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Evaluating Commercial Loan Request. Two types of errors in judgment regarding lending : Type I Error Making a loan to a customer who will ultimately default.

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Presentation on theme: "Evaluating Commercial Loan Request. Two types of errors in judgment regarding lending : Type I Error Making a loan to a customer who will ultimately default."— Presentation transcript:

1 Evaluating Commercial Loan Request

2 Two types of errors in judgment regarding lending : 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.

3 Five key questions/issues: 1. What is the character of the borrower and the 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? 5. What collateral is available ? (Secondary source of repayment)

4 Four steps in evaluating credit requests 1. Overview of management and operations 2. Spread the financial statements 3. Cash flow analysis 4. Pro forma projections and analysis

5 Overview of management and operations Gather information on: Business and related industry Management quality Nature of loan request Quality of the data

6 Spread the financials Spread the financials and compute common size ratios Compare with industry averages Compare over time (on trend) Calculate a series of financial ratios that indicate performance and risk Compare with industry averages Compare over time

7 Exhibit 16.3 Wades Office Furniture - Income Statement Wades Office Furniture [- H I S T O R I C A L -] RMA Unaudited:, SIC # % of2007% of2008% of6/30/07 - INCOME STATEMENT % Cha$ 1,000Total% Cha$ 1,000Total% Cha$ 1,000Total 3/31/08 Net sales#N/A7, %8.10%8, %51.88%12, % Cost of goods sold#N/A5, %6.58%5, %52.19%8, %67.3% Gross profit#N/A2, %11.20%2, %51.27%4, %32.7% Selling expenses#N/A %13.25%1, %58.67%1, % Management salaries#N/A00.0%0.00%00.0%0.00%00.0% General & administrative expenses#N/A1, %18.84%1, %39.47%1, % Research and development expenses#N/A00.0%0.00%00.0%0.00%00.0% Depreciation & amortization#N/A700.9%1.43%710.9%2.82%730.6% Other operating expenses#N/A00.0%0.00%00.0%0.00%00.0% Total operating expenses#N/A1, %15.69%2, %46.88%3, %25.7% Operating profit #N/A % -7.19% % 73.67% % 7.0% Interest on marketable securities#N/A00.0%0.00%00.0%0.00%00.0% Income on long term investments#N/A00.0%0.00%00.0%0.00%00.0% Interest expense - Bank Notes#N/A1411.9%-15.60%1191.5%31.93%1571.3% Interest expense - Term notes + LTD#N/A00.0%0.00%00.0%0.00%00.0% All other expenses#N/A630.8%36.51%861.1%17.44%1010.8% All other income#N/A00.0%0.00%00.0%0.00%00.0% Total All Other Income (Expenses)#N/A(204)-2.7%0.49%(205)-2.5%25.85%(258)-2.1% Profit before taxes #N/A % % % % % 6.2% Income taxes#N/A1001.3%-5.00%951.2%97.89%1881.5% Extraordinary and other income (exp.)#N/A00.0%0.00%00.0%0.00%00.0% Net income#N/A1832.4%-16.9%1521.9%123.0%3392.7% Dividends#N/A00.0%0.00%00.0%0.00%00.0% Retained earnings#N/A1832.4%-16.94%1521.9%123.03%3392.7%

