Presentation on theme: "Evaluating Commercial Loan Requests and Managing Credit Risk Chapter 14 S. Scott MacDonald, Ph.D. President and CEO, SW Graduate School of Banking Foundation."— Presentation transcript:
1 Evaluating Commercial Loan Requests and Managing Credit Risk Chapter 14 S. Scott MacDonald, Ph.D.President and CEO, SW Graduate School of Banking FoundationDirector, Assemblies for Bank DirectorsAdjunct Professor, Dept. of Finance, Cox School of BusinessSouthern Methodist University
2 Fundamental Credit Issues There are two types of loan errorsType I ErrorMaking a loan to a customer who will ultimately defaultType II ErrorDenying a loan to a customer who would ultimately repay the debt
3 Evaluating Commercial Loan Requests and Managing Credit Risk Important Questions Regarding Commercial Loan RequestsWhat is the character of the borrower and quality of information provided?What are the loan proceeds going to be used for?How much does the customer need to borrow?What is the primary source of repayment, and when will the loan be repaid?What is the secondary source of repayment; that is, what collateral, guarantees, or other cash inflows are available?
4 Evaluating Credit Requests: A Four-Part Process Overview of management, operations, and the firm’s industryCommon size and financial ratio analysisAnalysis of cash flowProjections and analysis of the borrower’s financial condition
5 Four Steps in Evaluating Credit Requests Overview of Management and OperationsSpread the FinancialsCash Flow AnalysisPro Forma Projections and Analysis
6 Overview of Management and Operations Gather Information on:Business and Related IndustryManagement QualityNature of Loan RequestQuality of the Data
7 Spread the Financials Spread the financials and compute common size Compare with industry averagesCalculate a series of financial ratios that indicate performance and risk
11 Liquidity and Activity Ratios Ratio AnalysisLiquidity and Activity RatiosLeverage RatiosProfitability Ratios
12 Liquidity and Activity Ratios Net Working Capital = CA - CLCurrent Ratio = CA / CLQuick Ratio = (Cash + AR) / CLDays Cash = Cash / Ave. Daily SalesInventory Turnover = COGS / Ave. INV.AR Collection (Days AR) = AR / Ave. Daily SalesDays Cash to Cash = Days Cash + Days AR + Days InventoryDays Payable Outstanding =AP / Ave. Daily Pur. = AP / ((COGS + DInventory)/365)Sales to net fixed assets = Sales/Net fixed assets
16 Profitability Ratios: Dupont Analysis Return on Equity (ROE) = Net income / Total equityOr Profit before taxes to tangible net worthReturn on Assets (ROA) = Net income / Total AssetsOr Profit before taxes to total assetsIncome:Asset utilization (AU)= Sales / Total assetsOther income / Total assetsExpenses:Profit margin (PM) = Net income / SalesCost of goods sold / SalesOperating expenses / SalesIncome taxes to profit before taxesSales growth = Change in sales / Last period’s sales
21 Cash Flow Analysis Cash Pays a Loan not NI Cash AssetsLet A1 = Cash, then:Let NW = stock + surplus + NI - DIVLet NI = Revenues - Expenses - Taxes
22 Sources and Uses of Cash Sources of Cash Are:Increase in Any LiabilityDecrease in Any Non-Cash AssetNew Issues of StockAdditions to SurplusRevenuesUses of Cash Are:Decrease in Any LiabilityIncreases in Any Non-Cash AssetsRepayment / Refunding of StockDeductions from SurplusCash Expenses, Taxes, Dividends
23 Understanding Sources and Uses Assets are a use of cash:-(At - At-1)Liabilities are a source of cash:+(Lt - Lt-1)Revenues are a source of cash:+RevenuesExpenses are a use of cash:-ExpensesJust sum up each part
24 Two Forms of a Cash Flow Statement DirectConverts the income statement into a “cash based income statement.”Begins with net sales and adjust for changes in balance sheet items.IndirectAdjusts net income for non-cash charges and changes in balance sheet items.
25 What about NI as Cash Flow? A banker or investors primary interest is in determining “free cash flow.”Free cash flow is basically cash flow before interest, taxes and required capital expenditures.Net income is almost never equal to cash flow—depreciation and amortization.
26 Four sections in either cash flow statement. OperationsIncludes income statement items and all current assets and current liabilities.InvestingIncludes all long term assetsFinancingIncludes all long term liabilities and equity (except retained earnings) plus dividends paid.CashTotal of the above, but must equal the actual change in cash and marketable securities.
