credit officer workshop july 2008. welcome ! two days together ……….. to think about and...

Credit Officer WorkshopJuly 2008

Welcome !

Two days together ………..To think about and discuss the profession we are all in – that of providing financing (and other financial services) to businesses - large and small

To reflect on the risks we take, how to assess them, structure and manage them, and how to protect our Banks in the event our borrowers weaken.

To talk about asset quality and how to maintain it

To review the key principles of credit and the basics of a credit culture every lending institution must have to succeed

… and at the same time

To help our customers become “better borrowers” for the sake of and for the future of their businesses

Who am I ?

Rick Clarke

• Graduate of the University of Notre Dame

• 35 years in commercial banking and corporate finance

• 30 years with Wachovia/ CoreStates in the US, Australia, Hong Kong, London, Latin America

• 5 years with Kasikornbank in Thailand – Head of Credit

Day One

• The Risk Management Process, Credit Culture and Asset Quality

• Borrowing Causes

• Information and Data Needs

• Special challenges with small businesses

• Sources of Repayment

• Cash Flow

Day Two

• Developing a common Analytical Focus

• Projections & sensitivity analysis

• Non-financial risk dimensions

• Credit facility structuring

• Loan Monitoring

• Dealing with Problem Loans

• Credit Risk Ratings

“Ultimate” goal for Commercial Banks

Same as for any private enterprise ……

Generate Shareholder “Value”

• Earn returns at “acceptable” and ”expected” levels

• Maintain “consistency” of returns

• Diversification of revenue streams

• Cost controls• Capital adequacy • Compliance

• Since key revenue producing assets are “risk assets”, Risk Asset Quality and Risk Adjusted return is crucial

• Quality is directly related to the soundness of origination, structuring, pricing and monitoring and to diversification

Focus of workshop

So what happened in the US recently ???

• Major losses in Banks and Investment Banks announced related to mortgage lending and leveraged lending

• Misplaced confidence by investors

• Raising new capital or merging to survive

• Calls for greater regulation

• Did bankers not care about the quality of their loans because they planned to sell them to someone else?

Let’s understand and remember the basics

Our focus has to be on Asset Quality – how to achieve it and how to maintain it

And on the risk adjusted returns needed to grow and maintain the business, and to preserve and grow retained earnings

Weak loans, NPL’s etc., and good loans don’t just happen. Cycles come and go, but the level of asset deterioration does not need to follow the economy and the liquidity conditions on a one to one relationship

We are responsible for the quality of our portfolios

Bust

Time

Boom

Loan Quality

Bust

Time

Boom

Nothing can

go wrong !!!

Nothing can go right !!!

Memory Forethought

Prevailing thought

The quality of a Bank’s portfolio

Should not be measured only by the level of NPL’s or delinquent loans ….

The condition of the loans in the “good portfolio” and the trend in the performance and financial position of those borrowers

Can foretell the “future”- its brightness or darkness

The quality of a Bank’s portfolio

Delinquency rates

and trends

Credit risk ratings and migration

Conditions and covenant compliance

RM coverage ratios

Adherence to limits

and review schedules

Concentration management

Tenor/maturity patterns

Documentation care and attention

Closemonitoring

Supervision quality

and attention

Info &analysis

RememberBanks do not succeed by avoiding risk. They

succeed by understanding the risks and by managing them.

Successful bankers focus on the key principles of making loans and managing loans

And then use their common sense and business judgment to balance market realities and sound practices

The principles are universal– not market specific

Small Business/Large Business

The principles of lending are the same:• The application of the principles may be

different• The expectations for information content

and detail may be different• Terms and condition design and

enforcement may be different• The monitoring process and frequency

may be different

SME’s a special challenge and a great opportunity

• High potential- highest relative risk

• Highest business failure rate• Fragility• Dependence on Bank debt• Limited sources of capital and

management• Little market leverage• Many recently started since &

have not yet operated under stress

• Collateral short and the liquidity of collateral a question especially in a down cycle

• Quality of information• Frequency of reliable

information – how to measure compliance?

• Availability of monitoring resources (credit issue and economic, efficiency issue)

Loan Quality

Is not just a characteristic of conservative banks

It is a characteristic of “quality” banks who exercise care in lending and in monitoring their risk assets in all cycles

Credit Culture

How “we” approach the business of extending credit

Our key principles & Our shared values

How we do things at “our” Bank

Elements of a strong Elements of a strong credit culturecredit culture

• Know our customer

• Cash flow is what pays obligations

• Two ways out, at least

• Finance what we understand

• Loan purpose is to be productive

• Sufficiency of information

• Credit decisions based on

sufficient facts

Who we are

How we dobusiness

What we care about


• Complete disclosure, inside and outside

• All Credit comes with conditions• We monitor our exposure (Active

Lending)• We take prompt action when we need

to• We recognize the risks of credit

concentrations


• We don’t take short cuts

Credit appetite, terms and pricing vary and bend

But the standards don’t bend and the culture doesn’t break

Know the customer, of course we do….

don’t we?

• Trust (Character) - Reputation

• Information -The business, the industry, the management, and the numbers

• Full disclosure

• Consistent communication

• The owners and the managers

Cash Flow

• Only cash repays loans. A lender must know what’s happening to the cash. Where it comes from and how it’s used

• We lend based on cash flow, not on collateral and our customers need to understand this.

Multiple exits

• Cash flow from operations is our first way out, always, but

• We look for secondary sources of repayment as well – our

back door

Finance what we understand– For a Productive Purpose

• Business credit for investment– consumer credit for consumption

• We will not provide financing for purposes or for projects which do not seem to make business and financial sense

• We do not finance transactions which are outside our experience and competence

• We intend to finance “cash flow” producing activities

Information and facts

• We make business decisions based on facts• We expect to have adequate information on

which to base or decisions, which means:

– Reliable, whether “audited or not” – Sufficient, what we need, not just what we get– Current, not just last year– We don’t make loans based just on projections

Disclosure

• We expect our customers to provide us with all the reasonable and relevant information we require (and not just the numbers)

• We promise each other within the Bank that we will be open, complete and transparent with information

Flexibility

• We have a common sense approach to business and negotiations, recognize that we have competitors and that some borrowers have sensitivities we may not completely understand…nevertheless

We do not compromise the key principles of our credit culture

Monitoring and Action

Post drawdown is not a time to lose attention – we have an “active” borrower and we employ “active”, ongoing due diligence

We take action to protect the Bank as appropriate ----- and promptly

Concentrations

We value our customer relationships, but we recognize there are prudential limits of exposure with one borrower, related borrowers, industries and geographies

And this is as important for our customer as it is for us, whether they recognize it or not

Diversification and the insulation/illusion of “small

exposures”

True, but with “consistent” quality

A portfolio is made up of individual assets, each of which should meet at least the minimum standards

Home mortgages !!!!!

The Culture Drives

….The way we approach customers

The expectations we have for reliable information

The way we analyze the borrower and the risks

The practices we follow

…..and the way we communicate inside and outside

The culture is healthy when…

• People understand the standards and expectations of the organization

• Supervisors from middle management on up also understand and reinforce it consistently and often

• The Bank has the RM’s and Underwriters with the necessary credit skills and business common sense……… AND

People who base their actions, not just their words, on the standards

The Bank is entitled to expect that RM’s * will always:

• provide a balanced assessment (rather than emphasizing only the positives);

• take the necessary steps to dig out the relevant information and ensure it is communicated

And admit what they don’t know

* Account managers

The credit proposal

Is not intended to be a marketing oriented document

…. Although it certainly is a recommendation- from the RM, the analyst, and the business unit itself.

But the approval process is not a contest !

A strong, well communicated, consistently reinforced and organized credit culture and the behaviors which it encourages are part of a continuous process towards consistent risk asset quality –

Through ALL business cycles

Bust

Time

Boom Zone of consistent quality

For all of us to make decisions better, more consistently and more

efficiently

“Better” decisions need not have a negative impact on new business development …or market share

Assuming……….

Why businesses need to borrow

Not “What” or “How Much” they want to borrow

But………….. why…..

What is the reason internally generated funds are not sufficient or available ?

Look behind the request to find the reason

To see and understand how the business itself operates

Understand the business like the owner understands it…………………….

BusinessBusiness

BorrowerBorrower

CurrentCurrent

CashCash

RequirementsRequirements

Investing in Investing in

GrowthGrowth

ContingencyContingency

Cash Cash Collections Collections from salesfrom sales

BusinessBusiness

BorrowerBorrower

Cash Cash Collections Collections from salesfrom sales

Contingency

Investing in growth

Current Cash requirements

Inventory, A/R, Op expenses

Debt payments, distributions

to owners

Capex,investments

Why does the borrowing cause matter?

