Credit Analysis Training for Credit Officers Banque Populaire Regional

Tangiers, MoroccoMarch/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

Leverage

• 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 default3. 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 Standby5. Asset Based Loans – Formula based, collateral reliance

Structural Considerations1. Clean-up provisions for lines of credit2. Payment terms consistent with loan purpose and projected cash

flows3. 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 sell5. Taking of personal guarantees. Value based on willingness,

liquidity, net worth, contingent liabilities6. Interest and debt service reserves7. Other credit facilities, position of other creditors, intercreditor

issues8. Intercompany flows and guarantees, borrowing arrangements

of subsidiaries, affiliates9. Documentation

Loan CovenantsBorrower 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 impacting collectability:

• Financial performance• Borrower size• Market position• Industry conditions• Access to capital• Quality of management• Likely future developments

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 systemSuperiorExcellentStrong

Above AverageAcceptable

Generally Acceptable (Bankable with Care)Criticized – Special Mention: Potential Weakness,

TransitionalClassified – Substandard: Well Defined Weakness, May be

ImpairedClassified – Doubtful, Impaired

Loss – Uncollectable

Handouts

1.Credit Risk Rating Grid2.Sample Risk Rating

Worksheet

Section VII

Monitoring and Early Warning Signs

• 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 Goals1. Assess performance versus expectations2. Confirm risk ratings3. 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

– High growth– Seasonality– High Leverage– Tightening cash flow– Industry downturn– Acquisitions

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)• Foreign accounts• Government accounts• Intercompany accounts• True sale versus contract receivables• Cross aging

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)