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Credit Risks in Working Capital and Equipment Loans Alexandru Cebotari.

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Presentation on theme: "Credit Risks in Working Capital and Equipment Loans Alexandru Cebotari."— Presentation transcript:

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: 1.Maintain working capital 2.Maintain productive assets 3.Meet debt service in schedule 4.Pay reasonable dividents 5.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.

3 Evaluating Historical Performance Income Statement Profitability? Return on Equity? Non- Current Assets Sources and Uses of Funds Long-Term Debt Equity Chang e in W/C Current Assets Current Liabilities Volum e Liquidit y Needs Servicin g Current Creditor Commit- ments Deficiency? Reserve? Long-Term Creditor Commit- ments Deficiency? Reserve? Evaluating Business Plans Manage- ment Ability Funds Adequac y Environ- mental Codition s Operatin g Practice s

4 Role of Working Capital Current AssetsCurrent Liabilities Short-Term Creditors’ Commitments W/C Non-Current Assets Long-Term Debt Equity Long-Term Creditors’ Commitments W/C

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

6 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

7 Cash Cycle Illustration Companies ABC 1. Sales rate per day$1M 2. Days sales in receivables Days sales in inventory Days in trading cycle Days sales in payables Days sales of working capital required Receivable investment (1x2)$30M$60M$15M 8. Inventory investment (1x3)60M90M0 9. Trading cycle investment (1x4)90M150M15M 10. Payable support (1x5)- 45M-30M- 15M 11. Required working capital support45M120M0 12. Current ratio relationship (9/10)2x5x1x

8 Cash Flow Quality Qualitative aspectHigh qualityLow quality Inventory valuationLIFO understates profits in inflationary period FIFO overstates profits in inflationary period Depriciation methodAccelerated depreciation more accurately matches replecement cost Straight-line depreciation under- reserves funds for fixed assets: thus, it overstates earnings Deferred assetsIntangibles are written off as quickly as possible Expenses are capitalized and earnings are overstated Deferred incomeIncome 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

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?

10 Overtrading? There are four elements of risk associated with overtrading: 1.Serious deplition of profit; 2.Organization failure associated with high volume; 3.Receivables losses; and 4.Inventory risks Rule of thumb: current assets should cover total debt at the seasonal low

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?

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 Target Payout Ratio Profit Margin 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 Assets at the beginning of year New assets needed to support increased sales Liabilities and owners’ Equity at beginning of year Additions to liabilities Additions to Retained Earnings Δs(t) p(s+Δs)(1-d)L p(s+Δs)(1-d)

14 Example: Sustainable Growth Rate in Loan Appraisal 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 Sales$1,375,000 Profit after tax$82,500 Dividents$8,250 Current assets$700,000Current liabilities$400,000 Net fixed assets$950,000Bank loan$500,000 Total assets$1,650,000Owners’ equity$750,000 Total$1,650,000 p =.06, L = 1.20, t = 1.20 d =.10

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 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

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


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