• Indicates why the funds are not available internally

• May tell us how the funds will be used• Can tell us how we’ll be repaid• Can tell us when we’ll be repaid• Can tell us what we should monitor• Can tell us how we should structure the loan By addressing the real requirements of the

borrower, we’re more likely to offer meaningful solutions

What are the most common reasons that companies need to borrow?

Behind the “need” lies the CAUSE

• Growth in sales (have to carry more inventory, more receivables)

• Seasonal peaks of working assets• Slowdown in sales of inventory• Slowdown in collection of receivables • To take advantage of supplier discounts• Replace other debt … reasons?• Buy fixed assets• Others?

Is the CAUSE related to the Operating Cycle?

51

PurchaseRaw Materials

Produce Product for Sale

Sell Product

Collect Cashfrom Customers

Cash

Operating Cycle

52

Timing Differences

PurchaseGoods

CollectPayment

SellGoods

Holding Period Collection Period

PaySuppliers

Payment Period

Cash Flow Timing Difference

Or is the borrowing CAUSE related to the Capital Investment Cycle?

54

Operating Operating CycleCycle InstallInstall

Produce Produce

SellSell

PurchaseEquipment

Cash Cash OutflowOutflow

CASHCASHCapital Investment CycleCapital Investment Cycle

Fixed Asset PurchaseFixed Asset Purchase

Two potential causes:

• Replacement of fixed assets

• Expansion of fixed assets

Borrowing to finance working capital

Is this a “short-term” cause, or a “long term” cause?

Well.......it depends

Borrowing to finance working capital

Is this a short-term cause, or a long term cause?

Should working capital be funded by short-termfinancing, or long term financing?

Is the need likely to continue ?

Long term sales growth

• (Non-seasonal) sales growth is likely to lead to a long term funding 1 cause for:– More inventory– More receivables

• This need might be partly offset by an increase in accounts payable

• Sales growth drives and depends on working asset growth – (the cause)- resulting in the “need” for more working asset finance

1 Long term funding options include: Equity, Subordinated Debt, Senior Debt.

Current Assets

fixedassets

current liabilities

long termdebt

equity

workingcapital

We don’t

intend

to be here

The requirement to finance working capital is normal and can be continual

The assets are converted and “turn over” , but they have to be replaced, maintained at certain level to keep the business running and may not completely “financable”, by supplier credit etc

So do “Banks” ever get their principal back?

Determine what the cause is = the “WHY”

The quantification i.e. amount and time

defines the “need”

HOW MUCH – HOW LONG (the What)

Working capital needs

Sales

Need for more inventory andreceivables, less increased payables(i.e. need for more working capital)

W.C.

Need for cash

Cashneed

Permanent (but based on recurring transactions)

seasonal

Seasonal needLikely to recur year after year.

Should be “paid down” during a portion of each year, even though the facility might beprovided on an on-going basis.

Failure to “pay down” may indicate a problem(or the development of other borrowingcauses).

65

Slowdown in Operating Cycle

Slowdown in Operating Cycle

For example:• Takes longer to sell inventory• Take longer to collect receivables• Suppliers/Vendors paid faster

All can be planned or unplanned.And can be temporary or permanent.

Look at the days in the cycle

2004 2005 2006Days inventory 65 72 85Days receivables 28 33 36Less: days payables 22 20 17

Days in the cycle 71 85 104

*The borrower may offer an explanation of “why”, or we may have to ask “why” either way, we have to know.

What does this trend mean for the way the company is financed?

Other borrowing causes

• Investments• Acquisitions of other businesses• Restructuring of liabilities

– To take advantage of trade discounts– Obtain better terms– Change banks– Resolve financing mismatches

• Losses (cash losses) !!• Dividends ?

68

• Sales Growth

Short Term (seasonal)

Long Term (consistent year after year)

• Slow Down in Asset Conversion Cycle

• Fixed Asset Purchase

Replacement

Expansion

• Restructuring liabilities

• Investment, Other ?????

The usual borrowing causes RECAP

The usual borrowing causes RECAP

RG11

• The “NEED” is the “WHAT”

• The “CAUSE” is the “WHY”

• The generation of excess cash over one or multiple business cycles is the “HOW” the debt is serviced

The cause: Some questions to ask

Does it make operating and financial sense ?

Is it directly related to the business?

How is it related to the expected source of repayment?

Is there a productive purpose?

Information

We are in the information business !

The raw material for our decisions

Where do lenders get their information?

How do we judge whether a company is likely to continue to meet its obligations?

• Are the financial statements enough?

• Can we always trust the financial statements?

• Are they recent enough?

• What else should we look at? Look for?

• If we don’t believe the financial statements, it means we can’t really trust our customer…

• …and if we don’t trust them (i.e. if we aren’t satisfied about the first C of credit: character), we should not lend.

• But neither should we think that the financial statements give us all the answers we need.

Information sufficiency

We need to be flexible about information “quantity”…. But not “sufficiency or

quality”

What is important is whether the information tells us what we need to know and whether it is RELIABLE

Internal Financial Information

“What management uses to make decisions”

Your right

Your obligation

Studying the financial statements is just one means we use to try to get a picture of what’s happening in the company. We want to knowthings like:

• do they make a good product?• can they sell the product effectively?• are their costs under control?• do they have enough liquidity?• have the shareholders put in enough money?• what happens to the cash?

• Factory visits (worth of land, building, vehicles, machinery working and maintained, etc.)• Inventory checks (amount and quality, etc.) • Receivables checks (talk to buyers)• Supplier checks• Management assessments• Industry analysis

Apart from the financial statements provided by the customer, we need to find other sources of information in order to complete our picture; for example:

InformationFinancial statementsSite visits and inspectionsTax returnsReputation checksBank account flowsIndustry informationManagement assessmentsEconomic informationOther

Does all this giveus confidence that the borrower will continue tomeet their obligations?

Even if the statements are credible…• Asset values on the balance sheet don’t

indicate what they can be sold for• Profit is an estimate, based on

assumptions• Profit doesn’t mean cash, and it’s cash

that will pay us back• Financial statements only look back, not

forward• Statements don’t tell us about risks,

cycles, competitive pressures, technology changes, management quality, et cetera, et cetera….

Information

The information you are given may not include information you NEED

Information and data needed to assess an SME borrower often difficult to develop, but

IT IS THERE

What is the business owner interested in? What does he/she like to talk about?

Information Sources

Large Borrowers/PublicFully detailed and usually reliablefinancial statements…Supplemented by data frommanagement:Quarterly statementsAgingsDebt schedulesForecastsBackground and explanation

Public information- Analyst reports, rating agencies, comparatives,

industry data

SME’s“Sometimes” reliable and “sometimes” consistently prepared financial statements period to periodRarely volunteer to provide interim dataNot sure what you need or whyInsecure about disclosureUsually not significant participants in their industry- no comparative data

BUT…..

If we are going to make “fact based decisions” and track performance going

forwardWe must find a way to develop the

information we need….

Can any business, regardless of size, succeed in the long run without …. ???

At a minimum

Sales data- for cash, for creditKnowing how long receivables

have been outstandingHaving purchasing data- for cash,

for creditKnowing how much is owned to

vendorsThe difference between the cost of

inventory and its selling priceKnowing what kind of and how

much inventory is on hand and for how long it has been on hand

What fixed assets are owned or leased and what the useful lives are

How much is owed to lenders, at what interest rates and when payments are due

Knowing the expenses for running the business day to day, week to week, month to month

Knowing what taxes are owed and when they are due

Knowing whether the business has more cash at the end of a period than at the beginning of the period

Knowing what the trends in the business have been, and the future likely trend

Having plans to maintain and/or grow the business

Necessary information for the

banker too

With this information…

And being able to differentiate between family finances and business finances the lender has what he or she needs to:

• Identify a borrowing cause

• Quantify the need

• Determine whether the business is likely to be able to service its debt and other obligations.

How often should we review information on our borrower ?

In most markets, the law requires public companies to provide information to investors and lenders quarterly

Why should we expect less of private companies ?

How often do we typically receive information?????

Sources of Repayment

So … What does it mean to be creditworthy ?

From normal operating activity, a business is expected to generate cash flow sufficient to pay expenses, meet obligations to debt and equity holders (interest, long-term debt amortization and dividends), and reinvest sufficient amounts to support future growth.

The determination of “Creditworthiness” comes from an informed (fact based) opinion about the future likelihood of a business to meet these requirements.

What is Creditworthiness?

A history of making all payments, of not being delinquent, of having a clean bureau record, of not having restructured- all good signs.

