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Evaluating Commercial Loan Requests and Managing Credit Risk Chapter 14 President and CEO, SW Graduate School of Banking Foundation Director, Assemblies.

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Presentation on theme: "Evaluating Commercial Loan Requests and Managing Credit Risk Chapter 14 President and CEO, SW Graduate School of Banking Foundation Director, Assemblies."— Presentation transcript:

1 Evaluating Commercial Loan Requests and Managing Credit Risk Chapter 14 President and CEO, SW Graduate School of Banking Foundation Director, Assemblies for Bank Directors Adjunct Professor, Dept. of Finance, Cox School of Business Southern Methodist University S. Scott MacDonald, Ph.D. 1

2 Fundamental Credit Issues There are two types of loan errors Type I Error Making a loan to a customer who will ultimately default Type II Error Denying a loan to a customer who would ultimately repay the debt 2

3 Evaluating Commercial Loan Requests and Managing Credit Risk Important Questions Regarding Commercial Loan Requests 1. What is the character of the borrower and quality of information provided? 2. What are the loan proceeds going to be used for? 3. How much does the customer need to borrow? 4. What is the primary source of repayment, and when will the loan be repaid? 5. What is the secondary source of repayment; that is, what collateral, guarantees, or other cash inflows are available? 3

4 Evaluating Credit Requests: A Four-Part Process 1. Overview of management, operations, and the firm’s industry 2. Common size and financial ratio analysis 3. Analysis of cash flow 4. Projections and analysis of the borrower’s financial condition 4

5 Four Steps in Evaluating Credit Requests Overview of Management and Operations Spread the Financials Cash Flow Analysis Pro Forma Projections and Analysis

6 Overview of Management and Operations Gather Information on: Business and Related Industry Management Quality Nature of Loan Request Quality of the Data

7 Spread the Financials Spread the financials and compute common size Compare with industry averages Calculate a series of financial ratios that indicate performance and risk Compare with industry averages

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11 Ratio Analysis Liquidity and Activity Ratios Leverage Ratios Profitability Ratios

12 Liquidity and Activity Ratios Net Working Capital = CA - CL Current Ratio = CA / CL Quick Ratio = (Cash + AR) / CL Days Cash = Cash / Ave. Daily Sales Inventory Turnover = COGS / Ave. INV. AR Collection (Days AR) = AR / Ave. Daily Sales Days Cash to Cash = Days Cash + Days AR + Days Inventory Days Payable Outstanding =AP / Ave. Daily Pur. = AP / ((COGS + DInventory)/365) Sales to net fixed assets = Sales/Net fixed assets

13 13 Liquidity Ratios: Wades Office Furniture

14 Leverage Ratios Debt Ratio = Debt / Total Assets Debt to tangible net worth = Debt / Tang. NW Times interest earned = EBIT / Interest EBIT = Earnings before taxes plus interest expense Fixed Charge Coverage = (EBIT+Lease pay) / (Interest expense+Lease Pay) Net Fixed Assets to Tangible NW Dividend Payout % = Dividends paid / Net profit

15 Leverage Ratios: Wades Office Furniture

16 Profitability Ratios: Dupont Analysis Return on Equity (ROE) = Net income / Total equity Or Profit before taxes to tangible net worth Return on Assets (ROA) = Net income / Total Assets Or Profit before taxes to total assets Income: Asset utilization (AU)= Sales / Total assets Other income / Total assets Expenses: Profit margin (PM) = Net income / Sales Cost of goods sold / Sales Operating expenses / Sales Income taxes to profit before taxes Sales growth = Change in sales / Last period’s sales

17 Profitability Ratios: Wades Office Furniture

18 Evaluating Credit Requests: A Four-Part Process Cash-Flow Analysis Cash-Based Income Statement Modified form of a direct statement of cash flows 18

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21 Cash Assets Let A 1 = Cash, then: Let  NW =  stock +  surplus + NI - DIV Let NI = Revenues - Expenses - Taxes Cash Flow Analysis Cash Pays a Loan not NI

22 Sources and Uses of Cash Sources of Cash Are: Increase in Any Liability Decrease in Any Non-Cash Asset New Issues of Stock Additions to Surplus Revenues Uses of Cash Are: Decrease in Any Liability Increases in Any Non-Cash Assets Repayment / Refunding of Stock Deductions from Surplus Cash Expenses, Taxes, Dividends

23 Understanding Sources and Uses Assets are a use of cash: - (A t - A t-1 ) Liabilities are a source of cash: + (L t - L t-1 ) Revenues are a source of cash: + Revenues Expenses are a use of cash: - Expenses Just sum up each part

24 Two Forms of a Cash Flow Statement Direct Converts the income statement into a “cash based income statement.” Begins with net sales and adjust for changes in balance sheet items. Indirect Adjusts 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. Operations Includes income statement items and all current assets and current liabilities. Investing Includes all long term assets Financing Includes all long term liabilities and equity (except retained earnings) plus dividends paid. Cash Total of the above, but must equal the actual change in cash and marketable securities.

27 Other Definitions of Cash Flow EBIT Earnings before interest and taxes. EBITDA Earnings before interest, taxes, depreciation and amortization. EBITDA – capital exp. -  working capital Generally, the faster the company grows, the less useful net income is. Working capital increases can be good and bad!

28 Cash Flow: Wades Office Furniture

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30 Other Cash Flow Measures Cash flow from operations-$128 Net Income…………………………..$339 Traditional Cash Flow………………$412 EBIT………………………………….$684 +Earnings before taxes$527 +Interest$157 EBITDA………………………………$757 +EBIT$684 +Depreciation$73

31 Sales growth and cash flow Dual edge sword of sales growth Good sales – more profit Sales growth – use of cash for A/R, Inventory and working capital In 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 growth Changes in operating policies also use or provide cash flow: Changes in credit policy Changes in inventory policy -Changes in accounts payable policy -Changes in operating expense accrual policy.

