1. Credit Risks in Working Capital and Equipment Loans
Alexandru Cebotari

2. Working Capital – Why Is It So Important
The financial element of risk is defined as the inability of cash generation to:
Maintain working capital
Maintain productive assets
Meet debt service in schedule
Pay reasonable dividents
Maintain some borrowing power
Cash generation is defined as profits plus depreciation. Is it true?
Opreating expenses on the net income statement include depreciation expense, which does not require a cash outlay
Decrease in current assets, other then cash, have positive effects on cash flows, and increases in current assets have a negative effect.
An increase in the current liabilities has a positive effect, and a decrease in current liabilities has a negative effect.
The first step in preparing the statement of cash flows is to determine cash flows from operating activities. The income statement indicates a business’s success or failure in earning an income from its operating activities, but it does not reflect the inflow and outflow of cash from those activities. The reason, as already mentioned, is that the income statement is prepared on an accrual basis. As a result, to arrive at cash flows from operations, the figures on the income statement must be converted from an accrual basis to a cash basis.
Depreciation expense: You have a cash outlay when you buy the long-lived productive asset. Cash payments for plant assets, intangibles, and natural resources occur when the assets are purchased and are reflected as investing activities on the statement of cash flows at that time. Accounting standards, though, do not recognize the expenditure immediately, but disperses them over the life span of the asset in line with the depreciation method chosen.
A decrease in a current asset frees up invested cash, thereby increasing cash flow. An increase in a current asset consumes cash, thereby decreasing the cash flow.
An increase in the current liability represents a postponement of a cash payment, which frees up cash and increases the cash flow in the current period. A decrease in current liabilities consumes cash, thereby decreasing the cash flow.

3. Evaluating Historical Performance Evaluating Business Plans
Manage-ment Ability
Current Assets
Current Liabilities
Current Creditor Commit-
ments
Volume Liquidity Needs
Servicing
Environ-mental Coditions
Deficiency?
Reserve?
Change in W/C
Long-Term Creditor Commit-
ments
Long-Term Debt
Servicing
Operating Practices
Income Statement
Non-Current Assets
Sources and Uses of Funds
As long as company is in active business, receivables and invetory must be thought of as as just as permanent an investment as bricks and mortar or oil in the piepline
Of the alternative long-term demans on the cash generated, most lenders clearly acknowledge the maintenance of capital expenditures, the requirement of debt service, and maybe dividend requirements. The additional requirements for cash generation to satisfy minimum working capital requirements are less well understood. A clear understanding of work capital is a critical aspect of financial statement analysis.
Lenders need to evaluate working capital clearly in order to determine the requirement and the risks involved in the requested working capital loan (is it enough or not) and determine the sources of working capital inadequacy (is this problem recurring or not).
W/C might have an impact not only on the servicing of current liabilities, but also of longer-term liabilites. Next slide.
Deficiency?
Equity
Reserve?
Funds Adequacy
Profitability?
Return on Equity?

4. Role of Working Capital
Current Assets
Current Liabilities
Short-Term Creditors’ Commitments
W/C
Long-Term Debt
Long-Term Creditors’ Commitments
W/C
The usual way to look at working capital is as difference between current assets amd current liabilities. It is equally true that working capital is the difference between deferred assets and the total of long-term debt and equity. This view of working capital helps understand what working capital is and what can cause it to change. Where long-term debt plus equity exceeds the level of deferred assets (figure above), the excess supports part of current assets. This is a positive working capital position. Where long-term debt plus equity is less than non-current assets, some of the current liabilities will support non-current assets – a deficit working capital position. For a firm’s working capital position to change, the relationship between non-current assets and long-term debt has to change. For working capital to increase, non-current assets must shrink or long-term debt plus equity must grow. What a company’s working capital position should be is determined by the relationship between the time it takes items to work their way through current-asset stream and the delay granted by all current creditors before payment is due.
Assume it takes current asset items 90 days to complete the cycle to cash. Also assume that the average delay granted by current creditors before payment is due is 30 days. To prevent the current liabilities from exceeding the amount available from current creditors, working capital would have to be equal 2/3 of the current assets. If the overall delay granted by current creditors lengthened beyond 30 days, the need for working capital would fall accordingly. Stretching the payment delay beyond 90 days would permit the firm to operate with deficit working capital position without causing any problems in servicing current liabilities.
Non-Current Assets
Equity