But they don’t say enough about today and they are not on their own sufficient to predict the future.


The assumption or the fact that the owner of the business may be very wealthy, whether a guarantor or not, is interesting and potentially supportive, but

is insufficient reason on which to base a lending decision


What are the primary sources of debt service ???

Sources of debt service

• Free Operating Cash Flow • Conversion of working assets to cash • Refinancing by another lender (s) • New capital or shareholders’ loans • Sale of working assets• Sale of fixed assets (surplus or core) • Guarantor support• Sale of the business itself• Liquidation of collateral via the legal process or

Deed in Lieu


First way

Free Cash Flow from Operations

#1

How would you define it ??

Definitions vary, but maybe this one is as good as any

“FOCF” – based on the income statement:

Gross profit less operating expenses, less taxes payable and less capital expenditures necessary to keep the business operating

This is what is available to service debt….. really??

Can’t forget

Changes in working capital

To get a “realistic figure

Secondary sources of debt service

Guarantees and Collateral are useful and helpful

They just aren’t very reliable

REASONS?

Guarantees---- Collateral

Personal – where is the individual’s net worth and liquidity invested?

Corporate – capacity?

willingness?

Does the guarantor have debt of its own?

Is the collateral made up of the core assets of the business?

Is the collateral revenue producing?

Is the collateral liquid? Specialized?

How long will it take us to take possession?

Guarantor Financial StatementCash 66.5 Home mortgage 8,645.0Investment in 23,300.0 H-P for car 399.0family business Credit card debt 133.0Home 13,325.0 Total liabilities 9,177.0Car 1,064.0 Net worth 28,578.5Total Assets 37,755.5

Debt in the Business ------ 46,550.0

“Value” of the business if it defaults on its debt?

Liquid net worth of the guarantor ? Value of the guaranty?

Collateral Issues

Is the collateral used directly in the business?

Is the collateral “specialized” ?How rapidly will the collateral depreciate?If your borrower isn’t being successful

“using” the collateral, is anyone else likely to be?

If you had to take possession, how long would it take?

Collateral Issues

If you had to sell it, how long might that take?

What would it cost to maintain, insure and sell (commission?) the collateral

*****Source of protection- maybe – source of repayment – not very reliable *****

Guarantees---- Collateral

Reliable repayment sources--- No

Possible ways of reducing or minimizing loss--- Sure

Means of keeping the borrower’s/owner’s attention focused on running the business well -- Absolutely


Key themes payment reliability and predictability:

• Cash Flow from core/normal operations

• Isolated from one time events (positive or negative)

• Expected to be “relatively” stable to improving regardless of external conditions

But our focus

Is on the primary source of debt service

…..the basis of the value for any business

105

Cash Flow – from

operations and Free Cash Flow

It’s all about the cash !

Difference in approach between Lendersand Accountants

Accountants tend to follow the profits.

Lenders follow the cash

© 2001 Omega Performance Corporation

We look at the financial statements differently, because we need and care about different kinds of information and the implications of the the data.

All Debt Service comes from future cash flows

Cash flow and net income

There are timing differences between recognizing certain revenue and expense items etc. versus actual inflow or outflow of cash,

e.g. taxes, accrued expenses, deferred revenue, depreciation and amortization

Cash flow and net income

There are also cash inflows and outflows which are not reported as revenue or expense:– Capex– Asset sales– Dividends– Investments– Etc.

Is it possible to be profitable but have poor cash flow?

Negative cash flow?

Is it possible for a business to be making losses, and yet have positive cash flow?

Examples ???

Why do bankers want to know about cash?

Because profits (the accountants’ estimates) don’t repay loans

ONLY CASH REPAYS LOANS

• Cash is fact!

• It came in or it didn’t. It was paid out, or it wasn’t

• At the end of the day, it’s really all that matters

So what is cash flow anyway?

EBIT?

EBITDA?

EBITDA less interest, cash taxes paid, dividends, capital expenditures, plus or minus the change in working capital, plus financing specific to capital expenditures?

• Cash flow from trading activities

• Cash flow from operations

• Cash flow after investment activityFree cash Flow from Operations

• Cash flow after debt service

• Cash flow after financing activities

SO… AS LENDERS we need to put things in perspective

• Positive operating cash flow

• Strong liquidity• Moderate funded

debt/cash flow

All indications of a strong borrower

• Profitability• Low Debt to Equity• Rapid growth

May be indicators of a strong borrower

The main drivers of cash flow

The main drivers of cash flow

• Changes in salesChanges in sales– Rapid growth will result in a need for more assetsRapid growth will result in a need for more assets

• Changes in asset turnoverChanges in asset turnover– Increases in INVDOH & ARDOH use cashIncreases in INVDOH & ARDOH use cash– Increase in APDOH provides cashIncrease in APDOH provides cash

• Change in marginsChange in margins– Higher profit margins means more cashHigher profit margins means more cash

• Investment in long term assetsInvestment in long term assets– Inevitable over timeInevitable over time

The ultimate testDoes our borrower’s business produce more cash

than it consumes, or does it at least have the clear ability to do so, over the reasonable near term? .

...and can you see it ?

If not, the customer is not viable, and our loan probably isn’t either.

Key message !!!

Funding Funding NeedsNeeds

Debt Debt RepaymentRepayment

Margin Margin & & TrendTrend

Revenue Revenue & Trend& TrendWorking Working

Capital Capital & Trend& Trend

Fixed Fixed Investment Investment & Trend& Trend

Cash ShortfallCash Shortfall Excess CashExcess Cash

Additional BorrowingAdditional BorrowingAdditional CapitalAdditional Capital

Operational ChangesOperational Changes

Expand InvestmentExpand InvestmentAccelerate Debt ReductionAccelerate Debt Reduction

Return capital to ownersReturn capital to ownersor Temporary investments

Cash Flow in “context”• Relative to the business, the industry, the Relative to the business, the industry, the

stage of the business, the extent of stage of the business, the extent of significant change going on in the significant change going on in the businessbusiness

• Sufficiency, Consistency and Sufficiency, Consistency and PredictabilityPredictability

Cash Flow and Structure

If cash flow is the most crucial issue…

Analysis, Structuring, Reporting and Monitoring ought to focus on it, right?

Do we?

D/E ?

Cash Flow Exercise for XYZ Company

Sales - $12,000

Cost of Goods Sold – 9,000*

Gross Profit – ______

Selling and General Exp- 800

Earnings before interest and taxes – ______

Interest Expense – 200

Earnings before taxes – _____

* Includes depreciation

Taxes (34%)- _____

Net Income – _____

Depreciation – 500

Provision for bad debts- 125

Increase in current assets – 350

Increase in current liabilities – 200

Investment in FA – 1,200

Cash Flow from Operations ____

Free Cash Flow _______

But do wecare about profitability ?

Why ?

Cash Flow is Most Important…..

Margins/ Cost Flexibility

Pricing Flexibility

Attract Capital

Risk Premium for Investors

“Moderate leverage” (D/E basis)

Retain Talent

“Capital source” for reinvestment

Sensitivity Analysis and Projections

Old NewsBalance Sheet: Even a recent one is out

of date. Many, probably most balance sheet accounts change in value daily.aily.

Profit & Loss: Historical revenues, historical statementmargins, historical costs

Only two chapters in a book with many chapters

A basic tenet of credit assessment

Looking at the past is only useful for what it can tell us about

the future.

We make lending decisions today based on our expectations of borrower performance in the future.

Another basic tenetThe only thing we ever know for sure

about projections is that they’ll be “wrong”, butthere is value in providing a realistic forecastof activity and the impact of the transactions

under consideration – and being confident about “Why”Always look at actual performance vs.

what the forecast indicated. If different… “Why”

Why projections are important

• They indicate what must happen (or not happen) in order for the borrower to be able to repay

• They indicate how sensitive repayment capacity is to various possible changes

• They can provide a basis for setting terms and covenants

• They indicate how much cushion the borrower

is likely to have – “forward monitoring”

Sensitivity analysis

• Allows for the “what if ?”• Creates multiple “Cases”• Shows the areas :

– Where cash flow is most sensitive to change in certain key variables

– Where risk is highest (if a change in that variable is likely)

– When/if the financial terms of the agreement may be breached, and when action may be necessary

Sensitivity analysis

If you are going to

stress the projections,

then…

Stress them!

Don’t be timid!

Base case

Upside

Downside

Sensitivity analysis – what to stress

Sales – volume/price

Margins

Debt levels

Interest rates

Currency rates

Turnovers

Find out where the stress is

When and where does it hurt!

Assumptions

We are not looking for those assumptions which show everything will be fine !