8 Wades Office Furniture: Historical Balance Sheet (Assets)

9 Wades Office Furniture: Historical Balance Sheet (Liabilities and Equity) Wades Office Furniture [- H I S T O R I C A L -] RMA Unaudited:, SIC # % of 2007 % of 2008 % of6/30/07 - BALANCE SHEET % Cha $ 1,000 Total% Cha $ 1,000 Total% Cha $ 1,000 Total 3/31/08 LIABILITIES & EQUITY Notes payable - bank#N/A %-9.49% %53.26% %6.0% Accounts payable#N/A %8.61% %41.19%1, %14.0% Accrued expenses#N/A2056.3%25.85%2587.5%34.88%3487.8% Income tax payable#N/A411.3%51.22%621.8%27.42%791.8%1.7% Current maturity - Term notes#N/A00.0%0.00%00.0%0.00%00.0% Current maturity - LTD#N/A752.3%0.00%752.2%0.00%751.7%3.6% Other current liabilities#N/A00.0%0.00%00.0%0.00%00.0%11.8% Current liabilities #N/A1, %4.72%1, %41.96%2, %37.1% Deferred tax liability#N/A00.0%0.00%00.0%0.00%00.0% Term notes#N/A00.0%0.00%00.0%0.00%00.0% Long-term debt (LTD)#N/A %-16.67% %-20.00%3006.7%20.1% Other noncurrent liabilities#N/A00.0%0.00%00.0%0.00%00.0%0.9% Total liabilities #N/A2, %0.44%2, %31.68%2, %58.1% Common stock - par#N/A %0.00% %0.00% % Paid-in surplus#N/A1003.1%0.00%1002.9%0.00%1002.2% Preferred stock#N/A00.0%0.00%00.0%0.00%00.0% Treasury and other equities#N/A00.0%0.00%00.0%0.00%00.0% Retained earnings#N/A3139.6%48.56% %72.90% % Stockholder's equity #N/A1, %15.00%1, %29.10%1, %41.9% Total Liabilities and Equity #N/A3, %4.96%3, %30.80%4, %

10 Ratio analysis Liquidity and activity ratios Leverage ratios Profitability ratios

11 Liquidity and activity ratios Net Working Capital = CA - CL Current Ratio = CA / CL Quick Ratio = (Cash + A/R) / CL Days Cash = Cash / Avg. daily sales Inventory Turnover = COGS / Avg. Inv. AR Collection (Days A/R) = (A/R) / Avg. daily sales Days Cash to Cash = Days Cash + Days A/R + Days inventory Days Payable Outstanding =AP / Avg. daily pur. = AP / [(COGS +  Inventory) / 365] Sales to net fixed assets = Sales / Net fixed assets

12 Wades Office Furniture: Liquidity Ratios Wades Office Furniture [- H I S T O R I C A L -] Unaudited:, SIC #2522 FINANCIAL RATIOS Credit sales$ 7,571$ 8,184$ 12,430 Liquidity Ratios Current Ratio Quick Ratio DaysTimesDaysTimesDaysTimesDaysTimes Days Cash x x x Days Accts Receivable (Turnover) x x x x Days Inventory (Turnover) x x x x Cash-to-cash asset cycle Days AP Outstanding (Turnover) x x x x Memo: COGS / Accounts payable x x x11.3x Days Cash to Cash Cycle x x x Est. W.C. financing Needs$1,417$1,320$1, $ 1,000 RMA 6/30/07 - 3/31/ $ 1, $ 1,000

13 Leverage ratios Debt Ratio = Debt / Total assets Debt to tangible net worth = Debt / Tang. NW Times interest earned = EBIT / Int. exp. where, EBIT = Earns before tax plus int. exp. Fixed Charge Coverage = (EBIT+lease pay) / (Int. exp.+ lease pay) Net Fixed Assets to Tangible NW Dividend Payout % = Dividends paid / Net profit

14 Wades Office Furniture: Leverage Ratios

15 Profitability ratios Return on Equity (ROE) = Net income / Total equity Profit before taxes to net worth = Profit before taxes / Tangible net worth Return on Assets (ROA) = Net income / Total assets Profit before taxes to total assets = Profit before taxes / Total assets Asset utilization (AU)= Sales / Total assets sometimes referred to as asset turnover Profit margin (PM) = Net income / Sales Sales growth =  Sales / Last period’s sales Income taxes to profit before taxes = Reported income tax / Profit before taxes

16 Wades Office Furniture: Profitability Ratios

17 Wades Office Furniture - Financial Ratios

18 Cash flow analysis: Cash pays a loan not net income Cash Assets Let A1 = Cash, then: Let  NW =  stock +  surplus + NI - DIV Let NI = Revenues - Expenses - Taxes

19 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

20 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: = +Revenues Expenses are a use of cash: = -Expenses Sum up each part

21 There are two types of cash flow statements 1. Direct Converts the income statement into a “cash based income statement.” Begins with net sales and adjusts for changes in balance sheet items. 2. Indirect Adjusts net income for non-cash charges and changes in balance sheet items.

