The Bank’s Perspective

The Bank’s Perspective
The purpose of this session is to introduce and explain commercial banking, in order to be better able to prepare project finance applications that are likely to be accepted by banks. This will be introduced by a senior representative from the local banking sector. NB: introduce the banker to the course, unless he/she has already arrived earlier at the course and been introduced. The banker may have his/her own material which they would prefer to use to support their presentation. The following slides are provided:- - to indicate the main points to be covered - to provide support for the instructor in case for any reason there is no banker at this point in a run of the course. The session will cover:- - the profile and purpose of commercial banking - the options (i.e. different financial ‘products’) which commercial banks usually offer - the application and approval procedure for bank loans - relevant current trends in commercial banking

Commercial banks: Purposes and profile (1)
Transfer funds from ultimate lenders to ultimate borrowers Acquire funds by receiving money from savers: savings accounts, deposit accounts, etc. Provide funds to borrowers through term loans, lines of credit, bonds, etc. A commercial bank provides a kind of marketplace within which, indirectly, savers who wish to invest their money safely but still earn a return on it can transfer it to borrowers who wish to raise finance, e.g. for firm projects. The bank is rewarded for providing this service through the profit margin that it realises between:- - the low rate of interest that it pays to savers - the higher rate that it charges to borrowers In principle this could be achieved by the savers lending their money directly to borrowers. This would avoid the costs of operating the bank, and the bank’s profit margin. However banks add value to the process in several ways:- - scale: they can combine several small savings accounts and deposits into a larger sum, sufficient to finance a firm project - duration: they are able to raise money from savers on short-term terms, so that savers retain liquidity, but make advances to borrowers on long-term terms - location: by raising money from areas or countries where savers exceed borrowers and transferring it to areas/countries where the opposite is the case - developing expertise in assessing risks by specialising in this skill

Commercial banks: Purposes and profile (2)
Commercial banks aim to: Maximise their returns Minimise the risks they accept Expertise in evaluating borrower credit-worthiness Competition between commercial banks helps to keep down lending rates Banks’ key concern is risk - if they consider that a particular firm is more risky than the average, they may:- - add a risk premium to their lending rate and increase the cost of the loan to the firm - insist on restrictions on the loan, for example to require security such as a mortgage on some of the firm’s assets, to provide collateral If their assessment of risk is too high, they may refuse a loan altogether. Banks therefore become expert in assessing the risks of firms, and any possible extra risk posed by a proposed new project. Firms can increase their chances of success in loan applications by providing assurance to banks that they represent only low risks. In economies where several banks compete with each other, the rates charged will tend to be lower since the banks have to compete with each other for borrowers (as well as for savers), though a basic minimum will be set by the base rate set by the government or the central bank. Banks may differ in their evaluations of risk and their readiness to accept greater risk in return for charging a higher interest rate, so firms should be ready to approach several banks to find the best offer available.

Project finance from banks: the main options
Term loans: Related to specific projects Specific amount and term Rate will reflect risk Rate may be fixed over time or variable Lines of credit: Limited amounts Flexible in use Higher interest rates Interest charged only on finance actually used These are the two main ways that banks provide finance to small and medium-sized firms, i.e. the banks’ “products”. A term loan is for a specific period, and must be fully repaid by the end of the period. This may be either a single amount at the end, or (more usually) in instalments over the period of the loan. The interest rate is set when the loan is agreed, either at a definite rate throughout the period of the loan, or variable on a pre-defined basis such as in relation to the national base rates set by government or the central bank. Lines of credit (or “overdrafts”) are facilities by which firms can “draw down” as much as they need, up to a set limit, and pay for only what they use. The interest rate is usually higher than for term loans. Although they may be guaranteed for a set period, they can often be repayable on demand by the bank, so are not suitable for firms who wish to finance large-scale projects that require capital for a long period. Generally, term loans are likely to be more suitable to finance investment in fixed assets, whereas lines of credit are suitable for financing investments in short-term working capital (inventories, debtors etc.) which may fluctuate seasonally over time.

Loan application and approval procedure (1)
1. Research and review potential sources 2. Initial informal discussions with bank loan officer 3. Fill out bank’s loan application form; obtain all necessary data 4. Submit to bank the loan application and supporting documents These are the main steps in a typical loan application and approval process, although the details will differ between different banks, and perhaps between different types of project. [The list of steps continues onto the next slide as well]. It is valuable already to have a good working relationship with a bank, and previous personal contacts with their senior staff, in order to build up an impression of business ability and financial reliability. The first bank to approach will obviously therefore be the firm’s main banker, with whom it keeps its current account. At the same time however, it is sensible to approach other banks as well, in economies where there is sufficient competition in the banking sector to make this possible. If each bank is aware that the firm is considering a number of different banks, this will help to encourage them to make attractive their own offer to the firm.

Loan application and approval procedure (2)
5. Review of application by bank 6. Negotiate specific terms of loan 7. Bank sends commitment letter 8. Bank sends a “term sheet” which defines the specific lending terms 9. Sign the loan agreement 10. Receive the funds 11. Proceed to implement project This continues the list which was started on the previous slide.