We are looking for realistic assumptions and

• Best case

• Worst case

Assumption development

Sales compared to GDP

+/- (lagging, emerging, trailing industry )

What if + 5%, 10%, 15%, 20%

What if 0%, -5% etc

Margins: Gross Margin, Operating profit margin, pre-tax and after-tax margins

Inventory and A/R: Impact due to higher sales levels, impact due to slowing turnovers

Accounts payable: % change the same as inventory?

Fixed Asset purchases: How much is needed to keep up with sales growth. How much is needed to replace aging assets?

More factors…..

Debt maturities: month by month, quarter by quarter, year by year

Put them all together, show different combinations ==== what is the impact on cash flow and what additional debt or capital might be required?

Recap: The main drivers of cash flow• Changes in sales

– Rapid growth will result in a need for more assets• Changes in asset turnover

– Increases in INVDOH & ARDOH use cash– Increase in APDOH provides cash

• Change in margins– Higher profit margins/EBITDA means more cash

• Investment in long term assets– Inevitable over time

Main drivers of value creation – can also be the main drivers which destroy value

Cash flow projections

• Look at the past as a guide to the future• Adjust for management plans and strategies• Adjust for industry, economic and other

developments• Sensitivity – the “what if…”

• What we want to know: is this company likely to be able to continue to meet its obligations? and

what do we need to monitor, to spot the early warning signs of problems?

Bankers need to be

Detectives and Forecasters…

because we must look through and behind the numbers and because

all debt service comes

From FUTURE cash flows

Cash Flow Sensitivity

Projection illustration

145.1138.2131.6125.4119.4Cash Flow from Operations (CF)

12.211.611.010.510.0Incremental Working Capital Investment

6.15.85.55.35.0Incremental Fixed Capital Investment

163.4155.6148.2141.1134.4Net Operating Profit After Taxes (NOPAT)

91.987.583.379.475.6Operating Cash Taxes

255.3243.1231.5220.5210.0Operating Profit

2,297.32,187.92,083.71,984.51,890.0Operating Costs

2,552.62,431.02,315.32,205.02,100.02,000.0Sales

Operating Cash Flows & Value:

10.00%10.00%10.00%10.00%10.00%Increm. Working Cap. Investment Rate (W)

5.00%5.00%5.00%5.00%5.00%Increm. Fixed Cap. Investment Rate (F)

36.00%36.00%36.00%36.00%36.00%√√ Operating Cash Tax Rate (T)

10.00%10.00%10.00%10.00%10.00%Operating Profit Margin (P)

5.00%5.00%5.00%5.00%5.00%Sales Growth (G)

2,000.0Historical Sales

200920082007200620052004Cash Flow Drivers:

√√

√√

√√

Base CaseBase Case Operating current assets, less operating current liabilities







2,297.32,187.92,083.71,984.51,890.0Operating Costs

2,552.62,431.02,315.32,205.02,100.02,000.0Sales




36.00%36.00%36.00%36.00%36.00%Operating Cash Tax Rate (T)


5.00%5.00%5.00%5.00%5.00%Sales Growth (G)



√√

Impact on Operating Cash Flow from Higher Incremental Investment Impact on Operating Cash Flow from Higher Incremental Investment in Working Capitalin Working Capital







2,297.32,187.92,083.71,984.51,890.0Operating Costs

2,552.62,431.02,315.32,205.02,100.02,000.0Sales






5.00%5.00%5.00%5.00%5.00%Sales Growth (G)



√√

Impact of Higher Incremental Investment in Fixed AssetsImpact of Higher Incremental Investment in Fixed Assets







4,479.03,732.53,110.42,592.02,160.0Operating Costs

4,976.64,147.23,456.02,880.02,400.02,000.0Sales






20.00%20.00%20.00%20.00%20.00%Sales Growth (G)



√√

Impact of Faster Sales GrowthImpact of Faster Sales Growth







4,479.03,732.53,110.42,592.02,160.0Operating Costs

4,976.64,147.23,456.02,880.02,400.02,000.0Sales






20.00%20.00%20.00%20.00%20.00%Sales Growth (G)



√√

Impact with lower Incremental Investment in Working Capital and lower fixed Impact with lower Incremental Investment in Working Capital and lower fixed asset investmentasset investment

√√







4,727.83,939.83,283.22,736.02,280.0Operating Costs

4,976.64,147.23,456.02,880.02,400.02,000.0Sales






20.00%20.00%20.00%20.00%20.00%Sales Growth (G)



√√

Impact of Lower MarginImpact of Lower Margin

-48.1-40.1-33.4-27.8-23.2Cash Flow from Operations (CF)






4,727.83,939.83,283.22,736.02,280.0Operating Costs

4,976.64,147.23,456.02,880.02,400.02,000.0Sales






20.00%20.00%20.00%20.00%20.00%Sales Growth (G)



√√

Impact of Impact of BothBoth Higher Incremental Investment in Fixed Assets Higher Incremental Investment in Fixed Assets andand Working Working CapitalCapital

√√

Since all debt service comes from future cash flows….

Lenders must be “forward thinking”

Yesterday Today

Tomorrow Next year Two years out Five years out

A side note on projections

We can’t make loans solely on the basis of projections (this is why start up loans are so difficult to make and justify)

Let’s not fool ourselves by how great a set of projections might look – sometimes we have to sit back and say…..

A side note on projections

“ You now what– I don’t care what the projections say. This deal doesn’t make any sense….I’m not going to get involved in this.”

Sometimes we just have to

listen to our gut !!

Let’s step back for a second…

Analytical Keys

“When we look at the same numbers, do we have the same thoughts?”

Everjoy Ltd. --- exercise

Industry Risk Analysis

Different characteristics

Why do we need to study the industry ?

• To understand whether there are particular risks associated with the industry, that might bring higher or different risks

• To understand what it takes to succeed in this industry, and to help us judge management’s experience and capabilities

• To guide us in what to monitor as part of our loan management process

Major risk categories

Major industry risks• Cost dynamics• Margins• State and direction of the industry• Technology and obsolescence• Cycles• Reliance• Competition- local and international• Substitution risk• Regulations

Major industry risks

Company “A” Company “B”

Sales 50mm

Fixed costs 6mm

Variable costs 40%

(% sales)

Pre tax 24mm

Sales dec. 20% --- 18mm = -25%

Sales inc. 20% --- 30mm = +25%

100 mm

56mm

20%

24mm

8mm = - 67%

40mm = + 67%

Break-even point

• Company B (high break-even point) might:– lock in long term sales contracts– keep its primary management focus on

marketing and selling– attempt to increase flexibility of costs

• Company A (lower break-even point) might:– focus on tight cost control

Breakeven sales

- - - - - - - - - - - -

- - - - - - - - - - - -

Which industries? Which industries?

Rev

FC

TC

VC

$

volume

$

volume


• Cost dynamics• Margins

High volume/low margin?

High margin/low volume?

High profits to reward for high risk?

High profits due to barriers to entry?

High profits due to key people?

Consistency of profits through business cycles?


• Cost dynamics

• Margins

• State and direction of the industry

Emerging?

Mature?

Declining?


• Cost dynamics

• Margins

• State and direction of the industry

• Technology

Rapid change?

Stable and evolving?

Means more than just computers


• Cost structure

• Profitability

• Maturity

• Technology

• Cycles

Cyclical industries

• Examples of cyclical industries?

• Concurrent

• Leading

• Lagging

• Countercyclical

• Independent

What’s the issue for a lender?


• Cost structure• Profitability• Maturity• Technology• Cyclicality• Reliance

On one or a few key customers or suppliers

On another industry (furniture/building) On an input (oil)


• Cost structure• Profitability• Maturity• Technology• Cyclicality• Dependence• Competition – domestic and international

ProtectionBuyers and suppliers

Major industry risks• Cost structure• Profitability• Maturity• Technology• Cyclicality• Dependence• Globalization• Substitution risk

Within the industry From other industries

Major industry risks• Cost dynamics• Margins• State and direction of the industry• Technology• Cycles• Reliance• Competition – domestic and international• Substitution risk• Regulations

Deregulation and regulation can both be risksCompetition, price, people, safety,

environment, reporting, etc.

Major industry risks• Cost dynamics• Margins• State and direction of the industry• Technology• Cycles• Reliance• Competition – domestic and international• Substitution risk• Regulations• Operations

Operations risk

• Inherent in what the business does

• Includes physical risk, computer failure, power failure, strikes – all the things that could go wrong…

• Ask management

• Safeguards?

• Insurance?

• Is this a particularly “risky” operation?