22 Four sections in either cash flow statement. 1. Operations Includes income statement items and all current assets and current liabilities. 2. Investing Includes all long term assets 3. Financing Includes all long term liabilities and equity (except retained earnings) plus cash dividends paid. 4. Cash Total of the above, but must equal the actual change in cash and marketable securities.

23 Converting the income statement into a cash based income statement 1. Operating: Cash sales: + Net Sales -  Accounts receivables = Cash sales Cash purchases (negative value): - COGS -  Inventory +  Accounts payable = Cash purchases = Cash gross margin

24 Converting the income statement into a cash based income statement (continued) Operating (continued): Cash operating expenses (negative value): - Operating expenses + Non-cash charges (dep. and amortization.) -  Prepaid expenses +  Accruals = Cash operating expenses Other expenses and taxes: - Other expenses + Other income - Reported taxes +  Income tax payables and deferred inc. tax = Other expenses and taxes = Cash flow from operations (CFO)

25 Cash based income statement (cont.) 2. Investing: - Capital Exps. =  Net fixed assets + depreciation -  Other long term assets = Cash used for Investing. 3. Financing: - Payments for last periods current maturity debt - Payments for dividends = Payments for financing +  Debt + EOP CM L-T debt + New stock issues = External Financing 4. = Change in cash and marketable securities

26 Wades Cash Flow from Operations Wades Office Furniture Unaudited:, SIC # CASH BASED INCOME STATEMENT $ 1,000 Net sales 7,5718,18412,430 Change in accounts receivable#N/A(145)(497) Cash receipts from sales#N/A8,03911,933 Cost of goods sold(5,089)(5,424)(8,255) Change in inventory#N/A(45)(559) Change in accounts payable#N/A72374 Cash purchases#N/A(5,397)(8,440) Cash margin#N/A2,6423,493 Total operating expenses(1,995)(2,308)(3,390) Depreciation & amortization Change in prepaid expenses#N/A(3)35 Change in accruals#N/A5390 Change in other current assets & liab.#N/A00 Cash operating expenses#N/A(2,187)(3,192) Cash operating profit#N/A Interest on marketable securities000 Income on long term investments000 All other expenses & income (net)(63)(86)(101) Cash before interest & taxes#N/A Interest expense - Bank notes(141)(119)(157) Interest expense - Term notes and LTD000 Income taxes reported(100)(95)(188) Change in income tax payable#N/A2117 Change in deferred income taxes#N/A00 Cash flow from operations (CFO)#N/A176(128) [- H I S T O R I C A L -]

27 Wades Cash Flow Statement (investing, financing and cash Sections). Wades Office Furniture Unaudited:, SIC # CASH BASED INCOME STATEMENT $ 1,000 Cash flow from operations (CFO)#N/A176(128) Capital exp. and leasehold improvements#N/A(49)(157) Change in long-term investments#N/A00 Change in intangible assets#N/A1(11) Change in other noncurrent assets#N/A00 Cash Used for Investments #N/A(48)(168) Payment for last period's CM Term note#N/A00 Payment for last period's CMLTD#N/A(75) Dividends paid (DIV)000 Payments for financing #N/A(75) Cash before external financing#N/A53(371) Change in short-term bank debt#N/A(61)310 Change in term notes & EOP CM term notes#N/A00 Change in LT debt + EOP CMLTD#N/A00 Change in stock & surplus#N/A00 Change in preferred stock#N/A00 Change in treasury and other equities#N/A00 Change in other noncurrent liabilities#N/A00 External financing#N/A(61)310 Extraordinary exp. and cha. In acct. prin.000 Current period accounting adjustment(130)00 Change in cash & mktbl securities#N/A(8)(61) Actual change in cash #N/A(8)(61) [- H I S T O R I C A L -]