Bank will usually require...
Procedural completed loan application forms additional documentation as required, e.g. the firm’s accounts Financial acceptable repayment plan proven economic viability (of both project and firm) collateral (i.e. security such as mortgage) There are two types of requirement that banks make on firms applying for finance:- - procedural, e.g. completing application forms correctly and providing further information promptly and in the required format - financial - the main substance of the bank’s evaluation, by which the bank assesses risk and can assure itself that its capital and interest will be repaid in due course

Banks’ information needs
To assess loan applications, banks need information on : 1- Economic viability of the specific project 2- The firm’s overall financial and economic situation 3- The general economic and political background of the country and sector This slide lists the three main areas in which a bank needs information in order to evaluate an application for project finance. The most important area is the overall financial and economic situation of the specific firm, but it will also require information on:- - the specific project, and how this relates to the firm’s existing business and future plans - general background information on economic and political aspects of the country, and on the industry sector as a whole. (Banks may be able to provide some of this themselves, from their own information systems, though firms are well advised to be ready to provide it themselves, as well).

1- Economic viability of the specific project 2- The firm’s overall financial and economic situation 3- The general economic and political background of the country and sector By the end of the day, participants are probably a little tired and ready to rest. But it is important to at least run through the major points covered today. This will help participants put things into the bigger perspective, and to prepare for tomorrow.

Information on the project
Purpose of the loan Expected cash flows from project Expected profitability of project (NPV, IRR...) Assessment of risks of project How project relates to the firm’s business generally This slide lists some of the main items of project-specific information that the firm should be ready to provide to the bank. Net Present Value (NPV) is the main indicator of a project’s profitability, though the firm should also calculate other indicators such as Internal Rate of Return (IRR) and the Payback Period. Possible risk items include both:- - factors specific to the project, e.g. how the project’s profitability might be affected if sales forecasts are less good than originally predicted, by different amounts (e.g. 5%, 10%, 15%, etc.) - external factors, either economic (e.g. what might happen if the national economy were to go into recession), r political (e.g. if strikes in the transport industry made it difficult to distribute its goods). As well as information on the project itself, the bank will expect the firm to be able to explain how this project fits with the rest of its business, and how it contributes to the firm’s overall strategy.

Purpose of the loan: to demonstrate:
How will the CP Investment produce the perceived... cost reductions and increase in revenue? sales and production levels increase? reduced risks? Reduce energy use Reduce material input costs Reduce penalty fees Increase in sales and production and establish increase in demand Improve product quality Environmental compliance and regulation costs

Cash flow forecast/projection
Look at the likely future cash position of the company. Examine the possible effects of changes in the cash flow components.

Profitability analysis: Profitability indicators
A profitability indicator, or “financial indicator”, is: “a single number that is calculated for characterisation of project profitability in a concise, understandable form.” Common examples are: Simple payback period Return on investment (ROI) Net present value (NPV) Internal rate of return (IRR) Now for the profitability calculations. This is a list of four that will be covered today. We will get started with Simple Payback before lunch.

Assessment of risks: Sensitivity analysis
What could go wrong with the plans for the project? What will be the effect on NPV if different assumptions are made re sales demand, costs, length of project life, etc.? The main tool for assessing the economic viability of the project is Net Present Value, and sensitivity analyses which are based on this. A “sensitivity analysis” of this project would take each element that has gone into the NPV calculation (each type of expected cost savings and increased revenues); and calculate by how much the amounts realised for each item could be lower than the predictions that have been assumed in the NPV calculation, before the project is no longer worthwhile. If a particular item could deteriorate by only a small percentage before the NPV of the project becomes zero, then the project is said to be very sensitive to this factor. This provides an indication of the project’s risk exposure to different elements in its environment.0

Concern about the financial facts of a business includes:
Organization's ability to meet current obligations The nature of liabilities The company’s ability to stand pressure from both internal and external sources The true worth of the various assets of the business (accurate picture)

The bank’s information needs
To demonstrate a company’s credit-worthiness, bank will require: past financial statements (balance sheets, income statements, etc.) forecast future financial statements past credit history and references information on the firm’s management This slide lists some of the main items of information that the firm should be ready to provide to the bank to evidence its overall credit-worthiness. Past financial statements (i.e. the firm’s ‘annual report’, or ‘accounts’) should be audited or at least reviewed by an independent accountant, with a ‘clean’ report from them. They should be up-to-date. Forecast future financial statements should make clear the forecasts and assumptions on which they depend. Any evidence that the firm can provide on its past credit-worthiness will help to reassure the bank. This evidence may include references from credit-rating agencies and from other banks that the firm has dealt with in the past. Information on the firm’s management should include:- - who they are, and their personal backgrounds and skills - the organisation structure : each person’s responsibilities, and who reports to whom

Business plan: Objectives
To show to outsiders to help to raise money To use within the business As a guide to future action To control the firm by using the business plan as a benchmark against which to compare performance A business plan is essential to any firm in any case, but especially when it wants to raise finance. All significant sources of finance will require that the firm can provide a business plan. The importance of a good business plan to financiers is not just in the forecasts it makes, but also as evidence of the quality of the firm’s management - that it understands its business, that it is able to make realistic plans for the future, and that it is able to implement them. The business plan is then also available to be used in managing the firm:- - to guide its management and staff in what they are expected to do - to anticipate possible problems (e.g. cash deficits, or falls in sales) and take action to deal with them at an early stage - to provide a standard, or benchmark, against which actual performance can be measured. This can help to identify when things start to go not to plan, so that they can be investigated and corrective action can be taken. Some firms prepare business plans only when they are needed by outsiders such as banks, but it is preferable to make this a regular part of the firm’s management processes (usually done annually).