33 Wades Office Furniture: Cash flow sensitivity

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] Sales 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 Use of Cash in Inventory is a function of: Sales (COGS) and Inventory Policy Sales 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 Projections Pro Forma projections of the borrower’s condition reveal: How much financing is required When the loan will be repaid Use of the loan 37

38 Evaluating Credit Requests: A Four-Part Process Financial Projections Pro Forma Assumptions Sales t+1 = Sales t × (1 + g Sales ) where: g Sales = Projected Sales Growth COGS t+1 = Sales t+1 × COGS % of Sales Accounts Receivable t+1 = Days A/R Outstanding × Average Daily Sales t+1 Inventory t+ 1 = COGS t+1 / Inventory Turnover 38

39 Evaluating Credit Requests: A Four-Part Process Financial Projections Pro Forma Assumptions Accounts Payable t+1 = Days A/P Outstanding × Average Daily Purchases t+1 Or Accounts Payable t+1 = Days A/P Outstanding × [(COGS t+1 + ΔInventory t+1 )/365] 39

40 Evaluating Credit Requests: A Four-Part Process Financial Projections Projecting Notes Payable to Banks Rarely will the balance sheet “balance” in the initial round of pro forma forecasts To reconcile this, there must be a balancing item or “plug” figure 40

41 Evaluating Credit Requests: A Four-Part Process Financial Projections Projecting Notes Payable to Banks When projected assets exceed projected liabilities plus equity, additional debt (assumed to be in the form of notes payable) is required When 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 41

42 Evaluating Credit Requests: A Four-Part Process Financial Projections Sensitivity Analysis Best Case Scenario  Assumes optimistic improvements in planned performance and the economy are realized Worst Case Scenario  Assumes the environment with the greatest potential negative impact on sales, earnings, and the balance sheet Most Likely Scenario  Assumes the most reasonable sequence of economic events and performance trends 42

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 sales Depreciation equals $110,000 annually. Noninterest expense equals $110,000 in 2014 and $135,000 in 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 taxes Income 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 Inventory turn increases to 4.9 in 2014 and 5.1 times in Days AP outstanding remains constant at 53. Prepaid expenses increase by $5,000 Accruals 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 Sales 2014 = Sales 2013 x (1 + gsales) = $12,430 x ( ) = $14,916 COGS 2014 = Sales 2014 x COGS % of Sales = $14,916 x 0.68 = $10,143 Selling Exp 2014 = Sales 2014 x Selling Exp. % of Sales = $14,916 x 0.13 = $1,939 G&A Exp 2014 = Sales 2014 x G&A Exp. % of Sales = $14,916 x = $1,820 Interest Exp 2014 = (Bank debt 2014 x rate on bank debt) + (L.T. debt 2014 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. AR 2014 = Days A/R x Average Daily Sales 2014 = 50 x ($14,916 / 365) = $2,043 Inventory 2014 = COGS 2014 / Inventory turnover = $10,143 / 4.9 = $2,070 Planned fixed asset expenditures can be obtained from the capital budget: Gross fixed (GFA) 2014 = GFA Capital Exp = $791 + $400 = $1,191 Accumulated dep 2014 =Accumulated depreciation Depreciation 2014 = $346 + $110 = $973 Determine 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: AP 2014 = Days AP x Avg. Daily purchases 2014 = Days AP x ((COGS  Inventory 2014 ) / 365) = 53 x ($10,143 + ($2,070 – $1,764) / 365) = $1,517 Principal payments on debt can be obtained from the capital budget: LTD 2014 = LTD New issues of LTD 2014 – Curr. Mat. LTD 2014 = $300 + $0 – $75 = $225 Term notes (TN) 2014 = TN New issues of TN 2014 – Curr. Mat. TN 2014 = $0 + $400 – $50= $350

48 Pro Forma Balance Sheet (Equity) Recall Balance sheet definitions: Retained earnings (RE) 2014 = RE (NI 2014 – Dividends 2014 ) + Acct Adjust. = $804 + ($339 – $0) = $1,893 and; Stock 2014 = Stock New stock issues Note: an accounting adjustment is only needed when adjustments have been made to retained earnings.

49 Proforma Income Statement: Wades

50 Proforma Balance Sheet: Wades

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52 Proforma Ratio Analysis: Wades

53 Proforma Cash Flow: Wades

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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 borrowers Reserve accounts The 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 borrowers Collateralization One or more parties pledge collateral against the loan Loan guarantees One or more parties pledge personal or business assets or are contractually bound to meet the obligations of the borrower if that party defaults Credit insurance Any party can purchase credit insurance, provided either privately or by a governmental unit, for loans that provide payments for losses stemming from default Credit derivatives Instruments or contracts that derive their value from the underlying credit risk of a loan or bond 55

56 Credit Default Swaps (CDS) CDS contracts are relatively unregulated derivative instruments based on the underlying payments and values of fixed- income securities These contracts are privately negotiated instruments between a buyer and a seller and are traded in over-the-counter markets 56

57 Credit Default Swaps (CDS) The buyer pays a premium and thus the CDS is similar to an insurance contract The buyer often owns the underlying debt and uses the CDS as a hedge The seller of the CDS plays a role similar to that of the insurance company Sellers generally do not own the debt and provide longer-term protection If an adverse event occurs the seller pays the buyer the change in value of the underlying asset 57

58 Credit Default Swaps (CDS) 58

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 manner Restructuring of the debt in such a way that the lender (investor in the debt) is negatively affected Bankruptcy or insolvency in which the debt is not paid Acceleration 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 59


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