28 Projections of financial condition Pro Forma projections of the borrower’s condition reveal: How much financing is required. When the loan will be repaid. Use of the loan. Pro Forma Projections Determine critical and non critical assumptions. Use industry projections, internal projections and judgment to determine sales projections.

29 Pro Forma: Income Statement Sales 2009 = Sales 2008 x (1 + g sales ) = $12,430 x ( ) = $14,916 COGS 2009 = Sales 2009 x COGS % of Sales = $14,916 x 0.68 = $10,143 Sell. Exp 2009 = Sales 2009 x Selling Exp. % of Sales = $14,916 x 0.13 = $1,939 G&A Exp 2009 = Sales 2009 x G&A Exp. % of Sales = $14,916 x = $1,820 Int. Exp 2009 = (Bank debt 2009 x rate on bank debt) + (L.T. debt 2009 x rate on L.T. debt) = $697 x [($75 + $50 + $350 + $225) x 0.09] = $186

30 Pro Forma: Balance Sheet (Assets) Associate balance sheet items with sales. AR 2009 = Days A/R x Average Daily Sales 2009 = 50 x ($14,916 / 365) = $2,043 Inventory 2009 = COGS 2009 / Inventory turnover = $10,143 / 4.9 = $2,070 Capital expenditures from the capital budget: Gross fixed (GFA) 2009 = GFA Cap. Exp = $791 + $400 = $1,191 Accumulated depreciation 2009 =Acc. Dep depreciation exp = $346 + $110 = $973 Determine appropriate turnover rates from historical trends or industry averages.

31 Pro Forma: Balance Sheet (Liabilities) Trade credit may be tied to inventory growth, thus accounts payable tied to inventory growth: AP 2009 = Days AP x Avg. Daily purchases 2009 = Days AP x ((COGS  Inv ) / 365) = 53 x ($10,143 + ($2,070 – $1,764) / 365) = $1,517 Principal payments on debt can be obtained from the capital budget: LTD 2009 = LTD New LTD 2009 – CM LTD 2009 = $300 + $0 – $75 = $225 Term notes (TN) 2009 = TN New TN 2009 – CM TN 2009 = $0 + $400 – $50 = $350 Note: CM = Current maturity

32 Pro Forma: Balance Sheet (Equity) Balance sheet definitions: Retained earnings (RE) 2009 = RE (NI 2009 – Div ) + Acct Adjust. = $804 + ($389 – $0) + 0 = $1,193 Stock 2009 = Stock New stock issues Note: an accounting adjustment is only needed when adjustments have been made to retained earnings.

33 Pro Forma: Determining the “Plug Figure” Sales growth will determine growth in receivables, inventory and profit. Net Income varies directly with sales in a stable environment. The difference in projected asset base and total funding without new debt determines additional credit needed or the Plug figure. When Assets 2009 > (Liabilities Net worth 2009 ) → Additional financing is required (notes payable plug): Notes payable 2009 = A 2009 – (L NW 2009 ) When Assets 2009 < (Liabilities Net worth 2009 ) → Surplus cash, invest (marketable securities (plug): Mkt. securities 2009 = – (A 2009 – (L NW 2009 ))

34 Wades financial projections assumptions: Most likely circumstances, income statement 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 2009 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 No dividends are paid.