Business plan: content
past and forecast future financial statements brief overview of business markets, customers and competitors products and services distribution management sales forecasts how the firm is to be financed This slide lists the main elements in a Business Plan. The degree of detail which is appropriate will depend on the size and complexity of the business, and the bank which is being applied to may be able to give some guidance on the length and depth that they expect. Banks will be particularly insistent on receiving a business plan when a firm is first set up, or it is the first time when it has approached the bank. As the relationship between the firm and the bank develops and becomes stronger, the bank will be able increasingly to rely on its own records so that this type of comprehensive overview may no longer be required regularly, and it is in the firm’s interest to make sure that the bank is fully aware of its up-to-date position, and any significant changes in its business should be advised to the bank. However even if it is not required by the bank and the firm has no plans to apply for new finance in the near future, the process of generating a business plan can still be valuable for its own management and can provide a valuable management tool.

Information: what makes it useful
relevance reliability consistency completeness comparability timeliness understandability materiality feasibility and cost-effectiveness This slide provides a check-list of the desirable characteristics of any information, for firms to refer to when providing information to banks. It is based on guidelines developed by the accounting profession to guide accountants when preparing firms’ financial statements. However the practical problem is that it is usually not possible to achieve at the same time all of these characteristics, so that choices (‘trade-offs’) must be made. For example, it may sometimes be preferable to provide information quickly even if this means that it has to be partly based on estimates and there has not yet been time to fully check it, and it is not yet complete: i.e. to give priority to timeliness rather than to reliability and completeness. For other types of information, on other occasions, it may be better to delay providing information until it can be proved to be reliable and complete, e.g. through a proper audit. It is not possible to set any firm rules for this which would cover all situations. The firm should assess what the particular situation requires and which characteristics are most important, and prepare and provide information accordingly using the above as a checklist.

Interpretation of financial statements
RATIO ANALYSIS Is useful to virtually all readers of financial accounting statements. Ratios are like a thermometer which takes the actual temperature of a business in relation to some standard measure. Ratio analysis can help to identify problem areas but in itself cannot offer solutions: these must be provided by the businessman.

Ratio Analysis For financial analysis purposes, it is useful to classify ratios under five headings: Profitability ratios which measure the overall effectiveness of managers as shown by the returns generated on sales and investments. Liquidity ratios which judge whether a business is likely to run out of cash in the short term.

Solvency ratios which measure the extent to which a business is financed by borrowed money and the risk involved. Activity ratios which measure how effectively the business is using its resources. Growth ratios which measures the business’s past rate of growth and assess the potential for future growth.

Profitability Ratios key question: at what rate does the business generate profit from its activities? Test 1: What is the proportion of direct trading profit contributed by every dollar worth of sales? Test 2: What is the amount of profit generated out of every dollar invested in the company? ‘Liquidity’ is the firm’s ability to meet its short-term obligations as they fall due, such as payments to suppliers of raw materials or other services. These have to be paid in the short-term, in cash, so the bank will review how adequate are the firm’s short-term assets, in relation to its short-term liabilities. There are two main tests of whether a firm has adequate liquidity:- - how adequate are its short-term assets, in relation to its short-term liabilities? (Long-term assets such as property or machinery do not help liquidity, since they cannot usually be turned into cash quickly, at least not without damaging the firm’s ability to carry on its activities) - how adequate are its regular net cash inflows, from trading? - will these be sufficient to meet its short-term liabilities? It is not only loss-making firms who can run into problems with liquidity. firms which try to expand too quickly can also have this problem, since expansion usually requires cash to be spent on more fixed assets and working capital, before it starts to generate any extra profits. So can companies with lax controls over working capital (e.g. those who fail to collect promptly collect debts owed by customers).