5. Asset Conversion Cycle
The Asset Conversion Cycle represents the number of days it takes a company to puchase raw materials, convert them into finished goods, sell the finished product to a custmer and receive payment for the product
The need for working capital revolves around the typical lag between cash inflows and cash outflows. To illustrate the way to determine the working capital requirement, the cash cycle analysis will be emplyed.
The cycle measures the average number of days that working capital is invested in the operating cycle. It starts by adding days inventory outstanding (DIO) to days sales outstanding (DSO). This is because a company "invests" its cash to acquire/build inventory, but does not collect cash until the inventory is sold and the accounts receivable are finally collected.
Receivables are essentially loans extended to customers that consume working capital; therefore, greater levels of DIO and DSO consume more working capital. However, days payable outstanding (DPO)--which essentially represent loans from vendors to the company--are subtracted to help offset working capital needs. In summary, the cash conversion cycle is measured in days and equals DIO + DSO – DPO

6. (Average Accounts Payable/Purchases)*365, where
The ACC has three components:
Days Receivables Outstanding
Measures the average number of days from the sale of goods to the collection of receivables
(Average Accounts Receivables/Sales)*365 days
Days Inventory Held
Measures the average length of time between acquisition and sale of merchandise
(Average Inventories/Cost of Goods Sold)*365
Days Accounts Payable Outstanding
Measures the average length of time between the purchase of goods and payment for them
(Average Accounts Payable/Purchases)*365, where
Purchases = Cost of Goods Sold+Ending Inventory–Beginning Inventory
ACC Illustration in Excel

7. Cash Cycle Illustration
Companies A B C
1. Sales rate per day
$1M
2. Days sales in receivables 30 60 15
3. Days sales in inventory 90
4. Days in trading cycle
150
5. Days sales in payables 45
6. Days sales of working capital required
120
7. Receivable investment (1x2)
$30M
$60M
$15M
8. Inventory investment (1x3)
60M
90M
9. Trading cycle investment (1x4)
150M
15M
10. Payable support (1x5)
- 45M
-30M
- 15M
11. Required working capital support
45M
120M
12. Current ratio relationship (9/10) 2x 5x 1x
The example above assumes that each frim has a sales rate of $1,000 per day and the turnover are at the low point of a seasonal cycle (that is, core levels below which unusual circumstances would be required). The example above computes all turnovers with sales for consistency. The reqiored level of working capital will be influenced by the industry.
Companies could have the following characteristics. A - an assembler of a fairly standard product. Many of the parts are purchased (giving rise to the the high payables) and assembled. Thirty-day terms are given to customers. At the rate of sales of $1M, company A would require $45M of permanently available cash (that is working capital) to avoid a cash shortage.
Company B produces a sophisticated, high technology product. Most costs are the skilled labor and engineering costs. The extendede production cycle is required by the individual work, and the low payable support is related to the relatevely minor portion of sales dollars represented by purchased materials. Since the product must be set up at the customer’s location and tested prior to becoming operational, extendede receivable terms must be given. Company B would require $120M in working capital to support the significant lag between cash inflows and cash outflows.
Company C could be an advertising company or an insurance briker. No inventory or spontaneous creditors willing to wait until cash is collected may eliminate the need for significant levels of working capital.
Choosing a seasonally low level is useful in distinguishing between a permanent and a short-term need. If company A must build its inventory to twice its low point prior to a selling season, such a temporary working capital would be filled with short-term debt.

