Credit Training Presentation eng

• Strong credit culture with active senior level involvement• Independent risk management oversight • Approval authorities based on experience and judgment • Portfolio diversification b

Credit Analysis Training for

Credit Officers

Banque Populaire Regional

Tangiers, Morocco March/April, 2009

FSVC Volunteer – Harris Berger

Financial Services Volunteer Corps

March 30 – April 4, 2009

Section I Credit Culture &

The Risk Management Process

• A profitable commercial lending business requires

strong portfolio quality, which, in turn, requires

an effective risk management process

• Defined as the process of managing risk-taking

throughout the organization

• Strong credit culture with active senior level involvement

• Independent risk management oversight

• Approval authorities based on experience and judgment

• Portfolio diversification by geography & industry

• Management concentrations; Adherence to limits

• Standards for client selection and underwriting

• Effective credit policy and risk rating system

• Standards for identifying and tracking exceptions

• Effective process for risk reporting and data analysis

Necessary Internal Ingredients of a Risk Management Process

• Strong accounting and auditing standards

• Legal and court system to allow enforcement of loan agreements contracts

and collateral

• Effective bankruptcy and insolvency process

• Reliable credit reporting agencies allowing banks to obtain borrower

histories and credit scores

• Standards for effective exchange of credit information and customer

experience among banks

• Conducive regulatory environment where banks are encouraged to take a

risk/return approach to lending, and where regulatory focus is on each

bank’s risk management process

• Borrowing public knowledgeable with bank products, borrowing

alternatives, application procedures

Necessary External Ingredients of a Risk Management Process

Section II

Due Diligence & Data Expectations

Information Sources – Areas of Inquiry

• Business plans, financial projections

• Industry, market data

• Historical financial statements, personal financial statements

• Accounts receivable and accounts payable aging, inventory breakdowns

• Tax returns – business and principals

• References – former banks, vendors customers, competitors, other bank customers

• Verification of resume data, employment history and loan application data

Information Sources – Areas of Inquiry (Cont )

• Background checks on key managers, directors, owners

• Assessment of management and director quality

• Internet and press checkings, credit bureau reports, industry and trade

publications

• For public companies – analysts reports, public filings, rating agency reports

• Visits to key offices, warehouses, production facilities

• Collateral inspections and appraisals, review of insurance

• Review of key sales and supply contracts

• Assessment of accounting systems, policies and practices, information systems and controls, effectiveness of internal and external audit programs

Information Sources – Areas of Inquiry (Cont )

• Face to face meetings with external auditors

• Initial and periodic field exams, direct account verifications

• Verification of borrower and guarantor liquidity

• Legal review – entity status, licenses, lien searches, litigation, prior insolvency proceedings, regulatory issues, insurance claims, environmental liabilities

• Review of related party transactions

• Internal inquiries and scans for prior business with company, owners or key managers

• Review of property rent roll information, leases

• Review of other borrowing arrangements – collateral, guarantees, terms,

covenants

Specific to SME’s:

• Smaller SME’s may lack sophistication and

resources for strong financial reporting

• Bankers can provide the financial discipline

necessary to make these businesses successful

Bankers should encourage SME businesses to track and understand:

• Sales data (cash and credit)

• Receivables data

• Inventory purchases, amounts owed to vendors

• Gross margins – difference between inventory cost and sales price

• Fixed assets used by the business, leased versus owned

• Debt payment schedule

• Expenses necessary for running the business, by day, week, month

• Taxes owing, due dates

• Cash position, beginning and end of period, and implications

• Business trends, likely future trends

Sound business practices for SMEs

• Record keeping

• Planning

• Tracking versus forecast, using key performance indicators

• Cash and working capital management

• Manage leverage, selling margins, concentrations

• Contain growth

• Personnel development

Section III

Underwriting &

Credit Analysis Concepts

The Approach

• Credit analysis is based on the assessment of historical and projected

financial performance driven by management’s direction and strategic

plans, competition, market considerations, and the particular risks,

constraints and opportunities faced by the business

• The goal is to determine a company’s debt capacity, as determined by

liquidity, leverage, debt servicing ability, and the risks faced by the business

• Projections are developed to arrive at an expected “base” case, along with

an adverse, or “downside” case, to asses the company’s future debt

servicing ability and interest rate sensitivity

• The loan structure will be consistent with expected borrower performance

and these expect cash flows

Key Areas to be Assessed

1 The Business – products and services, challenges, risks, opportunities,

competitive advantage, key success factors, life cycles, market share

2 The Industry - conditions, trends, markets, competition, ease of entry,

regulation, cycles, technological change, buyer/supplier concentrations

3 The Business Strategy – growth plans, resources required, impediments

to growth

4 Management Assessment – integrity, competence, depth, past

performance in difficult times, ability to implement strategy, succession plans, quality and independence of directors