Profitability Ratios Examples
Test 1: Gross Profit percentage on sales : = Test 2: Return on Capital employed : Gross Profit Gross Sales Profit before interest & Tax ‘Liquidity’ is the firm’s ability to meet its short-term obligations as they fall due, such as payments to suppliers of raw materials or other services. These have to be paid in the short-term, in cash, so the bank will review how adequate are the firm’s short-term assets, in relation to its short-term liabilities. There are two main tests of whether a firm has adequate liquidity:- - how adequate are its short-term assets, in relation to its short-term liabilities? (Long-term assets such as property or machinery do not help liquidity, since they cannot usually be turned into cash quickly, at least not without damaging the firm’s ability to carry on its activities) - how adequate are its regular net cash inflows, from trading? - will these be sufficient to meet its short-term liabilities? It is not only loss-making firms who can run into problems with liquidity. firms which try to expand too quickly can also have this problem, since expansion usually requires cash to be spent on more fixed assets and working capital, before it starts to generate any extra profits. So can companies with lax controls over working capital (e.g. those who fail to collect promptly collect debts owed by customers). Capital employed

Liquidity Ratios definition: ability to meet short-
term operating liabilities key question: how much is the total of the firm’s short-term liabilities? Test 1: are the liquid (short-term) assets sufficient to cover adequately these short-term liabilities? Test 2: are the regular operating cash inflows adequate to cover short-term liabilities, as they fall due for payment? ‘Liquidity’ is the firm’s ability to meet its short-term obligations as they fall due, such as payments to suppliers of raw materials or other services. These have to be paid in the short-term, in cash, so the bank will review how adequate are the firm’s short-term assets, in relation to its short-term liabilities. There are two main tests of whether a firm has adequate liquidity:- - how adequate are its short-term assets, in relation to its short-term liabilities? (Long-term assets such as property or machinery do not help liquidity, since they cannot usually be turned into cash quickly, at least not without damaging the firm’s ability to carry on its activities) - how adequate are its regular net cash inflows, from trading? - will these be sufficient to meet its short-term liabilities? It is not only loss-making firms who can run into problems with liquidity. firms which try to expand too quickly can also have this problem, since expansion usually requires cash to be spent on more fixed assets and working capital, before it starts to generate any extra profits. So can companies with lax controls over working capital (e.g. those who fail to collect promptly collect debts owed by customers).

Liquidity Ratios Examples
Test 1: Current Ratio : = Test 2: Acid test quick ratio : Current Assets Current Liabilities ‘Liquidity’ is the firm’s ability to meet its short-term obligations as they fall due, such as payments to suppliers of raw materials or other services. These have to be paid in the short-term, in cash, so the bank will review how adequate are the firm’s short-term assets, in relation to its short-term liabilities. There are two main tests of whether a firm has adequate liquidity:- - how adequate are its short-term assets, in relation to its short-term liabilities? (Long-term assets such as property or machinery do not help liquidity, since they cannot usually be turned into cash quickly, at least not without damaging the firm’s ability to carry on its activities) - how adequate are its regular net cash inflows, from trading? - will these be sufficient to meet its short-term liabilities? It is not only loss-making firms who can run into problems with liquidity. firms which try to expand too quickly can also have this problem, since expansion usually requires cash to be spent on more fixed assets and working capital, before it starts to generate any extra profits. So can companies with lax controls over working capital (e.g. those who fail to collect promptly collect debts owed by customers). Current Assets - Stock Current Liabilities The acceptable ratios depend upon the type of industry in which a company operates.

Solvency Ratios Test 2: are operating profits adequate
definition: ability to meet long-term liabilities such as debt key question: how much is the total of the firm’s indebtedness? Test 1: what are the relative proportions of (1) equity, and (2) debt? [“gearing”, or “leverage”] Test 2: are operating profits adequate to cover the interest that has to be paid regularly on the debt? ‘Solvency’ is the firm’s ability to meet long-term obligations as they fall due, such as repaying debt (long-term borrowings) on the dates that were agreed in the loan contract. The relative proportions of debt and equity are sometimes called the firm’s ‘gearing’, or ‘leverage’. A firm which has a high level of gearing, i.e. it has borrowed a high proportion of its capital rather than raising it by issuing more shares, may be seen by banks as risky and therefore find it difficult to borrow any more. There are two aspects to a firm’s solvency:- - the relative proportions of debt and equity, i.e. its ‘gearing’ or ‘leverage’. - its ability to pay the interest which it has agreed to pay to its lenders, on the agreed dates. Borrowing money to finance expansion is justified, but only up to a point. Debt has to be repaid on dates which are fixed in advance, and until then the interest on it has to be paid promptly. If this is not done, the lenders can sue the firm and in the worst case may close the firm down and sell off its assets in order to pay themselves what they are owed.

Solvency Ratios Examples
Test 1: Debt ratio : = Test 2: Times Interest earned : Total Debt Total assets ‘Solvency’ is the firm’s ability to meet long-term obligations as they fall due, such as repaying debt (long-term borrowings) on the dates that were agreed in the loan contract. The relative proportions of debt and equity are sometimes called the firm’s ‘gearing’, or ‘leverage’. A firm which has a high level of gearing, i.e. it has borrowed a high proportion of its capital rather than raising it by issuing more shares, may be seen by banks as risky and therefore find it difficult to borrow any more. There are two aspects to a firm’s solvency:- - the relative proportions of debt and equity, i.e. its ‘gearing’ or ‘leverage’. - its ability to pay the interest which it has agreed to pay to its lenders, on the agreed dates. Borrowing money to finance expansion is justified, but only up to a point. Debt has to be repaid on dates which are fixed in advance, and until then the interest on it has to be paid promptly. If this is not done, the lenders can sue the firm and in the worst case may close the firm down and sell off its assets in order to pay themselves what they are owed. Earnings Before Interest & Taxes Interest charges