8. Cash Flow Quality Qualitative aspect High quality Low quality
Inventory valuation
LIFO understates profits in inflationary period
FIFO overstates profits in inflationary period
Depriciation method
Accelerated depreciation more accurately matches replecement cost
Straight-line depreciation under-reserves funds for fixed assets: thus, it overstates earnings
Deferred assets
Intangibles are written off as quickly as possible
Expenses are capitalized and earnings are overstated
Deferred income
Income is deferred while expenses are flowed through: for example, benefits of investment tax credits are deferred
Expenses are deferred: for example, plant start-up costs and tax credits are taken immediately
Tax rate
“Normal” effective tax rate usually reflects minimal reliance on various tax deferral methods – investment tax credits, capital gains credits, percentage depletion deductions – and therefore, better quality
Low effective tax rate usually reflects reliance on various tax deferral methods and therefore, low quality
The LIFO (last in, first out) inventory accounting method signals higher earnings quality than FIFO (first in, first out) when prices are rising because reported profits under LIFO are minimized by the higher current costing of inventory used to calculate the cost of goods sold. During a depression, FIFO would be the better method.
Accelerated depreciation accounting is preferred over the straight-line method because it puts aside more funds for plant replacement and simultaniously reduces reported earnings. Accelerated depretiation increases the cash flow. When the company stops growing and the depreciation on an accelerated basis slips below the straight-line depreciation, the method is no longer so conservative.
Income deferral. When a company defers a chunk of plant start-up costs, the reported profit is probably overstated.

9. Servicing Current Liabilities
Sales volume, the rate of turnover of current assets, working capital and current creditors’ terms are factors that determine how a firm services current debts
Assume that sales double, the firm operates with positive working capital position and the commitments from current creditors do not increase. What scenario do you foresee?
What does happen if the rate ot turnover of current assets slows to half its former rate?
What does happen if the firm operates with a deficit working capital requirement?
By the time a borrower is forced to delay paying any debt, numerous payments, such as for trade debt, may already have been delayed.
First we need to see how the firm is servicing its current liabilities.
Lets assume the sales volume doubles. This, in turn causes current assets to double, since there are now twice as many items in the processing stream. With working capital remaining unchanged, current liabilities are forces to grow disproportionately, resulting in past-due debts. This is a problem that can result from rapidly growing sales. If working capital or the commitments from current creditors can keep pace with the increasing level of current assets, greater sales can be beneficial. But if this is not the case, it is actually possible fro a firm to “grow itself to death”.
Leaving the sales volume alone, let’s assume that the rate of turnover of current assets slows to half its former rate. This would cause, likewise, current assets to double. The same number of items would eneter the processing stream as before but take twice as long to work their way through, resulting in twice as many items in the stream. sWith no change in working capital, current liabilities would more than double, exceeding the sum committed by the current creditors.
Of the options for preventing or resolving a problem in servicing current debts, the one that involves the banker is a short-term loan. To consider a request for such a loan, a loan officer needs to determine which of the factors previously discussed (alone or in combination) led to the need to borrow and the prospect for a reversal or offsetting occurrence by the time the loan would come due.

10. Overtrading?
There are four elements of risk associated with overtrading:
Serious deplition of profit;
Organization failure associated with high volume;
Receivables losses; and
Inventory risks
Rule of thumb: current assets should cover total debt at the seasonal low
Deplition of margin. Sales minded managers will pursue sales volume at expense of margin profit. Sales of $100,000 at 10% yields $10,000 in profits, but sales at 9% margin require an increase of sales of 11% to make the same profit. 8% requires 25% more sales, 7% requires 43%, 6% requires 67%, and 5% margin requires 100% more sales to equal previous prfits. The decision to increase sale sprimarily through the device of cutting prices or profit margins may be a self-defeating exercise.
Organizational failure. Handling more inventory, receivables not only can be expensive in an organizational expansion sense, but the risk of a “snafu” (things are in a mess – as usual) raises its head very quickly. Consider the receiving, warehousing, stock control, production and servicing aspects.
Receivables losses. An attempt to increase volume means taking new customers in wholesale quantities. Besides the materially slower turn in assts, weak credits could be sold in the process.
Inventory risk. Inventory risk is always related to the nature of the product, but the risk seems to expand by the square of the defficiency in working capital to cover the inventory investment. What would happen if sales increase to $4,000 or $5,000? There will be no protection at all for creditors.
Rule of thumb: This may seem a sever caveat, but its violation considerably increases the risk to a lender. If it is violated, the security of a cashable nature should be adequate to justify the risk. Ideally, a banker should be in a position that a recession in volume of sales reduces inventory and receivables which turn into cash to pay the banker’s loans.
In this situation, consideration was given solely to the capital needs of the rading position, and that should remain in focus, no matter the size of the balance sheet.

