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Sathye, M., Bartle, J., Vincent, M., Boffey, R. (2003) Credit Analysis & Lending Management , John Wiley & Sons, Milton, Australia.
First published 2003 by John Wiley & Sons Australia, Ltd 33 Park Road, Milton, Qld 4064 Offices also in Sydney and Melbourne Typeset iilll/13 Berkeley © Milind Sathye, James Bartle, Michael Vincent, Ray Boffey 2003
National Library of Australia Cataloguing-in-Publication data Credit analysis and lending management. Includes index. ISBN 0470800410. 1. Credit. 2. Credit - Management. 3. Loans. 4. Risk management. 1. Sathye, Milind.
332.7 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electrOlltc, mechanical, photocopying, recording, or otherwise, without the prior permission of the publisher. Illustrated by the Wiley Art Department Cover image © 2002 Digital Vision/Sara Hayward
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10 9 8 7 6 5 4 3 2 1
Part 6 Current issues
Part 1 Overview 1. The principles of lending and lending basics 3
Part 2 Analysis and interpretation 01 credit risk 2. Financial statements analysis 3. Credit scoring techniques
45
88
4. Credit risk analysis - an introduction 108
15. Marketing of loans 442 16. Future directions 479
Part 7 Case studies Case study 1 - Boat Builders Pty Ltd
499
Case study 2 - Financial analysis of Boat Builders Pty Ltd 507
Case study 4 - Veterinary Clinic Pty Ltd
5. Consumer lending
137
6. Real estate lending
174
Part 4 Corporate and business lending 241
9. Small business lending
516
Case study 5 - Credit risk of major Australian banks 522
7. Security, consumer credit legislation and legal aspects of lending 205
10. International lending
413
Case study 3 - Orbital Engine Corporation Ltd 512
Part 3 Consumer lending
8. Corporate lending
14. Electronic banking and lending
266 311
Part 5 Assessment and management 01 risk 11. Credit risk measurement and management of the loan portfolio 335 12. Credit risk from the regulator's perspective 370 13. Problem loan management 389
Glossary
525
Index 533
The principles of lending and lending basics learning objectives After reading this chapter, you should be able to: 1. identify the basic principles governing bank lending and explain their importance
2. understand the framework within which credit and lending decisions are taken 3. understand the lending process 4. explain the characteristics of various types of bank advance 5. distinguish different types of borrowers and the special considerations that apply to them when giving loans 6. explain how advances are structured 7. explain the importance of credit culture in a lending institution 8. undersjandhow an advances portfolio is designed.
proposals. Even if the credit analysis is done by modem methods, however, it rests on the foundation provided by traditional analysis. One cannot exclude traditional credit analysis altogether; it must be taken into account. Traditional approaches comprise three methods of credit assessment: the judgemental method (also called the expert systems method), the rating method and the credit scoring method. We will explain the traditional approaches to credit analysis and then the modem approaches.
Traditional methods of credit analysis The purpose of any credit assessment or analysis is the measurement of credit risk. According to De Lucia and Peters (1993), borrowers' credit assessment is done using the following criteria, popularly known as the five Cs of lending: • collateral • character • conditions_ • capacity· • capital Some ,au'thors combine capacity and capital, a,nd conditions and collateral to have just three Cs of lending. The fact remains that credit assessment 'considers all the above ,actors; combining some of the Cs does not exclude' them from consideration. Also remember that these five Cs of lending are applicable whether the loan is made to a personal borrower or business borrower. We will refer to these Cs of credit assessment throughout this book. Weerasooriya (1998) suggests adding one more C to the list: compliance. This means compliance with various'statutes and regulations, particularly the Uniform Consumer Credit Code. We support Weerasooriya's observation because it puts the credit analysis in its proper perspective. The ,details' of .legal aspects with which lenders have to comply can be found in chapter 7. We will now explain each of the traditional five Cs and how their analysis helps a financial institution in judging the safety, suitability and profitability of a loan.
Character Character is perhaps the most important and, at the same time, the most difficult criterion to assess. The famous American banker, Pierpoint Morgan, once said: 'the first thing '1 look for is the borrower's character. 1 consider that more important than m~ney or property Ol' even before money or property or, anything else. M~:mey Cannor buy character. A person 1 do not trust could not get money from me on -all the bonds in Christendom ... 1 have known a man to come into my offiqe and 1 have given him a cheque for a million dollars when 1 knew he had not a cent in the world' (Weerasooriya 1998, p. 99). There is no more powerful,statemenuthan this, which highlights the importance of character in the assessment of credit. What is character? Character is the sum total' of human qualities of honesty;, integrity, morality and so on. The Macquarie Dictionary defines charaner as 'the ag'gregate of qualities that distinguishes one person ·or thing fromotherso'. Lenders 'Yant to know 'whether borrowers are morally honest or tricky, industrious or )azy, prudent or speculative, thrifty Or
I
6
Part 1: Overview
I
,I
~ .
spendthrift, and whether they have other such qualities. These qualities combined constitute the character of the borrower. A person who is not honest represents a risky proposition for a !ender, who will not know whether the money borrowed has been put to the stated use. This author, while working as a lending banker, encountered a borrower who borrowed money for farm improvement but used it to construct a farmhouse. The loan was to be repaid out of excess income to be generated by the farm improvement, but it was diverted for unproductive use. The borrower repeatedly promised that he would soon repay the loan used for' the farmhouse, but which banker would believe such a promise? Character is like glass. Ouce it is broken, it cannot be repaired. Even if repaired, the' mark~ of s~ch a ,epair are always present. Some people with high positions in.public lite have had to leave the position when their d:jaracter came into question. Dishonesty can lead to disgrace. For this reasop., preserving one's character is vital. . Given the importance of character in general and in' a.lending situatiqn in particular, how should one assess character? Character.is subjecti;'e; further, it represents different notions in different cultures. What is considered as good' character in one culture may not be so regarded in other cultures. A lender needs to account for these aspects while assessing character. The lending banker is concerned with the financial character of the borrower - that is, does' the borrower exhibit honesty and moral integrity in matters of finance? Many , times, it is hard to draw a line between financial character and general character. It is hard to believe that a person who is dishonest ip. general life would be honest in financial matters, so the total character of a person does matter for a lender. A lender must judge which of the information received about a borrower's character is material and which can be ignored. Given this subjectivity, how do lenders .assess character? Character assessment involves collecting information about the borrower's track record of integrity, repayment ability and spending habits. Such information is collected not only in personal loans, but also in business loans. In personal loans, character assessment may seem quite straightforward because information .iscollected on only one or maybe two individuals. For business ioans, character assessment involves analysis of the character' of all the owners , and ma'nagers of th~ business, In the case of a partnership, it involves assessing thd character of all the partners of the firm, In the case of joint stock companies (called public companies in Australia), tl.te character of the directors of the company is assessed, and in the case of a charit~ble trust, that of the trustees is assessed. Assessment of a borrower's track record should not be a problem if tlie borrower is an existing customeJ; of the bank. If the customer has been a previous borrower, then hislher performance in loan repayment could be a good indication of the ~character of the' borrower. Wa~ the customer prompt in repayment? Or was the mank required to follow up to get repayment? If a corporation has taken an ~,:,~rdraft, were all the proceeds of the busiuess routed through the ="'."
,,
'l'Y-:;;!'?f.;l?:,:.;-~~~:
Chapter 1: The prinCiples of lending and lending basics
overdraft account? If not, why not? These and other such questions can help the lender in assessing the character of the prospective borrower. Throughout this book, you will find various types of character-related question asked by lenders of prospective borrowers. Lending is all about asking the right questions and finding the true answers. The character questions that need to be asked for personal loans are fairly simple compared with those for business loans, for which many more issues need to be considered. Assessment of character for personal loans is not hard. Personal loans such as credit cards, home loans and car loans - are granted to individuals, so character assessment centres around the honesty and integrity of that individual or group of individuals. Assessment is generally undertaken by one or more of . the following means:
• If the individual is a customer of the bank; then infor:mation about himlher i? already with the bank. The credit history and dealings provide an indiuition of the individual's character. Has the customer previously borrowed from the bank? If so, did he/she 'repay the loan in time? Was the lender required to follow up to ensure repayment? How were the customer's dealings "vith the bank generally? If the information received in response to these questions is p~sitive, then the lender will conclude that the character of the party is good. Where the borrower is new and not a previous client of the bank, the lending officer should collect information from the customer's existing bankers. • In the case of an applicant who is a salaried employee, the lender contacts the applicant'S employers and seeks confidential information about the employee, particularly anything adverse. The bank must be careful while making such a contact and should not reveal any details about the customer, which could constitute a breach of confidentiality and secrecy obligations. The lending officer should collect information in a more general manner. • The bank may contact fri.ends and relatives of the prospective borrower to ascertain the character of the borrower. Similarly, lenders often require . borrowers to indicate referees, who can be contacted by the lender for a character reference. • Co'nfidentialreports from credit rating agencies are another sou~ce.ln Australia,-Credit Advantage (formerly, the Credit Rating Agency of Australia), for example, provides confidential reports about the character of the borrower. An individual'can seek a report on hislher own credit rating from this 'agency, free of q,arge. • Lenders often obtain documentary evidence s1,1ch as salal;)' statements, group certificates and a driver's licence so as to establish the identity of the borrow~r. When the borrower holds a valid driving licence, it establishes that he/she has not been involved in any offence and thus confirms good character. Similarly, a salary statement shows that the customer has a job and obviously is of good character, or no-one would have employed himlher. Australian banks usually require the follOwing documents as an identity check: a driver's licence, a birth certificate, a credit card, a passport or a rates notice. .
I
B
Pari 1: Overview
For business borrowers, character assessment involves assessing the character of the business owners or, in the case of companies, the members of the board. Sources of information that help lender's conduct a character assessment include: • Dun & Bradstreet journals and their company reporting service. • bank opinion. If the prospective borrower is a customer of another bank, then a report is usually obtained from that bank. Such a report is called 'bank opinion'. It is carefully worded and general in nature. It can reveal whether the party (prospective borrower) is financially sound, not so sound or weak. • the Australian Securities and Investments Commission (ASIC), which can provide company info~mation for a fee • reports frdm maiketllocal knowledge. Information about the prospective borrower can be obtained fr9m suppliers' and customers of the borrower. Simiiarly, market inquirie~ can be made. • credit reports from Credit Advantage • the relevant industry association. Integrity is another quality that is included in the concept of character. The Macquarie Dictionary defines integrity as a ~oundness of moral. principle and character, uprightness or honesty. People often say 'take my word for it', which means he/she will do all that is necessary to keep the word. This is integrity, which is an important attribute that banks expect to find in a borrower. If the borrower has integrity, then the lender can be certain that the promise of repayment will be honoured. Lenders judge integrity by the track record of the borrower. In the context of businesses, the integrity of management (the board of directors) is assessed. In the much-publicised corporate collapse cases of HIlI and One.Tel, the integrity of the companies' management was questioned. Another attribute of character is the ability of the borrower. 'Ability' refers to the technical and management skill of the owners. It is quite common to find that a borrower has strength in one area but a weakness in another. A motor mechanic, for .example, may possess excellent technical skills but lack business management skills. In such cases, the borrower has to demonstrate how he/she proposes to address the skill that is lacking. Hire suitable p~rsons? Admit a partner with su.itable skills? The lender is also interested in knowing whether a successor is being groomed to take over from present owners when they retire. A final aspect of char~cter is whether the borrower is spendthrift. .Company managements are often criticise~. by ordinaty .shareholders for extravagant spending. High salaries, high business expenses, the use of expensive company cars and business class travel are some of the indications of extravagant spending. Capacity Capacity is. the ability to repay the loan together with interest as per the predetermined schedule. (Here 'capacity' refers to financial capacity to repay loan. It is different from"legal capacity, which refers to capacity or eligibility to enter into a. loan contract. You will come across this concept in later chapters.) It
.'7
sufficient het income to service the loan repayment.. To assess whether the borrower's,financ~al position ·is sound, lenders "ften seek financial data from the' , \ . , ,",'r,' , . custolJler.,· ·jn .the 'case of p~rsona\ loans, borrowers are often required to give details of In'come' andexpertc\iture',. and the net surplus available for repayment. The lender' also seeks' :details ,D( the existing' assets and . liabilities of the borrower. Assets may consistof.pi(,perty,:ji\~?stment in stocks, managed funds and/or term deposits.'Liabilitiesmay consist of outstanding balances on loans and credit cards. In the case of businesses, lenders usually ask for audited financial statements and projected cashflow to determine the financial soundness or creditworthiness of the business borrower. The lender considers the profitability of the new venture proposed by the business, as well as the risks involved. Capacity is about the pjimary source from which repayment is expected to .take place. It is important to assess the primary sources ofloan repayment at theoutset. In the past, banks lent money on the strength of security that the party could offer for the proposed loan. Over the years, however, lenders have shifted to !ending against cashflow rather than lending against security. There are many reasons fonhis shift. If a loan is granted purely on the strength of security, then the recovery of the loan may involve selling the security. This is a risky proposition, first, because the market value of security may have depleted in the meantime and, second, because taking possession of security involves a long !egal process, which is often expensive. Further, bank staff have to spend a considerable amount of time and money to realise the security in satisfaction of the . outstanding loan. As a result, lenders have shifted their emphasis from lending against security to lending on the basis of cashflow. Borrowers are usually required to submit projected cashflows from which the lender can assess when repayment will occur and the sources from which it will come. This process presupposes a realistic construction of cashflow.
Capital Capital refers to the capital contribution that the borrower proposes to make in the total investment. An investment is usually financed partly by bank loan and partly by the capital contribution of the owner. The owner's contTibution is also wiled the 'owner's margin'. Such a capital contribution is important from lender's poiilt of view. It establishes the owner's stake in the project; . the greater the stake of the owner, the greater is the owner's (and thus the !ender's) confidence' in the project. Such a project has a high probability of success, so a lender feels confident about lending for the project. Lending institution~ insist on at least some contribution from owners. Even in personal loans such as home loans, banks usually require the owner to contribute at Ieast 20 per cent of the total investment. Where the owner's contribution falls below this share, lenders usually insist on mortgage insurance. Mortgage insurance protects the lender in cases where the owner's financial condition is not strong and the owner is contributing less to the total investment than required.
a
10
Part 1: Overview
I
Collateral Collateral is also known as the secondary sonrce of repayment. When a loan· cannocbe repaid au t of the primary sonrce, lenders usually take possession of collateral, dispose of it and use the proceeds to set off the outstanding loan amount. The literal meaning of the word 'collateral' is 'along side'. A security exists alongside a loan. When' a bank grants an overdraft against inventory, then ; the inventory is collateraL In corporate loans, lending institutions are generally reluctant to lend against a general charge on assets of a limited company, because unforeseen events could drastically reduce the market value of the company and thus endanger the;recovery of the outstanding loan amount. Lenders therefore 'generally lend against a particular asset. It is less complicated to value such a specific secnrity than to attempt the general valuation of the company This issue does not arise with other fonns of business such as a sale proprietorship or a partnership, where the owners are personally responsible for all debt and their personal assets are also liable for loan repayment. Lenders·look for the following qualities in a secnrity: • The price of the security should be stable, or not subject to wide fluctuations. Lenders may not be prepared to lend against highly speculative secnrities. Homes, machinery and easily saleable inyentorie~ are examples of secnrities for which prices can be expected to remain reasonably stable. o The marketability of the secnrity is another aspect that lenders consider. If the advance is not repaid, then the s",cnrity can be sold quickly and the proceeds set off against the outstanding loan amount. Lenders would be prepared to lend against blue-chip secnrities (company shares that can be sold quickly, such as the shares of Qantas and the Commonwealth Bank). • Lenders like a secnrity with a quickly ascertainable price. If the value of a security is difficult to ascertain, then lenders may be sceptical about its true value and may cQnsider it too risky It may be hard for a lending institution to determine the true value of an antique, for example, because valuation of such a security may widely differ, ., Dnrability is another. quality that le~ders look for in a secnrity' The secnrity should not deteriorate over time; for example, perishable goods .such as vegetables could easily deteriorate in a few days and may not hold any value thereafter. Lenders need to be extremely cautious when lending against such a secnrity.. • ApotheEpreferred quality is.portabili~y.lf the $ecnrityis'qlllckly trans,Portable or portable, then the lender cap.·selLit in another market, If the secuptyis nOt portable, then, ~he lender may'find it liard t6 seli'that sec\Jtity. the' lo~al market. Land and buildings are examples of secnrities that are not portable. It is hard to find a secnrity that possesses all the above qualities, and a lender is often required to judge an acceptable compromise. Land, for example, may have stable value over time but it lacks the qualities ofportability, ease of valuation and so on. Given the difficulty in determining the value of a secnrity, financial institutions usually hire the services of an approved valuer.
in
\
,
Conditions According to Weerasooriya (1998), an analysis of conditions covers external and internal factors. In our view, it also covers the conditions and terms of the loan. The riskier the advance, the stricter are the terms and conditions. Analysis of external and internal factiJrs is important. The external conditions - the condition of the economy, the condition of the relevant industry, the , threat of war and so on - do affect the repayment of a loan and need to be . considered wben a loan is granted. A proposal may be sound and the party may be creditworthy, but the business may not be profitable if external conditions are not favourable. External events that may affect business success include a downturn in the economy, industry-specific problems and international events . .·The tourism and airline industry in the United States, for example, experienced a slump in demand due to general reluctance to travel following attacks on 11 September 200 1. Credit analysis must also account for internal conditions, which may include lending policies, the lending budget and the availability of expert staff to monitor the loan. A financial institution may decide to follow a restrictive lending policy, as a result of a funds constraint, or to expand lending business in particular segments of the market. Credit analysis should take such aspects into account
,
soften the impact A,Ustnllia (REA) to tighten
'
;;;~;2!'~~~~~~~~~~~~~~'~~~;1 to
.
50-basis-point increase in lenders to business are they will have little scoP.". to
shopa~()~nd for a loan than ever before, '~.... ,.,
bt:'~~,t:~~r~~~~~ie~~ .. margins to reflect higher bad-debt risk may find ... '.'~ ./, ," ,. have had to share more and more of the comthe regional banks, and in the past year several no.nqank lerldet~~h.iiY'/'lt~,:keh steps to make their long-heralded move into the t:J;qrilpetitor'S have certainly improved their skills in the p'eter Coleman, general'manager of business finanBank (NAB), . the country's bigg~st l~nder to by the banking industry research group LM says the big banks have lost market share in the
I 12
Part 1: Overview
Financial statements analysis learning objectives After reading this chapter, you should be able to: 1. explain the key financial statements 2. explain the importance of analysis of financial statements in lending decisions 3. describe the various methods of analysis where project finance is involved 4. describe the special techniques of analysis where project finance is involved 5. describe how window dressing of financial statements can take place 6. explain which of the financial ratios are preferred by loan officers 7. outli'ne the limitations of financial statements analysis.
Lenders invariably obtain financial statements from prospective borrowers and analyse them. They may not, however, conduct a detailed analysis (as discussed in this chapter) for every borrower. The financial statements analysis for a sole proprietor may be fairly basic compared with that for a public limited company. The analysis is a time-consuming process that requires considerable skill, yet a financial institution will do some basic financial statement analysis for all business loans, big or small. Why do lenders place so much importance on this analysis?
Why lenders analyse financial statements Lenders analyse financial statements because they help answer the following three important questions, which are the subject of any credit analysis: 1. Should the bank give the requested loan 7 2. If the loan is given, will it be repaid together with interest? 3. What is the financial institution's remedy if the assumptions about the loan turn out to be wrong? It is less risky for a lender to give a loan to a business that is finanCially sound. But how can a lender know whether a particular business is financially sound? A sound business possesses the following characteristics: • The business has adequate liquidity so it can honour short-term obligations easily. • The business is run efficiently. • The business is run profitably. • The proprietor's stake in the business is high; alternatively, the business is not burdened with too much debt. By appropriately analysing financial statements (for example, ratio analysis), the lender can know whether the above characteristics are present. If they are present, then the business will be considered to be finanCially sound and loan approval will not be a problem. The second question of whether the loan will be repaid together with interest is a bit tricky. Financial statements analysis is essentially a post mortem and cannot provide an answer to this question. The financial statements belong to a period that has already elapsed, but the loan is to be repaid in the future and no-one knows what the future holds. How can a lender find an answer to the s<'cond question? How can the lender predict what will happen? While a lender cannot predict the future with absolute certainty, a reasonable guess can be made by analysing the following factors: 1. Trend (time series) analysis. If the business was run profitably for some years, then it may not be unreasonable to assume the trend will continue. The past trend and the projected surplus, the past trend and the projected cash surplus, the trend of various ratios and the likelihood of continuing of that trend are some factors that need to be examined.
"
I 48
2. Safety buffer. If the business has a large margin of safety (between actual sales and break-eveu sales), then some fluctuations in business conditions in the future may not be a cause for worry. 3. Stress testing. The business can be subjected to sensitivity testing. If the business continues to remain profitable, then the lender can be reasonably certain that the business can withstand shocks in the future. 4. Industry· analysis. What are trends and prospects for the firm's industry? If the industry is growing, then the lender can expect that the firm will also grow. 5. Econ01nic analysis. The lender can analyse trends in the domestic and international economies to gauge the possible impact on the business. The techniques thilt help the lender in analysing the above factors include: a projected income and expenditure account, a projected cashflow, margin of safety analysis, sensitivity analysis, trend analysis, interfirm comparison, industry analysis and economic analysis. Predicting the future of the business is just, a 'best , guess' by the lender; no-one can predict the future with absolute , certainty. Given that some amount of risk is always involved, the bank needs some form of insurance. Such an insurance and thus an answer' to the third question - what is the financial institution's remedy if the assumptions made while giving the loan turn out to be wrong? - are provided by the following: 1. Collateral. If everything goes wrong, then the banker can faU back on the security obtained while granting the loan. The bank will sell the security and use the proceeds to satisfy the outstanding debt. ' : 2. Charge on' assets. The lender sometimes prescribes a condition that there will be a floating charge on all the assets ofthe business. If the proceeds froin the collateral are ihsufficient, then the financial institution can stake a claim over the other assets of the business. 3. Guarantees. The lender will insist on personal guarantees of company directors so in the case of default the financial institution can recover dues from the personal property of the directors. Such a guarantee also acts to deter the company directors from taking actions that are detrimental to business interests. In sole proprietorships and partnerships, the owners are personally liable anyway, so the guarantees may be taken from friends or relatives of the owners. 4. Conditions. The financial institution may place conditions on a loan, such as a negative pledge (as explained in chapter 1), to ensure the business remains disciplined and does not take any action that may be detrimental to the lender's interest. Financial statements may show what kinds of assets are available, their book value, whether they are unencumbered: (that is, not given as security for other loans), and the likelihood 'of these assets being used, as security for. the proposed loan. ' '
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Part 2: Anal~is and interpretation of credit risk
It should be clear to you now that financial statements analysis and other types of analysis are used to find answers to the earlier three questions that are repeated here for ready reference: 1. Should the bank give the requested loan? 2. If the loan is given, will it be repaid together with interest? 3. What is the financial institution's remedy if the assumptions about the loan turn out to be wrong? Financial statements contain a wealth of information, but it takes skill and experience to unearth that information. If properly analysed, the financial statements can provide valuable insights into a firm's performance and financial condition. In the following section, we will discuss how financial statements are analysed to unearth their hidden information content.