Activity Ratios Key question: How effectively does the firm use its resources? Test 1: What is the turnover of stocks? Test 2: What is the quality of debtors and credit policies of the business? How many day’s sales represented by debtors? ‘Solvency’ is the firm’s ability to meet long-term obligations as they fall due, such as repaying debt (long-term borrowings) on the dates that were agreed in the loan contract. The relative proportions of debt and equity are sometimes called the firm’s ‘gearing’, or ‘leverage’. A firm which has a high level of gearing, i.e. it has borrowed a high proportion of its capital rather than raising it by issuing more shares, may be seen by banks as risky and therefore find it difficult to borrow any more. There are two aspects to a firm’s solvency:- - the relative proportions of debt and equity, i.e. its ‘gearing’ or ‘leverage’. - its ability to pay the interest which it has agreed to pay to its lenders, on the agreed dates. Borrowing money to finance expansion is justified, but only up to a point. Debt has to be repaid on dates which are fixed in advance, and until then the interest on it has to be paid promptly. If this is not done, the lenders can sue the firm and in the worst case may close the firm down and sell off its assets in order to pay themselves what they are owed.

Activity Ratios Examples
Test 1: Stock Turnover Ratio : = Test 2: Debtors Turnover Ratio : Sales revenue Stocks (at period end) Debtors (Balance sheet) ‘Solvency’ is the firm’s ability to meet long-term obligations as they fall due, such as repaying debt (long-term borrowings) on the dates that were agreed in the loan contract. The relative proportions of debt and equity are sometimes called the firm’s ‘gearing’, or ‘leverage’. A firm which has a high level of gearing, i.e. it has borrowed a high proportion of its capital rather than raising it by issuing more shares, may be seen by banks as risky and therefore find it difficult to borrow any more. There are two aspects to a firm’s solvency:- - the relative proportions of debt and equity, i.e. its ‘gearing’ or ‘leverage’. - its ability to pay the interest which it has agreed to pay to its lenders, on the agreed dates. Borrowing money to finance expansion is justified, but only up to a point. Debt has to be repaid on dates which are fixed in advance, and until then the interest on it has to be paid promptly. If this is not done, the lenders can sue the firm and in the worst case may close the firm down and sell off its assets in order to pay themselves what they are owed. Average Daily Sales Sales as per income statement Average Daily Sales = Days (365)

Limitation of Ratios (A) differences found among the accounting methods used by various companies, which make comparisons difficult even when talking about the same industry (B) financial statements are based upon past performance and past events, we must project our evaluation from this basis

Conclusion Though with limitations, ratios still provide guides and clues in spotting trends towards better or poor performance and in finding significant deviations from average or an acceptable standard, if any is available. It is in the interpretation of such trends and deviations that the analyst will use his skills and experience to determine what is likely to happen in the organization.

General economic background
National and world economy: - forecasts of economic growth - forecasts of inflation - political or economic instability Sector-specific background: - developing new technologies - changes in product markets - new legislation and regulation - level of competition in the sector The general economic background will be relevant to any application for project finance - when an economy is in a slump or recession, all would-be borrowers will find it more difficult to raise finance, even for good projects. How much these factors matter, for any particular firm or project, will depend on how vulnerable the firm or project is to them, so this should be linked to the risk assessment. Similarly, the bank will want to research the current background in the firm’s sector and assess whether this is likely to be a good sector to be operating in. Banks may be able to provide a lot of this information for themselves, since they will usually have well-staffed economics departments which monitor the wider economy, and may already be familiar with the firm’s sector if they already have other customers in this sector. However a firm which is seeking finance will be well-advised to anticipate this and obtain the information for itself, in order that it can be ready to answer any questions which the bank’s lending officers may raise.

Conclusions (1) Banks have specific demands for
information due to their loan application/approval procedures Most information should be provided by applicants Banks will maintain some data themselves (e.g. general economic data) This slide (and the following two slides) summarises the main points made in the session. Firms are advised to try to understand the bank’s perspective and develop a good personal relationship with their bankers. A part of this is to anticipate the information that the bank is likely to find useful, and set up its own systems in advance by which this can be collected and provided at the time it is needed. Even where banks may be expected to collect their own data, for example macro-economic data, firms are advised also to monitor this themselves, since the reason that banks are interested in it is precisely because it is relevant for their firm-borrowers’ businesses. Banks can sometimes also be a valuable source of information and advice to the firms that they deal with, since they may also be dealing with several other firms in the same sector. This means that they can be in a position to gather the same data on several different firms which can then be used to make comparisons, and benchmark to establish what is best practice.