5 Financial Analysis – historical and projected financial performance

Handout

“One Risk Manager’s Approach”

Section IV

Financial Analysis & Cash Flow Concepts

Sales / Earnings / Margins

• Volumes, trends, results by business segment, sales mix, selling

terms

• Results versus projections, versus industry trends, versus

competitors

• Margins – gross margin, operating margin, net margin

• Quality/consistency of earnings: Annuity earnings versus one

time events

• Balance Sheet Leverage  Total Liabilities ÷ Net Worth

• Debt to Capital  Total Funded Debt ÷ (Debt + Net Worth)

• Cash Flow Leverage  Total Funded Debt ÷ (Earnings Before Interest –

Taxes + Depreciation)

Liquidity Ratios

• Current Ratio  Current Assets ÷ Current Liabilities

• Working Capital Trends  Current Assets - Current Liabilities

• Cash to Cash Ratio  Days Receivable + Days Inventory - Days

Payable

• Efficiency of Working Capital  Adjusted Working Capital ÷

Sales

– Adjusted Working Capital = Current Assets Net of Cash - Current

Liabilities Net of Borrowings

Debt Service Coverage

• Interest coverage by operating cash flow (earning before interest,

taxes and depreciation divided by interest)

• Cash flow coverage by operating cash flow (earnings before interest,

taxes and depreciation, minus capital expenditures, divided by total debt service)

• Cash flow coverage, adjusted for working capital changes

• Fixed charge coverage (operating cash flow net of rent expense

divided by debt service plus rent)

• Debt service coverage for real estate investment properties (rental

income less operating expenses divided by debt service)

Cash Flow Concepts

• Operating cash flow is the most critical component to analyze as the primary

measure of a borrower’s ability to repay debt

• Short term versus long term financing: different sources of cash flow for debt

repayment

• Accounting conventions: Direct versus Indirect Funds Flow Statement

• True Cash Flow from operating earnings versus Cash Flow from

Asset/Liability Changes

• The Basic Approach: Key Cash Flow Drivers for debt payment (sales, margins,

taxes, capital expenditures, working capital changes)

• Utilization of the basis approach in forecasting models

Handout:

Sample Cash Flow Statements

Section V

Credit Structuring & Covenants

Types of Credit Facilities

1 Lines of Credit

– Support short term working capital cycles, financing gaps and seasonality

– Typically renewable annually

– Repaid from asset turnover

2 Revolving Credits

– Longer term, committed, multi-year facilities with covenants, events of default

3 Term Loans

– Support equipment purchases, contain covenants and events of default

– Repaid from operating cash flow

– Maturities not to exceed useful lives of equipment

4 Letters of Credit – Trade versus Standby

5 Asset Based Loans – Formula based, collateral reliance

Structural Considerations

1 Clean-up provisions for lines of credit

2 Payment terms consistent with loan purpose and projected cash flows

3 Appropriate capital structure determined as part of underwriting effort

(level and composition of debt and equity)

4 Taking of collateral Issues of nature of collateral, valuation, ability/time to

take possession and sell

5 Taking of personal guarantees Value based on willingness, liquidity, net

worth, contingent liabilities

6 Interest and debt service reserves

7 Other credit facilities, position of other creditors, intercreditor issues

8 Intercompany flows and guarantees, borrowing arrangements of

subsidiaries, affiliates

9 Documentation

Loan Covenants

Borrower compliance of financial tests

required in order to assure lender of continued performance versus

underwritten business plan

Importance of Loan Covenants

• Waiting for payment defaults not sufficient, as a company can weaken and

still make payments

• Also serve as an early warning system to protect lender if company

performance moves adversely to business plan

• Violations provide lender with an opportunity to re-structure, re-price,

request additional support, or call debt

• Covenants focused on preservation of debt repayment capacity; Should be

meaningful (reflect the risk in the loan) and sufficiently tight, but also allow borrower flexibility to operate the business