11. Sustainable Growth
If a rapidly growing company can maintain a prudent balance between debt and equity sources, the reliance on external capital creates no problems
In too many instances, rapid sales growth, coupled with modest profit margins and an inability to sell new equity, forces the company to rely increasingly on bank credit
Rapid growth may lead to increasing debt ratios and increasing banker headaches
Two questions to be answered to when contemplating a loan to a rapidly expanding firm:
Is the applicant in balance? Given the company’s growth targets and financial policies, will the company be able to maintain a stable debt ratio over time?
When can the bank expect repayment of the loan? Is the requested amount sufficient or is the contemplated loan likely to be just the downpayment on a much larger commitment?
It takes money to make money and this old saying is nowhere more applicable than in financing rapidly growing enterprises. Although additional dollar of sales adds a few cents to profits, growth also requires significant new investments in receivables, inventories, and fixed assets. Sometimes this required investment could be financed internally through retained earnings, but very often it calls for external financing.

12. Sustainable Growth Rate (1)
Sustainable growth rate – the annual percentage invcrease in sales which is consistent with a stable capital structure
Sustainable Growth
Target Debt Ratio
Profit
Margin
Calculation of a loan applicant´s sustainable growth rate is by no means a substitute for detailed financial projections in evaluating loan requests. However, used in conjunction with a detailed projection, the sustainable growth rate has several appeals:
Can be calculated by hand in a few minutes
Focuses on those variables that are of most importance to a banker
Gives the banker a simple way to coordinate the company’s growth objectivesand its financial policies
Target Payout Ratio
Capital-Output
Ratio

13. Sustainable Growth Rate (2)
p = profit margin on sales
d = the target divident payout ratio => (1-d) is the target retention ratio
L = the target debt-to-equity ratio
t = the capital-output ratio defined as totral assets devided by net sales
s = sales at the beginning of the period
Δs = the increase in sales during the year
Liabilities and owners’ Equity at beginning of year
Assets at the beginning of year
The figure above illustrates the idea. The new assets required to support increased sales of Δs is Δs*t. On the other side of the balance sheet, total profits for the year will be p*(s+ Δs) and additions to retained earrnings will be r*(s+ Δs)*(1-d). Finally, because every dollar added to retained earnings enables the company to borrow $L, without increasing its debt-to-equity ratio, new borrowings equal p*(s+ Δs)*(1-d)*L.
To calculate g, make sure additions to assests equal additions to liabilities: Δs*t = r*(s+ Δs)*(1-d) + p*(s+ Δs)*(1-d)*L. => find sustainable growth rate
Additions to liabilities
p(s+Δs)(1-d)L
New assets needed to support increased sales
Δs(t)
Additions to Retained Earnings
p(s+Δs)(1-d)

14. Example: Sustainable Growth Rate in Loan Appraisal
Sales
$1,375,000
Profit after tax
$82,500
Dividents
$8,250
Current assets
$700,000
Current liabilities
$400,000
Net fixed assets
$950,000
Bank loan
$500,000
Total assets
$1,650,000
Owners’ equity
$750,000
Total
p = .06, L = 1.20, t = 1.20
d = .10
President of Radar contacts the loan officer at the bank to secure a term loan of $500,000
Radar’s target sales growth rate is 20% per year
Loan officer fears that the company’s debt ratio will rise steadily in future years and could jeopardize the bank’s position
Radar is a small company and cannot sell new shares. Unless it can improve its profit margin or reduce capital-to-output ratio, it will be unable to increase sales at greater than 11% per year without increasing its debt-to-equity ratio. Let’s exclude the possibility that they can cut divident payout.