Conclusions (2) banks obtain information on firms through: the application forms and supporting documents submitted by the firms face-to-face contacts and visits to the firm the history of the bank’s relationship with the customer post-funding control enhances the relationship and facilitates future borrowing The first bullet-point lists the different channels though which banks will draw their information. Emphasise that this is not limited to only ‘hard’ information through formal channels such as written documents, but also ‘soft’ information which they will obtain through meetings with the firm’s management and staff, and visits to the firm to help them to understand its activities. Firms are advised to be proactive here, and voluntarily to offer to the bank information on developments in their businesses before the bank asks for it, to help to develop a long-term understanding. A major influence on the success of future loan applications will be how the firm has managed earlier loans; for example:- - are the funds which the bank provides invested promptly, for the purposes as set out in the application and agreed by the bank? - have all payments of interest and repayments of capital been made promptly and without problem on the due dates? - has the firm regularly and promptly provided further information to the bank as agreed whilst the loan is outstanding, for example copies of its audited financial statements? - has the firm carried out a review to see how far the project has gone according to plan, and achieved is original aims?

Conclusions (3) Firms should set up and maintain adequate information systems:- Before They are needed ! A frequent problem when firms apply to banks for finance is that they may not be able to provide all the information that the bank requires, to the required quality. This is both a problem in itself since it can slow down the application/approval process, or even be sufficient for it to fail, and because the bank might interpret this as weakness by the firm and a failure to plan ahead. Often it is difficult or impossible to collect data retrospectively, and the best that can be done is estimation. This could be avoided if the firm sets up in advance adequate information systems to capture and collect the data that is relevant to its business, even if it does not see a need for this immediately. These should include the usual financial accounting systems but extend beyond this to include data on other factors which is relevant to the firm’s business:- - other internal data, e.g. production records, staff-related records such as staff turnover, sickness, etc. - relevant external data such as on the firm’s markets and customers, changes in technology that could affect the firm’s business, etc.

Group exercise - Acme: Part 1 Preparing a ‘bankable’ proposal
Read the Acme case overnight, it is detailed in your handout Tomorrow morning you will be working in a small group with others The task will be to develop a proposal to a bank for finance for acme’s project Your group will present this to the banker Plan ahead - what points to include? Shortly before closing the course at the end of Day 1, encourage participants to prepare themselves for the main activity of the course, on the following morning. The time available to work in the groups is limited and is best used for discussing and preparing the proposal - there is not sufficient time at this stage to read the case for the first time. Participants will be able to get much more benefit from this activity if they have been able to find the time to read the case beforehand.

Developing a Bankable Proposal: Acme Electroplaters Part 1
See separate “Additional Notes - Developing a Bankable Proposal” in the Instructors Guidance Notes section. The next two slides are provided in order to get participants oriented in the right direction before going to work in their groups, by setting out in advance:- - what is required from each team, in terms of outputs from the task - the criteria by which the results of their work will be assessed.

Group exercise - Acme: Part 1 The task
1. Prepare presentation to a bank making the case for finance for Acme’s project 2. Complete the standard application bank loan application form, located in your handout 3. Anticipate possible questions from the banker This slide summarises what is required from each team. When making their presentations, participants will be taking the role of the directors of Acme if they were presenting their proposal to a banker in a meeting. This will include being ready to answer questions from the banker on points arising from the presentation. The banker should aim to ask 2-3 questions to each team immediately following their presentation, preferably directed to members of the team other than the person(s) who did its presentation, in order to involve as many people as possible. The presentations should be based on write-on acetates or flip-chart sheets (depending on what is available) which are prepared by the team. The standard loan application form provides a basic set of required information, which can be obtained from the case study, but this is mainly only a ‘hygiene factor’ - necessary but not sufficient. What will determine the success of an application is the strength of the case that the firm’s management can make for the firm as a whole, and the specific project and the management’s competence to manage it.

Group exercise - Acme: Part 1 Criteria for success
firm’s current financial position history of firm the project’s expected returns and risks availability of relevant information firm’s ability to implement the project This slide identifies some of the main criteria that banks will usually look for when evaluating applications for project finance. However, what the bank wants will vary from project to project, and it is not possible to generalise absolutely. These items are set out, with further detail and explanations, in a separate handout for participants. There is data in the Acme case study on most of these points, although there may be some aspects on which there is no data,or it is only partial (for example, the past personal financial histories of the firm’s owners). Here, it is sufficient for participants to indicate that they have at least considered these points, and in a real situation would be seeking further information on them. Teams can make assumptions about those aspects of the firm and its business which are not fully made clear in the case study if they feel that this is necessary and appropriate, but should make clear in their presentations where they have made such assumptions. NB: the final point on this slide (the firm’s ability to implement the project’) should not be considered yet - this will be done in a later session.

Checklist: “Funding Application Format Checklist”
This slide identifies some of the main criteria that banks will usually look for when evaluating applications for project finance. However, what the bank wants will vary from project to project, and it is not possible to generalise absolutely. These items are set out, with further detail and explanations, in a separate handout for participants. There is data in the Acme case study on most of these points, although there may be some aspects on which there is no data,or it is only partial (for example, the past personal financial histories of the firm’s owners). Here, it is sufficient for participants to indicate that they have at least considered these points, and in a real situation would be seeking further information on them. Teams can make assumptions about those aspects of the firm and its business which are not fully made clear in the case study if they feel that this is necessary and appropriate, but should make clear in their presentations where they have made such assumptions. NB: the final point on this slide (the firm’s ability to implement the project’) should not be considered yet - this will be done in a later session. Refers to the checklist document

Developing a bankable proposal: the banker’s response

Post-funding management and control
This session considers what happens after the finance has been obtained - the phase of implementation and subsequent management of the project after it has come ‘on-stream’ (i.e. it has gone into production and is generating benefits for the firm). There will usually be terms within a loan agreement with which a firm which has borrowed finance will have to comply. There is also the potential to develop a good relationship with the lender which will help in raising further finance in future when this is needed.