Business Risk vs. Financial Risk

• How risky is the borrower’s business (i.e. the industry it operates in, the way it manages risk, etc.)?

• How risky is the borrower’s financial structure (i.e. the way it finances the business)?

Business and Financial RiskBusiness Risk Financial Risk

Low Risk + High Risk = Okay(?)

High Risk + Low Risk = Okay(?)

High Risk + High Risk = Risky

Low Risk + Low Risk = Sub-optimal(?)

An Example

Airline industry

• Cost structure: High fixed costs/high break even• Profitability: Barriers to entry; unpredictable profits• Maturity: Well established• Technology: Fairly rapid change• Cyclicality: Very cyclical• Dependence: Oil! Economic conditions• Globalization: Global by definition…• Substitutes: Other travel, stay at home,

videoconference• Regulations: Highly regulated• Operations: Pretty risky!

So, what sort of financial structure would you want an airline to have?

Business Risk Financial Risk

Low Risk + High Risk

High Risk + Low Risk

High Risk + High Risk

Low Risk + Low Risk

So, what sort of financial structure do most airlines have?

Business Risk Financial Risk

Low Risk + High Risk

High Risk + Low Risk

High Risk + High Risk

Low Risk + Low Risk

Why do we need to study the industry

• To understand whether there are particular risks associated with the industry

• To understand what it takes to succeed in this industry

• To be able to judge management against those standards

Other Risk Elements

“Management” Risk

• Competent management is usually the key to a successful business.

• More businesses fail because of poor management than for any other reason.

• Asking management to identify and explain the foundations of their operations is a good way to determine whether the company is well directed.

• Possibly the hardest, but also possibly the most important part of the credit analysis.

Management

Experience

Understand external risks

Understand internal risks

Understand financial risks

Strategy -Planning

Why do businesses sometimes fail ?

Sometimes because of a poor product

Or because of poor marketing and selling

Or poor location

But more often for different reasons…….

Most corporate failures are due toMost corporate failures are due tomanagement.management.

Most corporate failures are due toMost corporate failures are due tomanagement.management.

And many (most?) are due to And many (most?) are due to financial financial managementmanagement

Financial managementBusinesses regularly fail because management fails to understand:

• The difference between profit and cash flow• The importance of liquidity (not just “cash”… but “working

assets” which convert to cash reliably and rapidly)• The importance of having a debt load appropriate to the

businesses ability to service it, today• That growth needs “cash sources” to continue• That management must grow with the business• That planning is crucial• That if you have a “risky” business, you need a strong financial

structure

What about….

Economic

Country risk

Political

What about….

Event Risk

Financial analysis

One dimension among many

Financial Statement Analysis

A useful tool only

Numbers can mislead

Some more comments about ratios

• Ratios don’t tell us the answers; they simply tell us what questions to ask

• Ratios are more meaningful over a period of several years (i.e. trends)

• Ratios can be more meaningful when compared with similar companies

What might the trends be telling you ?

Year 1 Year 2 Year 3 Year 4

Total Liab./TNW 0.78 1.06 2.24 2.36

EBIT/Interest 4.0 3.0 1.8 1.2

Funded Debt/Ebitda 2.4 3.6 4.0 5.7

ABC Company

About the business, the industry ?

ABC Company

Current ratio 1.59 1.11 0.96 0.91

Quick ratio 0.80 0.60 0.40 0.25


About how management is motivated ?

ABC Company

Gross margin 29.0% 25.0% 20.% 12.0%

Net profit margin 9.8% 8.0% 4.0% neg%

Return on equity 12.5% 15.1% 9.0% neg %


About “forward thinking” ?

ABC Company


Sales growth 29% 25% 20% 30%

Net income growth 10% 35% 6% neg.

Total assets growth 38% 33% 62% 21%

Total liabilities growth 41% 51% 36% 20%

Net worth growth 27% 20% 11% -5%

About managements focus and capabilities ?

ABC Company

Days receivables 18 25 35 40

Days inventory 35 45 50 68

Days payables 40 38 30 55


Analytical FrameworkMultiple Dimensions

The decision

Management experience

ability, and INTEGRITYThe

Industry

Current and prospective

economic conditions

Track record

Financial condition

Current performance

PurposeConditions

Financial condition

Revenue Margins Liquidity Leverage

The Basics and the Essentials

Structuring of Limits and Loans

© 2001 Omega Performance Corporation

Structure

• The “framework” of the asset• The terms and conditions applying to

borrower and lender• Includes the “mutual” promises and

agreements• Indicates the “consequences” for failure to

comply• Creates the “map” to allow efficient and

effective monitoring of the asset

In the structure…….

What are the principle matters to be dealt with?

-----

In the structure…….

What are the principle matters to be dealt with?

Amount, tenor, pricing, repayment schedule, conditions precedent representations and warranties, covenants, events of default

Some credit facility types

• Seasonal • Short term• Medium term• Legally committed or uncommitted• Amortizing, bullet, balloon, revolving• Asset based• Borrowing base driven• Bridging

Selecting the “right” type of facilityPurpose Credit FacilityWorking capital Seasonal limit

Annually renewable limit

Business expansion Term loanFixed asset acquisition Term revolving credit

Project Finance Term Financing

“Bridge Loan” Single/bullet repayment

Assumed repayment sourceCredit FacilitySeasonal limit Conversion of working assets to

cashAnnually renewable limit Asset Turnover/margin generated

CFRefinancing

Term loanTerm revolving credit “Excess” cash flow over multiple

years

Project (Term) Financing Project specific cash flow/Refinancing

Committed/assumed Asset sale, bond/stock salecash injection from another “capital” source Be Prepared !!

The lending process

Understandborrowingcause

Quantify the need

Monitor the asset throughout its life

Forecast

Assess, qualify and quantify the risks

Develop the information Design and negotiate the

structure

We need to think about monitoring before the loan is

booked –

Our strategy and tactics for asset management

Step one

• Do we believe that it is likely that this business will continue to meet its obligations with cash flow from operations?

• Is the belief based on fact – on logic This is the first way out…Operating cash flow over one or

multiple business cycles.

The Credit Basis

• First: do we believe that it is likely that this company will continue to meet its obligations with cash flow from operations?

This is the first way out.

• Second: if there is a problem with the first way out, will we get our money back through other means?

The “other ways out”

To summarize – the first way out

OUR EXPECTATIONSFOR CASH FLOW

WHAT COULD GO WRONG?• Industry risks• Business risks• Financial risks

CAN MANAGEMENT

Execute ?

THE FIRST WAY OUTTHE SECOND WAY OUT

THE STRUCTURE• Term• Repayment schedule• Conditions Precedent• Collateral• Covenants• Other conditions

The framework of your asset

What is it that separates us, the lenders,

from equity holders?

What are the differences in the “risk/reward expectations”

Availability – Conditionality - Accountability

Bank

Debt Capital

Borrower

RM

Availability

&

Usage with

Conditions

Borrower Accountability

for

Debt Service, Compliance

&

Information

Two Primary Elements of Structure

• What amount and type of credit facility meets the borrower’s immediate and future needs?

• What conditions ?

**Promote alignment between our expectations for the borrower’s ongoing financial status and performance and its accountability for maintaining that status and achieving that performance**

Conditionality

What is it – we really care about?

• For an already healthy borrower:– Maintain “creditworthiness”– Continual position of debt and other

obligations serviceability

• For a weaker borrower:– Improving status and performance on

expected track and timing

What do we mean by “Covenant” ?

Condition & Covenants

The understandings and promises made between the parties in a legal agreement to which they agree to be bound

Why isn’t it sufficient to rely on the condition/requirement of regular payments of interest and principal ?

It is the usual method of “monitoring consumer debt- so why not for business?

“Payments” tracking or Performance Tracking ?

Credit to business – for investment purposes. Intended to create value – so we need to see the value creation

A business can be weakening seriously while still keeping current on its payments, until it no longer can

Amounts larger and borrowers have fewer “common characteristics”- so portfolio based monitoring is not enough

The making of payments means that there was cash available from some source.

We are interested in the continuing future ability to service debt from cash flow generated from operations

DSCRDSCR

3.03.0

Last Last yryr

11

22

33

44

55

66

FD/EBITDAFD/EBITDA

2.12.1

1.81.8

1.51.5

1.21.2

Last Last QtrQtr

Loan Disbursement Jan 1, Loan Disbursement Jan 1, 20072007

QQ11

QQ22

QQ33

QQ44

QQ55

QQ66

QQ77

QQ88

QQ99

Q Q 1010

Q Q 1111

Q Q 1212

Q Q 1313

Q Q 1414

Q Q 1515

Q Q 1616

Q Q 1717

Q Q 1818

Q Q 1919

Q Q 2020

Financial Covenant Example

…AND the conditions within the Structure

Are tools to guide the borrower’s performance and financial condition to meet the expectations we both have for the future and include……

- “Indicators” of performance and condition- “Restrictions” on operations and investment- “Requirements” for good governance and sound

management- The “information sources” allowing us to monitor- Triggers for possible action

Covenants

Our position is:

We’ll lend you the money, if you agree to do (or not do) the following….., once we’re satisfied that certain things (conditions precedent) have been completed.