Analysis of financial statements Financial statements analysis is the principal tool of the lending banker in assessing the financial performance and condition of any business. Foster (3.986) distinguishes three broad types of analysis technique: • cross-sectional techniques • time series techniques .0 a combination of financial statement information and nonfinancial statement information. We will use the same classification in the following discussion.
Cross-sectional techniques Cross-sectional analysis techniques analyse financial statements at a 'point in time'. Two commonly used techniqnes ar~ financial ratio analysis and common-size statements.
Ratio analysis A ratio is an arithmetical relationship between two figures. When the figures are taken from the financial statements, we call it financial ratio analysis, which is the most widely used cross-sectional technique (Foster 1986). Two financial statements are generally used for calculating ratios: the statement of financial position and the statement of financial performance. From these two principal financial statements, several ratios can be calculated. The various ratios that lenders generally use can be grouped into the following categories: • liquidity ratios o efficiency ratios • profitability r~tios • leverage r,atios. Here, we will discuss each of these ratio categories. To facilitate the discussion, the following statement of financial performance and statement of financial.position will be used.
"'/-
-
City First Saddlery Limited Statement of financial performance for the year ending 31 March ($'000)
.
.<
,
Net sales Cost of goods so1d Inventory Salary and wages Other manufacturing expenses Gross profit Operating expenses Depreciation General administration Selling Operating profit Nonoperating surplus/deficit Earnings before interest and tax Interest Profit before tax Tax Profit after tax Dividends Retained earnings
,
2003 _
-.
2002·' 1 ~
70.1 55.2
47.5
14.9 5.6
14.8 4.9
9.3 (0.4) 8.9 2.1 6.8 3.5 3.3 2.7 0.6
9.9 0.6 10.5
2.2 1.8 21.0 17.46
28 1.8 20.0 17.07
62.3
42.1 6.8 6.3
3.0 1.2 1.4
2.2
8.3 4.1 4.2 2.7 1.5
Per share data
Earning per share Dividend per share Market price per share Book value per share
Source: Data adapted from P. Chandra 1993, Fundamentals of Financial Management, Tata McGraw-Hill, New Delhi, India, p.115. City First Saddlery Limited Statement of financial position as at 31 March ($'000)
I 50
Part 2: Analysis and interpretation of credit risk
I
Liquidity ratios Liquidity refers to the ability of a firm to meet its short-term obligations - that is, whether the business is in a position to pay financial obligations that will arise in, say, the next year. Liquidity is an important aspect to be watched in any business. The failure of many businesses has been due to lack of adequate liqUidity: Liquidity can be described as the lubricant that helps the business run smoothly: just as a car needs to have sufficient lubricating oil (engine oil, breaking oil and so on), a business needs to have adequate liquidity at all times. To check whether a firm has adequate liqUidity, financial institutions compute liquidity ratios. Two principal ratios that are commonly used to judge the liquidity position of any business are: • the current ratio • the quick ratio.
The current ratio The current ratio is the ratio of current assets to current liabilities. Current assets include cash, marketable securities, debtors, closing stock (ending inventory), loans and prepaid expenses. Current liabilities are borrowings for the short term, trade creditors, accrued expenses and provisions. Formula
The current ratio is calculated by the following formula: Current assets Current liabilities . .for City Saddlery Ltd, the current ratio was: 2002
2003 23.4
= 1.34
,
17.4
15.60 = 147. 10.60 .
The denominators 17.4 and 10.60 are arrived at.by adding unsecured loans and current liabilities and provisions - that is, 6.90 -¥ 10.50 and 2.50 + 8.10 respectively: Benchmark
Generally, the benchmark current ratio is 2. Clemens and Dyer (1986) have recommended a ratio of 2 to 1. If the ratio is 1.5-2, then it is considered to be satisfactory: If it/ails below 1, then it is indicative of liquidity problems. If it is over 2, then it indicates excess liquidity: These benchmarks are just rules of thumb and need not be given undue importance. Factors such as industry practice and past trends of .the firm are more important and should be the deciding factors over the rules of thump. This is true for all types of ratio. What is the assumption behind this benchmark of 21 The assumption is that even if the business were shut dowu today and cu~rent assets sold at half price (fire sale), the business would still have sufficient funds to pay current obligations. The current ratio of 2 is like an insurance against shorHerm insolvency of the firm.
-/
~
Interpretation
A ratio of 2 is regarded as ideal yet seldom does a business have the ratio exactly at 2. The ratio could fluctuate between 1.5 and 2, which is not a concern. A ratio that is too high or too low, however, should be a concern. A very high ratio may arise due to one or more of the follOwing reasons: • A very high ratio indicates excess liquidity. The business may be losing opportunities to make profitable use of current assets. • The high ratio could also be because the party (borrower) is holding excessive debtors or perhaps because debtors have not been collected. As a result, the figure of current assets - that is, the nominator - will be very high, as will be the ratio. Check for these possibilities: check, for example, the average collection period or the debtor turnover ratio (discussed later). If thest ratios are not excessive - that is, the collection period is normal (according to industry practice or the past trend of the party) - then we have nullified the possibility that excessive current ratio is due to high trade debtors. • The party might have sold some goods just before the date on which financial statements were prepared, so tlie figure of trade debtors may be liigh, raising the current ratio. In sucli cases, calculation sliould be based on average debtors during the year. To find tlie average debtors, add the debtors at the end of each month in the year and divide the resultant figure by twelve. • A high current ratio may arise due to excessive inventory build-up. For this reason, the average inventory (ca!culated using the same procedure as indicated earlier for debtors) level should be checked and used in the ., calculation of current ratio. • As in the case of debtors, the ending inventory figure may be excessive because some goods were sold just after the date of the statement of financial position. Check for such possibilities and use average figures rather than. year-end figures to arrive at the current ratio. .. • Inventory valuation is another grey area. Overvaluing of the inventory can artificially raise the figure of stock held and thus also the current ratio. The . party may change the basis of inventory valuation and thus obtain a higher value for the same quantity of stock. The Australian Accounting Standards Board recommends the use of the 'first in, first out' (FIFO) method for inventory valuation, not 'last in, first out' (LIFO). You may corne across these concepts in your study of cost accounting. Overvaluation of stock will not only raise the current ratio, but also will overstate profits. A low current ratio is indicative of liqUidity (working capital) shortage and is a cause for concern. In sum, both low and high current ratios need to be watched carefully.
The quick ratio Another measure of liquidity is the quick ratio, also called the acid test ratio. It is much the same as the current ratio except that inventory is excluded from its calculation.
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Part 2: Analysis and interpretation of credit risk I
The quick ratio is a ratio of quick assets to current liabilities. QUick assets include all current assets except inventory (raw material, work in process and finished goods).
Formula The quick ratio is calculated by the following formula: QUick assets Current liabilities' For City First Saddlery Limited, the acid test ratio for 2003 and 2002 was: 2003
12.8 = 0.74 17.4
200,2 " 7.0 -1 6 ' =0.66. O. 0
(Please note that the figure of inventory for 2002 is assumed at 8.60, so the nominator will be 15.60 - 8.60 = 7.)
Benchmark and interpretation The quick ratio is a fairly stringent measure of liquidity. It is based on those current assets that are considered to be highly liquid. Inventories are excluded from the numerator of this ratio because they are considered to be the least liquid component of current assets. The rule of thumb for quick ratio is 1: 'many firms like it (acid test ratio) at 1:1 or better' (Argenti 1976, p. 139). This means that quick assets should be eql.!al to current liabilities. Selling of inventory may be a difficult process and the lender wants to ensure the business can meet current liabilities out of qUick assets alone (current assets other than inventory). If the ratio is unity (equal to 1), then the business can easily meet the CUrrent liabilities out of its quick assets. Efficiency ratios We stated earlier that one of'the characteristics of a financially sound business is that it is run efficiently. To measure efficiency, financial analysts cal-' culate the efficiency ratios. The efficiency ratios measure how efficiently the business has employed its assets. These ratios are based on the relationship between the level of activity (represented by sales or the cost of goods sold) and the levels of various assets. Efficiency ratios are also called turnover ratios, activity ratios or asset management ratios. The important efficiency ratios are: • the inventory turnover ratio • the average collection period.
The inventory turnover ratio The inventory turnover ratio shows the effiCiency of management of inventory. The ratio of net sales to inventory is called the inventory turnover ratio.
Formula
The inventory turnover ratio is calculated by the following formula: Net sales Inventory· For City First Saddlery Limited, the inventory turnover ratio was: 2003
70.1 10.6
= 6.11
2002 62.3 9.12
= 6.83. .
(The inventory for 2002 has been assumed at 9.12.) The number of days for which inventory is tied up can be calculated by the following formula: Days in year Inventory turnover ratio· For our example, the days for which money was tied up in inventory in 2002 equalled 365 divided by 6.11, or 59 days. For 2003, the number of days equalled 365 divided by 6.83, or 54 days. Benchmark
There is no benchmark for this ratio because the type of inventory determines what the ratio should be. Where items are fast moving, the ratio could be as high as 12; in other cases, it could be as low as 3 or 4. If the business is producing and selling daily necessities (perishable goods) - say, wholemeal bread - then the ratio will be very high. On the other hand, if the business is producing and selling durable goods - say, refrigerators - then the movement of inventory will not be that fast. A rnle of thumb could be that the ratio is equal to 4. Interpretation
A high ratio would indicate that the inventory is fast moving and that the products of the business are in high demand. The higher the ratio, the better it is. It means that the inventory management of the business is very efficient. Caution needs to be exercised, however, in interpretation of the ratio. A higher ratio may result in frequent stock-outs and a consequent loss of sale and customers. While calculating inventory turnover ratio, note the following points: • The ratio can easily be manipulated by a change to the basis of the inventory valuation. • Sales should always be gross sales minus sales returns - that is, net sales. Instead of net sales being used as the nominator, the cost of goods sold is sometimes taken as the nominator. This seems reasonable because both the nominator and denominator are then at cost.
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Part 2: AnaJysis and interpretation of credit risk I
• The year-end inventory figure may be misleading, so the average inventory figure needs to be taken as the denominator. The average inventory can be calculated by taking the average of month-end inventory figures; for example, add the figures of inventory at the end of each month QanuaryDecember) and divide the sum by twelve to arrive at the average iuventory. • The ratio should be compared. with the ratio of competitor firms or the average ratio for the industry
The average collection period This ratio shows the efficiency in collection of receivables. A business that is efficient in debt collection will face fewer liquidity problems. The average collection period is the ratio of receivables to average sales per day. Formula
The average collection period is calculated by the following formula: Receivables Average sales per day' For City First Saddlery Limited, the average collection period was: 2003 11.80 70.1 -;- 36S = 61 days
2002 9.76 S6 d ays. 62.3 -;- 365 =
(The figure of 9.76 for 2002 has been assumed.) Benchmark
The average collection period should be equal to or less than the firm's credit terms for its customers. If it is the policy of City First Saddlery Limited to allow up to one month's credit only, then the ratio as above is unsatisfactory. The firm's credit policy is usually determined according to the general market practice. New firms generally allow a longer credit period to penetrate the market. Similarly, firms may allow a longer credit period when introduCing new products. Interpretation
If the average collection period calculated by the above formula is less than the credit term generally allowed by the firm, then the debt collection of the firm can be regarded as efficient. On the other hand, if it exceeds the credit term, then the collection cannot be regarded as efficient. Note the follOwing points: • The nominator should be average receivables instead of year-end receivables. As in the case of inventory, the average receivables can be calculated by averaging the month-end receivables. • Similarly, average sales can be calculated by averaging the month-end sales figures.
• The average collection period ratio hides the age-wise distribution of receivables, so it should always be read in conjunction with the summary of age-wise (days collection in arrears) receivables. For thi.s purpose, the receivables can be classified into three categories: receivables pending collection for more than three months - receivables pending collection between one and three months - receivables pending collection for less than one month. If most of the receivables are in the last category, then there is no cause for worry If most of the receivables are in the first two categories, however, then receivables management is slack This situation may lead to liquidity problems. Profitability ratios A financially sound business is likely to be a profitable business. The two popular profitability ratios are the gross profit-sales ratio and the net profit-sales ratio.
·'D1e gross profit-sales ratio This is the ratio of gross profit to net sales, where gross profit is defined as the . difference between net sales and the cost of goods sold. Formula
The gross profile-sales ratio is calculated by the following: Gross profit Net sales . For City First Saddlery Limited, the ratio was:
2003
~~:i
= 0.21, or 21 %
2002
~~:~ = 0.23, or 23%.
Benchmark There is no benchmark for this ratio, but the ratio is expected to be at least equal to the industry average or more. Interpretation The higher the ratio, the better it is. The ratio measures the pricing and production cost control aspect. The firm may have less control over pricing, because the market decides price, bnt it Can control the costs. The ratio should be compared with the ratio of other firms in the industry
The net profit-sales ratio This ratio captures the profitability of the firm when all the costs (including the administrative costs) are considered. Formula
The net profit-sales ratio is calculated by the following formula: Net profit Net sales·
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Part 2: Analysis and interpretation of credit risk
For City First Saddlery Limited, the ratio was: 2003 3.3 7 0.1
2002
6~~ = 0.067, or 6.7%.
= 0.047, or 4.7%
The ratio can be calculated by taking either net profit after tax (as in the above case) or net profit before tax as the nominator. Benchmark
Again, there is. no benchmark for this ratio. The ratio should be equal to or more than the industry average. Interpretation
The higher the ratio, the better it is. The ratio provides a valuable understanding of the cost-and-profit structure of the firm. Leverage ratios Financial leverage means the use of debt finance. Leverage ratios help us assess the risk arising from the use of debt capital. It has been found that if a positive financial leverage could be established, then debt capital is a preferred source of finance. Analysis of financial leverage generally uses two types of ratio: structural ratios and coverage ratios. The structural ratios are the debt-equity ratio, the proprietary ratio and the debt-assets ratio, while the coverage ratios are the interest coverage ratio and the fixed charges coverage ratio.
The debt~equity ratio This ratio -~hows the proportion of amount borrowed by the firm compared with the proprietor's own investment in the business. It is a ratio of debt to the equity of the firm. The debt consists of all liabilities of the firm, whether short term or long term, and the equity consists of capital and reserves. Formula
The debt-equity ratio is calculated by the following formula: Debt Equity For City First Saddlery Limited, the ratio was: 2003 31.7 = 1 21 26.2 .
2002 23.70 25.60
= 0 93. .
Benchmark
Generally, the ratio should not exceed 2. This means that at least 33 cents in a dollar should come from the firm's own funds. In some firms, the debt-equity ratio could be much higher as a result of the nature of the business. Mining, fertiliser, shipping and cement companies, for example, may have a much larger ratio.
--If --
Interpretation The lower the ratio, the better it is. A lower ratio, as in the case of City First Saddlery Limited, indicates that creditors enjoy a higher degree of protection because the proprietors' stake in the business is large. Note the follOwing points: • The book value of equity may be understated, where equity is shown at historical (book) value in the statement of financial position yet the true worth of the company is much higher. • Some long-term debts, such as debentures, may already be secured by a charge on assets of the firm. • A lower debt-equity ratio is not necessarily a good sign. It may mean that the firm is not making use of the leverage to its advantage. • Two other ratios that give information similar to the debt-equity ratio are the proprietary ratio and the debt-assets ratio. The former is the ratio of the proprietor's funds to total assets, while the latter is the ratio of debt to total assets. The debt-equity ratio is the ratio of these two ratios: that is, the ratio of the proprietary ratio to the debt-assets ratio is equal to the debt-equity ratio. The proprietary ratio indiCates the stake of the proprietor in the business. The higher the stake, the better it is. Australian banks generally require a proprietary ratio of 40 per cent.
The interest coverage ratio The interest coverage ratio is the ratio of earnings before interest and taxes on debt interest. It shows whether the firm has sufficient resources to cover the interest portion of the debt. In the case of a firm having financial difficulties, the . bank may postpone the repayment instalment but would insist on, at least, payment of the interest on the debt. If a fum is unable to pay even the interest, then it is in serious financial difficulty. Fonnula The interest coverage ratio is calculated by the following formula: Earnings before interest and taxes Interest payable on loans For City First Saddlery Limited, the ratio was: 2003
8.9 2.1
= 4.23
2002
10.5 2.2
= 4 77
..
Benchmark There is no benchmark for this ratio, but the ratio should be at least 2 to give the firm sufficient buffer to pay interest on the debt. Interpretation The higher the ratio, the better it is. Earnings before interest and taxes are considered as the nominator because interest is usually paid before taxes.
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Part 2: Analysis and interpretation of credit risk I
Further, interest on the debt is a tax-deductible expense. Lenders commonly use this ratio. Note, however, that payment of interest comes from cashflow and not from earnings, so the lender must carefully examine the cashflow statement in addition to this ratio. This ratio is sometimes calculated by adding depreciation to the nominator.
The fixed charges coverage ratio This ratio is the ratio of earnings before interest and taxes plus depreciation to interest on the loan and the loan repayment instalment It is used to measure the debt servicing capacity of the firm. Formula
The fixed charges coverage ratio is calculated by the following formula: Earnings before interest and taxes + Depreciation Interest on loan + [Repayment ofloan + (1 - Tax rate) 1. For City First Saddlery Ltd, the ratio was: 2003 11.9 = 3.27 2.1 + 1.0 + 0.65
2002
13.5 2.2 + 1.0 + 0.65
= 3.52.
(Depreciation has been assumed at 3.0 for 2002, and the repayment instalment has been assumed at 1.0 for both years. The tax rate has been assumed at 35 per cent.) Please note that only the repayment of the loan is adjusted upwards for the tax factor, because the loan repayment amount (unlike interest) is not tax deductible. Benchmark
There is no benchmark for this ratio. The higher the ratio, the better it is. Interpretation
The ratio measures the debt servicing ability because, besides interest on the loan, it also includes the repayment instalment. This ratio is partici:Ilarly important in project financing. Here ends our discussion of ratio analysis. We will now turn to the other cross-sectional technique: common-size statements.
Common-size statements Common-size analysis came into vogue because interfirm comparisons were needed. When firms are of different sizes, it is hard to compare them unless their financial statements are expressed in a common form. This common form is created by expressing the components of the statement of financial position and statement of financial performance as a percentage of total assets and total revenue respectively Table 2.1 (page 60) illustrates a common-size statement of financial position.
f
-
Credit scoring techniques Learning objectives After reading this chapter, you should be able to: 1. list the development of credit scoring techniques 2. discuss the behavioural aspects of credit scoring 3. explain the imperative for credit scoring 4. discuss the application of credii scoring techniques 5. list the various modelling techniques used for credit scoring 6. discuss the steps to take in implementing a credit scoring process.
Introduction In chapter 1, it was indicated that credit scoring techniques are increasingly being used by lending institutions for credit assessment In this chapter we will look at the evolution and application of various statistical credit scoring techniques. Statistical credit scoring allows for rigorous and disciplined decision-making. Other chapters discuss the techniques and products available to a modern financial institution; this chapter discusses analysis within a centralised model that can be overlaid across the whole organisation to reduce the potential for error in credit scoring. Statistical credit scoring has been a popular analytical tool of financial institutions since the mid-1980s, fuelled by the exploSion of technology and the ability to apply computer solutions to human problems. It is important to realise, however, that the concept of credit scoring has been around for as long as credit has been extended. There have always been criteria on which credit decisions have been made and loans have been extended or rejected. These criteria were based on comparison and lending to the best risk. What separates the scoring techniques of today from those of yesterday are the reliance on technology and statistical analysis, and the downgrading of the loan officer (in the consumer market) to a sales rep~esentative.
Overview Since the early 1950s, per person outstanding credit in developed countries has risen exponentially and has continued to increase in velocity. The old systems of manual scoring are no longer affordable. The increase in credit applications coincided with the evolution of computer technology. This change not only offered a way to speed up the process of credit scoring but also provided organisations with a tool that could be used to expand business. As demand continues to increase and the need for timely credit decisions creates pressures for performance within a highly competitive system, statistical credit scoring will become increasingly important because it allows a lower cost structure to be overlaid on the pricing of the loan. This pricing aspect can ultimately mean the difference between survival or failure within the financial institutions defined markets. Credit scoring as used today is a statistical method of ranking the probability of an unknown outcome (that is, a loan paid or a loan defaulted) by allocating a points system to known variables. The credit information of an applicant is assessed and graded numerically to gain a total score, which is then ranked according to the expectations of the financial institution. A critical aspect of scoring is that it should not discriminate on the grounds of sex, race or religion, and credit should not be refused on the sole basis of location. Ultimately, a valid statistical credit scoring system exhibits the follOwing three basic characteristics. 1. It must not rely on prohibited information, and the information used must be statistically justified. 2. The information used should contribute positively to a client's creditworthiness. 3. The credit extended should contribute to the credit health and quality of the lending institution.
The ultimate aim of any credit scoring technique is to improve the quality of the loan book that a financial institution maintains. Statistical credit scoring is widely used in the consumer and small business areas, and is progressively being implemented across the larger business and corporate sectors. Changes to credit scoring methods are being progressively introduced as financial institutions continually re-engineer processes and practices for the ultimate aims of efficiency and productivity: Credit scoring techniques, as statistical measures, can forecast a probable result, depending on the accuracy of the data on which the system is based. There is still a real need for active management and timely intervention if the true state of the loan diverges from the statistical prediction.