35 Wades financial projections assumptions: Most likely circumstances, balance sheet A/R collection improves to: 50 in 2009 and 46 in Inventory turnover increases to: 4.9 in 2009 and 5.1 times in Days AP outstanding remains constant at 53. Prepaid expenses increase by $5,000 Accruals increase by $20,000 annually. $400,000 is loaned to purchase new equipment, with the principal repaid in 8 equal annual installments. depreciation on the new equip. $40,000, while depreciation on old will be $70,000 per year. The minimum cash required is $120,000. Other assets remain constant at $50,000.

36 Pro forma Projections: Wades Office Furniture, Income Statement Wades Office Furniture [- H I S T O R I C A L -][-- P R O F O R M A --] Unaudited:, SIC # % of 2009 % of 2010 % of INCOME STATEMENT % Cha $ 1,000 Total% Cha $ 1,000 Total% Cha $ 1,000 Total Net sales 51.88%12, %20.00%14, %20.00%17, % Cost of goods sold52.19%8, %22.87%10, %20.00%12, % Gross profit51.27%4, %14.33%4, %20.00%5, % Selling expenses58.67%1, %19.11%1, %20.00%2, % Management salaries0.00%00.0%0.00%00.0%0.00%00.0% General & administrative expenses39.47%1, %7.74%1, %20.00%2, % Research and development expenses0.00%00.0%0.00%00.0%0.00%00.0% Depreciation & amortization2.82%730.6%50.68%1100.7%0.00%1100.6% Other operating expenses0.00%00.0%0.00%00.0%0.00%00.0% Total operating expenses46.88%3, %14.12%3, %19.43%4, % Operating profit73.67%7856.3%15.20%9046.1%22.43%1,1076.2% Interest on marketable securities0.00%00.0%0.00%00.0%0.00%00.0% Income on long term investments0.00%00.0%0.00%00.0%0.00%00.0% Interest expense - Bank Notes31.93%1571.3%-35.62%1010.7%-48.49%520.3% Interest expense - Term notes + LTD0.00%00.0%#N/A850.6%-16.47%710.4% All other expenses17.44%1010.8%8.91%1100.7%22.73%1350.8% All other income0.00%00.0%0.00%00.0%0.00%00.0% Total All Other Income (Expenses)25.85%(258)-2.1%14.76%(296)-2.0%-12.84%(258)-1.4% Profit before taxes113.36%5274.2%15.41%6084.1%39.60%8494.7% Income taxes97.89%1881.5%16.46%2191.5%39.60%3061.7% Extraordinary and other income (exp.)0.00%00.0%0.00%00.0%0.00%00.0% Net income123.0%3392.7%14.8%3892.6%39.6%5433.0% Dividends0.00%00.0%0.00%00.0%0.00%00.0% Retained earnings123.03%3392.7%14.82%3892.6%39.60%5433.0%

37 Pro forma Projections: Wades Office Furniture Balance Sheet (Assets)

38 Pro forma Projections: Wades Balance Sheet (Liabilities and Equities)

39 Pro forma Projections: Wades Office Furniture Liquidity and Leverage Ratios Wades Office Furniture [- H I S T O R I C A L -][-- P R O F O R M A --] Unaudited:, SIC #2522 FINANCIAL RATIOS Credit sales$ 12,430$ 14,916$ 17,899 Liquidity Ratios Current Ratio Quick Ratio DaysTimesDaysTimesDaysTimes Days Cash x x x Days Accts Receivable (Turnover) x x x Days Inventory (Turnover) x x x Cash-to-cash asset cycle Days AP Outstanding (Turnover) x x x Memo: COGS / Accounts payable x x x Days Cash to Cash Cycle x x x Est. W.C. financing Needs$1,870$2,068$2,235 Leverage Ratios Debt to Tangible Net Worth2.05x1.84x1.37x Times Interest Earned4.36x4.27x7.90x Fixed Charge Coverage2.09x2.19x2.89x Net Fixed Assets to Tangible Net Worth46.97%52.79%36.16% Dividend Payout0.00% 2009 $ 1, $ 1, $ 1,000