Covenants• Not intended to restrict the customer’s

business, rather…• To align the business performance

with the lender’s expectations and the understandings reached with the borrower

• If the borrower wants no accountability, then he should use his own money

Covenants• Focused on the “preservation of

repayment capacity”

• Provide signals and triggers, assure the steady flow of information and place the lender in a position of influence should deterioration occur

We all live and work with conditions….

Why would borrowers not have

conditions?

Conditions

• Commercial Loan

-

-

-

-

-

• Apartment Lease

-

-

-

-

-

For the Borrower’s sake, esp. SME

We really don’t do the borrower a service by providing “capital” on an “unregulated” basis

Financial and operating discipline is crucial to any successful and lasting business

Help them become “better borrowers”

Promote sound business practices

• Record keeping• Planning• Tracking actual vs.

forecast• Cash and working asset

management• Track key performance

indicators• Encourage “protective”

actions and policies

Managing leverage

Margin discipline

“Containing” growth

Managing concentrations

Personnel development

“Estate” planning

Expect competitive advantages

Covenants• Three basic kinds:

– Affirmative covenants– Negative covenants– Financial covenants

Examples of Covenants

Preserve repayment capacity looking forward

Provide EARLY WARNING OF POTENTIAL PROBLEMS COMING

Covenants

What covenants could we impose to control, maintain or monitor the value (to the borrower and to us) of fixed assets?

CovenantsWhat covenants could we impose to control,

maintain or monitor the value and amount of fixed assets?

• Maintain insurance (bank as loss payee)• Maintain in good repair• Right of inspection• No liens• Limit ability to sell fixed assets

Covenants

What covenants could we impose to prevent cash from leaving the company, outside the ordinary course of business?

CovenantsWhat covenants could we impose to prevent

cash from leaving the borrower ?

• Limit on capital expenditures• Prohibition on investments (except……)• Prohibition on acquisitions• Limit on dividends and stock buybacks• Prohibition on loans from the company to

affiliates, shareholders, directors etc.

Covenants

What covenants could we impose to ensure continued management business focus?

• Loan purpose and use of proceeds• Prohibition of change of management• Prohibition of change of business activity• Prohibition of change in ownership

CovenantsWhat covenants could we impose to ensure

that we are kept informed?

• Provision of annual & interim financial statements within XX days of the end of the……

• Maintenance of existing accounting procedures• Right of inspection of financial records • Inventory agings, A/R agings etc• Notification re litigation or other significant

events• Receipt of annual budgets, refreshed projections

InformationHistorical information is necessary but

not enough

To measure performance TODAY- To determine compliance TODAY- To make decisions TODAY…

Current information is absolutely crucial“real”

CovenantsWhat covenants could we impose to

ensure that the company doesn’t become leveraged beyond prudent levels ?

• Limit on additional borrowings• Negative pledge• Maximum leverage – various measurements• Minimum capital - restrictions on dividends


ensure that the company maintains acceptable liquidity?

• Minimum amount of working capital• Minimum current and quick ratios• Maintain “unused availability”• Limitation on types of permitted

investments• Control fixed asset purchases


monitor the company’s operating performance?

• Minimum EBIT or EBITDA

• Minimum interest coverage

• Minimum debt service coverage

Compliance etc., based on what numbers?

• Audited – unaudited interim (i.e. actual, consistently reported)?

• How often would we check for compliance?

(How frequently and when do you want to know ?)

What can’t be optional ?

The “must haves”

What can’t be optional ?• Use of proceeds• Provision of Information – how often is reasonable ?• Cross default• Change in business• Change in ownership• Restricted payments (loans, investments)• Material change• Negative pledge – “except for”…

If a condition etc. isn’t in writing and agreed by both parties, then it isn’t a binding condition

No informal “understandings”-

This is Business

What’s the right level?

• Default should be triggered when performance and condition still allows for payments to be made and for the business to operate

• Default should indicate potential problems or undue stress before there is a payment problem

• Levels should be based on projections and sensitivity analysis – with a cushion

• ! You are lending because you expect performance to be acceptable. Covenants let you know when there is a danger of leaving the acceptable zone, the comfort zone

Covenant Map

Marginal

Comfort Zone

Marginal

Default• LeverageLeverage

• Max. Max. DividendsDividends

• EBIT / INTEBIT / INT

• DSCRDSCR

• CRCR

• MIN. NWMIN. NW

Default

• Stay in Core BusinessStay in Core Business

• Investments / LoansInvestments / Loans

• Qtly ReportingQtly Reporting

• Additional DebtAdditional Debt

Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9 Q10 Q11 Q12

Covenant level/trigger

Setting covenants

• Covenants don’t have to be static• Compliance can be “time sensitive”• They should not be based only on year end numbers• Levels can rise or fall to guide the direction in financial condition we expect• Covenants can be adjusted as conditions change. We are open to adjust but we will not agree up front to do so

Measurement

Covenant

Stress Point

EBIT/INT “Actual” Performance

Quarters 1 2 3 4 5 6 7

MeasurementFD/EBITDA

Covenant

Decision Point

Stress Point

“Actual” Performance

Quarters 1 2 3 4 5 6 7 8

Events of Default

Just so we are clear….

Not just missed payments…!

There are other issues of critical importance which are likely to occur before a payment problem

The bigger The bigger picturepicture

Critical areas of Financial and Operating Risk



Loan Structuring



Loan Structuring

Loan Monitoring

Loan Monitoring

Why do we have covenants, conditions precedent?

• Because borrowing is “conditional” and borrowers are “accountable”

• We are not running the borrower’s business, but we know what condition we want our asset to be in

The lender cannot passively accept the borrower’s deteriorating performance and health

We monitor the health of our borrower

By monitoring operating and financial performance

And operating and financial condition

In addition to watching the flow of payment activity

WHAT DO MANY BORROWERS THINK ABOUT COVENANTS ?

They often don’t like them.

Why?

Borrower issues

• Fear of lack of control

• Lack of financial sophistication

• Lack of confidence in themselves

• “XYZ Bank” doesn’t ask for them

• Do not understand why they are important to a responsible (“reliable”) lender

• “How do I explain to my Board, the owners…”

How it’s shown

• “You have collateral, isn’t that enough?” (NO)

• “You never asked this before” (I’m asking now)

• “Don’t you trust me?” (Yes, but this is business)

But to have the ability to exercise some degree of control over OUR ASSET…..

We have to be in a position to……

We’d prefer not to……..

Structuring Examples

What are the key risks, What would you monitor, How would you control ??

Apartment construction and rental

Steel distributor

Retailer

Contractor

Leasing company

Heavy equipment manufacturer

Lending is a “Risk” Business

• We get paid for taking risk• When we understand it, structure it and monitor

our individual exposures and portfolio concentrations we should be in a better position than our competitors in good times and bad times

But losses do occur:

Preventable ? and“Not preventable” ?

SME’s in context

What about SME’s, especially “small and micro” SME’s

Some may lack the financial sophistication and the resources to deal with “complex” financial measurements –nevertheless

Structure and information flow is necessary in commercial lending

What are the critical issues ?

LeverageOperating cash flowDebt service coverageRevenue growthMarginsControlling working capitalControlling fixed asset and other long term

investment

Leverage

• Existing Funded Debt (bureau check ?)

• Credit facilities and Loans from other lenders + terms and conditions

• Outside net worth of owners

Restrict additional debt

Subordinate shareholder loans to the business

Restrict withdrawals

Operating Cash Flow

Clearly define it !