The development of statistical credit scoring Credit scoring as a measure of loan success in its modern form began about thirty years ago, and it has evolved and matured alongside the evolntion of computer technology: The development of scoring systems continues to parallel the increase in per person outstanding credit, the expansion of the credit industry and the drive for cost reduction and productivity: The evolution of credit scoring reflects not only the growth of credit, but also a reaction to the need to differentiate and recognise population subsets where only related characteristics are immediately apparent (in other words, where the characteristics that separate the population are not obvious). Durand (1941) was the first person to recognise that the idea·of discriminating among population groups (first introduced by Fisher in 1936) as a pure statistical tool could be used to identify good loans and bad loans (Thomas 2000). Consumer credit expanded rapidly in the 1960s with the introduction of credit cards and the ability to use future money or earnings for small consumer purchases. Financial institutions realised the advantage of an effective scoring system, initially based on manual completion and certification. Technology supplied the missing link in the 1980s as the volume of applications outstripped both economic and staffing resources within institutions. The scene was set for even more rapid expansion of credit and, in turn, the further development and sophistication of the credit scoring techniques. The implementation and acceptance of scoring was not an easy transition because many traditionalists opposed the idea of a statistical measure applied arbitrarily across the whole population. Capon (1982) argued that 'the brute force empiricism of credit scoring offends against the traditions of our society'. He felt that there should be more dependence on credit history and that it should be possible to explain why a scoring system needs certain characteristics and not others. This view was more than offset by evidence that the default rate would drop by more than 50 per cent. Reports from Myers and Forgy (1963) and Churchill, Nevin and Watson (1977) cleared the way for wholesale implementation of the process within a large range of financial institutions. They were able to demonstrate that statistical credit scoring
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Part 2: Analysis and interpretation of credi't risk I
models would not only add value to the credit analysis process, but also add rigour through the application of probabilities and measurable outcomes. Most of the developed world has introduced legislation that makes it illegal to discriminate in the granting of credit unless the reason for credit refusal can be statistically proved or supported. The success of the application of statistical credit scoring techniques in the credit card market made it inevitable in the 1980s that financial institutions would expand their use into other areas, including personal loans, housing loans and small business loans. The techniques are now used for the full range of lending products, from individual to larger corporate loans. There are many reasons for the success of statistical credit scoring. Once the system has been tested and put in place, it ensures more accurate risk identification and significant cost reductions. There is also a substantial reduction in the interaction between the lender and the applicant, allowing for more time to be spent on developing the relationship and less time on number crunching or negative activities. Successful application of a statistical credit scoring process also allows a financial institution to restructure its staff profile, with more emphasiS on sales. This leads to an increase in the availability of credit because resources are released to deal with the increases in application volume. The lowering of the staff experience level and profile can lead to the potential for loan pricing to be discounted, with a proportion of the savings passed onto the consumer. Not all borrowers face a price reduction. Some will face a price rise because credit scoring models are able to distinguish good loans from bad loans in a non-emotional way This ability to make non-emotional decisions will improve in the financial arena. Historically, banks in particular have performed poorly in their pricing decisions because they have had a 'one size fits all' mentality Advances in the field of credit scoring have allowed accurate forecasting of portfolio values and, consequently, an increase in the securitisation of lower level financial products. With the success in the consumer market, it was inevitable that the same processes and procedures would be re-engineered for the small business market. N ow, the same degree of savings and efficiency gains are being reaped in this important area of lending.
The behavioural aspects of credit scoring The financial environment has been in constant change for the past twenty years, as old methods are replaced with new ones. The new methods are usually technology based t6 ensure an adequate return of shareholders' funds can be achieved economically Judgemental decision-making versus credit scoring has been a source of tension within banking circles since the latter's full introduction. Traditionally; banking has been about judgement and contact, with the relationship between the banker and the customer a paramount business concept. The bank manager used to be the human face of the bank and also the decision-maker in the majority of contacts.
/
-
Times change. The old-fashioned way of banking has ceased in the face of the techniques that evolved from the 1980s. The concept of a fully fledged bauk manager waiting to service the needs of the client were too expensive in the brave new world of finance. Technology was used to replace expensive finance managers with new sales-focused staff. These sales staff use analysis techniques to score a proposition that can be passed up the line for approval. The link between the manager, as the decision-maker, and the client has become redundant as new methods evolve to ensure financial institutions remain profitable, and as technology and process replace judgement and relationships. Today's sales force can enter into many more transactions than were possible under the old regime, simply as a result of the application of credit scoring techniques. Credit analYSis is about risk management. The judgemental approach built very sophisticated techniques for analysis, with many checks and balances built into the system. The successful functioning of that system depended on the individual lender being a highly trained individual who supported the network. Credit scoring has supplanted this individual. It is risk management by design, allowing costs to be reduced and businesses to expand at a previously impossible rate. Other behavioural reasons for the implementation of credit scoring included the breakdown of the judgemental system during the 1980s due to the frantic drive for market share and the worldwide deregulation of the' financial system. The 1980s were a watershed in the development of the modern financial system. Banking and the environment of banking had changed little in the previous fifty years; processes and procedures had remained constant. Deregulation was also an irresistible force, as countries across the globe removed restrictions on capital movements and exchange rates. Australia was one of the leading proponents of deregulation. We were faced with a choice: deregulate and modernise or place higher barriers to market entry. Australia chose to deregulate and modernise, which was the right decision because our economy has grown rapidly in the intervening years to be about twenty times larger today than it was in 1981. This environment of change and the entry of new competition in financial markets forced the existing players in Australia to respond, first in the drive for market share and second in the maintenance and growth of value for shareholders. .
The imperative for credit scoring A major problem in Australia in the search for the perfect credit scoring system is the small size of the population for analysis. Implementation of credit scoring within financial institutions in the 1990s nevertheless led to a Significant reduction in the v~lume of bad debts within the consumer market. Banks realised that credit scoring enabled them, for the first time, to have a true measure of risk in a given loan portfolio. Once a true measure could be set, then the next step waS to implement a standardised form of control and monitoring by senior management. In other words, losses within a given loan portfolio can now be predicted with a certain degree of accuracy Competitive advantage, beyond just
I 92
Pari 2: Analysis and interpretation of credit risk I
the individual safety of the loan, is derived from the cost savings and efficiency gains that credit scoring techniques can generate. Dun & Bradstreet developed a set of criteria that justify the imperative for statistical credit scoring (Thomas, Crook & Edelman 1992). The application of strong statistical tools helps reduce the cost of credit analysis and, in standardising the process, apply more rigour to the overall loan portfolio. The process extends to allow for market segmentation of the total loan book, such that cross-subsidisation can be identified and eliminated. First, a test score result is compared with actual operator analysis, to identify and verify statistically the accuracy of the system. Once this verification has been conducted and validated, the system becomes an operational tool with little human input. The process is updated on a needs basis. The cost of credit analysis is thus reduced. Correct application of statistical credit scoring techniques also allows for an increase in revenue through the increased volume of credit applications. Faster credit decisions allow for increased volume within scarce or existing resources, which means the portfolio creation process is more productive and ultimately more profitable. The consequent change to the staffing profile allows for the loan book to grow without a subsequent growth in the cost of maintenance. Statistical credit scoring models thus help lending institutions to cut costs and increase their volume of new customers. Importantly, they can also be used to check existing clients. The sale of products to existing customers can be better monitored and expanded, and new client segments can be targeted with . applicable products. By applying better methods of credit analysis to new clients, statistical credit scoring techniques allow for quick and accurate segmentatiOll of customer groups and quick reaction to competitor action. They also proVide the potential to prioritise future collections or identified cashflows, allowing for improved collection methods and cashflow management. Once this potential is released, a financial institution can grow its portfolio by more effectively using recurrent cashflow. Clients nominally share in the process and benefits where a financial institution's continual improvement and cost reduction lead to pricing discounts. Given that the above principles represent the functions of a statistical credit scoring system for a financial institution, a strong statistical scoring system has the follOWing advantages for an institution: • Credit scoring can increase returns by identifying good versus bad propositions based on the preferences and inputs of the financial institution. • An accurate credit scoring system reduces credit risk to a significant degree, or at least to a statistically accurate percentage of an outstanding loan book. • Credit scoring saves time in considering new credit applications, which allows for volume increases without necessitating personnel increases. • Credit scoring allows increased flexibility and expansion in the area of small and medium enterprises (SMEs). Again, this is based on the volume versus resources argument.
, .
• Where a poor credit score is calculated, the lender can take corrective action in the case of existing customers or refuse new business from a potential client. • A stronger lender/customer relationship can develop from the ability of the financial institution to predict performance. This feature can allow a modern financial institution to service customers' needs, not their wants. Brill (2001) noted: They say past performance does not guarantee future results, but in the world of credit decisions history often proves to be a reliable indicator. Credit scoring
models that measure the likelihood of delinquent payments using actual payment history along with other financial and demographic statistics are familiar to most credit managers as useful tools for pre-qualifying sales prospects and making informed credit decisions. These days, however, credit managers are discovering that the disciplined use of sophisticated statistical credit scoring models can also create a significant bottom line impact by improving cashflow and collections.
Statistical credit scoring techniques versus traditional judgemental methods In implementing and monitoring credit scoring techniques, it is important to measure and ensure the validity and application of the assessment. When applying a credit scoring system, the financial institution must clearly define and understand the outcome. Statistical measures to be used must be verified as to their applicability and alignment with traditional judgemental measures. It is wise to compare a statistical system to a judgemental system to ensure the credit scoring system adds value to the organisation. Any comparison between the two systems will be in the eye of the beholder. Statistical systems score highly when dealing with inexperienced staff and organisations. Experienced lenders place a high value on judgemental methods, but the sales focus of the modern financial institution mitigates against the development of experience. Table 3.1 summarises the differences between statistical and judgemental c~edit scoring techniques. TABLE 3.1
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94
Statistical versus judgemental credit scoring
1. Population difference
Impractical' or unsound mixtures of population are not sampled.
Credit officers make an unspecified _adjustment
2. Definition of creditworthiness
Precise corporate rules are defined and agreed.
The system relies on individual interpretation of what is good and bad.
3. Use bf credit rules
Credit rules are avoided because th~ system will generat~ its own 'best' rules.
Credit rules are often· based on limited data that dwell on the past.
Part 2: Analysis and interpretation of credit risk
I
,TopiC', ,
0,
0
,",'
",:,,:
-;"'4-:
,'o ,'SI~liSlic8lSCO!ing~
"
0
",
,Jud~m~nta(sillring"
'
Less information is needed because redundant information is ignored.
Wide use is made of data that are sometimes conflicting.
Analysis reveals distinctive and objective patterns of good and bad behaviour.
Rarely is a precise or accurate analysis produced to gUide the future.
6. Validity of characteristics and interrelationships
The impact and validtty of individual bits of information can be assessed.
Decisions are made without knowing the true value of items of information.
7.
Scoring formulations call be tested against a variety of samples for consistency and prediction.
It is not practical to measure the precise effect.
8.' Operational impact! flexibility
The system is based on high volume versus low cost.
The system can be· time consuming and accordingly expensive.
9. Improved calculations and,expected results
Calculations can be made for decisions' on-good, b,,!-d or reject behaviour.
It is difficult to estimate the value bf a model to measure performance.
10. Management control.
Management sets and defines policy by the ability to vary the cut-off score. according to conditions.
tt is difficult to tighten or ease credit policy withou t causing an overreaction or underreaction.
11. Monitoring and wider use
Measures can be monitored against current practice and developmental models.
The level of performance can be measured bu t the financial institution has no ability to easily pinpoint scope. for improvement.
Use of applicant - -informarion
!.';
':,
0
-:-5. Analysis of account behaviour
Validation of system used
Source: Adapted from L C. Thomas, J. N. Crook & D. B. Edelman 1992, Credit Scoring and Credit Control, Oxford Press, Oxford.
Several schools of thought exist in the development of techniques and methods. Based on table 3.1, however, two broad categories of scoring can be identified: 1. In aCCQunting,based systems, credit analysis forms the basis for the model and ratios are used as the base for analysis of data. Information can be gathered independently or by access to prepared data from organisations such as Dun & Bradstreet, Standard & Poor's, Moody's and Australian Ratings. The basis of the analysis is to seek deviations from the average (or mean) that generates questions or comparisons that the borrower must answer before the lender commits to giving an advance. These models are univariate (one variable) and have generated much debate about the continuing relevance of analysis based on single factor analysis .
• -"I"
_
Although univariate models are still in use today, many practitioners seem to disapprove of simple ratio analysis as a means of assessing the perfor-
mance of a business entity. Many respected theorists downgrade the arbitrary rules of thumb (such as company ratio analysis comparisons) that are widely used by practitioners; instead, they favour the the application of more rigorous statistical techniques (Caouette, Altman & Narayanan 1998). Some examples are Altman's Z score model and its variants, the emerging market score (EMS), the ZETA credit risk model Can evolution of the original Z score) and the seven-variable model. 2.' In quantitative credit screening, two broad streams have emerged: Ca) credit approval models, which use decision-reaching analYSis (b) behavioural scoring models, which are used to improve the profitability of accounts and products. Both categories rely on the use of statistical measures. The major difference is the predictive nature of the accounting-based models as opposed to the rear-view analysis of the quantitative models. In both cases, however, the aim is to predict an outcome based on available information. We will now discuss this second set of statistical credit scoring.
Statistical deCision-making methods used in credit scoring models Scoring models are designed to measure risk so the exposure of the lender can be managed. The first stage of statistical analysis is the gathering of data. Consider how much personal and financial information the average financial institution gathers from its customers. More often than not, the data are collected for an administrative requirement; imagine if that information could be galvanised and used for the safety of the institution. The real skill in any model is to identify the information that is needed and to source data in a timely and productive manner. Management information systems have been built progressively over the past two decades to ensure the data are available and accessible. This information retrieval aspect is one of the reasons that credit scoring has mushroomed from retail to corporate use in sophisticated credit risk analysis. The development of credit scoring hastened when the financial community accepted the concept of uncertainty in the early 1980s. The sector preViously assumed that risk was predictable given the regulated environment that existed in the developed world. In the context of a deregulated environment, the risk of a loan is the probability of the borrower making the repayment and the. uncertainty is the actual predictability of the borrower's future cashflows. Credit modelling provides a statistical base to the predictive models. In other words, risk and uncertainty are modelled to give a picture of future probabilities. Different methods were developed to meet the various demands of the end users (lending institutions), including the following thirteen main methods described by Hoyland (1997).
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There is a body of literature, beyond the scope of this text, that defines the characteristics of a 'good' lending contract. In summary, the contract should protect the interests of the lender without discouraging the performance of the borrower. Our main interest is in whether the borrower makes payments in accordance with the contract. There are three stages to this: 1. the credit risk analysiS applied to the borrower's application for a loan (topic of this chapter) 2, the assessment of the credit risk profile during the term of the loan (a topic
started in this chapter but expanded in chapter 11) 3. the credit risk profile when a loan becomes a problem (a topic discussed in chapter 13). Point 2 reminds us of a very important issue. It has long been assumed that credit risk is static, but both academic and practical experience has shown that credit risk can vary during the life of a loan. This phenomenon is known as credit migration and can be best explained by a simple illustration. If a bank extends a ten-year loan to a company, then it is unreasonable to expect the company to remain the same over the term of the loan. If it is a good company, then its credit risk profile will improve; if the company performs badly, then its credit risk profile will deteriorate. It is important that these changes are encapsulated over the term of the loan.
How do we analyse credit risk? This chapter will survey credit risk analysis over the recent period. Keep in mind that some of the tools discussed in this chapter are complex and some financial institutions still use the most basic of tools. In other words, every one of these tools are still used in one form or another. The tools can be grouped under the following four broad categories: 1. Expert systems are defined as essentially labour-based systems that depend on human judgement. The main technique used is five Cs analysis (see chapter 1) or a variant of this method (as in this chapter). 2. 'Some methods, called risk premium analysis, infer credit risk from financial market-based premiums. 3. Econometrics are systems that use more and more extensive and complex statistical methods. These methods include regression analysis and multidiscriminant analysis. In particular, we will examine risk premium-based and multidiscriminant models. 4. Hybrid systems build on financial theory and use these understandings to predict credit risk. The best example is the method that is used by KMV Corporatipn (see chapter 11, page 341).
Expert systems Expert systems are a misnomer, given that we should not infer that the methods used under this heading are superior to other categories. In the overall context
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of lending, they are probably the worst performers, These systems are characterised by the lending officer usiug predetermined credit criteria to make a decision on a loan application, The problem with this method, other than the obvious issues of time, is that the performance of such systems is very uneven, The performance problem reflects the experience of the lending officer and the application of the credit criteria, The success and failure of expert systems relies on the experience and performance of the lending officer. Many lending officers have the 'instincts' to make good lending decisions and effectively analyse lending applications; many, however, unfortunately do not have those instincts, In many instances, decision-making processes are clouded by the lender's relationship with the borroweL This is a reason for the rise of unambiguous statistical tools, The issue of the lending criteria is somewhat bound up with the previous point. Unless carefully written, credit criteria can be ambiguously interpreted as the lending officer desires, Again, the lender's relationship with the client can pollute the interpretation of the criteria, It is also worth mentioning that these methods were developed before the development of sophisticated computers and statistical tools, Many simple lending organisations, such as small credit unions, nevertheless would still base their decisions on such models, with limited support from other methods, In summary, these systems tend to be manually based, with some computer assistance for the calculation of simple financial ratios, In essence, the whole procedure is based on paper, from credit application to approval and funding, The follOwing stages are an example of this process: On receiving application from the prospective borrower, the lending institution attaches a checklist to a file and follows the steps, • The lender analyses and assesses each element of the checklist. • The loan is granted or declined, • In the event of loan approval, documentation is completed and the loan is funded, The most common procedure of this type is five Cs analysiS,
The live Cs As mentioned, financial institutions use a number of 'expert systems', of which five Cs analysis (or derivations) is the most common, In essence, these systems seek to cover the most basic of risk issues for the lender, including questions such as whether the borrower is allowed to enter into the contract and whether they have the means to pay back the loan under most circumstances, Expert systems seek to set a framework that helps lenders ask the right questions, This is the aim of five Cs analysis, which will now be examined in turn: • character
• • • •
capacity, cash collateral conditions.
Note that this discussion is different from that in earlier chapters. It is based on Rose's (1993) derivation of the five Cs and is designed to highlight that there are different approaches. Character almost equates to the moral fibre of the borrower. Is the purpose of the loan well defined? Does the potential borrower appear to be truthful in answering the questions? This issue can be vexing if the borrower is new to the financial institution and has no established track record. Capacity is a legal question. Does the borrower have the legal capacity to borrow? Court proceedings throughout the world have judged the position of persons signing loan documentation. The follOwing issues need to be considered here, depending on the loan. • For retail loans, a minor cannot execute loan documentation. • The situation for business loans is a little more difficult. A company representative who has a title that appears to confer authority does not necessarily have that authority The position of 'manager', for exampk, has caused problems in the past, as in a case relating to AWA Limited. For business loans, it is suggested that the lending institution seek board minutes on the delegation of financial management, to ensure management can sign the binding documentation. It is no surprise that the most important C is cash, because that is what repays the loan. Much of the financial statements analysis in this chapter is conducted to ensure the borrower can generate sufficient cashflow Cas opposed to accounting earnings) to repay the loan. The following ratios are used most often: Current ratio . Inventory turnover ratIo
0
Current assets Current liabilities
~ -:;----c-:-;-c;-:-;--
~
Net sales :------Inventory
. Net profit Net profit-sales ratIo ~ 1 Net sa es 'b"
.
.
O e t-eqmty ratIo
~
Debt - - .- . Eqmty
The importance of cashflow should not be subordinated to collateral, which can be considered only a secondary source of assuranCe of repayment. Whether for a business requesting project funds or an individual needing a home loan, the primary source of repayment should come from the project's earilings Cas opposed to the liquidation value of the project) or the individual's income' respectively This brings up the problematic matter of collateral. Collateral is the securing of a loan with an underlying asset. The most common example of collateral is the home from a home loan. Twenty years ago, banks often would rely on collateral rather than cashflow as comfort that the loan would be repaid. Tight financial conditions often produce difficulties in accessing collateral, however,
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Consumer lending Learning objectives After reading this chapter, you should be able to: 1. explain what consumer loans are 2. outline the major types of consumer loan 3. explain how different types of consumer loan application are evaluated 4. explain, with the help of specimen consumer loan applications, how the principles of lending are applied in practice 5. enumerate the precautions to be taken in assessing consumer loan applications 6. discuss how credit scoring of consumer loan applications is done 7. briefly explain the laws and regulations affecting consumer loans 8. outline the trends in consumer credit 9. explain the pricing aspect of consumer loans.
institutions pay to one another are called interchange fees (Reserve Bank of Australia and Australian Competition and Consumer Commission 2000). The card-issuing bank also charges the customer (a) an annual fee for issuing a credit card and (b) interest on the outstanding balance. Having discussed the different types of consumer loan, we will now explain how consumer loan applications are evaluated.
Evaluating consumer loan applications Here, we will present the general principles of credit assessment of consumer loans, followed by a step-by-step approach used by one of the financial institutions in Australia.
General principles Like all other evaluations of loans, the assessment of a consumer loan application follows the three fundamental Cs of lending: character, capacity and collateral (Bock 1994). Some authors (Weaver & Kingsley 2001, for example) add capital and conditions, and thus have the five Cs of lending. According to Caouette, Altman and Narayanan (1998), the three Cs of lending are character, capacity and capital. 'Capital', however, is usually included under 'capacity to repay' and 'conditions' are usually included under 'collateral'. According to Rose (1999), there are only two Cs: character and ability (or capacity) to repay: In this chapter, for convenience, we will follow the three Cs of character, capacity and collateral, incorporating the other two Cs (capital and conditions) therein.