27 Other Definitions of Cash Flow EBITEarnings before interest and taxes.EBITDAEarnings before interest, taxes, depreciation and amortization.EBITDA – capital exp. - Dworking capitalGenerally, the faster the company grows, the less useful net income is.Working capital increases can be good and bad!
30 Other Cash Flow Measures Cash flow from operations -$128Net Income………………………….. $339Traditional Cash Flow……………… $412EBIT…………………………………. $684+Earnings before taxes $527+Interest $157EBITDA……………………………… $757+EBIT $684+Depreciation $73
31 Sales growth and cash flow Dual edge sword of sales growthGood sales – more profitSales growth – use of cash for A/R, Inventory and working capitalIn a stable environment, sales growth and in use of cash for A/R are the same.Growth in A/R > growth in sales, use of cash.Impact of credit policy.
32 Cash flow sensitivity analysis Cash is used to support sales growthChanges in operating policies also use or provide cash flow:Changes in credit policyChanges in inventory policy-Changes in accounts payable policy-Changes in operating expense accrual policy.
34 Impact of changes in operating ratios Sales effect for 2013:A/R impact on cash with no change in credit policy:A/R would have been higher with ‘12 credit policy:= [‘12 Days A/R x (‘13 Daily Sales)]= 2,125 = * (12,430k / 365)Use of cash with no change in credit policy:= -726k = -[2,125k - 1,399k]Impact of changes in operating ratiosSales growth used cash ($726k) but the tighter credit policy was a source of cash! Change in cash from change in credit policy: = +229k = -(1,896k - 2,125k)= (‘12 A/R – constant credit policy A/R)The total use of cash in A/R for ‘13 was -497k = -726k + 229k.Note that sales growth used cash but the tighter credit policy was a source of cash!
35 Note that the faster turnover of inventory was at source of cash! Use of Cash in Inventory is a function of: Sales (COGS) and Inventory PolicySales effect for 2013:Increase in sales, increases inventory (use of cash) even when inventory policy remains constant.Change in inventory policy effect for 2013:Inventory turned over faster in 2013, as compared to 2012, hence less cash was used than would have been if inventory policy had not improved.Note that the faster turnover of inventory was at source of cash!
36 Accounts payable did not provide as much cash due to repaying creditors faster A/P is a function of sales, inventory policy and trade credit provided.Note that Wades Days A/P went from days to days.So, even though A/P provided $374k in cash, if Wade’s had continued to ride creditors for days, A/P would have provided even more cash flow!
37 Evaluating Credit Requests: A Four-Part Process Financial ProjectionsPro Forma projections of the borrower’s condition reveal:How much financing is requiredWhen the loan will be repaidUse of the loan
38 Evaluating Credit Requests: A Four-Part Process Financial ProjectionsPro Forma AssumptionsSalest+1 = Salest × (1 + gSales)where:gSales = Projected Sales GrowthCOGSt+1 = Salest+1 × COGS % of SalesAccounts Receivablet+1 = Days A/R Outstanding × Average Daily Salest+1Inventoryt+1 = COGSt+1/ Inventory Turnover
39 Evaluating Credit Requests: A Four-Part Process Financial ProjectionsPro Forma AssumptionsAccounts Payablet+1 = Days A/P Outstanding × Average Daily Purchasest+1OrAccounts Payablet+1 = Days A/P Outstanding × [(COGSt+1 + ΔInventoryt+1)/365]
40 Evaluating Credit Requests: A Four-Part Process Financial ProjectionsProjecting Notes Payable to BanksRarely will the balance sheet “balance” in the initial round of pro forma forecastsTo reconcile this, there must be a balancing item or “plug” figure
41 Evaluating Credit Requests: A Four-Part Process Financial ProjectionsProjecting Notes Payable to BanksWhen projected assets exceed projected liabilities plus equity, additional debt (assumed to be in the form of notes payable) is requiredWhen projected assets are less than projected liabilities plus equity, no new debt is required and existing debt could be reduced or excess funds invested in marketable securities
42 Evaluating Credit Requests: A Four-Part Process Financial ProjectionsSensitivity AnalysisBest Case ScenarioAssumes optimistic improvements in planned performance and the economy are realizedWorst Case ScenarioAssumes the environment with the greatest potential negative impact on sales, earnings, and the balance sheetMost Likely ScenarioAssumes the most reasonable sequence of economic events and performance trends
43 Wades Office Furniture Financial Projections Assumptions: Most Likely Circumstances Sales increase by 20 percent annually.Cost of goods sold equals 68 percent of sales.Selling expenses average 13 percent of sales,G&A expenses average 12.2 percent of salesDepreciation equals $110,000 annually.Noninterest expense equals $110,000 in 2014 and $135,000 in 2015.Interest expense equals 14.5 percent of bank debt and 9 percent of other long-term debt.Income taxes equal 36 percent of earnings before taxesIncome tax payable increases annually by the rate of change in 2013.