Aims ensure repayments are made in full and on time
avoid foreclosure / calling in security comply with all loan contract conditions build strong credit history and relationship for the future This slide is titled simply ‘Aims’, since the aims of both parties to the transaction (both the lender and the firm) are the same here. Once the finance has been agreed, it is in both parties’ interests that the project goes well, and that a relationship is built which makes it more likely that further business can be done in future which will be mutually profitable to both parties. These are the main outcomes that both sides will aim at: there are some more detailed actions which the firm should undertake in order to achieve them. These are covered in the following slides.

Post-funding management and control: issues
1-implementation phase 2-security for loans (collateral) 3-other loan contract conditions 4-regular financial information 5-evidence of strong internal management 6-keeping the lender informed These are the main topics that will be covered in this session, as ways to ensure that the ‘aims’ listed on the previous slide are achieved. The main area (which several slides will be devoted to) is ‘regular financial information’, including a review of how lenders and others are likely to use this to evaluate a firm’s performance.

1-Implementation need to synchronize:
receiving the finance acquiring the new asset(s) starting the new business activities project management techniques and skills, e.g. ‘critical path’ analysis clear organizational responsibilities Getting agreement of the application by the bank (or other source) is only the first step. The implementation phase can be crucial, in order to minimise the time during which the firm has raised and is paying interest on the loan, but the new asset is not yet earning money. One example of how NOT to do this is provided by the shoe manufacturing firm who borrowed heavily in order to invest in expensive new automated machinery that would reduce waste. The new machinery was large as well as expensive, and required a new building to be erected; however when the funds were provided by the bank, the machinery was ordered but it was then found that planning permission for the new building had not yet been finally granted. Only when this was approved could work start to erect the new building, and this took several further months to complete. During this time the new machine had to be stored, under protective wrapping, in the firm’s car park - and the firm had to continue paying the interest on the loan to finance it, even though the new machine was not yet producing any benefits. Project management techniques such as critical path analysis and GANTT charts are valuable in this phase. However the single most important factor in project management is usually the basic one, to define clear organisational responsibilities for the project, and to monitor progress regularly and hold accountable those responsible.

2-Security for loans usually requested by banks, though less crucial than the firm’s ability to repay can include owner’s personal assets as well as the firm’s assets need to protect assets used as security Third-party guarantee Most loans by banks (and many by other sources) involve some security, although this is less important for banks than their confidence in the firm’s ability to make payments of interest and repayments of capital out of its operating cash inflows. (Banks prefer not to have to enforce loans by taking over the assets used as security, and see this as only a last resort when all else has failed). Some assets are more useful as security than others - ideal are those with a long life, and for which there is a ready second-hand market. Property is ideal, as are some types of high-quality industrial equipment, and motor vehicles. However computers may not be welcome by the bank since these quickly become obsolete, and are also very portable. Where the firm does not own suitable assets, its owners may be able to use their own personal assets as security for loans to their firm, e.g. their own homes. However this can be risky for the owners. Assets used as security need to be protected. They must not be sold (which would break the terms of the loan), and they should be properly maintained to keep them in good condition.

3-Loan contract conditions (‘covenants’)
Examples: - adequate liquidity - adequate solvency (gearing / leverage) - no significant changes in: - nature of business - ownership - no sales of major assets without the prior agreement of the lender Lenders may also set other conditions that borrowers have to comply with. If they do not, the lender may be entitled to foreclose on the loan (i.e. to end the agreement and insist on immediate repayment - failing this, perhaps to take over the assets which have been used as security). These are usually efforts by the lenders to ensure that the firm does not put itself into a weaker position to repay the loan than at the time it was applied for and agreed. One aspect of this is that the firm stays liquid enough to pay its suppliers’ bills, tax payments etc. as needed, so that it does not risk being forced into bankruptcy. Another is that it does not take on further borrowing which would increase its total risk. Indicators which reflect these risk factors can be calculated by lenders from the management reports which they will insist that firms regularly provide them with (which will be covered later in this session). Other fundamental aspects of the firm which the bank may wish to insist, when drawing up the loan contract, do not change may include sales of major assets, or changes in ownership or in senior management.