Character The character of the prospective borrower is the single most important factor that influences a lender's decision whether to approve or reject a loan. Character is the most important and, at the same time, the most difficult factor to assess. As quoted by Weerasooriya (1998, p. 99), the famous American banker Pierpoint Morgan told a Senate inquiry that 'the first thing that I look for is the borrower's character'. (We include the full quote on page 6.) Nothing can be more powerful than this statement to adequately emphasise the importance of character in bank lending. Although assessment of character is a subjective issue, the following factors can assist: • Track record of the individual. If the intending borrower is already a customer of the bank, then it is easy for the banker to assess the track record because the borrower's complete financial history is available. The longer the relationship, the better it is. If the borrower is a customer of another bank, then bank verbals (opinions) are requested from that bank. Banks sometimes also refer to credit reference agencies and make enquiries with the borrower's friends and relatives. Before making such enquiries, the bank must obtain written consent from the borrower to this effect, as required under the Privacy Act 1988.
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Ability. The ability of the borrower can be judged from the formal education that he/she possesses in the area of activity that he/she wishes to undertake. In addition to a formal trade or other qualification, the borrower's experience in the particular area of activity is also an important consideration. These aspects become particularly important in the case of business loans. • Purpose oj loan. The third important factor to be studied is the purpose for which the borrower wants finance. The lending banker must ensure that the purpose is lawful, and is consistent with the loan policy of the bank. • The integrity oj the borrower. The client must have both the ability and willingness to repay tbe loan. The ability to repay can be judged from the capacity to repay, but willingness to repay is a question of character. The borrower may have sufficient surplus to repay the loan but may still try to avoid repayment of the loan in time. Borrowers often do not realise the importance of timely repayment and are lax in making payments to the bank. In the case of existing borrowers, their track record proves useful for forming an opinion of this aspect of character. In case of new borrowers, the bank bas to be more circumspect. • Spending habits. The borrower's spending habits are important. Some borrowers are 'Big Spenders' - that is, they spend far beyond their capacity to repay from their earnings. The likely result of such habits will be the borrower defaulting on a loan sooner or later. The bank must take adequate precaution at the time of granting the loan. Large outstanding balances on a credit card, multiple debts and a lifestyle inconsistent with earnings are some of the symptoms that give rise to suspicion. Borrowers who have a known history of gambling need to be handled with more caution.
Capacity 10 repay If satisfied that the purpose of the loan is genuine aud if the character checks on the prospective borrower are all encouraging, then the lender will start taking a serious interest in the loan applicatiou. The lender cau judge the repayment capacity of the borrower iu several ways. • Net income. The first and foremost consideration is the level of net earnings of the borrower. Net income is the income remaining after payment of all expenses.. The application form for consumer loans normally seeks details of the sources of income and expenditure. Income includes income from employment, receipts by way of dividends and so on. If the spouse of the borrower is earning, then the spouse income needs to be taken into account. Expenditure includes items such as rent, the living expenses of the family, and repayment of any other debts. • Deposit balances with the bank. Another way to check the creditworthiness of the borrower is to check the average balance maintained in his/her accounts with the bank. • Stability oj job. Job stability and continuity are other indicators of capacity to repay. Borrowers that have contractual jobs need to be assessed with care.
• Stability of residence. This is another factor taken into account in personal loans. It is generally believed that a borrower who has a stable residence has a more stable personal situation. Home ownership is often viewed as solid evidence of a stable financial situation. Having one's own telephone, house and household furniture is an indicator of a stable financial position. • Borrowers margin. The larger the borrower's contribution relative to the bank's contribution, the better it is. The borrower's margin is the borrower's capital in the total investment.
Collateral Collateral literally means 'along side'. Something that go'es 'along side' the loan is called collateraL In banking circles, the term 'collateral' is used as synonymous to 'security'. It .is often said that a prudent banker never gives a loan against security alone, which means that security should not be the prime consideration in giving a loan. The main consideration should always be the viability of the venture. This is especially true in the case of business loans. Loans should be given if the borrower has capacity to repay. Collateralis something to fall back on if the circumstances of the borrower change and he/she finds it hard to repay the loan out of normal sources of income. Invoking collateral is the last resort when all other means to secure repayment of the loan have failed. It is a legal process that is both time consuming and expensive for the banker. It may also create bad feeling between the borrower and the bank. If no avenues are left to recover the loan; however, a banker should use the right to dispose of the collateral and use the proceeds in repayment of the loan. Finally, general economic conditions should also be taken into account. In recessions, financial institutions may be less confident about lending. The above principles guide all lending decisions. We will now present a step-by-step approach that is generally followed while assessing a personal loan (for example, a vehicle loan). This will help you grasp the essentials of evaluating consumer loans. Many steps are common to all types of loan, although some of the details may vary.
Step-by-step assessment of personal loans The steps used in evaluating personal loans are discussed below.
Step 1: obtaining a prescribed application form Applications can be received by telephone or mail or at the branch. Applicants must be residents of Australia and preferably are residents of the service area of the branch. The lender should ensure the application is fully completed. In particular, the full name and address of all the borrowers, information about employment of the borrowers (such as designation, contract term, salary tax and other deductions) and living expenses should be obtained. The lender also should ensure to take authorisation for the disclosure of the applicant's information to Baycorp Advantage/Credit Advantage (formerly the Credit Reference Association of Australia). The authorisation should be signed by all applicants/
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guarantors. Dependents noted on the application must include children from a previous relationship for whom the applicant pays child support. If the applicant is not an existing customer of the bank, then it may be appropriate to open a savings account first, after following the usual precautions. It is important to obtain documentary evidence to support all the information given in the application. In Australia, financial institutions mostly use the credit scoring models (discussed in subsequent sections) where certain points (scores) are allotted for each piece of information that the borrower provides. The sum of all these points is compared with a cut-off score.
Step 2: conducting a preliminary assessment Credit Advantage should conduct a check on all applicants, including guarantors. All information obtained and its source should be recorded in writing. The bank official doing the credit check should sign and date the record. Check the applicant's capacity to repay by calculating hislher net income. To calculate net income, minus all deductions from gross income. The total commitments of the applicant should not exceed 50 per cent of the applicant's net income. Total commitments are equal to the repayment instalment of the loan applied plus other commitments (such as payment of other loans). In the case of joint applicants, the income of both applicants should be added. Allowances and overtime payments should be added to income. Allowances on which tax is levied should be added to gross income, while others should be added to net income. Income from other sources could be added to gross income if received on a regular basis. In the case of self-employed applicants, the lender should refer to their tax returns for the previous two or three years or audited statements of financial performance. Maintenance payments received by divorced persons are not to be treated as income. Proof of income - pay slips, group certificates, verification from employers and so on - used in calculating the borrower's repayment capacity should be held on file. An applicant's current employment, together with the term of current employment, must be verified. If the current employment is for less than two years, then the lender should make checks about the applicant's previous employment. An' employment check involves contacting employers or, in the case of self-employed applicants, contacting accountants. The address of the applicant can be verified by telephoning the landlord or sighting rent receipts, mortgage documents, council rates notices, a house insurance policy or confirmation from employers.
Step 3: accepting and loading applications Applications that are accepted and loaded on the bank's computer system would be given to customers for signing. An application can be cancelled anytime before disbursement, but a letter to this effect must be obtained from the customer and held on record. Customers also must be informed in writing. Even where applications are not sanctioned, the reasons for rejection should be noted in detail on the application. This is useful if there are subsequent complaints, disputes or enquiries.
Step 4: taking securities Securities that will be taken for personal loans consist of one or more of the following documents: a registered bill of sale over a motor vehicle, boat, caravan and so on; a charge over banklbuilding society deposits (that is, term and savings accounts); and a charge over the surrender value of a life insurance policy. All vehicles secured by a registered bill of sale should have comprehensive insurance registered in the name of the banklbuilding society as mortgagee. In the case of vehicles purchased from a licensed dealer, details such as the full price of the vehicle, the registration number, the engine number, the chassis number, the make and model, the year of manufacture, the dealer's registration number, the deposit paid and the amount ofloan should be recorded on the invoice. Where vehicles are purchased privately; various searches should be conducted to establish title, nonencumbrance and, in some cases, bankruptcy. The vehicle should be registered in the State where the banklbuilding society is located. The present owners of the yehicle are required to sign a certificate that they are not bankrupt and that the vehicle is not subject to any encumbrance. All vehicles used as security should be registered with the State Motor Vehicle Securities Registry. Boats are registered with the Department of Consumer Affairs Bill of Sale Registry The full cost of the vehicle is never financed. The borrower is required to contribute a margin (that is, hislher own share) to the cost of the vehicle. In the case of new vehicles, generally 80 per cent of the invoice price and, in the case of used vehicles, 70 per cent of the invoice price or the price as per the dealer guide (whichever is lower) is financed. Financial institutions generally insist that the value of the vehicle should be at least $10000. The norms of valuation in respect of different types of vehicle are generally indicated in the loan manual of the bank. The disbursement of the loan is generally made directly to the seller of the vehicle. A bill of sale registration fee is also charged to the borrower's account. Funds held in the account of the borrowers or guarantors may be frozen automatically at the time of approval. This is known as the creation of a charge over deposits. All the parties in whose name the deposit account stands are required to sign such a charge. Banks sometimes obtain a charge over the surrender value of the life insurance policy of the borrower. The surrender value should be ascertained from the insurance company and 75 per cent of the value may be reckoned as security. An assignment form and memorandum of transfer are completed and registered with the insurance company. A guarantee usually cannot be used for a personal loan, except perhaps where security is falling short. The relationship between the borrower and guarantor should be studied. The guarantor should be given full particulars of the loan contract, which should not be altered without the knowledge of the guarantor. An alternative to guarantee is co-borrowing. Here, the co-borrower's name appears on all the loan documents and he/she signs all the documents.
Step 5: determining interest, lees and charges To calculate the interest to be charged on the loan, the lender deducts some percentage (for credit score concession and security) from the standard rate. The
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fees and charges that are generally levied include: an application fee, loan contract stamp duty, a bill of sale registration fee, an encumbrance search fee, a bankruptcy search fee and a registered owner search fee.
Step 6: approving/rejecting applications Applications are approved as per sanctioning powers given to managers working at various levels of the bank. Where an application is rejected as a result of the Credit Advantage report, the borrower may be advised accordingly: In all other cases, the borrower may be advised that the application did not meet the guidelines of the bank; there is no need to give any specific reason. If a loan is approved, then at the time of disbursement, a senior officer should be present to verify all the documents, ensure the borrower and guarantor sign in hislher presence and certify that this has been done.
Step 7: supervising the loan and following up Personal loan accounts do not require much supervision, just a regular follow-up to ensure the repayment of loan instalments are made in time. Reminder letters may be sent to the borrowers whose instalments are in arrears. The first reminder is generally sent within one week of the instalment falling in arrears, and a second is sent a week later if the payment still has not been received. Every effort should be made to assist borrowers who are in arrears. This could involve temporarily extending the repayment period or accepting available payment now and the remainder at the time of the next instalment. The credit/kgal department of the controllinglhead office generally takes legal action when the borrower fails to pay despite follow-up. Where security is to be repossessed due to nonpayment of dues, banks generally appoint a mercantile agent. Borrowers should be informed in advance about the action and given sufficient time to bring the goods to the bank themselves. If this warning fails, then the mercantile agent may be asked to possess the goods and bring them to the yard of the bank. The loans department reports loan defaults to Credit Advantage.
Step-by-step assessment of credit card loans The assessment of credit card loans is similar to that of personal loans. It is even simpler, involVing fewer steps than those needed for personal loans. • Step 1: obtain the duly filled-in prescribed credit card application form and ensure all details have been completed. Applications can be received by telephone or mail, over the Internet or at branches. • Step 2: conduct credit checks via Credit Advantage, employers and from other banks where the customer holds accounts. • Step 3: if the checks are satisfactory, then load the details of the application . on the computer system. The computer system will automatically work out the points and give a decision against a set cut-off as to whether the application can be accepted or rejected. • Step 4: where the application is approved, request that a credit card be made ready, indicating the name of the card holder and the date to which the card is valid. An approval letter and a detailed book of instructions about using the
credit card will be sent to the applicant. The card need not be sent directly to the applicant, who instead may be advised that the credit card is ready for collection at a local branch. The branch will hand over the credit card when the applicant produces this letter and signs the card issue register. Where the application is not approved, the applicant may be suitably advised.
Example of a consumer loan application Referring to the Commonwealth Bank's personal loan application form and credit card loan application form as examples, we will explain how the information sought on the forms ultimately helps the lending banker to assess the quality of the loan proposal. We have tried to relate the questions on the application forms to the three Cs of lending explained earlier.
Personal loans An application form for a personal loan is downloadable from the Commonwealth Bank's website (wwwcommbank.com.au). It will help to have the form handy while reading the follOwing discussion.
Character • On the loan application, the bank obtains the authority of the prospective borrower to collect information from a credit reporting agency and to exchange that information with other credit providers. Such an authority helps the bank to carry out credit checks. The information that the bank will receive will throw light on the character of the borrower. The bank may ask whether the applicant has any other debts. Some applicants may not disclose this information, which may not serve them well because the bank will come to know from other sources whether there are prior debts. If an applicant hides information, the banker does not form a good opinion about the applicant. In short, the applicant becomes an 'at risk' party and the bank may not view him!her favourably. • Some questions on the application form relate to the particulars and contact details of the applicant. The bank will verify these details. Evidence that will be used by the bank includes a driver's licence, proof of age card, a citizenship certificate and an overseas or Australian passport. The bank can verify the applicant's residential address by telephoning or visiting the residence. The bank will also send letters to the residential address and request the client to come to the bank with those !etters. This confirms that the applicant is actually residing at the address indicated. The bank also seeks the applicant's length of residence at the address provided. Changing residence frequently may not be viewed favourably by the bank. It shows that the applicant is not stable at one place. As indicated in the discussion of credit scoring models (see pages 155-8), a longer period of stay at a residence earns more points. • One question on the loan application seeks details about the applicant's previous employment. The banker may contact the previous employer to check the applicant's character.
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The loan application contains a further qnestion about character assessment. From the status of an applicant's friends, a banker can obtain an idea of the social strata to which the applicant belongs. Influential friends are a positive in this assessment process.
Capacity • Some questions on the loan application are about employment. The banker is trying to assess the stability of the applicant's employment. If the employment is stahle, then there will be a stable source of income from which the bank can expect repayment. The banker wants to ensure the prospective borrower is able to service the debt (both the instalment and interest) on time. The bank seeks the tenure of the applicant's employment. Casual or part-time employees may not find favour with a banker. Again, the banker will also make inquiries with employers about the status of the applicant's employment. • Some questions on the loan application seek to assess the repayment capacity of the applicant in one way or the other. The banker also seeks to know whether the purpose for which the loan is sought is an approved purpose under the bank's loan policy Details such as the items to be purchased and their prices are sought by the bank to know how the loan is going to be used. The bank may also require a quotation. • Some questions on the loan application seek information about the amount the applicant wants to borrow and the approximate monthly repayment that the applicant proposes to make. The amount that the applicant wants to . borrow reveals the applicant's own margin or contribution (recall the C of capital). The bank will compare these details with the net income of the applicant to judge whether the applicant can service the loan together with interest. The bank asks whether the applicant is a new customer of the bank or an existing customer. If the applicant is an existing customer, then the . bank probably already knows hislher financial dealings and has a good idea about hislher character. If the applicant is new, then the bahk will be more circumspect. Some questions seek details about the income and expenditure of the applicant, so as to arrive at the net surplus available to service the loan.
Collateral The purpose of some questions on the loan application is to know the financial standing or creditworthiness of the applicant. If the applicant has property and investments, then the risk .in giving a loan is much less. A further purpose is to know what collateral (security) the applicant can offer. One question has a similar purpose, requesting details of the applicant's friend/relative. The bank can suggest that the friend/relative stand as a guarantee for the loan if needed.
Credit card loans An application form for a credit card is downloadable from the Commonwealth Bank website Cwww.commbank.com.au).The information requested by the bank is much the same as that requested on a personal loan application. This is because the purpose of s,eeking the,information is the same in both cases. Some
/
-
additional questions have been included, however, and here we will explain why this information is required. The relevance of some of the additional questions is obvious. The bank wants to know the applicant's requirements of the credit card: that is, the type of card, the interest-free purchase period required and whether the applicant is a member of the bank's 'rewards' program. The interest rate that the bank will charge on outstanding balances and the card fee will vary, depending on the type of card option chosen by the applicant. One question on the credit card application seeks information about the applicant's reSidency status. If the applicant is not a permanent resident, then the bank may be circumspect in issuing the card. It may be hard for tbe bank to chase up credit card holders residing overseas if there are any outstanding dues.
Precautions to be taken in granting consumer loans Consumer loans are rar simpler to assess and monitor than, say, corporate loans or farm loans, but it is still important to take adequate care to avoid problems down the track. A banker may face some of the following challenges: 1. Individuals may withhold information that is crucial to decision-making. There could be issues relating to health or continuity of employment. 2. The applicant may provide inconsistent information. The inconsistencies may be intentional or due to lack-of knowledge of bank procedures. 3. Verifying some of the information provided could be a problem. On many occasions, employers may not be williug to disclose details about their employees to tbe bank. Tbe bauker also needs to be more cautious in disclosing information about a prospective or existing borrower. In the case of Toumier v. National Provincial and Union Bank of England (1924), the banker, in the absence of Mr Toumier, told Mr Toumier's employer of his gambling habit and the state of his bank account. Mr Toumier's contract was not renewed; he lost his job and successfully sued the bank for slander and breach of confidentiality. 4. The applicant may have a good character otherwise but not realise the importance of making repayments on the due date. 5. Individuals are susceptible to sickness, injury, loss of employment and other such issues that may affect their ability to repay. Even family dispu tes can affect the repayment performance of a borrower. 6. Individuals tend to overcommit through nondisClosure of other debt. 7. The individual must have a capacity to enter into a loan contract. A loan contract, like any other contract, requires that the person should not be a minor (less than 18 years of age), someone of unsound mind or an insolvent. 8. The personal loan borrower should be encouraged to maintain a savings account with the bank. 9. Borrowers must sign loan documents in the presence of an authorised bank officer and preferably at the branch of the bank.
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10. Loans should normally be not given to repay an existing loan from another source. 11. In the case of salaried borrowers, their salary should be credited by the employers directly to a savings acconnt with the bank. 12. If the terms of the loan are changed, then all the documents (including guarantees) need to be re-executed. 13. Interest is calculated on a daily basis from the date of advance and debited to the loan account on the last day of each month. 14. Many banks follow a credit scoring system for assessing personal loans. The system serves as a gUide, with approval decisions to be based on income capacity, length of time in residence, length of time in employment, association with the bank and previous credit history. 15. In the case of fixed interest loans, if payment is received in advance, an early repayment penalty applies. The penalty applies where the current fixed interest rate is lower than the contracted fixed interest rate. The penalty is equal to this difference. 16. The Privacy Act (Commonwealth Government legislation) applies to all consumer loans. It requires that credit checks cannot be done without written permission from the prospective borrowers. All parties to the loan contract, including guarantors, have to sign the authorisation to carry out credit checks. In case of applications over the telephone, verbal authority should be obtained and then written authority should be taken before loan approval and kept on record. 17. The bank is legally bound to give information relating to borrowers' accounts to the Australian Taxation Office, the Department of Social Security (via CentreLink) and the Public Trustee. In all other cases, no information can be passed on to any third party without the express written authority of the borrower. 18. A bankruptcy search is conducted through the Bankruptcy Registry in the nearest capital city. An encumbrance search is conducted through the State Motor Vehicles Security Registry, while a registered owner search is conducted through the State Department of Transport. 19. The loan officer should carefully read the loan policy manual of the bank and meticulously observe the procedures indicated therein, the documentation required and other such details. 20. The bank's head office advises the branches and offices of changes to the loan policy from time to time. It is necessary to ensure loan officers are up to date with all the changes.
Credit scoring consumer loan applications As already explained, banks assess the applicant'S character, capacity to repay and collateral before approving or rejecting an application. For credit assessment, banks traditionally used judgemental procedures. As per these procedures, the lending officer of the bank subjectively interpreted the information provided by
the applicant, keeping in view the bank's lending policy, and decided to accept or reject a loan. Banks thus 'relied on the judgement of their officers, who were usually given adequate training before they started as lending officers. Judge. mentallending was not only subjective but also time consuming. The cost of credit assessment was considerably high, given that the number of applications one could assess in a day was limited. In more recent years, banks have developed a more efficient and cost-effective system of assessment of consumer loans. Many banks today use credit scoring to evaluate the consumer loan applications. The major credit card companies such as MasterCard and Visa use the credit scoring system to evaluate credit card applications. Similarly, a growing number of banks and nonbanks are using credit scoring models to evaluate motor vehicles loans, home loans and other types of consumer loan. Credi t scoring systems have many advantages over the judgemental systems, including the following: • a large volume of credit applications Can be handled • applications can be processed speedily • the operating cost of using credit scoring models is low compared with that of judgemental models • there is no need for elaborate training of loan officers, and training time and costs can be saved • customers like the convenience and speed with which applications are processed and decisions are reached. Many consumer loan applications can now be lodged over the Internet; for example, the Commonwealth Bank of Australia and many other Australian banks accept online consumer loan applications. The decisions regarding approval or rejection are often given within a short time, either online or by telephone, after the bank makes credit checks. Credit scoring models are developed using statistical models (equations). In these models, several variables are simultaneously used to arrive at a credit score or ranking for each applicant. If the score exceeds the pre-determined cut-off score, then the application is automatically approved. The variables that are used in the credit scoring models include age, marital status, number of dependents, home ownership, income. bracket, credit rating, time in current employment, number of bank accounts held, the type of accounts held and telephone ownership. The credit scoring models attempt to segregate the good loans from bad (risky) loans based on the past experience of the bank. The bank collects data of loans that have proved to be sound and those that have proved to be risky against each of the above parameters, then runs a statistical model (like a regression or discriminant function) that gives the relative weights (points) for each of the above variables. These weights are then used for constructing a credit scoring model against which all applications are evaluated. The scoring models are dyuamic; that is, they are tested and re-tested periodically, and revised if necessary. If a drastic change in auy of the variables is found to influence the model differently, then the model would be adjusted for that change. /
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The following table 5.1 shows the variables (factors) that are used in a typical credit scoring model and the cut-off points for decision-making. TABLE 5.1
Points value of factors in credit scoring models
1. CustoH'Iers occupation,
or line ofworh
, Professional or business executive Skilled worker - Clerical worker Student
10 8 7 5
4
Unskilled wOlker Part-time employee' 2. Housing status Owns home Rents home or ap'art:rrlent Lives with friend or relative . 3. Credit rating Excellent Average No record Poor 4:' Length 'of time in ~urrel1t fob More than o~e_-year One year or .less . 5. Length of time at current address More than one year One year or less 6. Telephone in home or aparlinent
2 6
4 2
10 5 2
o 5 2
2 1
Yes
2
o
No 7. Number of dependants reported by customer None One
3 3
Two
4
4
Three More than three 8. Bank aaounts held Both cheque and savings Savings account only Cheque account only None
o
Point score value or range
Credit decision
2
4 3
2
Reject application Extend credit up to Extend credit up to Extend credit up to Extend credit up [0 Extend credit up to Extend credit up to
28 points or less 29-30 points 31-33 points 34-36 points 37-38 points 39--40 points 41-43 points
$500 $1000 $2500 $3500 $5000 $8000
Source: P. Rose 1999, Commercial Bank Management, Irwin McGraw-HiH, Boston, pp. 610-11 .