Revenue from normal operations less cost of goods sold and general and administrative expenses

Consistency year to year, quarter to quarter

Debt Service Coverage

Operating cash flow

plus depreciation and

interest paid

Interest and bank fees paid, plus scheduled debt payments, plus X% of short term debt

Revenue Growth and Margins

We need the real numbers and we need them more often than annually

…and we need to know the reasons behind the changes

Working Capital Management

• Monthly reporting of inventory and trade receivables

• Aging

• Current and Quick Ratios

• Notice of significant new customers and vendors – and loss of significant customers/vendors

Fixed Assets & Long term investments

Bank approval required for new asset purchases or leases (over some amount)

Restrict investment and loans outside the business

Prohibit “out of core” investment and activity

Monitoring is not about dealing with “Bad Loans”

It’s about actions to keep good loans that way

About how we may be able to detect weakening loans and keep them from becoming delinquent or

worse

Asset quality is dependent on how well we make a loan and how we manage the loan

Objectives and IssuesObjectives and Issues

• Customer Performance Monitoring

• Finding the time

• Early Warning Signs• Potential problem identification • Taking the initiative - prevention

• Action steps to resolution

The Credit ProcessIncludesKeeping our eye on the ball

Loan management• Most loans are good loans on the day they’re

booked. If problems come, they come later!• If you wait until a payment is missed, you’re

probably too late• If you wait for the financial statements, you may

find the evidence of the problem which has already done the damage

• If you have covenants, you must monitor them• We must be alert to the early warning signals

Some indications…Some indications…Borrower performance weakening

Covenant compliance tight

Lack of current information/data

Condition breached

Industry/customer outlook bleak

Last but not least… Payment

delays

Payment monitoring vs. Performance monitoring

• Monthly payments of interest and principal do impose a discipline on the borrower

• The primary method of tracking the health of consumer loans

• Business loans are different (“for investment purposes”) and the condition and performance of the borrowers may be deteriorating and therefore the quality of the loan may be weakening seriously even while payments are being made – we need to know and we may need to act.

Loan Management Loan Management meansmeans

Do we know WHY the good loans are good and whether there are any negative signs?

Do we know WHY the stressed loans are stressed and what are the positive or negative trends?

All based on FACTS (current)

Lending Lending == Origination Origination andand MonitoringMonitoring

• Maintaining consistent contact• Routine performance/status checks• Compliance testing• Check for defects in terms and conditions• Check for emerging weaknesses, trends• Looking for opportunities• Demonstrate to the borrower that we are paying attention• Looking at the numbers and behind them, the behavior, the

changes

Lending Lending == Origination Origination andand MonitoringMonitoring

Payment tracking PLUS performance and condition tracking

And To Decide, whether to…And To Decide, whether to…• Maintain• Increase• Upgrade and retain• Reduce exposure and exit

Decision points through the life of a loan

Annual review is a decision point – one of many

We don’t expect perfect….We don’t expect perfect….

We understand that some loans will not be repaid, in part or even in total

Our job is to minimize the number, minimize the damage they cause

Prevention !

Monitor to Manage

• How is my borrower performing? Balance Sheet items, Liquidity – Revenue growth –Margins- Cash flow- Strategy changes- Management changes- Industry/Economic condition changes

…. Since I last checked

…. Versus my expectations

Key word

Monitor to Manage

Status versus the conditions

Do I see trends developing?

What might the impact be on cash flow?

Always forward looking

Because……

All debt service comes from ……

Key LinkagesKey Linkages

Critical areas of Financial and Other Risk Factors



Loan Structuring



Loan Structuring

Loan Monitoring

CONDITIONALITY

Which borrowers need Which borrowers need monitoring?monitoring?

… All of them.

This is Rule # 1

Extent and Frequency of Extent and Frequency of MonitoringMonitoring

The application of the rule.

Judgment and experience guide the application.

So… Prioritize

Where is my concern the highest ?

Where is the potential damage the greatest ?

10%50%

30%

Occasional Regular Frequent High “Daily”

Low

Borrower Quality

CRR, QRS, Tris and

Your honest assessment

“Risk Volatility”

Exposure size

Deal complexity

High % Customers

Frequency of

Monitoring

… Often enough, deep enough to know what the status is and the likely near term prospects

Depth ofMonitoringMonitoring

10%

Attention and Action:Attention and Action:Before a problem develops into Stress

Before Stress develops into Distress

Before Distress results in Default…

Especially payment default.

What should we monitor ??

The Key Drivers

What are the main drivers of success… of growth and cash flow….?

1.

2.

3.

4.

The Key Drivers

What are the main drivers of success – growth and cash flow….?

1. Revenue growth

2. Margins

3. Working Capital Investment

4. Fixed (LT) Asset Investment

What’s What’s important?important?

Anything and everything which has an impact on the serviceability and ultimate repayment of our loan.

What’s What’s important?important?

• Cash Flow - its sources and its uses

• New Initiatives Investment, Expansion

• Business Scope Changes

• New Debt

• Management Changes

• Any indications of stress

When do we need to know

?

What’s important?What’s important?

Anything and everything which has an impact on the serviceability and ultimate repayment of our loan.

Cash Flow,

Liquidity, LeverageManagement Industry and

economic conditions

And how is “CASH” deployed ?

A/RInventoryOperating expensesFixed assets/other LT InvestmentsDebt repayment

Or…. Other places possibly not “as productive” !

None are hard to track if the information is available

So the Key Items to Track…

• Revenue• A/R• Inventory• New Fixed asset investment or other LT investment• Margins• Debt levels and the payment pattern

Are you comfortable with the trends – are they what we expected?

Areas of risk What needs to beMonitored ?

Structure

FrequencyFrequency

Reviewing/analysing annual numbers is like reading a history book

Monitoring is like reading a newspaper, or, even better, knowing what will be in the newspaper before it’s printed.

Projections

• Actual performance tracking vs. projections

• What is different ?

• What has changed?

• Do the projections need to be revised?

A Monitoring Map !

Don’t want to wait until 4 months after the close of the year to find out if the prediction was reasonably accurate.

ToolsTools• “Face time” – multiple channels of info• Interim financial statements/data• Rolling four quarter performance• Compliance checklist• Current account activity• Trade finance flows• OD and PN activity –usage patterns• Credit bureau

•Decision makers

•Influencers

•“Old hands”

Exposure monitoring by type of credit

Commited/Uncommited

• Term lending – funded commitment or unfunded

Conditionality applies

• Short term – funding revolves – periodic review renewal is NOT automatic, and

not just annual ……Conditionality applies

Conditionality always applies

Problem Loans and Early Warning Signals

Recognizing problem loansIt’s the Credit Officer’s job to make sure the

Bank always knows the current situation, i.e.

HealthyHealthy SteadySteady MarginalMarginalDeteriorating Deteriorating In troubleIn trouble

• Bankers hate surprises. If a missed payment comes as a surprise, then usually the RM hasn’t been watching

Early Warning Signs

Early Warning SignalsEarly Warning SignalsSome might be … ?• • • • • • • •

Early Warning Early Warning SignalsSignals

• Periodic, interim financial data indicatingunexpected changes in balance sheet, income statement or cash flow statement items

• Changes in operations which are troubling

• Inventory turnover slowing A/R turnover slowing

• Management answers to questions or their inability to do so

Detect by…?

Financial Statements and Financial Data

Historical but can carry signs indicating emerging and developing stress

Tells us where the borrower has been and more importantly maybe the direction in which the borrower is headed


Others might be …• Drop in cash and cash equivalents• Changes in current account activity• Increase in average credit outstandings• Payables turnover increases• Inventory turnover slows• Unexpected requests for additional credit• Requests for additional credit for

unexpected reasons• Requests for additional credit for unclear purposes


Some might be …Rollovers / Extension requestsInsensitivity to interest margin increasesReturned checks – Inbound or OutboundNegative press, negative industry newsLoss of significant customerBureau report shows increased debt --

business/personalUnexpected fixed asset purchases or

investmentsOthers? – missed insurance premium payments…

Why weren’t you told?

PreventionPrevention earlyearly

Continuing due diligence

PreventionPrevention earlyearly• Raise the issue as a question - not an

accusation• Management may not be able to “see”,

because they are focused elsewhere• You may be doing them a favour• They may be able to quickly ease your mind• Better to ask than to wonder• Active vs. passive• Lender as a partner with a common interest

Control and Support

A Question of Balance

! !Later stage warning Symptoms

Options now becoming more limited

Later stage signs might beLater stage signs might be• Suppliers tighten terms

• Unexpected asset sales

• Idle equipment

• Late financial statements

• Delinquencies, but quickly paid

• Evidence of deferring expenses

Other, later stage signs might Other, later stage signs might bebe

• Management unavailability, non responsive

• Abrupt changes in management• Loss of key people• Limit reductions or cancellations by

other banks

Stock price Bond price

???? Request to refinance another lender

But …

But …

A 5 – 10 day delinquency or breach of a loan covenant

Are not early or even signals. The problem is here!

