Approach to credit analysis -INTRO
September 14, 2015 at 05:58PM
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A useful framework for sorting out the facts and opinions in credit analysis is the "Five P" approach:
People, Purchase, Payment, Protection, and Perspective. The "Five P" model dissects the information and focuses on risk. This enables a banker to reach a conclusion rapidly in each category and to make his/her final decision by weighing the categories, with People and Payment normally carrying the most weight (despite the predilection of many bankers for Protection, probably because it is the easiest area to quantify). I recommend
I. Means ofConducting Business
Any meaningful quantitative analysis must be based on a solid understanding of the qualitative factors which affect the company; this is captured in an analysis of People. People should be appraised on three bases: Business Operations, Management/Ownership, and Banking relations. An evaluation of operating and economic trends, returns on equity and returns on total assets relative to those of competitors can be good indicators of success. Keep in mind, however, that private companies often mask their true profitability in order to shelter taxes and therefore can be difficult to compare to the industry. An investigation of the principals' background through the normal sources of professional relationships, supplier and competitor checks, and agency and litigation records is indicative of their integrity and professional competence. The company's treatment of its bankers is demonstrated by the principals' willingness and ability to repay debt as agreed, their negotiations in good faith, their reasonable attitude toward disclosing appropriate and representative financial and credit information, and their realization that a fair profit for the bank is a prerequisite for a continuing relationship.
II. Actual vs. Stated Financing Needs
The next major area to explore is the Purpose of the loan. Is this a productive loan which is appropriate to the company's funding needs? In balance sheet terms, the purpose of every bank loan can be assigned to one of three categories: (1) support or acquire assets; (2) replace liabilities, or (3)replace equity. Assets may be further divided into three types: (1) current assets of seasonable na ture, (2) current assets of a non-seasonable nature, and (3) non-current assets, often for productive capacity. Replacing liabilities can take the form of either assistance in taking trade discounts, making tax payments, or the significantly riskier category of “taking out” (or "bailing-out") other banks or financial institutions. Replacing equity is a risky purpose since the effect of substituting debt for equity will substantially increase leverage. Occasionally such a loan is appropriate, however, partic ularly in solving control problems of highly profitable companies.
III. Repayment Analysis: The Core of Credit Judgment
Payment is the main focus of the analysis. The real test of the analyst is his/her ability at the outset of a loan to establish a "roa dmap to repayment." Payment normally is related to Purpose, and as such should be both appropriate for the borrower's need and within the acceptable time-frame (tenor) for the financing requirement. The analyst must examine the source and timing of repayment and be convinced that the probability of fulfillment is high. The difficulty in analyzing repayment is that the analyst is dealing in the uncertainty of the future, armed primarily with information from the past. The past will suggest the probabilities of future events unless the company is involved in significant mergers, acquisitions or divestitures, or is changing the nature of its operations through consolidation or diversification. Alternatively, the borrower may exhibit a high degree of technologic al or regulatory change by the nature of its industry or may have an extremely volatile track record. Projection analysis is an integral part of Payment.
Asset conversion loans, whether for seasonal needs or a "one-shot" contract, should beanalyzed using the "accordion" balance sheet concept: when and how much do total footings expand, and when and how much do they contract? The source of repayment lies in the increase in trading assets purchased with bank funds. Their timely reconversion into cash should retire the bank debt and provide an increment to retained earnings to offset inflationary cost increases and to finance growth. The single best historical indication to use in seasonal loan repayment analysis is whether the company has been able to accomplish at least a 30-day all-bank clean up at the low point of its natural operating cycle. As a corollary, management's policies and procedures regarding inventory and receivables should be explored. What procedures does management use in developing credit information on new customers, limiting concentration, policing slow payers, and recognizing bad debts? As far as inventory is concerned, how good is management's judgment or style or technology; what is the raw material, work-in-process, and finished goods mix; are there control problems (e.g., consignment transactions); is there an inventory "cushion", and is there adequate insurance coverage? Asset conversion loans normally are for a limited time period only. The uncertainty of the future is less than in other loans because their short tenor is more readily analyzed; however, cash flow is important to analyze because it may provide a viablelonger-term source of payment if asset conversion is inadequate in timing or magnitude. Any loan which is not repaid by seasonal asset conversion is a cash flow loan which is repaid from future internally generated funds or external funds, debt or equity, which the firm can attract because of its financial condition or potential. Therefore, the analyst must focus his examination on the quality, the magnitude, and the trend of reported profits, being key drivers of cash flow.
Non-cash charges, principally depreciation, amortization and deferred taxes, must be analyzed as to their continuity. Capital expenditures, due to inflation, technological change, and growth, will normally exceed depreciation expense and deferred taxes, just as deferred taxes arising from installment sales are usually more than offset by higher receivable levels. With few exceptions, non- cash charges are sources of cash which are exceeded by the related uses of cash. This forces an analyst back to a judgment about the magnitude of future profitability relative to the calls on that profitability in the form of debt maturities, dividends, and requisite asset levels, particularly receivables, inventory, and capital expenditures. Because of this complex matrix of uncertainties, a reasonable margin for error must be built into any repayment schedule.
IV. The Second Way out
A properly structured loan includes a "second way out"; in case the primary repayment source fails. Protection can be internal, where the lender looks exclusively to the borrower, and external, where a third party adds its responsibility to that of the borrower. Internal protection can be either specific collateral or future cash flows if the primary source of repayment is asset conversion. Collateral should be analyzed as to whom controls it physically (the bank, the borrower, or the third party), its marketability, and therefore, the appropriate advance rate (for formula -based facilities). Internal protection can be enhanced by loan agreement covenants alerting the lender to liquidity problems, excessive leverage, third party claims to assets, and a variety of other restrictions. External protection most commonly takes the forms of guarantees, endorsements, or repurchase agreements. However, a loan based solely on the credit responsibility of the guarantor is often a high risk loan at the outset because there is only onesource of repayment.
V. The Overview - Risks and Mitigants
The last of the "5P's" of credit is Perspective; does the credit make sense within the basic framework of risks and mitigants? Here the principal risks of a particular borrower or those inherent in a specific transaction should be reviewed. The analyst should assess how the risk are being mitigated, or where a risk cannot be fully recovered, why we should proceed with the proposed transaction.
The pricing and structure of a transaction are important components of the Perspective section. It is important for every banker to understand the new capital adequacy guidelines because they affect the price and cost of products both on and off the balance sheet. For each product and transaction, it is important to know the capital requirements, the cost of capital, and whether product revenues will likely cover he cost.
Commercial banking is more art than science, particularly in this rapidly changing and complex credit environment. However, a systematic approach such as the "5P's" touches on the basic issues of almost any transaction in a logical and time-saving manner. An analyst who has mastered the basic techniques of financial statement and cash flow analysis, and who organizes the data in this decision-making framework, should find that his/her credit judgment is more focused.
September 14, 2015 at 05:58PM
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