• Common financial tests- interest coverage, debt service coverage, cash flow

leverage, balance sheet leverage, capital expenditures

• Other important covenants – Use of proceeds, reporting requirements,

change in business or ownership, limitations on additional debt and

dividends

Other important covenants

• Use of proceeds

• Reporting requirements

• Change in business or ownership

• Limitations on additional debt and dividends

Handout:

Compliance Checklist

Section VI The Risk Rating Process

Risk Rating Systems

• Critical component of portfolio management, risk-based pricing, and asset quality monitoring

• Drives policy provisions – approvals, review schedule, reporting

requirements, reserves

• Requires thoroughly understood and accepted ratings definitions, identifying responsibility and accountability for initial determination, accuracy, and timeliness of changes

• Rating should change immediately as borrower risk profile changes

Definitions take into account all key factors

Use of Risk Ratings Systems

• Analyze migration trends

• Set Risk Appetite

• Early Identification of Deterioration

Additional risk rating concepts

• Migration

• Double jumps

• Dual rating systems

– Obligor Rating / Facility Rating

– Probability of Default / Loss Given Default

Sample risk rating system

SuperiorExcellentStrongAbove AverageAcceptableGenerally Acceptable (Bankable with Care)Criticized – Special Mention: Potential Weakness, TransitionalClassified – Substandard: Well Defined Weakness, May be Impaired

Classified – Doubtful, Impaired

Loss – Uncollectable

1 Credit Risk Rating Grid

2 Sample Risk Rating Worksheet

• Importance of regular customer contact

• Importance of timely receipt of financial statements, annual and interim statements

• Credit file maintenance, annual file comments

• Monitoring of customer performance, industry

conditions, credit usage, delinquencies, overdrafts, changes in management, account history, changes in credit scores

Internal portfolio reviews

3 Goals

1 Assess performance versus expectations

2 Confirm risk ratings

3 Set strategy for deteriorating credits

Handout & Case Study

1 “Warning signs of a Troubled Credit”

2 3 Case Studies for Group Discussion (from FSVC Volunteer

Rick Clarke):

– Retail Leasing Maroc (LTM)

– Transport Express Ltd (TEL)

– Pan Africa Security, Ltd (PAS)

Section VIII

Asset-Based (Formula) Lending

Characteristics of Asset-Based Borrowers

Receivables as Collateral

• Payment terms

• Delinquency trends, turnover

• Characteristics of account debtors

• Concentrations

• Credit and collection practices

• Accuracy of internal accounting and reporting

• Dilution (Returns, Allowances, Discounts, Bad debts, Contra Accounts)

Inventory as Collateral

• Content, perishability

• Raw materials / work in process / finished goods

• Costing / Accounting Methods / Valuation

• Physical condition, obsolescence, turnover

• Marketability

• In transit and consignment inventory

Field Exams

• Purpose : Valuation, Verification, Identify Credit Risks

• Review of accounting systems, information and reporting quality, systems

and controls

• Cash accounts – deposit activity, review of disbursements

• Accounts receivable - Identify exposure for loss (bill and hold, pre-billing,

partial shipments, dilution), verify of shipping, review and reconcile aging reports, credit process, concentrations

• Inventory – Identification of exposure for loss (theft, manipulation of

components, impaired marketability, overstatement of quantities),

validation of costs and quantities valuation at lower of cost or market,

physical inspection

Structural Components of The Asset Based Loan

• Initial and periodic field exams

• Inventory and accounts receivable eligibility (3 billing cycles rule),

advance rates (2x dilution+10% rule)

• Inventory caps

• Monthly accounts receivable and inventory reporting

• Blocked accounts, dominion over cash

• Daily / Weekly borrowing base reporting

• Concentration limits, Cross aging limits

Section IX

Concluding Case Study

Handout & Case Study

TTT Tapioca Co Ltd.

(Formulated by FSVC Volunteer Rick Clarke)