15. Short-term lending: What does short-term mean?
Under short-term lending, the lender can get paid in the ordinary course of events in the short-term (such as within a year)
The lender is required to have a clear understanding of the working capital adequacy – if permanent working capital is inadequate, slow payment of continuous refinancing beyond a year should be anticipated
The elements of appropriate short-term lending include:
Understanding the specific purpose
Structuring the maturity in line with the primary source of repayment
Identifying the certainty of secondary sources of repayment implicit in the purpose
Evaluating alternative protection available from the balance sheet; and possibly
Ensuring access to secondary protection by taking security

16. Characteristics of working capital loans
Seasonal versus Permanent Working Capital Needs
All firms need some minimum level of current assets and current liabilities
The amount of current assets and current liabilities will vary with seasonal patterns
Permanent Working Capital
The minimum level of current assets minus the minimum level of adjusted current liabilities
Adjusted Current Liabilities
Current liabilities net of short-term bank credit and current maturities of long-term debt
Seasonal Working Capital
Difference in total current assets and adjusted current liabilities

17. Dollars Dollars q Time Total Current Assets Minimum Current Assets
Total Current Liabilities
Minimum Current Liabilities
Total = Permanent Working Capital Needs
+ Seasonal Working Capital Needs
Permanent Working Capital Needs q
Time
Seasonal Working Capital Needs
Dollars
Dollars

18. Short-Term Commercial Loans (1)
Open Credit Lines
Loan is seasonal if the need arises on a regular basis and if the cycle completes itself with one year
Used to purchase raw materials and build up inventories of finished goods in anticipation of later sales
It is self-liquidating in the sense that repayment derives from the sale of finished goods that are financed

19. Short-Term Commercial Loans (2)
Open Credit Lines
The bank makes a certain amount of funds available to a borrower for a set period of time
Often used for seasonal loans
The customer determines the timing of the actual borrowings (“takedowns”)
Borrowings increase with inventory buildup and decline with the collection of receivables

20. Short-Term Commercial Loans (3)
Open Credit Lines
Typically require that the loan be fully repaid at least once during each year to confirm that the needs are seasonal
Commitment Fee
A fee, in addition to interest, for making credit available
May be based on the entire credit line or on the unborrowed balance

21. Short-Term Commercial Loans (4)
Asset-Based Loans
Loans Secured by Inventories
The security consists of raw materials, goods in process, and finished products.
The value of the inventory depends on the marketability of each component if the borrower goes out of business.
Banks will lend from 40 to 60 percent against raw materials that are common among businesses and finished goods that are marketable, and nothing against unfinished inventory

22. Short-Term Commercial Loans (5)
Asset-Based Loans
Loans Secured by Accounts Receivable
The security consists of paper assets that presumably represent sales
The quality of the collateral depends on the borrower’s integrity in reporting actual sales and the credibility of billings

23. Short-Term Commercial Loans (6)
Asset-Based Loans
Loans Secured by Accounts Receivable
Accounts Receivable Aging Schedule
List of A/Rs grouped according to the month in which the invoice is dated
Lockbox
Customer’s mail payments go directly to a P.O. Box controlled by the bank
The bank processes the payments and reduces the borrower’s balance but charges the borrower for handling the items

24. Short-Term Commercial Loans (7)
Revolving Credits
A hybrid of short-term working capital loans and term loans
Typically involves the commitment of funds for 1 – 5 years
At the end of some interim period, the outstanding principal converts to a term loan
During the interim period, the borrower determines how much credit to use
Mandatory principal payments begin once the revolver is converted to a term loan