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Security, consumer credit legislation and legal aspects of lending Learning objectives After reading this chapter, you should be able to: 1. understand the legal framework tha't governs consumer and real estate lending 2. explain the various lending documents that need to be obtained in consumer ard real estate lending, and their purpose 3. understand the special legal rights of lending bankers 4. explain the legal requirements that are specific to home loans 5. explain other relevant legal aspects (such as banker's lien, the right to set-off and appropriation of payments) in bank lending 6. prepare a checklist that lending officers can use to ensure they have satisfied fundamental legal requirements of lending.
Warning: TllB following outline of the workings relating to lending. It is should not be used as, proper textbook on law competent solicitors.
material is a bare of the legislation not intended as, and a substitute for a or the advice of
legislation dealing with contracts and consumers The Contracts Review Act 1980, the Fair Trading Acts and the ConSUl11er Transactions Act 1972 are State-level statutes, which have the object of protecting consumers and striking down unfair and unjust contracts. The Contracts Review Act is New South Wales legislation, while the COnSUDler Transactions Act is South Australian legislation. The Fair Trading Act of each State is similar to the Commonwealth's Trade Practices Act. According to Blay and Clark (1993, p. 599), 'The [fair trading] legislation was largely designed to overcome the constitutional limitations of the Trade Practices Act 1974 which applies largely to corporations'. Fair Trading Acts apply to individuals. The second phase of lending is concerned with the legal aspects of pre-loan approval: loan documentation, the rights and obligations of bankers and CUs. tomers,actions in the case of default and other relevant issues. In the following sections, we will discuss each of these aspects.
loan documentation Lenders require borrowers to sign many documents before the disbursement of a loan can take place. Lending officers are often warned not to disburse a loan until the necessary legal documentation is completed. The loan documents are elaborate and carefully drafted by the lender's legal advisors. It is often said that the documents are deSigned to protect the lender in all situations and may not be in the best interests of the borrower. Staff are often advised to adhere to the standard documentation prepared by the head office and not to make anyalter. ations without express authority. This is necessary because the legal advisors of the lender consider past cases and incorporate suitable clauses to protect the lender from an eventuality. The complexity of documentation has resulted in several court cases in Australia and overseas, prompting moves towards drafting the documents in plain and commonly understandable English (see Weera· sooriya 1998 for a detailed discussion of these issues). There is still a long way to go, however, and the documentation remains quite complicated. As a result, lenders often take an undertaking from the borrower that he/she has consulted legal experts and understands hislher obligations by signing the documents. Lending officers should be cautious about offering any.interpretation of the clauses in the documentation; a safer alternative is to advise the client to consult a solicitor. Having understood the common difficulties faced by borrowers and the precautions that lending officers should take, we will now turn to other details about documentation. From the loan application form of the Commonwealth Ba).1k of Australia (see the bank's website, as instructed on page 186, chapter 6), we know that lenders obtain the following types of document before advancing consumer/real estate loans.
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Promissory note A contract of loan arises when one person lends or agrees to lend money to another person in consideration of a promise (express or implied) to repay the loan with or without iuterest. Such a promise is made in the form of a promissory note. It is a basic loan document and is invariably obtaiued by banks in all types of loan, whether for personal or business purposes. It is a simple promise to pay the interest and repay the loan amount borrowed.
Mortgage deed A mortgage is the transfer of an interest ina specific immovable property to secure a loan. The party transfering such an interest is called a mortgagor, the transferee is called a mortgagee, and the transfer instrument is called a mortgage deed. Various forms of mortgages are recognised by law. The forms commonly found in Australia are legal mortgages, statutory Torrens mortgages and equitable mortgages. Weerasooriya (1998) lucidly explains the difference between a legal mortgage and a statutory Torrens mortgage. A legal mortgage is the conveyauce or assignment of the legal estate of the mortgagor in property (real or personal) to the mortgagee. Under the Torrens system, the mortgage takes the form of a statutory instrument which, when registered, confers on the mortgagee an interest in the land. In a legal mortgage, the legal interest in the property is transferred to the mortgagee. In the Torrens system, the legal interest remains with the mortgagor and only equitable interest is transferred to the mortgagee. As opposed to legal mortgages, in an equitable mortgage, the mortgagor does not make a legal transfer of a proprietary interest, but merely a binding undertaking to confer such an interest. The mortgagor has a right to payoff the debt and redeem property. Banks use standard forms to obtain a mortgage. Specimens. of a promissory note and a mortgage deed can be found in Sirota (1994); specimens oflending documents can be found in Francis (1987).
Guarantees A guarantee is one of the simplest forms of security taken by lenders. A contract of guarantee is a contract to perform the promise or discharge the liability of a third person in the case of default. The principal debtor or the borrower is a person for whom the guarantee is provided. The person who provides the guarantee is called the guarantor and the person for whom the guarahtee is provided is called the creditor. A guarantee covering a single transaction is called a specific guarantee, while a guarantee covering a series of transactions is called a continuing guarantee. The liability of the surety (the guarautor) depends on the default of the third party (the principal debtor). Given that all the parties to a guarantee - that is, the guarantor, the principal debtor and the creditor - subscribe to the contract, any changes to the terms of the original credit cOntract must be made with the consent of the guarantor. The guarantor is discharged from liability if the terms of the contract between the principal debtor and. the creditor are
changed without his/her consent. In the case of a con tinning guarantee, on the death of the guarantor, his/her estate will not be liable for future trans. actions. The guarantor can revoke a contract of continuing guarantee bl' giving suitable notice. If the principal debtor is released, then the guaranl~r is automatically released. Lenders usually obtain a continuing guarantee and use standard forms to obtain guarantees.
Bill of sale Hire purchase companies use this type of security when lending for motor vehicles. It is important to ensure the bill of sale is properly drawn. II should be prepared on the usual stationery of the vendor (the vendor's printed forms), bear a current date (not be a stale bill) and be signed with the seal of the vendor. It should be ensured that the bill of sale indicates the registration .number of the vendor and is drawn in the name of the borrower, indicating the borrower's full address. When such a bill of sale is furnished by the borrower, the lender should confirm its veracity Lenders usually make payment directly to the vendor against delivery of the goods specified under the bill of sale. The bill of sale is a primary document of evidence of the sale contract.
An assignment of shares or life policies Assignment means a transfer of a right, property or debt by one person (assignor) to another person (assignee). The borrower gives an irrevocable order that the proceeds from life policies may be paid directly to the lender In the event of default, the creditor has. a right to enforce the assignment and use the proceeds towards the satisfaction of the debt. Lenders consider assignment of life policies to be one of the most satisfactory forms of security This is because the value of the security (assignment) can be readily ascertained, it is stable and it can be eaSily realised. Lenders often prefer assignments to guarantees. According to Weerasooriya (1998), a life policy is considered to be a much more tangible, reliable and acceptable banking security than the average guarantee. Another security that lenders may accept is the company shares that are listed on the stock exchange. Lenders normally accept only those shares that are quoted and marketed in recognised stock exchanges. They prefer shares of blue-chip companies such as BHP Billiton, Lend Lease and Amcor. Although value of shares may fluctuate (and even sharply at times), the prices can be readily ascertained and the shares can be readily sold. Lenders normally insist on legal mortgage 0 f shares. This means the debtor assigns it in favour of the bank by filling in the share transfer form, which can be obtained from the relevant company Snch a transfer usually takes place subject to an agreement that the security will be transferred back to the borrower when the loan is repaid. Transfer of the shares in the name of the lender 'incurs a transfer fee. Once the fee is paid, the share registry of the company issues a holding certificate (called a share certificate overseas) in the name of the bank. To save the transfer fee,
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Corporate lending Learning objectilles After reading this chapter, you should be able to: 1, apply the principles of corporate lending 2, explain the application of lending criteria 3, list the contents of the loan structuring proposal 4, discuss the importance of financial information 5, explain the importance of managing the loan portfolio 6, demonstrate awareness of available loan products,
Intm d1.1 eli 0 n C01porate lending is an intuitive process that is more an art than a science at this stage of its evolution. Credit scoring techniques are fast being developed and applied to corporate lending, however, and are set to add a layer of protection over the approval process. The side effect of credit scoring is the acceptance that a percentage of loans will go bad; in the past, loans did go bad but would not have been approved unless the analysis indicated the ability to repay. . In this chapter, we will examine the principles of corporate lending and their application in the construction of corporate loans. In addition, we will examine the actions of the loan officers in line with the success or failure of the loan process. Within this process, we will examine the lifecycle of a loan to demonstrate the difference between the products of a financial institution and those of other corporate entities.
An overview of corporate lending Corporate lending represents the high end of the loan portfolio mix for a modern bank or financial institution. It is also a fiercely competitive arena where margins can be small and the risks can be great; a successful lender understands the overall market and its niche in that market. Careful consideration needs to be given to the type of client, and their reputation and standing; the selection of a carefully balanced book ensures prosperity in the good times and survival in the bad times. The correct mix and share of various industries is essential to overall success. Too much market share in one segment of the economy makes the institution vulnerable to movements in the economy; in other words, a snccessful bank sometimes declines good business so as not to be overexposed in a particular market segInent. A good lender needs to balance the requirement to meet their target against the quality of the business they write. The hallmark of a successful lender is the ability to say 'no' to a bad or suspect proposition. One of the most important of the many rules of lending is not to lend for the sake of lending. The approval process should be in line .with the lending criteria of the institution and the individual's common sense.' Loan quality is the essence of good management of the loan portfolio. The importance of loan generation and the credit competence of the approving officers cannot be overemphasised. The structural changes and the reliance on technology in the finance indnstry conld send a signal of the relative unimportance of credit approval, but the growth of a loan book involves risk, which involves acconntability, which introduces the need for education. A successful loan officer understands the principles of lending and that segmentation in the marketplace allows for an expertise to be gained - in this case, in the area of corporate lending. Nobody can get it right all the time. A lender who claims to never have been involved in a loss has probably never effectively and profitably lent money The
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major reason for this risk is timing: lenders are using today's iuformation to predict behaviour into the future. It is an inexact science at best; at worst, it is about a most unpredictable form of human activity. The lender assesses the viability of a particular borrower for a set amount for a given purpose over a pre-determined period of time at a particular cost or interest rate, accounting for known facts and predicting those facts into the future or making decisions in a context of uncertainty. Two major methods are used to facilitate the approval process in corporate lending: (1) the traditional or knowledge-based approach and (2) the credit scoring or statistical method. The skill of lending is to know when to accept the risk; but first the able banker must be able to evaluate, assess and trust that risk (Mather 1972). Flexibility is a key ingredient for success. To apply basic principles as inviolate rules will mean good business is declined or the special needs of an existing customer are ignored, to the detriment of both the loan book and the success of the financial institution in the medium to long tenn.
The purpose of corporate lending Success is based on the premise that each party to the transaction has confidence that the other will honour the tenns of the agreement. The lender's primary purpose is to ensure the growth of the loan book in a quality way, so as to make profits that ensure shareholder value .is maximised in the long term. Given that financial institutions deal in intangible assets, it is important to recognise the hidden costs of loan approval and management so true value is obtained via a properly researched and constructed loan policy.
The loan portfolio The creation of the loan portfolio is a key success factor for a successful financial institution. Lenders need to ensure the structure of their loan portfolio demonstrates assets with varying interest rates, cashflows and maturities that is, a mixture of fixed, floating, interest only and at-call. The major considerations in the construction of the loan portfolio are: asset mix and loan types diversification, to ensure the management of loan runoffs and therefore protect the institution's internal cashflows geographiC limits, which must be within the capability of the institution and sufficiently diverse to allow a good balance of business • expertise. To enter a defined market segment, a financial institution must have staff that understands the market segment. Failure to address this issue will result in an inability to generate positive income from the business. policy formulation, involving a correctly documented and articulated loan policy to ensure direction is maintained environmental issues, focusing ou economic activity, demographic infonnation, income and spending/expense profiles .
a competitive environment, which the lender recognises by giving its loan officers information about competitors and their structures, pricing policies and management. This information will allow loan officers to predict competitor reactions to initiatives. • delegation, which must be clearly articulated so lending officers know the limits of sustainable activity and the likely reaction time • audit and review, which are key success factors in providing the hindsight necessary to grow and develop corporate memory and culture. Finally, in assessing the worth and sustainability of the loan portfolio, it lllUSt be remembered that risk is the basis of return and must be considered in the construction of the portfolio., Risk is a function of the cashflow relationship between a portfolio's assets and its liabilities; that relationship is the key to the profitability in relation to exposure of the loan book.
The principles of corporate lending There is an element of risk with every corporate loan application. Some risks are apparent at the start of the transaction, while some underlying risks may occur later and are not immediately obvious. Business development can become a key driver as long as there is a conscious acceptance of increased risk. Unfortunately, there are no rules for risk-free' or trouble-free corporate lending, although adherence to well-researched principles and practice will lessen the potential for disaster and ensure, as a minimum, a disciplined approach to corporate lending growth. A successful lender is, able to identify the risks involved in a lending transaction and assess th()se risks to decide whether they are acceptable and they contribute to statement of financial position quality and growth. A lending officer must ensure the safety and security of the financial institutions; at the same time, he/she must manage uncertainty. The future is unknown and the risk of the portfolio needs to be managed. A safe loan book is potentially an unprofitable loan bool< in a corporate sense. The one unalterable rule of lending to the corporate sector is known as hurt money. This rule states that the resources of the borrower are the first tranche of funding; the lender advances funds only after the first tranche is fully committed or spent. This funding sequence ensures the borrower has an investment in the business or project and thus is committed to the success of the venture, An examination Qf project failures will demonstrate to the loan officer the peril incurred in ignoring this rule. The following are the three overarching principles of corporate lending: 1. Safety. This principle looks at the ability to repay the loan - that is, whether acceptable security, a satisfactory financial position and essential personal elements exist. 2. Suitability. This principle looks at the lending policy of the institution, the purpose of the loan, the amount of the loan, the amount of hurt money (or the contribution by the borrower), and the repayment schedule. 3. Profitability. This principle looks at the collateral advantage to the institution and the return on investment.
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By adhering to the above principles, the financial institution ensures, as far as possible, the loan is in accordance with the doctrine, can be repaid and contributes to the overall growth iu line with expectations. A corporate loan is given on the expectation of repayment in full over the agreed period of time. A wise lender, however, will ensure there are at least three ways out of a loan. 1. The only true repayment of a loan is where the borrower fully complies with the loan agreement and fully repays the loan. 1. If the loan is not repaid and is in breach of the covenants, then the lender can activate liens over physical security and initiate the recovery process. 3. If the loan defaults and the physical security is either exhausted or does not exist, then the lender targets the intangible assets of the business to realise their value. ' It is important to note here that only the first way guarantees that the financial institution will recover its investment along with its return. The second and third ways mey result in substantial losses if the security valuations are problematic or out of date.
Methods of lending assessment There are many differing methods of assessing the extension of corporate facilities. Different lending institutions use different methods and require adherence to set criteria that reflect the corporate culture of the institution. Chief amongst these criteria are the five Cs - a method of remembering the five key factors of loan approval- and PARSER (a made-up word that reflects a slightly different method for analysis and approval of corporate loans - see page ll5). It is important to realise, whatever the method chosen, that the aim is to confirm the safety, suitability and profitability of the applicant and whether the proposal fits the risk profile of the institution. The five Cs approach seeks to direct the enquirer to the key aspects of the loan proposaL (It has several variants, including the three Cs.) The major weakness -of this method is that it does not formally point the analyst to the reason for the loan. Character. The importance of assessing the character of a corporate cannot be overstated. Specific attention should be paid to the history of the company, how was it set up and by whom, the stakeholders, the organisation's structure and accountability through the organisation. What a,e the products that the company manufactures or accesses? Have they changed over time? If so, what effect have the changes had on the organisation? What is the reputation of the entity? (Reputation is a significant goodwill factor in the valuation of companies. It is seen as the greatest risk faced by a modem corporate.) How does the company manage the value of its reputation and is it growing over time? What is the record of management? What is their combined expertise? Does management foster a good relationship with the financial institution? All these factors allow for detailed analysis of a potential borrower and its character. A company builds a personality over
,
-
time. The question is whether the identified personalty is one that the financial institution would deal with as a lender. Capacity. A lender should be interested in not just the ability of the corporation to repay a loan but also the ability of the corporation to borrow Company records or incorporation deeds are essential to ensure the corporate entity has the ability to commit to any future transactions. Collateral. This refers to anything that is promised or deposited in support of a loan and that the lender has taken a charge over - that is, security: Security fulfils two basic needs for a lender: first, to ensure the borrower's full commitment to the project and, second, to provide a second or third way out fat the lender in time of need (as discussed on page 245). Conditions. These indicate the future potential problems that may have an impact on the business. Conditions can be external (those over which the corporate has little or no control) or internal (those over which the business has full control). • Capital. An indicator of financial strength, capital can be demonstrated by careful analysis of the company's financials. The capital contribution from the corporate comes from its shareholder equity (the hurt money). In lending terms, hurt money represents the borrower's contribution before the lender makes a contribution. Care should be taken ifthe tax component of the loan is necessary for approval of the faCility. The PARSER method allows a staged approach to the analysis of six areas of interest. Importantly, it identifies the purpose of the loan. Personal element. The characteristics of the corporate are analysed from a cultural and ethical viewpoint. Prime areas for consideration are the determination of the company to repay the debt, as shown by the integrity of the board/senior management and its reflection in the corporate culture. The asset position of the company and its track record in managing events for positive outcomes will demonstrate the company's business ability in line with its experience and spread of business. Lastly, the personal element identifies the borrower's position and standing in the business community. Amount required. What is the purpose of the loan? Is the amount requested sufficient for the achievement of the purpose? Correct analysis ensures the suffiCiency of the advance in relationship to the turnover, and identifies links of need within the business. Repayment. The repayment of the loan cannot be problematic; in other words, it should not be based solely on the cashflows of the transaction. Consideration needs to be given to how much is required, when the money will be needed, and from what source the lender can expect to be repaid. The lender must hold current financials that demonstrate the effect of the loan on the entity. This will involve trend analysis, detailed cashflow projections and the determination of repayment options available to the lender. Finally, the lender needs to be comfortable with the amount of the advance in relation to the total turnover of the company.
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Security. This represents the second and third ways out for a lender. It is important to accept, however, that security does not guarantee the ability to repay but rather the ability to support. A strong understanding of the type of security, either tangible or intangible, and the suffiCiency of cover ensures the strong management of the facility Total security may depend on the saleability of specialised security and the recording of second mortgages, especially over vacant or undeveloped land. Expedience. This represents the business opportunity for the lending institutidn. What is the SUitability of the transaction for the lender? What is the lender's capacity to allocate funds from the available pool. Is the loan being provided in a target market segment where the lender has capacity in the portfolio for growth? Can other corporate business, credit facilities and international business be gained from the provision of this particular request? Remrmeration. How profitable is the loan? Is it good for the institution and does it fit the loan criteria as laid down by the credit committee? Has the loan been correctly priced in terms of the interest rate, application fee and commitment fees? Does the acceptance fee and customer profitability analysis demonstrate the viability of the transaction?
The lending cycle The lending cycle (figure 8.1, page 248) follows a loan from birth to death - that is, from approval to repayment. Personnel involved in lending must understand that the moment a loan is approved is the beginning of the transaction, not the end. This is the key differentiating factor of a financial institution from other forms of corporate entities. In most cases, the sale by a corporate is the end of the transaction and the asset is converted into cash or, at worst, a debtor's list for a short period of time and then into cash. At the moment of asset creation by a financial institution, however, a series of cashflows is created over the life of the loan. Ina strong marketing environment with a strnctured segmentation of duties, the asset creation process and lifecycle can be overlooked. The sale of the loan is seen as the end of the process, with the management of a loan being an entirely separate issue. This lack of transferred ownership can lead to a lowering of loan quality in the corporate book if not formally managed by policy. A loan consists of three fundamentally different activities which can be managed separately or collectively. In today's financial arena, there is a strong separation of duties at the functional level. A successful corporate lender, however, manages the activities collectively in at least a policy sense. The three activities are: 1. origination 2. funding 3. managing.
(
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than that needed to expunge the loan. The difference is the profit gained by the risk taken by the borrowing entity. Loan structuring is about creating the optimum terms and conditions from both the lender's and the borrower's viewpoint, and must account for issues such as loan amount, maturity and repayment. It is vital to realise that the basic methods of assessment are the same for a large corporate and a small enterprise; lending to the larger corporates, however, has its own distinct features and pitfalls. The successful lender ensures answers to certain questions are obtained and analysed before the actual advance takes place. The following are examples of these questions: Is the loan amount sufficient to accomplish the task? Is the cash available and is it identifiable for repayment? • What is the term of the debt: is it long term (that is, over twelve months) or short term (under twelve months)? • If it is long term, do the future projections of cashflow demonstrate sustainability and does the purpose of the loan match the term (that is, fixed asset acquisition)? If it is short term, does the asset conversion cycle, along with the working capital efficiency, generate sufficient cash for repayment? Does the borrower demonstrate a seasonal need and conform to peaks? Or, is the corporate a revolving borrower that is bordering on hard-core debt? Finally, great care needs to be exercised to avoid double dipping of security - that is, taking the assets of the company as security, along with a shareholding of a director or owner. In other words, the lender should avoid taking security over both the assets and the liabilities of the borrowing entity.