40 Pro forma Projections: Wades Profitability, Cash Flow and Growth Ratios Wades Office Furniture [- H I S T O R I C A L -][-- P R O F O R M A --] Unaudited:, SIC #2522 FINANCIAL RATIOS Profitability Ratios Return on Net Worth (ROE)22.54%20.56%22.30% Profit Before Taxes to Net Worth36.24%33.00%35.58% Return on Assets (ROA)7.57%7.38%9.53% Profit Before Taxes to Total Assets11.76%11.53%14.90% Equity multiplier (leverage = TA / TE)2.98x2.79x2.34x Income Tot. asset turnover (net sales / TA)2.77x2.83x3.14x All other income / total assets0.00% Expenses Net profit margin (NI / net sales)2.73%2.61%3.04% COGS / net sales66.41%68.00% Operating expenses / net sales27.27%25.94%25.81% Income Taxes to Earnings Before Taxes35.67%36.00% Sales / Net Fixed Assets18.20x15.33x20.74x Cash Flow Ratios CFO / (DIV + last CMLTD) CFO / (DIV + last CMLTD + bnk notes) CFO / (DIV + last CMLTD & CM Term + bnk Notes) Growth Rates Sales Growth (annualized)51.88%20.00% Cost of Goods Sold52.19%22.87%20.00% Net Income123.03%14.82%39.60% Total borrowed debt-20.00%#N/A-47.62% Total Assets30.80%17.77%8.04% 2009 $ 1, $ 1, $ 1,000

41 Pro forma projections: Wades Cash Based Income Statement (operations) Wades Office Furniture Unaudited:, SIC # CASH BASED INCOME STATEMENT $ 1,000 Net sales 12,43014,91617,899 Change in accounts receivable(497)(147)(213) Cash receipts from sales11,93314,76917,687 Cost of goods sold(8,255)(10,143)(12,171) Change in inventory(559)(306)(317) Change in accounts payable Cash purchases(8,440)(10,214)(12,192) Cash margin3,4934,5555,495 Total operating expenses(3,390)(3,869)(4,621) Depreciation & amortization73110 Change in prepaid expenses35(5) Change in accruals9020 Change in other current assets & liab.000 Cash operating expenses(3,192)(3,744)(4,496) Cash operating profit Interest on marketable securities000 Income on long term investments000 All other expenses & income (net)(101)(110)(135) Cash before interest & taxes Interest expense - Bank notes(157)(101)(52) Interest expense - Term notes and LTD0(85)(71) Income taxes reported(188)(219)(306) Change in income tax payable Change in deferred income taxes000 Cash flow from operations (CFO)(128) [-- P R O F O R M A --] [- H I S T O R I C A L -]

42 Pro forma Projections: Wades Cash Based Income Statement (investment, financing and cash) Wades Office Furniture Unaudited:, SIC # CASH BASED INCOME STATEMENT $ 1,000 Cash flow from operations (CFO)(128) Capital exp. and leasehold improvements(157)(400)0 Change in long-term investments000 Change in intangible assets(11)00 Change in other noncurrent assets000 Cash Used for Investments (168)(400)0 Payment for last period's CM Term note00(50) Payment for last period's CMLTD(75) Dividends paid (DIV)000 Payments for financing (75) (125) Cash before external financing(371)(157)338 Change in short-term bank debt310(195)(338) Change in term notes & EOP CM term notes04000 Change in LT debt + EOP CMLTD000 Change in stock & surplus000 Change in preferred stock000 Change in treasury and other equities000 Change in other noncurrent liabilities000 External financing310205(338) Extraordinary exp. and cha. In acct. prin.000 Current period accounting adjustment000 Change in cash & mktbl securities(61)480 Actual change in cash (61)480 [-- P R O F O R M A --] [- H I S T O R I C A L -]


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