44 Wades Office Furniture Financial Projections Assumptions: Most Likely Circumstances AR collection improves to: 50 in 2014 and 46 in 2015.Inventory turn increases to 4.9 in 2014 and 5.1 times in 2015.Days AP outstanding remains constant at 53.Prepaid expenses increase by $5,000Accruals increase by $20,000 annually.No dividends are paid.$400,000 is loaned to purchase new equipment, with the principal repaid in 8 equal annual installments.Depreciation on the new equipment $40,000, while depreciation the old assets will be $70,000 per year.The minimum cash required is $120,000.Other assets remain constant at $50,000.
45 Pro Forma Income Statement Sales2014 = Sales2013 x (1 + gsales) = $12,430 x ( ) = $14,916COGS2014= Sales2014 x COGS % of Sales = $14,916 x 0.68 = $10,143Selling Exp2014 = Sales2014 x Selling Exp. % of Sales = $14,916 x 0.13 = $1,939G&A Exp2014 = Sales2014 x G&A Exp. % of Sales = $14,916 x = $1,820Interest Exp2014 = (Bank debt2014 x rate on bank debt) (L.T. debt2014 x rate on L.T. debt) = $697 x (($75 + $50 + $350 + $225) x 0.09) = $186
46 Pro Forma Balance Sheet (Assets) Associate balance sheet items with sales or cash budget.AR2014 = Days A/R x Average Daily Sales = x ($14,916 / 365) = $2,043Inventory2014 = COGS2014 / Inventory turnover = $10, / = $2,070Planned fixed asset expenditures can be obtained from the capital budget: Gross fixed (GFA)2014 = GFA Capital Exp = $ $ = $1,191Accumulated dep =Accumulated depreciation Depreciation2014 = $ $110 = $973Determine appropriate turnover rates from historical trends or industry averages.
47 Pro Forma Balance Sheet (Liabilities) Trade credit may be tied to inventory growth, thus accounts payable tied to inventory growth:AP2014 = Days AP x Avg. Daily purchases = Days AP x ((COGS DInventory2014) / 365) = x ($10,143 + ($2,070 – $1,764) / 365) = $1,517Principal payments on debt can be obtained from the capital budget: LTD2014 = LTD New issues of LTD – Curr. Mat. LTD = $300 + $0 – $75 = $225Term notes (TN)2014 = TN New issues of TN – Curr. Mat. TN = $0 + $400 – $50 = $350
48 Pro Forma Balance Sheet (Equity) Recall Balance sheet definitions: Retained earnings (RE) = RE (NI2014 – Dividends2014) + Acct Adjust. = $ ($339 – $0) = $1,893and; Stock2014 = Stock New stock issues Note: an accounting adjustment is only needed when adjustments have been made to retained earnings.
55 Credit Enhancements Excess cash flow Many securitized assets are placed in pools in which the required payments to investors are less than the contractual payments of borrowersReserve accountsThe originating institution creates a trust for losses up to an amount allocated for a reserve which is used to make up any deficits in payments by borrowersCollateralizationOne or more parties pledge collateral against the loanLoan guaranteesOne or more parties pledge personal or business assets or are contractually bound to meet the obligations of the borrower if that party defaultsCredit insuranceAny party can purchase credit insurance, provided either privately or by a governmental unit, for loans that provide payments for losses stemming from defaultCredit derivativesInstruments or contracts that derive their value from the underlying credit risk of a loan or bond
56 Credit Default Swaps (CDS) CDS contracts are relatively unregulated derivative instruments based on the underlying payments and values of fixed-income securitiesThese contracts are privately negotiated instruments between a buyer and a seller and are traded in over-the-counter markets
57 Credit Default Swaps (CDS) The buyer pays a premium and thus the CDS is similar to an insurance contractThe buyer often owns the underlying debt and uses the CDS as a hedgeThe seller of the CDS plays a role similar to that of the insurance companySellers generally do not own the debt and provide longer-term protectionIf an adverse event occurs the seller pays the buyer the change in value of the underlying asset
59 There are several credit events that potentially trigger a payment from the seller of a CDS to the buyer:Failure to pay principal and interest payments in a timely mannerRestructuring of the debt in such a way that the lender (investor in the debt) is negatively affectedBankruptcy or insolvency in which the debt is not paidAcceleration of the principal and interest payments prior to the scheduled date(s)Repudiation or moratorium in which the debt issuer rejects or refuses to pay the debt