Small corporate entities Banks and financial institutions automatically divide clients into categories: personal clients, small businesses, medium-sized enterprises, small corporate entities and large corporate entities. Different institutions undertake the segmentation process differently, depending on the strategic thrust of the bank or financial institution. The segmentation methods are similar in that they are based on turnover, employee base, client book and so on. Small corporate entities as discussed here are at the medium to upper end of the sector of small and medium-sized business. They are not limited to listed companies, because some of the largest entities in a modern economy are privately owned or strong family businesses .. The lender faces significant pitf'l]ls in this segment of the loan market because the borrower can vary from a solid organisation to one that initially appears strong and vibrant but is actually fundamentally flawed.· A characteristic of this segment is the suspect nature of some of the financial statements. They are presented to give comfort to the investors and do not necessarily reflect the true nature of the firm.
/
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Large corporate entities Some financial institutions structure their corporate lending into a separate discrete activity, allowing efficiencies and a concentration of highly trained staff. The basic methods used in assessing larger companies are the sanie as for other segments; there are some discrete differences, however, because this end of the market does not need the banking system to the same extent that other segments do, owing to its ability to interact directly with the money markets. In other words, large companies do not always need the banks or financial institutions for funding or treasury services. Large corporate entities can obtain funds directly from the market by issue of their own paper. They usually have their own treasury function and obtain advice and services from a range of advisers, some of whom may have resources in excess of those available to a lending institution. Because their paper is tradeable, there is intense scrutiny by the investment community. Transparency of information is a key success factor for long-term survival. Not all public companies or large corporates are well managed, as history tells us, but audited accounts generally make their financial statements more reliable than those of other segments in the loan portfolio. In the case of listed companies, the constant scrutiny of their share price and the involvement of rating agencies militates against bad performance. Successful !ending institutions at the high end of the market in the future will be those that develop and supply new and innovative lending solutions together with traditional lending products that allow for diversification across product and industry segments. Paramount among this new generation of financiers will be those financial institutions that supply and enhance the financial risk management functions of the corporate entity.
Product structure and application Products available to the corporate sector are essentially the same as for the market in general: term loans, term loans with bill conversion, bill facilities, overdrafts - in other words, intermediated funding. It is important to read other books that go into much more detail about the specific characteristics of loan products, because a loan officer has a particular duty of care to offer the best available mix of loan products to their clients. This duty of care is both moral and legal. Larger corp orates have access to a wider variety of products and providers than normal. Some are large enough to access the market themselves and obtain funding from the capital market directly; in some cases, their strength may be equal to or greater than that of a financial institution. Distinctive features of a modern large corporate are its high degree of bargaining power, access to alternative financial resources, and legal and financial advice of a high quality. Large corporations often diversify their banking sources, which may have some benefits for the borrower but can lead to problems if renegotiation or restructuring is reqUired. All of the lending institutions involved may have to agree to the amendments before they can take affect.
I 252 Part 4: Corporate and business lending
Small business lending learning objectives After reading this chapter, you should be able to: 1. define what a small business is and provide an overview of the main characteristics of the market for small business lending in Australia 2. explain the theory underlying small business finance, using the concepts of asymmetric information, credit rationing, adverse selection and moral hazard 3. describe the distinctive risks of lending to small business 4. outline the main characteristics of a relationship managed approach to small business lending 5. outline tile main characteristics of a credit scored approach to small business lending (using recent experiences in the United States) 6. comment on how lending to small business in Australia is likely to change over the next decade.
Small business in the economy Using the Australian Bureau of Statistics definition, there were 1175000 smal! businesses operating in Australia in 1998-99. Collectively, these small businesses represent 95 per cent of the total number of businesses and produce 30 percent of all private sector output. Data quoted later in this chapter indicate that Over half of all small businesses consist of only one owner (and no employees). By way of contrast, the average small business has three employees. In aggregate terms, employment by small business represents 40 per cent of the total workforce and 50 per cent of the private sector workforce. TABLE 9.1
•
Small business in the economy, 1999-2000
.'
_ ~_ •
, E~pjoyment - - Sha;e ~I induslry Number 01 smaiL - - - - - - - - - ' - - Share 01 industry operating prolit . businesses (a) Number ;Share ofjndustry sales (b) belolll tax (b) ('000). ('000) " _ (%) , • (%j • (%).
Agriculture (c) Mining (e) Manufacturing Construction
Wholesale trade Retail trade Al2commodation, cafes and restaurants
100 2 86 209 64 165
249 9 275 474
74 12 29 82
244
43
590
48
31 64 24
183 163 58
52 20
207 25 69 38
584 65 230 91 184 3430
55 31 43 47 71 49
Transport and storage Finance and insurance
44
na
na
12
36 28 68 24 69
13
55 31 43 40 21 30
44
47
57
19 40
Property and business services Education Community services Culture and recreation Personal and other services
Total private sector Cd)
77
1175
na
na
46 15 52 30
71 18 43 39
(a) Excludes public sector. (b) Data are for 1997-98 and exclude agriculture and nonemploying businesses. (c) Number of businesses and employment data are for 1998-99. Cd) Includes utilities and cominunications. na Not available. Source: Australian Bureau of Statistics, cited in Reserve Bank of Australia 2001, Reserve Bank of Australia Bufletin, May, p.29.
As indicated in table 9.1, small businesses operate over a variety of different sectors of the economy. The Reserve Bank of Australia (2001) notes that small business is most commonly found in the property and business services, con· struction and retail sectors. Half of small business employment is found in these sectors. The sales and output of small business are only 30 per cent of total sales and output, even though small businesses account for 50 per cent of total employment in the private sector. This reflects the labour· intensive nature of many small businesses, particularly those in the construction and retail sectors.
t
268 Part 4: Corporate and business lending
t
collateral. They concluded that relationship lending generates important information about the quality of the borrower. Another interesting conclusion from this research concerns the unique structure of the US banking system. By way of background, the US banking system' is not horhogenous. Thousands of smaller banks have operations that tend to be confined to a particular localised area or community, while some very large banks have national operations. Researchers have noted that the smaller community banks are most active in the small business lending market. These smaller banks. also tend to use a relationship lending model. In many ways, this makes sense: a smaller bank operating in a local community is ideally positioned to develop a relationship with its small business borrowers and thus collect the 'soft' information that is a feature of relationship lending. The larger national banks tend to use a different style of lending. Researchers such as Frame, Srinivasan and Woosley (2001) have found that these banks are more likely to employ a more objective approach, which uses, for example, standard financial statement criteria in making loan decisions. Again, this also makes sense: the larger banks are often based in major population centres and, as a result, probably lack the community links of the smaller banks. For the larger banks, effective implementation of a relationship lending model is more difficult. Here, we have used the theory underlying small business lending to explain why the use of a relationship lending model for small business is reasonably widespread. In the next section of the chapter, we will provide more detailed coverage of what a relationship lending model involves. We will also cover the credit scoring approach. In covering credit scoring, we will again use the theory of small business lending to explain the implication of credit scoring for the lender-borrower relationship.
The decision to lend to small business Certain principles of lending are universal, including the ideas that: the first way out of any loan should be·via cashflow from operations • th~ second way out should be from security • the lender needs to understand all the key risks associated with the first and second ways out, and mitigate them wherever possible. While these principles do apply to small business lending, a small business lender must understand the distinctive nature of the risks involved. Here we will look at these distinctive risks and consider two different approaches to making a small business lending decision: a relationship management approach versus a centralised management approach.
SpeCialised risks associated with lending to sma Ii business Lending to small business generally involves more risk than lending to mediumsized and larger business, for a number of reasons. One reason relates to the small size 'of th~ business. We noted earlier that the Australian Bureau of Statistics
288 Part 4: Corporate and business lending I
defines a small business as any business with fewer than twenty employees. Table 9.5 contains information on the numbers of small businesses classified according to number of employees. The table shows that one-half of all Australian small businesses are owner-operated without any employees. An additional one-third of small businesses have between one and four employees. That leaves 16 per cent of small businesses with between five and nineteen employees. TABLE 9.5
Total numbers of small businesses classified by number of employees per business,
1999-2000
Number of businesses ('000)
542.2
365.7
167.1
1075.0
(a) The owner works in the business without any employees
Source: Australian Bureau of Statistics 2001, Small Business in Australia, cat. no. 1321.0.55.001, Canberra.
Key person risk From a lender's point of view, there are risks in lending to such small entities. A major risk is the so-called key person risk. This is almost certainly going to be a significant risk for those 50 per cent of small businesses where there are no employees and the owner is the key person in the business. Consider a situation where the owner of the business dies or is incapacitated through injury or sickness. In such cases, the continuing operation of the business may become doubtful, as would the cashflow on which the lender is relying as the first way out for repayment of the loan. While the size of the key person risk can be very high for one-person operations, it can also be very high for larger small businesses. It depends on how much the owner has involved other persons in the running of the business. Consider the hypothetical business of an Asian food importer. Fifteen persons are employed in the business: seven in the warehouse, four to deliver product to restaurants and shops, and four in sales and office management. The owner spends one week out of every three travelling through Asia to source product. He has excellent connections throughou t Asia and has been able to negotiate low prices for a lot of his product lines. The key p. ;on risk is high for this business because the owner has been relatively secretive about his contacts in Asia. No-one in the business has ever accompanied him on any of his trips and he has not. kept written details of his contacts and agreed pricing over the year ahead.
The lack of capital Small businesses are widely recognised ashavi.ng a lack of capital (Weaver &: Kingsley 2001), for a number of reasons. Often, lack of capitalsirnply reflects the limited financial resources of the· owner. Establishing a business can be expensive and the owner may have·to ·~ely on a lender.to· prOvide the bulk of the . . funding for either the purchase or ~et-llp of -the busineSs.
./ -
A second reason is that the net worlh of the owner may be tied up in the family". home. This means the owner may be trying a deliberate strategy to maximise the .amount of busil;1ess debt because he/she can claim tax deductibility on the' interest Private debt, in the form of the loan for the family hoihe;"dues not have tax deduc"tibility 0):1 the-interest, so the owner may look to minimise Ihis debt. '. A third reason for a lack of capital is that the owner may be fundi~g the busi'ness 'Via loans to thebusiness rather thimthrough.capital. This approach can be attractive for the owner in thatit allows the loans funds to be withdrawn. Capital, in· contrast, generally cannot be withdrawn from the business. Most lenders would prefer the owner to fund the business· via capital rather than ioans. A fourth reason is that the owner may be using a business structure that typi'cally involves only a smal(amoimt of capital. The.entity may be'structtired as a trust,with only a ~mall settled sum Csimilarto capital in a company), for example. Alternatively, the business may be structured as a two-dollar company Again, the amount of capital is negligible in this case. . , . . A final reason for lack of capital is that the owner inay be drawing all the profits out of the business. This would mean that the level of retained profi.ts is minimal and makes no significant contribution to the capital funding of the business. Whatever the reason for a lack of capital, it means a high level of gearing for the business. In conceptual terms, this means that the business is exposed to a high level of financial risk. .. A lack of capital often has an impact on a small business when the business rapidly grows. Not having a significant capital base to fund its expansion, the business uses short-term working capital to fund expansion. A typical scenario would be that the business uses its overdraft to fund the growth of various current assets such as stock and debtors. In extreme cases, the short-term working capital can be used to fund longer term assets. Whatever the sequence of events, a common symptom of overtrading is extreme pressure on the liquidity of the business.
Lack of a IraGk record Lenders are usually at their most comfortable when they are lending to well-established businesses. A history of the business gives the lender the confidence to predict cashflow from operations and, in turn, loan repayments in the future. Also' important is ·evidence that the ownerlborrower can be relied on to repay borrowings. This is the important 'character' consideration from the five Cs of lending: character, capacity, collateral, capital and conditions. For many small business borrowers, lenders do not have this level of comfort The ownerlborrower may be a first-time business borrower without a track record of haVing repaid debts. Further, the concept behind the'business may be relatively new and untested in the locil market. If the borrower is purchasing an established business, then there may bedoubts about the ability of the borrower to run that particular type of-business. In this situation, the lender cannot analyse three years of historical financials foithe business, so the cashflow budget projections are best guesses rather than an extrapolation of a trading history. \'-
.<, ...
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(290 Part 4: Corporate and business lending
The following examples show when a lack of track ~ecord may cause a problem with repayment of the borrowing. • A police officer retires a;'d purchases a lunch bar. , , A person returns from a 'holiday in Canada with an idea· to stan a .business based on a new retaili';g concept that l;!as recently been successful in Canada. ' The concept involves selling supermarket products (for example,.flou~; sugar, cereals and so on) in'an unpackaged, form. I Customers, weigh ~ut the. quantities lheY'.~eq)1ire and save on the cost of packaging. A recently qual;fi~d.mechani~ is looking to import damaged Cadillac cars. from the 'United States, repair them' and sell them in Australia.
The poor quality of Ih~ accounting information
The poor quality ~\ the accouhtin~ information ~upplied by sl)1all business is a common theme ,.mentioned by Writers on .small business lending (see Rouse 1"994). Anyone v:tith '¥xperi~nce in lending io mediur;i-sized to large businesses would expect mo$fbusinessesito prepare the follOWing: annual statem,ents,ol finanCIal ppSltlOn, statements of financial performance and casbflow statehients,pr~pared in accQrdance with the ,elevant aq:ounting standards '. monthly actual 'statements of financial position and statements of financial performance monthly budgeted statements of financial position and statements of financial performancl' f9r comparison against actual figures a yearly cashflow budget monthly cashflow statements. In comparison, much less accounting information is regularly prepared by smalt,businesses. Typically, a small business prepares onlY,an annual statement of financial position and statement of financial performance. Whereas most medium-sized to large busines~es have an in-house accountant to prepare'accounting reports, such an employee is more the exception than the rule with most s;"'all businesses. Often the owner of the small business prepares the financial statements. Given that he/she has' many jobs to,do, the accounting information may be prioritised down the list of things to do. Almost all small businesses. have access to an external accountant who can produce financial statements. This can be expensive, however, so a typical proprietor looks to minimise the use of an accountant beyond the preparation of annual taxation retums and annual statements of financial position and statements of financial performance. As Hey-Cunningham (1998) notes and we will discuss later, the,focus in these tax-driven financials may not match the information in which the lender is interested. The overall quality Of the accounting information supplied by small businesses is' thus· generally jaw. Here, we will explain why this is the case. Delays in the pre'pa!.ation of financial statements One reason,for poor quality results from delays in the preparation of the financials. The longei? the time period that elapses between the balance date (30 June) ", and the delivery of the financials to the lender, the less will be the likely valne .of those financials to the lender. This is particularly the case when the financials
,iilli.
are being used for an assessment of the business's liquidity The quantities of current assets and current liabilities are 'likely to have changed Significantly since the balance date. Unfortunately, many lenders to small business experience long delays in receiving financial statements, so the value of those financials is questionable as an up-to-date assessment of the business's financial position. Emphasis on taxation A second reason for poor quality accounts is the heavy emphasis on taxation in the preparation of the accouuts. Hey-Cunningham (1998) suggests :that many small businesses border on being obse,>sed with minimising their tax rather than on maximising the performan~e ~f their business. This foc]lg' c'an'lead to a variety.of transaction',; that act to reduce'l:irofit sathe amomit o(tax paid is minimised.' The owner' of a business "may decide, for pcample, to make large contributions to hislher superannuation, account, ,which acts as a charge on the profit of the business. This can make thebljsmess seem less profitable than it really is. Another example would be where the business proprietor does not disclose certain cash sales, to avoid having to pay tax on tho~e sales. Reporting freedoms for a small proprietary company It is common tor Australian' small businesses to use a company structure. As a company, a small business has considerable flexibility in the way in which it must prepare and present its financial accounts. To be more specific, most small businesses qualify as a small proprietary company under the provisions of the Corporate Simplification Act 1995. Section 45 A(2) of the Act defines a small proprietary company as having at least two of the following three requirements: for the company and entities it controls, consolidated gross operating revenue for the financial year of less than $10 million for the company and entities it controls, a value of consolidated gross assets at the end of the financial year ofless than $5 million, for the company and entities it controls, fewer than fifty employees at the end of a financial year. Based on discussion on page 267, nearly all small businesses Cas the term is used in this chapter) would be likely to be classed as 'small proprietary companies'. The Australian Bureau of Statistics definition of a small business involves having a maximum of only twenty employees, which is well under the fifty employees nsed to define a small proprietary company: The Reserve Bank' of Australia definition of a small business is based on a maximum borrowing of $500000, which is argued to roughly corresp~nd with a turnover of $5 inillion. Again, this is well short of the $10 million gross operating revenue for a small proprietary company: In general terms, therefore, nearly all small businesses operating as a company are also small proprietary companies. Wherever a reference is made to a small proprietary company in the following discussion, this should be taken also as a reference to a small business. The definition of a small proprietary company becomes importa)lt in terms of the' accounting information that small proprietary companies are required - or, perhaps more importantly, not required - .to provide. In general terms, small
1 292
Part 4: Corporate and business lending
'I"
proprietary companies have considerable freedom in the pieparation and presentation of their accounting information. They do not have to have their annual statements of financial position and statements of financial performance audited. The absence of compulsion and also the expense involved mean thaI most small businesses choose not to have their accounts audited. Lenders thus almost always, except where they require otherwise, receive un-audited financial statements from their small business c)ls\omers. . , . A second area of freedom is that slmill proprietary companies are not required to prepare annual financia~'statem~nts. This is a freedom 'in duplicate' for small prop~ietary companies 'bec~)lse other larger companies that do have to prepare annual financial st;J.tements must also present them in a comprehensive format . . , 'Broadly speakin'g, the fbrmat includes: financial statements, including: a statemertt,of financial performance for the year a statement of financial position as at the end of the year a statement of cashflows for the year a ·consolidated version of the preceding statements detailed notes to the financial statements directors' declaration. Additionally, larger companies are required to ensure their financial statements conform to the accounting standards published by· the Australian Accounting Standards Board. So ,what do all these ,reporting freedoms mean for the lender 'to the small business (that is, small proprietary company)? The answer is that the small business lender needs to be very careful in how he/she reads and analyses any financial statements received. Some small business lenders use the phrase 'habitually sc~ptical' to describe their perception of financial statements. This seems a reasqnable 'starting point given that these financial statements are typically.not audited,i'do not necessarily conform to all the accounting standards and are not, in a 'comprehensive form· that includes a cashflow statement, detailed notes to the accounts and a consolidated set of accounts.
, Deception ,'. ' , A foutth and final reason for poor quality financial accounts is deception on the pa~t oLthe owner and/or the accountant. Borrowers will inevitably look to present their business in the most positive way, but at some point this changes from being positive to being deceptive. If freedom in the preparation and presentation of financial statements is combined with a desire to deceive the lender, then ,the consequences can be disastrous. The financial statements will end up presenting a picture of the business that is very different from the reality.
Risks and small business failure A consequenc,e of the high risks as~ociated with small business is a high failure rate for small bnsiness, Hey-Cunningham (1998) gives a thorough overview of the numbers of small busine~s' failures and the reasons for. these failures. Q~oting research from within Australia, he provides the statistics on page 294,
Over 30 000 small busin~_sses fail -each year-. _ , One-third of all small businesses f~il within the first year. Almost another one-third fail in the second and third years combined: • , Three-quarters of all small busineSses have failed after' five years .. Reasons for failure include: • the inexperience and incompetence of managemEmt . poor quality accounting and other records p~oblems with financial management and liquidity • lack of expert advice • too much reliance on debt funding. Any lender faced with these statistics would be justifiably cautious about lending to small business. A lender can mitigate. these. risks, however. One way involves having a strong second way out (that is, security), which explains the preference ~f many small business lenders to lend agalrrstland~d security This has been an area of intense competition over the past few years. The other way of mitigating risk~ involves spending more time in both the initial assessment and the ongoing management of the loan. The problem for the lender is that this effort is laboudntensive, which means it is expensive. Loans to small business are typically small, so' the ability to spread these ~xpenses over a small loan i~ limited. The move by the Commonwealth Bank of Australia and the National Australia Bank to centralise and automate their small business lending may be evidence that they are wanting to focus their lending on small businesses with the most straightforward and lowest risk.
Two approaches to small business lending We have mentioned the significant changes that are occurring in small business lending in Australia. Central to these changes is the push by a number of small business lenders to increase the proportion of small business customers that are centrally managed via the use of credit scoring models. This means reducing the proportion of small business customers that are relationship managed. In the discussion that follows, we will provide more detail on what these two approaches to business lending - relationship management and credit scoring - involve.
The relatio_nship management approach During the 1990s, relationship management was Widely used with small business accounts. According to the National Australia Bank, the' model has beeri very successfully used by the bank' and was a key factor in the bank's strong growth over 2000-01. Thebank has claimed that the strength of the relation-. ship management approach is that it allows the lender: .. : to develqp an understanding of their customers' business, in all phases of the economic cycle, and .to offer appropriate ?olutions to their needs. The relationship manager draws on the expertise of National specialists in a range of areas such as treasury, payments, leasing and superannuation to provide business customers with a fully integrated financial service. (National Australia Bank 2001, p.26)
.1
294 Part 4: Corporate and business lending
1
The relationship Ulanager can develop an understanding of the husiness by carefully analysing the business's financials. SOUle of the financials analysed are historical in nature. These are 'the standard statement of financial position, statement of financial perform'!llce and cashflow statement for past accounting periods. For small business, projections usually involve only cashflow projections (or cashflow budgets as ihey are sometimes known).
