer’sfinancialneeds45TheAmountandFormofBankFinancingTheRepaymentTermThetermoftheloanisthetimeperiodduringwhichtheloanpaymentsarefixed.Theamortizationperiodistheperiodoverwhichtheloanisscheduledtoberepaid.Forexample,someonepurchasingahousemayhaveamortgagewithatermof5yearsbutamortizedover25years.RepaymentperioddependsonwhatthemoneyisbeingusedforTransactionloansarefortemporaryfunding-eg.abridgeloan46TheAmountandFormofBankFinancingOperatingloans(floatingprimebasedloans)areusedtofinanceacompany’saccountsreceivableandinventoryandfluctuateasthefirmmovesthroughdifferentsellingseasonsLetterofcredit-saysthatthebankwillpayacertainsumonthedeliveryofspecificdocumentstothebank.Theyarecommonlyusedforinternationaltrade.Whenthebankpays,theywillthenrequirepaymentfromtheborrowerTermloans-usedtobuyspecificfixedassetsandwillbepaidoutovertimefromthecashflowstheassetgenerates47LendingandtheLegalEnvironmentAsecuredcreditorisonewithspecificlegalrightsagainstparticularassetsofthedebtorwhichmaybeexercised,shouldthedebtorfailtofulfillpromisesgiventothecreditorAnunsecuredcreditorisanyonetowhomthedebtorowesmoney-theunsecuredcreditorhasnospecificrightsagainstthedebtor’sproperty,otherthanthegeneralrighttosueforenforcementofthedebtor’’spromisetopay.Abasicunderstandingofthelegalsystemisessentialtothosemakingdecisionsoncommercialcredit48SecuringtheLoanRoleofcollateralsecurityinvolves3tasksDetermineavailableassetsthatcouldbepledgedascollateralandestimatetheirnetrealizablevalueasasecondarysourceofrepayment.Beknowledgeableoftheproceduresfordocumentingandregisteringasecurityinteresttoensurethatthebank’sinterestareprotectedMonitortheborrower’scollateralpositionovertime49LendingandEnvironmentalLawLegislationmayincreasedefaultriskinseveralwaysLegislationwhichrestrictshowaborrowercancarryonitsbusinesseg.controlsonemissionsorwastedisposalincreasesthecostofrunningabusinessThevalueofthesecuritymaybediminishedbyenvironmentaldamagetocollateralsecurityIfthelenderassumescontrolsoftheborrower’sassets,thelendermayfacethecostofcleaningupthesiteunderenvironmentallegislation.Suchcostsmaywellexceedthevalueoftheloan.Ifenvironmentalriskisaconcernfromthestart,itmaybebettertodeclinetheloan.50PricingtheLoanAbankseekstoearnapositivemarginbetweenwhatitearnsonallofitsfinancialassets(primarilyloanstobusinessesandconsumers)andthecostofitsfunds(deposits).Netinterestincomeiscriticaltoabank’sprofitability!FactorsintheloanpricingdecisionincludePerceiveddefaultriskontheloanCostofhandlingtheaccountProfitabilityoftheentirerelationshipincludingfeeschargedNegotiatingabilityoftheborrowerandaccountmanagerCompetitiveconditionsbetweenfinancialinstitutions51PricingtheLoanTakeintoconsiderationthetypeofriskratingsystem.Whichkindsofloansareexcellent,verygood,goodandacceptable?Considerthebank’srequiredreturnoncapital.Typically15-20%ROE.Capitalisthelongtermfundsinvestedinabankintheformofdebenturesandvariousformsofequity.Thegreatertherisk,thegreaterthereturndemandedbythesuppliersofcapital52DesigningloanagreementsandloancovenantsAloanagreementisacontractbetweenaborrowerandalenderwhichlaysouttheconditionsoftheloanLoanagreementscanvarybutwilltypicallyincludethefollowing:IdentifiestheBorrowerTheAmountThetypeoffacility;operating,revolvingortermAdvancesandConditionsPrecedentPurposeTermInterestRate53DesigningloanagreementsandloancovenantsLoanAgreements(continued)RepaymentScheduleCollateralSecurityRepresentationandWarranties-statementsoffactabouttheclientwhichthebankhasassumedtobetruewhenmakingtheloanoffer.Forexample,theexistenceofcertaincontracts.Covenants-guidelineswhichtheborrowerpromisestofollowinthefutureoperationofthebusinessEventofdefault-theeventswhichleadtoadefaultoftheagreementCostsandPricing54DesigningloanagreementsandloancovenantsImportantCovenantsmayinclude:Submissionoffinancialstatements-interimmonthlystatementsandfinalannualstatementsSubmissionofotherdata-forexample,monthlyaccountsreceivablereportsMaintenanceofliquidity-maintaincertainlevelsofworkingcapitalandratiosMaintenanceofassets-maintainassetsingoodconditionMaintenanceofmanagementandownershipwithoutpriornotificationtothefinancialinstitution55DesigningloanagreementsandloancovenantsInsuranceCoverage-eg.fireandtheftinsuranceovercompanyassetsMaintenanceofacertainnetworthortheratioofequitytodebtNegativeCovenants-preventtheclientfromtakingactionsunacceptabletothebank.Someexampleinclude:LimitondebtRestrictionsondisposalofassetswithoutpriornotificationtothebankRestrictionsonchangesinthenatureofthebusinessincludingacquisitionsandmergers.56DesigningloanagreementsandloancovenantsNegativeCovenantscontinuedRestrictiononassetpurchaseorinvestmentsLimitonsalariesanddividendsGuidelinesinSettingCovenantsAllbanksprovidetheirlendingofficerswithaspecimenloanagreementwhichoutlinesthemostcommontermsandcovenants.Thebankermustthentailortheloanagreementtotheneedsandrisksofhisclient.57PartIV.LoanManagementMonitoringtheLoanManagingProblemLoans58MonitoringtheLoanMonitoringinvolvesasetofactivitiesaimedatensuringthatanoutstandingloanisbeingrepaidasscheduled,theclient’’sabilitytorepayisnotdeterioratingandthecollateralsecurityisbeingmaintained.Whatshouldbemonitored?Daytodayoperations-cashflowsTheacquisitionandsaleofassetsThetakingonorrepaymentofliabilities59MonitoringtheLoanMonitorCashFlows-regularfinancialstatements,clientmeetingsandfollowingeconomiceventswhichmayinfluencetheclient’sbusinessMonitortheClient’sAssets-financialstatements,accountsreceivable&inventoryreportsandvisitstothecustomers,pluspersonalfinancialinformationforsmallbusinessownersMonitorclientliabilities-toseewhatthecompetingclaimsare.Dothiswithfinancialstatementsandwithperiodicsearchesatkeyregistryoffices60MonitoringtheLoanTheannualreviewisthemostsignificantmonitoringevent.Analyzethefirm’’skeysuccessfactorsandwhathaschangedDeterminehowthefirmhasorwillrespondtothesechangingsuccessfactorsDiscussthepreviousyear’scashbudgetandprojectedstatementsDiscussthecurrentfinancialstatements.Probeforreasonsiftheyhavedeterioratedorimproved.61MonitoringtheLoanReviewtheclient’saccountprofitabilityUsingtheprojectedfinancialstatement,identifytheclient’’sfuturefundingneedsDiscusstheclient’suseofotherbankservicesandidentifyfuturemarketingopportunities62ManagingProblemLoansThreemajorcomponents;1. Identifyingproblemloans2. Workingouttheloan3. EndingtherelationshipProblemloansarestatisticallyinevitableAllriskcannotbeeliminated,ratheritmustbemanagedAProblemLoanisonewheretheborrowerisunableorunwillingtorepaytheobligationandthereispotentialforpartialortotallosstothebank63ManagingProblemLoansEarlyWarningSignalsDelinquentLoanPaymentsDelayedfinancialinformationChangeindepositpatterns,excessesandreturnedchequesMajordifferencesinplannedresultsversusactualLossofborrowerrapport-poorcommunicationAdverseinformationfromtheborrower’scompetitors/customersIncreaseininquiriesfromtradecreditorsUnusualbusinessactivities64ManagingProblemLoansWarningSignscontinuedChangesinManagementBreachesofcovenantsDetermineifthesearetemporaryorpermanentproblemsTheWorkoutPlanStrengthenthebank’sposition-increasingcollateral,additionstothecompany’scapitalbaseorrefinancingFormulateaworkoutplan-theborrowermustdevelopadetailedactionplanthatisconvincingandachievable65ManagingProblemLoansShort-termcompanyinitiatives(tosuggest)EliminateexcessexpendituresDismissineffectivepeopleAddmissingskillsReduceinvestmentinfixedassetsScaledowncompanyoperationsSecurecooperationoftradecreditorsClarifytypeofbanksupport66ManagingProblemLoansTerminatingtheLoanRefinancingmaybepossibleEnforcecollateralsecurityReviewalldocumentationtoensurethatthesecuritycanbeenforcedChoosehowtoenforcesecurityandgaincontroloftheassetsProspectsarebestiftheb