4-Regular financial information Financial Reports (FR’s): rules
based on legal rules and accounting standards (‘Generally Accepted Accounting Practice’) required annually by law lenders may require more frequently and promptly with supporting analyses Companies, and most other types of firms too, are required by law every year to publish for their shareholders and other outside stakeholders, an Annual Report. This will include, at a minimum, a Balance Sheet and Income Statement. This should be audited and certified as ‘true and fair’ by an independent accountant. The content of the Annual Report will be defined by both the law and accounting standards set by the accounting profession. These reflect the practices of how accounting has developed over a long period - ‘Generally Accepted Accounting Practice’. Lenders will expect to receive a copy of its Annual Report from every firm to whom they have lent money. They will also usually, as a condition of providing the loan, require that the firm produces a similar financial report at more frequent intervals (say, every 3 months) so that they can monitor its performance and the safety of their loan. Since this is not required by law, the format need not necessarily be the same as the Annual Report, though the lender may also require further analyses of particularly sensitive items, for example:- - an aged analysis of the firm’s debtors - an analysis of any items which have changed significantly Lenders will usually require that these reports are produced promptly within a time-period which is defined in the loan agreement (say, 6-8 weeks). Lenders often interpret a firm’s ability to do this, and show that it is reviewing its own FR regularly, as an indicator of good management.

Analyzing FR’s FR’s can be analysed by readers to evaluate the firm’s likely return and risk position, as reflected in: liquidity solvency profitability operating efficiency The factors listed all have implications for either or both, the firm's likely future returns or its likely future risk. If the firm has insufficient liquidity, for example, this could cause it to fail if it is unable to pay its bills for operating expenses. High levels of profitability and operating efficiency mean higher returns, provided that this is not achieved by having to take excessive risks. The method usually taken in using FRs to assess the performance of a firm is to take related pairs of figures from the FRs, and to combine them by dividing one into the other, to produce a ratio. For this reason, this technique is frequently referred to as ‘ratio analysis’. However, calculating the ratios is only the first step - the main part of evaluating a firm's performance is to then interpret them, by comparing them against appropriate comparators.

Analyzing FRs: comparators
over time ‘vertical’, or ‘trend’, analysis against other (comparable) firms ‘horizontal analysis’, or ‘benchmarking‘ against other standards Indicators do not have any meaning on their own - they need to be put into context by being compared against appropriate comparators. There are three broad types of these. Comparisons over time within a single firm (‘vertical analysis’) should be relatively easy to do, since the data is immediately available and should be on a consistent basis. However, an apparent improvement over time, on its own, may be misleading - it may simply mean that the firm has improved from ‘dreadful’ to ‘poor’! If possible, the indicator should therefore be judged also against the same indicators for other, similar firms (‘horizontal analysis’). The problems here are (1) the data may not be easy to obtain, and (2) there may be differences in either the nature of the business, or in how the different firms have prepared their FRs (i.e. differences in accounting policies) that mean it is not wholly comparable. Lenders such as banks are often in a strong position to compare the performances of different firms, if they are lending to several different firms within the same industry sector. There may also be other standards which can be used as comparators. For example, ‘debtor-days’ can be calculated and compared against a firm’s official credit policy, to see whether customers are complying with it. (NB: for Acme, debtor-days = 29/203 x 365 = 52 days).

Preparing FR’s: guidelines for management
disclose accounting policies, especially if different from normal be open where estimates and approximations have been necessary indicate if any amounts in the FR’s are no longer realistic ensure reliability of the accounting systems which collect the data thoroughly review FR’s before sending outside the firm Preparing FRs is not a simple or mechanistic process; it may require an element of judgement and estimation, where accurate and reliable data is not immediately available. Lenders will usually appreciate this and be tolerant provided that they can see that the firms have tried to be as accurate and fair as possible in preparing their FRs, and are open about anything unusual.

5-Evidence of good internal management
performance indicators budgeting costing and cost control ex-post audit of projects Part of the reason that lenders require information from firms, as well as to help them to assess its performance, is to get an indication that the firm is managing itself competently. A firm which can produce accurate and prompt FRs, and show that it has reviewed them and can relate what they say to what is actually happening in their business, will reassure lenders that its management is in control of its business. Similarly, good management practice is evidenced by firms which apply standard techniques such as those indicated in this slide. These are ‘management accounting’ techniques since they are done for the benefit of the firm’s own management, rather than to report to outsiders. It is unlikely that a lender would want to examine these in detail; but if it can see that the firm is doing so, and applying them in its business, this will help to develop confidence in the firm as a good credit risk. (NB: risk is not an absolute quantity which can be objectively measured, but depends on the judgement and perception of lenders and investors).

6-Keeping the lender informed
Keep lenders informed about any significant changes in: trading the firm’s risk factors key personnel nature of the business any other factors relevant to risk and return Following the same principle of helping the lender to feel confidence in the firm, it is in the firm’s own best interest to be open about any significant changes which could affect its future risks and returns, and to indicate that it has recognised and evaluated them and knows how to respond to them.

Post-funding experiences
any experience during this phase? what terms did lenders impose? were any difficulties met, in complying with these terms? how did the firm deal with them? To conclude the session, some participants may have their own experiences of this phase which can be shared with the rest of the group, which will help to inform the next session in which they will be asked to develop an action plan for post-funding control. This slide offers a few questions to stimulate this discussion.

Acme Electroplaters: Part 3

The Bank’s Perspective

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