Analysis of historicaifinancials There are two broad stages in the analy~is of historical financials. The first stage involves preparing the. financial statements for analysis. The second stage .involves conducting the a~alysis ,,:sing tools such as ratios. Stage 1: Avoiding garbagi> in, garbage ;'ut The first stage is important becau'se it is essential that the financial statements reflect the current state of the business. If they do not, then the second stage of detailed financial analysis can end up being 'a case of garbage in, garbage out (GIGO): The following are examplesof'GIGO in financial analysis: • A menswear business has ahigh level o{st~ck due to'a quantity of old stock being inchided in the overall stock figure. On the face of it, the liquidity ratio (that is, the current ratio) for the business is quite strong. In reality, however, the'business has a limited ability to sell this old stock for anything close to its historical cost. Consequently, the liquidity of the business is far worse than it appears from a superfiCial calculation and analysis of the liquidity ratio. • A transport business has sold one of its trucks, The income generated from the sale has been included as 'other income' in the statement of financial performance. The lender has ignorantly included this other income along with the transport income in calculating the gross margin forthe business, thus Significantly overestimating the gross margin of the business. The directors of a small technology company have increased the valuation of the company's technology as shown on the statement of financial position. This revaluation has resulted, as the other part of the double entry, in an increased amount of shareholders' funds on the statement of financial position. SuperfiCially, the gearing of the business appears strong. Given that the revaluation of the technology is really not justifiable on commercial grounds, the gearing of the company would remain a major concern, So how does the lender go about avoiding the possibility of GIG07 It is not easy to set a strict set of rules to follow, but the follOWing are some thoughts: Maintain a c'ritical mindset when considering the financials. The ABC of criminology - accept nothing, believe no-one and confirm everything - is too extreme for 'use, with most borrowers, but its value is that it signals the need for the lender to have an inquiring mind. Continually ask whether the financial statements accurately reflect what you already know about the business. Look at the wages expense, for example. How many people are employed by this business? Is the wages expense about right for the number of people employed? .
•
\ "
I 296
Get to know the business. One way of doing this is through discussions with both the owner of the busin'ess and the accountant. These discussions should involve questions, some of which will relate to the financial statements. Ask, for example, how they arrived at the stock level on the statement of financial position and whether they did a_full stocktake ,or just roughly Estimated stock at 30 June, . A second way of getting to know the bysiness is to visit ·it. Ask yourself whether what you see matches what is being ilresented in figures in the financial statements. How many defivery vanS does the business have in its carpark? Are these vans owned or leased? Are lhese vans shown on the statement of finaIlci~1 position? Some lenders describe site visits as a chance to 'ki'ck the tyres'. Just as a picture says" thousand words, a site visit can leave a lender with a comprehensive impression about the business. A final way of, getting to know the business is by researching the characteristics of similar businesses in that industry Coming up with the right questions is a skill that develops with experience, The best leriders have an impressive ability to read a set of financials and quickly identify the key questions to ask the owner or accountant. They also tend to make very inSightful observations during a site visit. Case study 1 on Boat Builders Pty Ltd (page 499) provides an opportunity to develop these important skills, Financial'ratio~ can be grouped under the following headings: short-term liquidity • business performance longer term solvency. It is useful to consider some of the GIGO issues that arise in using these ratios. For a small business, GIGO issues are often crUcially important in inter· . preting the short·term liquidity ratios, Debtors, creditors and stock are the major current asset and current liability categories, but they are also often referred to as traditional soft spots in the statement of financial position. These numbers can be very 'soft' if they have not been accurately estimated. Take the case of the stock figure, For many small businesses, the proprietor of tire business calculates this figure. The accountant will not be directly involved and will generaliy take the figure as it is supplied by the proprietor. The quality of this figure depends on how much work the proprietor has put into hislher esti· mation at the time of stocktake, Also relevant for the lender is whether the overall st~ck figure includes any damaged or old stock. Similar comments can be made about debtors and creditors. An additional consideration with debtors and creditors is that of ageing, If a debtor is out to 180 days, then there is a reasonable doubt about whether the business will ever be able to collect this debtor. For this reason, it may be best to not include this debtor in the calCulation of the business's liquidity. Business performance ratios need to be carefully calculated, A key issue revolves around how profit is defined (Hey-Cunningham 1998). Does it include abnormal items? Is it before or after tax? To what extent has the profit for the
Part 4: Corporate and business lending
I
business been 'homogenised'? To illustrate, consider the statement of fi~ancial performance for a service station. There are three potential main sources of income: fuel sales, shop sales and workshop repairs. If all. three sources of income ~re grouped together in the statement of financial performance and a gross margin is calculated, then what does this homogenised gross margin ratio mean? The ideal way to answer this que.stion would be to have financial performance information for each of the three profit centres of the business. This approach' would allow the lender to better understand the underlying profit~bility of the business. Longer term solyency ratios for small business are not usually that affected by GIGO considerations. Their main problem is in their interpretation, which we will cover in the next section. Stage 2:'Detailed analysis of historical financials . Once the financials are in a form where they reflect the true state of the business, the next stage involves their detailed analysis. Ratios usually form a major part of this analysiS. We noted earlier that fin~ndal ratios are typically grouped as shorHerm liquidity ratios, longer term solvency ratios and business performance ratios .
.ShorHenn liquidity ratios Once GIGO issues are dealt with, the calculation and analysis of short-term liquidity ratios is reasonably straightforward. A word of caution,· however: it is. probably not useful to place too much emphasis on the short-term liquidity ratios by themselves as a source of information about the· business's liquidity. The inevitable delay between the balance date and the time of receipt of the financials by the lender plays a big part in reducing the value of the liquidity ratios. Perhaps more importantly, the point of these ratios - particularly in the case of the current and quick ratios - is to provide information about how the business is managing its overall liquidity position. Where the borr,ower has provided cashflow projections to the lender, these will probably be a better way of assessing the overall liquidity position of the business, particularly where the prOjected figures are reconciled against actual figures on a monthly basis. Similar caveatS can be attached to more specific short-term liqUidity ratios such as the two turnover ratios (debtors and creditors). Rather than spending a lot of time calculating and analysing these two ratios, it is likely to be more useful. to obtain an aged listing for each of them. Most small businesses are in a position to generate such a listing from a standard accounting package that they use. The advantage of the listing is that it is hopefully up-to-date. It will give more insight into the ageing of individual debtors and creditors. Longer tenn solvency ratios These ratios can be tricky to interpret in the case of small business customers, which frequently have low levels of paid-up capitaL The result is that the standard longer term solvency ratios end up taking extremely large values (for example, fixed assets! shareholders' funds) or extremely small values (for example, shareholders' funds! total assets).
-.'/
-
Capital is generally recognised as having four key properties: it provides a permanent and "unrestricted commitment of funds; it is freely available to absorb losses;"it does not imposeany,unavoidable sei:viciug charge against earnings; and it ranks below tpe claims of depositors and other creditors in the event of wind-up (Australian Prudential Regulation Authority 200l} Discussion earlier in this chapter higl,lighted that small businesses are short of capital for two main reasons: (1) they ar~ ;;hort of capital due to limited )inancial resources or because they do not leav,e any,profits in the bnsiness, or / (2) they are using other proxies for capital (such as providing loans to the busine~s or using equity in the family home as security for the loan)" If a borrower has no capital, then the lender wouldcondude that there are no funds" that: • pr6vide a permanent and unrestricted commitment of funds ' are freely available to absorb losses do not impose any unavoidable servicing charge against earnings rank below the claims of depositors and ,other creditors in the event of wind"up" The lender would then need to assess the risks resulting from this lack of capitat If a borrower is using other proxies for capital, then the lender would need to ask how well these proxies substitute for capitaL Loans to the business are likely to have the four key properties of capitat These loans are likely to be withdrawable," for example, whereas capital is a permanent commitment of funds" The lender may choose to attach various conditions to the borrowing so these directors' loans behave more like capitaL Table 9"6 provides a summary of some of the main conditions that can be used" TABLE 9.6
Conditions imposed on a borrower where the borrower is funding the business with loans rather than with capital
1. Provides a permanent and unrestricted commitment of funds.
Owner is not allowed to withdraw the loan without the prior approval of the lender.
2.15 freely available to absorb losses.
Not applicable
3. Does not impose any unavoidable serVicing
A limit is set on the interest rate that the owner can be paid on the loan.
charge against earnings.
4. Ranks below the claims of depositors and other creditors in the event of vvind-up.
The owner's loan is subordinated to other depositors and creditors in the event of wind-up"
Equity in the family home is sometimes used as a proxy for business capital, through being provided as security A house provided as security is clearly not a form of funding for a business, so the business still needs to borrow The difference is that the lender now has some security to be used against that borrowing" The family home does not satisfy the first and third properties of capital; it just
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provides a mechanism to meet losses if the business experiences difficulties .. The lender thus needs to carefully assess the financial risk faced by the bor. rower. The existence of security in the form of the family home does nothing to limit that financial risk.
Business perfofY!1ance ratios Business performance ratios. are an important source of information about small business: The gross margin'latio is of particular interest because it is relatively uncontaminated by outside influences. To be of most use, however, gross marginS should be 'calculated for the relevant profit centre rather than globally for the business. The, net,margin ratio, in contrast, is often less useful to the extent that it is influenced by various expenses that may be linked to tax-based strategies (such as superannuation contributions).
Analysis 01 cashllow projections One approach to the perceived problems with the historical financials of small businesses is to focus more on the business's cashflow projections (sometimes also called cashflow budgets, although the former term will be used here). It is important to stress that cashflow projections are very different from cashflow statements.
There are a nurhber of advantages of relying on cashflow projections in small bUSiness lending: A cashflow projection is based entirely on cash movements, so it clearly indicates the financing requirements of the business. A cashflow projection is typically used to indicate a peak level of debt that a business will have in its overdraft account over a year. This can be an important role for the cashflow projection, given that overdraft lending makes up around half of all small business lending (Reserve Bank of Australia 1994). Cashflow projections can be a tangible way of monitoring the progress of a business, for both the proprietor and the lender. In simple terms, a cashflow occurs when there is a movement of funds into or out of an account. In most cases, the major cashflows will be in or out of the business's overdraft account Both the lender and the borrower are typically in a good position to follow these movements via electronic access to overdraft account information. In addition, these cashflows are relatively straightforward to understand because they are simple movements of funds in and out of an account. profit is an alternative to cashflow as a measure of business performance, but it has the disadvantage of not being as easy to understand., As an accounting concept, profit is based on a number of accounting assumptions. Its calculation can involve noncash items such as depreciation. These assumptions can mean that profit is a more difficult and less tangible measUre of a business to track, for both the proprietor and the lender. Cashflow projections have a particular advantage where the lender wants to tightly manage the account given the possibility of further deterioration in the account and ultimately default. The goal of the tight management may be to enforce an upper limit on the exposure of the lender to the borrower.
/
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· Baseej on available security, the lender may want to limit the exposure to the business to $500 000, for example. A typical cashfiow projection would be divided into units of months over a calendar or financial year. It is a reasonably straightforward matter for the lender to compare monthly actuals ' against budgeted figures as a way of tightly controlling the account: Relying heavily on cashflow projections also has its disadvantages. The assumptions underlying a cashflow projection can be very unrealistic, possibly as the result of deliberate manipulation of the assumptions by the borrower. Alternatively, the borrower might have been overly optimistic - a problem that often CClmbines with a lack of commercial experience. In some instances, unrealistic cashflow projections have been unflatteringly referred to as 'dream sheets'. The proprietor is so optimistic that the cashflow projections resemble a dream more than reality. Establishing the reality. of the assumptions underlying the cashflow projections can be a particular problem where the business is new. A new business means that there is no track record on which to judge the assumptions underlying the cashflow. In such cases, it is advisable to use a checklist to analyse the cashflow in detail. An example of such a checklist follows in table 9.7. TABLE 9.7
A five-stage checklist for analysing cashflow projections
Who prepared the cashflow? Why was it prepared?
1. The origins of the cashflow
What were the relative inputs of the customer and the accountant in
generating the cashflow? 2. The starting
point of the cashflow 3. Internal numerical
consistency 4. Validity of the und~;lying assumptions
What is the opening bank balance? It call be the subject of manipulation. It can easily be confirmed, however, by, reference to account balance information. Mlstak€:s ,,~th $pre.adshe'et fonnul~s can' e'asHy be made, so it is essential to always check numerical consistency._A cross,-check of total~ is a good _ov.erall guide to nu'merical consistency: i\ cashflo"\j\T is alm6stmea~ingless Without knowledge of the assumptions
on which it has been based. . Has the accountant (~r ~ustom:er) written down the key assumptions tha! hive been made? How-does the accountarit (or- ~ust6:rher) feel
5. Critical consideration Of . senSitivity
analysis
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Part 4: Corporate and business lending)
Has the accountant (customer) undertaken any sensitiVity analysis7 Has this sensitivity analYSis been thorough enough to- identify the critical assumptions of the cashflow? What other sensitiVIty analysis should be undertaken?
Assessment of risks Lending to small business is very risky. High rates of small busiuess failure are the tangible evidence of these risks. The lender needs to underst~nd all the risks involved in a small business deal and mitigate them where possible. Earlier in the chapter, we identified the following distihctive risks associated with lending to small business: • key person risk lack of capital lack of a track record • poor quality of accounting information: delays in the preparation of financial statements an overemphasis on taxation reporting freedoms for a small proprietary company deception.
The importance of security Some types of lending, such as project finance, do not greatly rely on security. In small business finance, however, security can be a very important consideration in deciding whether to approve a deal. Over the past five years, lenders have shown a strong and increasing preference for small business borrowers who are able to offer residential security. This security is seen as a way of offsetting the other risks associated with lending to small business. It also has the added advantage of minimising the time required to make a decision on the deal: if the second way out is strong, then relatively less time needs to be put into analysing and ultimately feeling confident with the first way out.
Problems with the relationship management approach For the relationship manager to make a decision on a small business deal can take time: lots of questions get asked of the proprietor/accountant; the financials (historical and projected) are analysed in detail; and risks and risk mitigants are carefully detailed. Once the loan is approved, the ongOing management can be quite labour intensive. Another problem with relationship lending relates to credit quality: As dis. cussed previously, an important feature of relationship lending is the role played by 'soft' information that is collected by the loan officer. Berger and Udell (2002) suggest that use of a relationship lending model should involve a greater delegation of lending authority to an institution's loan officers. A consequence can be that the institution will be exposed to greater credit risks because 'soft' . information, as discussed previously, is notoriously difficult to quantify, substantiate and communicate within a lending organisation. The institution often responds to this risk by allocating more of its resources to reviewing the work of its loan officers and measuring loan quality. This can be quite expensive for the institution. These various problems lead to a key question: does the use of a relationship lending model in small business lending generate the maximum return for
shareholders? Judging by what a number of small business lenders are doing, the answer is 'no'. In comparison, a credit scoring approach offers a way of cutting costs and increasing returns.
The credit scoring approach What exactly does a credit scoring approach to the management of small business accounts involve? Typically at its centre is a mathematical model, which is the credit scoring modeL Various pieces of information about the borrower are inputs into the mathematical modeL This information can include the credit history of the borrower, various financial information/ratios, the current level of borrowing and years of experience in the industry. The output from the model is a single number that measures the likely future loan performance of the borrower (Feldman 1997). . The lender can use this credit score in a number of different ways. Some lenders may use credit scores in an automated process that approves or rejects loan applications; others may use credit scores as extra information to be included as part of the overall credit assessment. The major US banks began experimenting with credit scoring of small business loans in the early 1990s. Now, almost ten years later, some Australian banks are starting to credit score their small business loans. This gap of a decade roughly corresponds with other estimates of how far Australia lags behind the US financial system. Battelino (2000), for example, has calculated that the Australian financial system is fifteen years behind that of the United States. Given this ten-year gap, the US experience with credit scoring of small business loans is used here as an important indicator of how things are likely to develop in Australia.
A background 10 small business lending in Ihe United Slales What constitutes a small business in the United States is slightly different from the definitions used in Australia (and discussed earlier in this chapter). A small business is defined in the United States by the Small Business Administration as an enterprise employing fewer than five hundred employees (compared with the cut-off of twenty employees used by the Australian Bureau of Statistics). By the US definition, small businesses comprise 99 per cent of the twenty-three million nonfarm US firms. Despite the potentially large size of a small business in the United States, a small business loan is consistently defined by researchers as a loan of up to $100 000. For this reason, Frame, Srinivasan and Woosley (2001) note that a $100 000 business loan is probably better described as a small loan to a business rather than a small business loan. The classification of small business loans being less than $100 000 nevertheless remains in widespread use in the United States and will be continued here. A clear point of difference between the US and Australian banking systems is the number of banks. At 30 September 2001, there were 8149 insured commercial banks in the United States, contrasting rather dramatically with the fifty-one banks that operated in Australia around the same time. Making up the
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large numbers of US banks have been those banks with a small number of branches (in some cases, only one) and a distinctive focus on their local community. Hempel and Simonson (1999) suggest that these local banks may now be on the endangered species list as their number continues to decline. At the same time, there have been increases in the size of larger multiple-office banking institutions. The significance of the local banks is that they have traditionally been the main source of finance for small business (Frame, Srinivasan & Woosley 2001). Moreover, they have provided this finance through the use of a relationship management approach. As we will discuss later in this section, however, the role of these local banks is now changing quickly with the larger banks' increasing use of a credit scoring approach.
The past and present Lise of credit scoring in the United States Credit scoring has been widely used in decision-making on US consumer loans since the early 1990s. The current industry standard is for credit scoring of consumer loans to be fully automated (Eisenbeis 1996). Despite the initial success with credit scoring of consumer loans, there was a feeling among some participants in the industry that it would not be possible to extend credit scoring to business loans. Business loans were fdt to be too complex, heterogeneous and varied in terms of documentation. A number of factors nevertheless collectively created a push to develop credit scoring of small business loans (Eisenbeis 1996). • Cost savings. Competition in the banking industry leading to shrinking margins increased the pressure to reduce costs. The manual credit analysis of business loans is a labour-intensive, time-consuming and, consequently, expensive proc~ss. Mester (1997) reports that a typical loan approval process takes about two weeks and involves around 12.5 working hours per small blisiuess loan. Credit scoring offered the potential of reducing this time to under an hour. Availability of databases, Commercial entities such as Dunn & Bradstreet provided large-scale databases on which credit scoring models could be tested. Political reasons. There was a desire in the United States to increase lending to small business. One way of doing this involved securitisation, but a precondition for securitisation was a ·better measure of risk among business borrowers. Credit scoring offered a way of quantifying this risk. • Changes in govemment regulations. The US Government relaxed some of the regulations relating to securitisation of small business loans, making securitisation and the associated use of credit scoring techniques more attractive. to lenders. The push to develop credit scoring of small business loans in the United States over the past decade seems to have been a success. In 1997, two hundred of the largest banking organisations in the United States were given a survey (Mester 1997). Sixty-one of the ninety-nine institutions that responded
to that survey indicated that they were credit scoring their small business loans - a significant rise from the 23 per cent in 1995. While more recent figures are not available, it would seem that the growth in the take-up of small business credit scoring has continued. Authors such as Frame, Srinivasan and Woosley (2001) and Mester (1997) suggest that credit scoring is causing a transformation in small business lending. Before looking at what this transformation involves, we will examine the structure of these credit scoring models.
The structure of US credit scoring models While the structure of credit scoring models is in the process of ongoing development, something can be said about the recent structures and possible future . developments. One of the first points to make is that many financial institutions lack the in-house expertise and data to develop a model themselves. Eisenbeis (1996) identified four companies as being the key players - Fair Isaac, CCN-MDS, TRW and Dunn & Bradstreet - and examined each of the four models. Mester (1997), in providing information on some of the different credit scoring models in use, makes the following points: At least 30000 applications are needed to develop a model for small business loans. Fair Isaacs typically starts with fifty variables and, from these, attempts to find the combination that most accurately predicts loan repayment. • The final combination usually involves ten variables. The statistical method used in a credit scoring model ranges from the more traditional linear probability, logit, probit and discriminant analysis models, through to options pricing theory and neural networks. What are the ten key variables which typically feature in Fair Isaacs' credit scoring model? This is where the story becomes very interesting, as the following quote indicates: FICO [Fair Isaac] asserts that augmenting data on the owner of the firm with very basic information obtained from a loan application and a business credit bureau, such as past credit repayment experience collected by Dun '& Bradstreet, produces
a reliable credit score. Perhaps more importantly, FlCO claims that data which had heretofore received much scrutiny in the traditional underwriting process, such as ratios from financial statements, are not crucial in determining the repayment
prospects of the small firm. In fact, FICO's most popular small business scoring system does not require the small firm to provide financial statements. (Feldman 1997, p. 4.)
For anyone with practical experience in small business lending, this is likely to be a perplexing if not a shocking finding. To suggest that detailed analysis of financial statements may not be that relevant to assessing credit risk is to turn the existing approach to small business lending on its head. But is this such a surprising finding? Earlier in this chapter we mentioned the poor-quality accounting information typically supplied by small business to lenders. Perhaps Fair Isaac's findings reflect these information quality problems. This would seem likely, given that Fair Isaac have also found that the quality of the accounting
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information is directly correlated to the size of the company (Eisenbeis 1996). To be mOre precise, 'the smaller the company; the lower is the predictive content of company financials as compared with the principal's financials' (Eisenbeis 1996, p. 275). This finding also tallies with a more recent and substantive piece of research by Kallberg and Udell (2002). They found that if you were keen to know how likely a creditor company was to repay money owed, then analysis of the borrower's financial statements would not be the best place to start. How regularly the borrower has been paying its creditors over the last year is likely to give you a much better predictive variable.