Timing is everythingTiming is everything

The best time to deal with a problem is when the problem is developing

Formal receipt of financial reports……

should only confirm what you already know

. Problem . Problem IdentificationIdentification

. Solution . Solution OptionsOptions

Pro Active Pro Active ResolutionResolution

Action Timeline

All All PositivePositive

Indications Indications of Stressof Stress

Early Early WarningWarning

Covenant Covenant BreachBreach

Payment Payment DefaultDefault

Later Stage Later Stage WarningWarning

Reactive Reactive ResolutionResolution

. . CureCure

. Resolve. Resolve

. Action Options. Action Options

. Fewer Options. Fewer Options

. Relationship . Relationship JeopardyJeopardy

. Litigation. Litigation

Resolution Resolution Under DuressUnder Duress

Creditor- first position, first to act

• To enforce rights requires an Active vs. a Passive approach

• Whether the borrower is “still profitable” or not • Whether the problem is their “fault” or not• Whether the customer has been with us many

years or not…..• If the agreement has breached ….if we detect

weakness it has to be dealt with

--- NOW

• Call a halt – a time out

• Remind about the rules – the conditions

• Clarify if necessary

• Confirm the facts

• Caution about a repeat incident

• Keep a more watchful eye on the specific issue going forward

Action !

Speed Without Panic

No payment default- no breach of conditions, but signs are troubling

Probe – clarify - confirm

Create common view of the problem issue(s) and actions to be taken to address them

Agree on timing

Create common understanding of implications

Record for our records- confirm by letter to borrower

What probably won’t workWhat probably won’t work

– Wishful thinkingWishful thinking– Waiting for another sign of stressWaiting for another sign of stress– Waiting for the next set of financial Waiting for the next set of financial

statementsstatements– Waiting for the next scheduled Waiting for the next scheduled

meetingmeeting– Hoping the problem will go awayHoping the problem will go away– WorryingWorrying

What can we do if there’s a breach of a covenant/condition or worse (payment default !!!)? There are many options

but…Going down with the ship or watching

it sink is not part of the deal !

ResolutionResolution

Whose problem is Whose problem is it ?it ?

What can we do if there’s a breach?

Ignore the default (not recommended !)• Formally waive the default• Demand immediate (partial or full) payment• Renegotiate with (more) collateral and/or• Renegotiate with tighter controls and/or• Renegotiate the pricing

Covenants aren’t likely to get your money back immediately, but they can give you the power to improve your position.

And they can place you in a better position than other lenders.

Borrower Actions -Borrower Actions -

POSSIBLE ACTIONS OF A RESPONSIBLE BORROWER…… ?

Self medication

They don’t have to like

it

What else?

Borrower Actions -Borrower Actions -• Make the payment• Supply req’d / requested information• Take other actions necessary – (like?)• Reverse action already taken• Increase capital• Cut expenses• Add subordinated debt• Find a new lender

Not all defaults or breaches are curable

They don’t have to like

it

What else?

Joint Joint ActionsActionsWaiverWaiver - Temporary

- One time- Permanent

Restructure

And finally, the last resort,legal action

Fee event ? Increase margin?

Return to stability/health via

Operations…. Not …..

Return to stability/health via

Operations…. Not via Debt Relief…..

Negotiation Negotiation ConsiderationsConsiderations

Always tradeAlways trade – rather than – rather than givegive

What might you trade for??What might you trade for??

Monitoring recap…Monitoring recap…

• Lending process lasts Lending process lasts through through repaymentrepayment

• Some well made loans turn badSome well made loans turn bad• Financial assets depreciate too, but Financial assets depreciate too, but

maintenance can keep them healthymaintenance can keep them healthy• Time management and organization – Time management and organization –

critical to successcritical to success• PromptPrompt action and communication action and communication

Loss Prevention

Trade and Short Term Financing

Loss Prevention Ideas

• Key !!! Knowing your borrower

• Being aware of current condition

• Insisting on accurate and timely information, at least quarterly – monthly for many borrowers especially small businesses


• Finance “self liquidating transactions”– Export finance vs L/C, purchase order,

contract– Import finance against orders– Control the documents– Trade/transaction flows through your bank– Require the borrower to hedge the FX risk


• Potential dangers– Double financing– Fraudulent orders– Speculative buying Get Agings !– Slow receivables– Stale inventory Have and use

the Right to inspect inventories


Beware of Concentrations in Accounts Receivable

Monitor the level of accounts payable and short term debt compared to the levels of accounts receivable and inventory


What business is your borrower in?

Are there risks specific to that industry?

For example: A trading company


Are the borrower’s assets invested in appropriate areas?

Are the assets funded as you would expect? (i.e. a mix of payables and short term debt)

Are the risks of the equity holders and the lender in the appropriate proportions?

How does this borrower’s performance compare to other borrowers in a similar business?


Characteristics of a trading company:• Relatively high leverage• Low gross and net margins• Heaviest areas of investment• Subject to margin squeeze

Inventory and Accounts Receivable


Where in the supply chain does your customer add value?

Is the value being sustained – continuing ?

A borrower whose business is a “continuing one” will do all they can to Protect their source of working capital finance.

Real time awareness, conditions which focus on repayment capacity and frequent questions for your borrower –

The best means of prevention

Above all

Be in a position to be able to follow the flow of cash through the borrower

For which you need “access” and reliable, current information

Credit Risk Ratings

Keeping Score !

Loan Monitoring and Accurate, “Real Time” Rating

If you only recognize problems as payments are missed, then it’s usually too late to fix them.

In most major banks, the business unit (i.e. the credit officers) carry full responsibility for monitoring the early warning signals and rating the borrower.

Credit Rating Systems

Designed to track the quality of individual borrowers over the passage of time

Allows “comparative evaluation” borrower to borrower

Provides “trend” indicators

May be used to require special actions

Provides qualitative assessment on specific portfolios

Credit Rating Systems

Can be used for RAROC purposes

Can be a tool for determining provisions

Provides senior management a vision of asset quality and the trends in quality and can help to guide decisions regarding credit risk appetite

Can help to identify “risk” concentrations

Credit Gradings

Smart banks understand that the best way of knowing whether the relationship managers are on top of their account management responsibilities, is whether they have applied the correct credit gradings.

Credit Gradings (cont’d)The Credit Grading system will take into

account everything that goes into credit judgment:

Industry conditions Market positionCustomers SuppliersProfitability Liquidity Access to “capital/bank” Management

markets Cash flowAsset turnover The economy

Leverage Threats and

risks…etc.

Credit Gradings (cont’d)

The Credit Grading system will take into account everything that goes into credit judgment:

And if things change, the loan grade gets changed immediately.


The Credit Grading system will take into account everything that goes into credit

judgment:

Considers the history the current status, trends and likely future

developments

Loan Grading System

• Any loan grading process has to start with a clear policy statement of how it works.

Including:– Definitions of loan grades– Comparisons to external ratings, as applicable– The issues that will lead to loan grade changes– The process for setting grades and for making changes

(i.e. who approves etc).– The expected actions for loan management at each level– The implications for improper rating– The final authority for grade setting

Credit Risk Grading Matrix

"Quality component" Rating 1 2 3 4 5 6 7

IndustryCompetitivenessCustomer/supplier diversityRevenue concentrationProduct dependenciesManagement structure, capability and experienceCash Flow from operationsCash Flow after capexCash flow after debt serviceReliability of cash flowRevenue growth history and prospectsProfitabilityLiquidityLeverage

Borrower Rating as shown

Facility rating may be higher or lower depending on facility characteristics, e.g. type and liquidity of collateral or guaranty could drive the rating higher.Subordinated debt or unsecured debt behind secured debt is likley to drive the rating lower.

8

Facility rating may be higher or lower depending on facility characteristics, e.g. type and liquidity of collateral or guaranty could drive the rating higher.

Composite rating___

Credit Risk Rating Grid


Most important of all:

Credit gradings are under constant review, and are totally dynamic.

A major shift in a loan grading suggests that somebody wasn’t watching…..

And this is part of the risk culture.

A few reminders and concluding thoughts

Over time, the banks with strong risk cultures donot lose market share.

To the contrary, they gain the respect of themarket and of their clients.

They are seen as leaders who can bring value to their clients over the long term.

A few remindersOnly cash repays loans. A lender must

know what’s happening to the cash.

A few high level reminders

Only cash repays loans. A lender must know what’s happening to the cash.

We lend against cash flows. We do not lend against collateral.

When we lend, we impose conditions, and we expect them to be respected.

Best wishes to you !

And to your Banks for consistent growth in the future with asset quality and earnings consistency you can be proud of !!!!

Thank you !

Rick Clarke

[email protected]

credit officer workshop july 2008. welcome ! two days together ……….. to think about and...

Documents

risk asset quality

risk assets

darknessthe quality

crucial quality

trendscredit risk ratings

credit culture

investment banks

banks portfolioshould