Changes in credit scoring and some predictions . A number of 'researchers have reported some fascinating findings associated with the move in the United States to credit scoring of small business lending. These findings have a strong link to the theoretical framework of small business lending covered' earlier in the chapter. Remember that this framework involves concepts of information asymmetries, credit rationing, moral hazard 'and adverse selection. The following is a summary of the major findings to date, starting with a paper by Frame, Srinivasan and Woosley (2001). These authors examined the use of credit scoring by the top two hundred commercial banks. They found that when one of these banks changed over to credit scoring of its small business loans, on average it was able to increase its small business lending by $4 billion. Their conclusion was that credit scoring seems to achieve this by reducing the information asymmetries between the lender and the borrower. This means that the extent of any credit rationing should be reduced. Akhavein, Frame and White (2001) established that the first users of credit scoring were the larger national banks (rather than the smaller community banks) and also those banks located in New York. This finding seems to be consistent with the economies of scale associated with the adoption of the credit scoring technology In an innovative study, Frame, Padhi and Woosley (2001) found that while the adoption of a credit scoring method has led to increased levels of small business lending overall, the effect is more pronounced in lower to medium income levels. The use of credit scoring in a low to medium iucome area has resulted, on average, in an increase of $16.4 billion in small business Iendingtwo and a half times the effect in a high income area. The authors suggest that credit scoring achieves this by reducing information asymmetries, which seem to be most pronounced iu lower to medium income areas. These areas have been 'historically bypassed because of their questionable economic health' (Frame, Padhi &: Woosley 2001, p. I). On a more pragmatic note, Mester (1997) notes the reduced cost of lending resulting from the use of credit scoring. For a commercially supplied credit scoring system, the cost per loan can be as high as $10 but will reduce to $1.50
/
-
per loan if volumes are large. This would seem to be much less than the cost inherent in twelve and a half hours of relationship manager time required in a typical loan approvaL Given these changes so far, what is the likely future for small business lending in the United States' In attempting to predict the future, it is best to start with a caveat. Credit scoring of small business loans is still a relatively new phenomenon. Some time will need to elapse before it is possible to claim it as a success over the long term. One prediction is that the small business lending market in the United States will end up being like the credit card market (Feldman 1997), eventually characterised by the following: a lack of any face-to-face contact between lender and borrower simple online application forms and very short approval times the possibility of large geographic separations between lender and borrower mail-outs of pre-approved facilities to prospective customers who have been identified through processing commercial databases using a credit scoring model cost reductions leading to increased competition and consequent price reductions the dominance of the lending market by a few large lenders (similar to the top ten credit card lenders accounting. for over half of that market) who operate nationally and are able to exploit economies of scale from the technology From the perspective of the smaller community-oriented banks, which have traditionally dominated the small business lending market, this is a sobering prediction. Small business lending using a relationship lending model has been a strength of these banks over the larger national banks. The concern is the extent of the change that will be forced on the smaller community banks as they lose market share to the larger national banks. For the large national banks, which are likely to end up as major players in the small business lending market, there will be a number of advantages. Credit scoring models provide much greater accuracy in the measurement of small business ci:edit risk, which should flow on to the pricing of this risk. Feldman (1997) reported that Wells Fargo, since implementing credit scoring, has moved"to price its small business customers anywhere betwe~n the reference rate plus 1 per cent to the reference rate plus 8 per cent. Lenders .using a relationship lending approach do not usually differentiate pricing to this degree. The larger national banks are unlikely, however, to have this market all to themselves. Feldman (1997) suggests that already there are signs that nonbanks such as American Express, AT&T and the Money Store are moving to "target small business borrowers using credit scoring technology vVhichever large institutions end up dominating this market, they are likely to have a better understanding and pricing of credit risk. This should make securitisation of their small business debt relatively more straight-
1
306 Part 4: Corporate and business lending)
forward. Already there appears to be a significant growth in securitisation of small business debt linked to the introduction of credit scoring models (Feldman 1997). Implications for Australia Small business lending in Australia appears to be on the verge of significant change. A number of major banks, which are the dominant lenders in this market, have moved to centralise their lending to some small business borrowers. While credit scoring is not in widespread use by the major banks, it is not difficult to imagine it becoming a standard feature in the near future. All the reasons given for the rapid growth of credit scoring in the United States also seem to apply to Australia. Further, some banks in Australia, such as Citibank, will be able to leverage off their US experience with credit scoring; plus, the commercial vendors such as Dun & Bradstreet and Fair Isaac are already looking to market their product into Australia. Credit scoring of small business loans may be the norm in five years.
Summary 1. What is a small business? What are some of the main characteristics of the market for small business lending in Australia? A small business is usually defined as a business with total loans of less than $500000. Lending to small business in Australia is dominated by the major banks who provide three main types of finance: floating rate finance, fixed tate finance and bill finance. Competition among the major banks and other financial institutions is intense. In an attempt to reduce costs, the major banks are increasing the proportion of small business customers that they manage centrally (rather than through face-to-face contact). Perhaps as a result of these changes, surveys indicate deteriorating attitudes of small businesses towards their lenders. There is evidence of increasing political interest in small business lending issues. 2. How do the concepts of asymmetric infonnation, credit rationing, adverse selection and moral hazard relate to the theory underlying small business finance? In lending to small business, there is asymmetric information because typically the borrower has much better information about the business than has the lender. This asymmetry, combined with adverse selection and moral hazard effects, can lead to credit rationing - that is, a situation where not every business that wants to borrow at the current price can do so. 3. What are the distinctive risks associated with lending to small business? The wide range of different risks include key person risk, lack of capital; lack of a track record and the poor quality of the accounting information. These risks are often linked to the high rate of failure of small businesses.
Problem loan management Learning objectives After reading this chapter, you should be able to: 1. outline why loans default 2. highlight the extent of problem loans 3. explain why the business cycle is important for problem loans 4. define problem loans, provisions and regulatory issues 5. discuss the capital issues of problem loans 6. define 'structure dynamic provisioning' 7. restructure problem loans 8. illustrate a case from law.
Introduction For most of this book, our focus has been on the assessment and approval of loans. Lending is clearly a risky activity, however, and lending institutions occasionally grant loans that incur a loss. The loss may occur as a result of many factors, from poor management of the borrower to the timing of the busi. ness cycle. The primary issue of problem loans is that they can impair the value of a finan. cial institution. Too many impaired loans on the statement of financial position of a lending institution may threaten its solvency. It is expected that some loans will become problem, but the aim of a financial institution is to manage the problem in such a way as to reduce the loss of value to shareholders. The first course of action, therefore, is not to foreclose, but to manage the asset or firm.
Causes of default A default is defined here as a loan for which the repayments are overdue. Lending institutions may experience defaults and problem loans for the following reasons (Galin 2001): lack of compliance with loan policies lack of clear standards and excessively lax loan terms inadequate controls over loan officers • overconcentration of bank lending loan growth in excess of the bank's ability to manage inadequate systems for identifying loan problems • insufficient knowledge about customers' finance lending outside the market with which the bank is familiar. All these reasons for default are found within a lending institution. Many problem loans could be avoided by better lending procedures and poliCies. Credit risk is never static, however, and many loans that were validly granted can become bad for many different reasons. Two examples are when a recession affects firms that rely on cashflow or when firms wind up because their prod· ucts have become outdated. The issue then becomes how best to monitor these situations. MOllitoring is easier said than done. While it may be easy to monitor a small portfolio of loans, the situation becomes more complex as the financial institution becomes larger. This complexity introduces higher and higher costs for monitoring. To ensure effiCiency, indicators (such as consecutive missed payments) are normally implemented. These indicators are normally 'noisy', however, which means that they do not present a clear picture of the situation or indicate remedial action. In many cases, these indicators highlight a problem loan when it is too hite,resulting in a less than optimal situation for the lending institution. In chapter 11, we noted that one function of default models is that they can provide early warnings of developing problem loans. This"can be helpful for monitoring purposes.
art 5: Assessment and management of risk
Case study 1 -
Boat Builders Pty Ud*
Learning objectives After completing this case study, you should be able to: 1. critically examine a set of financial statelnents for a borrower, from the perspective of how well those financial statements represent the real position of the business 2. develop a set of questions about the financial statements to ask the owner(s)1 accountant of the business before unde~taking a detailed financial analysis 3. modify the financial statements on the basis of the answers that you find to your questions.
Introduction The detailed analysis of financial statements is an important task for any lender. Chapter 2 deals with how ratios are calculated and analysed, how projections are sensitised and how risks are identified. Another important step is required, however, before this detailed financial analysis. It involves a critical examination of the financial statements of the borrower. The purpose of this step is to ensure the financial statem.ents accurately reflect the real state of the business. If they do not, then the detailed financial analysis is likely to end up being a case of 'garbage in, garbage out' (GIGO). Consider the follOWing illustrations of GIGO in financial analysis: • calculation and analysis of liquidity (Yia a current ratio) when a proportion of the debtors shown on the balance sheet are bad debts • calculation and analysis 'of a gross margin using· a level of sales for the business that has been deliberatdy understated • calculation and· analysis Df the gearing of a business when the capital level has been inflated by an artificially high land valuation on the balance sheet. How does the lender eliminate the possibility of GIGO? It is not easy to set strict rules to follow, but the following are some ideas: Maintain a critical·mindset when considering the financials. Continually ask whether the financial statements accurately reflect what you know about the business. • Get "to know the business by' asking questions of the proprietor or a~countant) by making site .visits and by researching the characteristics of similar businesses in that industry.' Chapter 9 elaborates on these ideas in the context of lending to small business. In chapter 9, the point is made that Goming up with the right questions is. a skill that lenders develop with experierce. The best lenders have ." Disclaimer: This case study is hypothetical. Any resemblance to actual events, locales, entities or persons is entirely coincidental.
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Case study 1: Boat Builders pty Ltd 499
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an impressive ability to read a set of financials and quickly identify the key questions to ask the owner/accountant. They also tend to make insightful observations during a site visit. For the following case study on Boat Builders Pty Ltd, a site visit and a dialogue with the owner/accountant is obviously not possible. For this reason, you are required only to develop a set of questions to ask the owner/accountant about the financials. Make sure that you read and analyse the information contained in the case study thoroughly, because your understanding of this information will determine the quality of the questions that you are able to develop.
Baal Builders Ply Ltd Date: 1 September 2003 Background
Boat Builders Pty Ltd hasbeen a customer of Excel Bank since 1991. It is based in Sunshine, which is a regional centre and the port for a thriving fishing industry. The business has developed into the largest aluminium boat building business in Sunshine and one of the larger aluminium boat builders in the State. Reg and Judith Gibb own Boat Builders. The structure is a standard two-dollar company, with the Gibbs owning one share each. Reg is a qualified boat builder and Judith is experienced in office management. Both are aged in their late 40s. They started the company in 1991. Trading conditions were extremely difficult during the first two years due to high interest rates and depressed economic conditions, but the company has since become well established. Reg is well respected in the industry as a boat builder. Reg and Judith have three children: Jack, Ruby and Charles. Jack is 30 years old and has worked in the business since leaving schooL Ruby and Charles are both studying at university and have no plans to work in the business. Boat Builders recently completed building two 20-metre boats for Deep Sea Fishing Enterprises Ltd (DSFE), which is headquartered in Sunshine but also has fishing operations elsewhere in Australia. DSFE bas plans to expand its operations over the next three years and has indipted to Boat Builders that it will be lodging further orders for fishing vessels over the next three years. Over the past year, DSFE has accounted for 65 per cent oUhe turnover of Boat Builders. Boat Builders currently leases premises in the port area. These premises have proven unsatisfactory because they are quite small, given the size and number of boats that have been built over the past year. Space limitations prevented Boat Builders from participating in tenders to build tWo large boats during the previous financial year. The ongoing demand for boats from customers, particularly from DSFE, led Boat Builders to decide during 2002 to build a large factory unit on land that it purchased two years ago for $94000. Construction of the factory unit commenced in January 2003 and is now close to completion. Boat Builders is
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scheduled to move into the factory unit in November 2003. This coordinates well with the expiry of the lease on the existing factory unit at the end of October 2003. So far, construction expenses have totalled $230 000. A bill facility has been used to finance these expenses, with a top-up coming from the owners of Boat Builders. The builder of the factory unit recently provided a detailed conservative estimate of the remaining costs: $220 000 over October and November. Once completed, the factory unit and associated land will have an estimated value of $650 000. The existing borrowings for Boat Builders are as follows.
'Working capital
Overdraft
$110000
-$82000
Fixed term loan no. 1
Factory equipment
n/a
-$21841
Fixed term loan no. 2
Land
nla
-$58778
$220000
-$220000
Bill facility
Construction costs
nla Not applicable
Recent account balance information for the overdraft is as follows.
July 02
-18142
46061
190520
41395
August 02
-22 578
33843
121240
28085
September 02
-24183
83221
242480
27 921
October 02
-27 581
29277
144276
18092
November 02
-30207
-4936
69280
-5092
December 02
-43155
51687
121240
46895
January 03
-19990
27146
103920
22170
February 03
-20402
-9671
144276
-14062
MaTch 03
-78648
-4575
69280
-8145
April 03
-80575
-12194
185231
-66423
May 03
-89058
-16166
156519
-50494
June 03
, -102050
12000
144276
-88322
Current balance 4 000
Annual credit turnover I 692538 Notes 1. The total value of deposits into the cheque aG.count in a month. Normally, this would tally with the
monthly sales of the business. 2. The average of each of the daily closing balances for the month.
Gase study 1: Boat Builders Ply Ltd 501
I
Request for increased funding
Reg and Judith Gibb have approached you with a request for the following increases in the facilities for Boat Builders.
Overdraft
$1]0 000
$300 000
Increase in base limit (see disclIssion below)
Bill facility
$220 000
$220000
Bill facility malures in October 2003. FaCility is to'be refinanced on an interest-only basis for three years.
Lease for boat lifter
nJa
$60000
Lease [or metal fabrication machinery
nJa
$140000
To be purchased in October 2003 To be installed in the new factory (October 2003)
n/a Not applicable
According to the directors of Boat Builders, the increase in the overdraft limit . to $300 000 will be required only until June 2004. At that point, the limit will be reduced to $11 a 000. Tlie increase in the overdraft limit is to cover the following cash outflows: a taxation payment of $95 000 due on October 2003; constructi()n costs of $220 000 which will be payable during October and November 2003; superannuation payments due in December 2003; and the cost of increasing stock levels following their reduction before the move to the new factory. Since May 2003, DSFE has owed $280 000 to Boat Builders. This debt relates to a boat that was built for use in a joint venture between DSFE and the Commonwealth Scientific and Industrial Research Organisation (CSIRO). Reg Gibb believes that Boat Builders will receive this money by January 2004. This would allow the increase in the overdraft limit to be removed, returning the overdraft to its previous level of $110 000. The Gibbs have offered the following security for the borrowing: 1. a first mortgage over the soon-to-be-completed factory unit (valued at $650000) 2. unlimited guarantees by the directors, Reg and Judith Gibb 3. a fixed and floating charge over the assets of Boat Builders 4. a registered first mortgage over the residence of Reg and Judith Gibb (valued at $260 000). Financial statements
The following financial statements for Boat Builders (pages 503-5) were prepared by Accountiug Partners.
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Accounting Partners Certified Practising Accountants 15 Marine Parade Sunshine Boat Builders Pty Ltd Disclaimer For the year ended 30 June 2003 We have prepared the accompanying statement of financial position as at 30 June 2003 and statement of financial peiJormance for the year then ended ('the Accounts') from the books and record.s of the Company and other infonnation provided by the officers of that Company an.d at the request of and exclusively for the use and benefit of the Company. Under the terms of our engagement we have not audited the acco.unting records of the Company or the Accounts. Accordingly, we express no opinion on whether they present a true and fair view of the position or of the year's trading and no warranty of accuracy or reliability is given. In accordance with our firm policy we advise that neither the firm nor any member or employee of the firm undertakes responsibility arising in any way whatsoever to any person (other than the owners) in respect of the Accounts including any errors or omissions therein arising through negligence or otherwise however caused. Accounting Partners Certified Practising Accountants 15 July 2003
$1692 538
SALES
$418829
LESS COSTS OF SALES 67734
Consumables (welding)
37261
Drafting services
257229
Direct wages
17481
123424
2502
Electricity
2670
Freight
10646
Painting and sand blasting
40275
53828 637 2176
Repairs ~ plant and equipment Replacement tools
879402
Aluminium purchases
101861
Subcontractors
1405299. 287239
2188
509 54877 8114
TOTAL COST OF SALES
257514
GROSS PROFIT FROM TRADING
161314
These accounts have not been audited and constitute special-purpose financial statements. This statement must be read in conjunction with ·tlH!"attached disclaimer of Accounting Partners.
Case study 1: Boat Builders Ply Ltd 503
CURRENT ASSETS
Debtors
$ 35168
$ 35530
S[Ock
30000
30000
4978
Cash
1545
Director's loan '(:1 Gibb)
36026
Director's lmin(R Gibb)
600
CURR~NT
107717
TOTAL
103000
Factory unit land
1545 66410
ASSETS
134085
NONCURRENT ASSETS
140803 (44469)
103000
Plant_.and equip'11e"u -
at cost
Less Provision for depreciation
40450 (23062)
vVrilten-down value
,96334
66756 (19601)
47155
Motor vehides -
17388 31147
at cost
Less Provision for depreciation
(17098)
Written-clown valUE
4353 (! 572)
2781
Office equipment -
14049 2964
at cost
Less Provision for depreciation
(!
1m
Written-down value
480 (288)
1836
Capitalised borrowing costs Less Provision [or amortisation
Amortised value
191
480 (19]) 287
249461
TOTAL NONCURRENT ASSETS
136560
357178
TOTAL ASSETS
270645
CURRENT UABILITIES
(4000)
Overdraft
66875
7001
Creditors
35156
216780 '
Bank bill
219781
TOTAL CURRENT LIABILITIES
102031
NONCURRENT LIABILITIES
40916
Loan - R &J Gibb
43671
Loan -
19931
Boat Bl.lilders Ply Ltd superannuation fund
Loan-Bank
13832
22496
Fixed tenn loan 1 -
fa~tory
60048
Fixed term loan 2 -
land
equipment
7869
83205
123460
TOTAL NONCURRENT LIABILITIES
168509
343241
TOTAL LIABILITIES
270540
SHAREHOLDERS' FUNDS
2
Paid-up capital
2
13935
Retained earnings
103
13937
TOTAL SHAREHOLDERS' FUNDS
105
357178
TOTAL LJA81UTIES AND SHAREHOLDERS' FUNDS
270645
These accounts have not been audited and constitute special-purpose fmandal statements. This statement must be read in conjunction with the attached disclaimer of Accounting Partners.
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504 Part 7: Case stUdies
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EXPENDITURE $
6298
Accounting
1438
Advertising
3677
Ba-r;k charges
96 21408 5432 444 2060
$
4723 719
1067
BOIiowing costs
96
Conference fees
345
Depreciation on plant and equipment
4140
Depreciation on motor vehicles
5002
Depreciation on office equipment
414
Donations
157
179
Fines
335
:H:ire of plant and equipment
3556
General insurance
4001
9340 11198, 3289 838 12224
WorkCare insurance .'.
Bank interest -....... Inlerest -
Boat Builders Ply Ltd superannuation fund
28186 3289
Interest- fixed term loan 2 (land) Leasing payments
U500
1018
Legal costs
1134
Loss on sale of fixed assets
lil03
Petrol and oH \ \BEpairs and maintenance]
9.JI31
7358 2923
Registration and insurance
1415
(7181) 57 1605 887 79 3706 11021 , 53 1043 35922
1646
Less Employee contribution Permits, licences and fees
583
Postage Printing and stationery
293
Protective clothing and safety gear
1085
Rates and taxes
3032
Rent
9899
'.' Repairs and maintenance Staff training Superannuation contributions
845 21
202
5025
Telephone
4941
1931
Travelling expenses
1468
828
Union fees
156775
TOTAL EXPENDITURE
93670
130464
NET PROFIT
67644
OTHER INCOME 13832 369 14201 144665
. Capital gain on"sale of fixed assets
35681
Net property income TOTAL OTHER INCOME OPERATING PROFIT (BEFORE TAX)
35681 103325
Th~se accounts have not been audited and constitute special-purpose financial statements, This statement must be read in conjunction with the attached disclaimer of Accounting Partners.
Casesludy 1: Baal Builders Ply Ltd 505
I
Discussion questions In the following discussion questions, you are not being asked to conduct detailed financial analysis of the statement of financial position and the statement of financial performance. This financial analysis, which includes ratio analysis of the the statement of financial position and the statement of financial performance, will be done in case study 2. In this case study, you only need to consider the financial statements in terms of how accurately you feel they depict the true state of the business. 1. The accountant has stated in the footnote to these financial statements that the accounts 'constitute special-purpose financial statements'. Ca) What are special-purpose financial statements and how are they different from general-p>'lIpose financial statements 7 'i (b) What is the significance to you, as a lender, of these being special-purpose financial statelnents? CMost introductory accounting textbooks contain information on both special-purpose and general-purpose financial statements. Chapter 9 also discusses these two types of statement.) 2. Identify any concerns that you have about the financial statements supplied for Boat Builders in terms of them not accurately depicting the true position. of the business Cfor reasons of error, accounting assumptions, creativity or dishonesty) . 3. Rank all of your concerns in terms of their Significance to you as a lender to this business. Justify your rankings. 4. Based on your concerns, identify five key questions that you would ask the proprietors of the business about their financial statements. 5. In a practical lending situation, the proprietors/accountant would answer the questions that you have identified. Potentially, this could lead to the financial statements being modified before your detailed financial analysis commences. In the context of this case study, there is no proprietor or accountant to provide answers to your questions, so you are asked to modify the financial statements based on your best guess of what the answers to your five key questions would be. Explain and justify each modification that you would make.
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Case study 2 - financial analysis of Boat Builders Ply Ud* Learning objectives After completing this case study, you should be able to: 1. complete a detailed financial ratio analysis of a series of statements of financial position and a statement of financial performance 2. complete a detailed financial analysis of a cashflow budget using a five-stage checklist 3. generate conclusions from this analysis about the risks you face as a lender to this business.
Introduction You need to complete case study I (Boat Builders Pty Ltd) before· commencing this case study. The focus in case study I was on identifying any concerns that you had about the balance sheets and profit and loss statements for Boat .Builders, to ensure there was limited scope for garbage-in, garbage-out (GIGO) in the financial analysis stage. In this second case study, the focus is on the subsequent financial analysis stage. Based on the concerns that you identified in case study I, you were asked to make adjustments to the financial statements. These are the adjusted financial statements that you will analyse in this second case study.
Boat Builders Pty LId Date: I July 2003 Background
Case study I provided a detailed background on Boat Builders. Here, you are asked to conduct a detailed financial ratio analysis of the balance sheets and the profit and loss statements that the directors of Boat Builders have supplied. Many different financial ratios could be used as part of this analysis, but we recommend that you use the following ratios (and ratio groups).
Current ratio
~urrent
Quick ratio
(Current assets - stock) divided by (current liabilities - overdraft)
Debtors turnover
Trade debtors divided by average daily sales
assets divided by current liabilities
(continued)
"* Disclaimer: This case study is hypothetical. Any resemblance to actual evenLS, locales, entities or persons is entirely coincidenlal.
I Case study 2: Financial analysis of Boat Builders Pty Ltd
507
I
Stock turnover
Average stock divided by daily cost of goods sold
Creditors turnover
Trade creditors divided by average daily purchases
Shareholders' funds divided by total assets Shareholders' funds divided by outside liabilities Fixed assets divided by shareholders' funds
Gross margin
(Sales - cost of goods sold) divided by sales
Net margin
Net profit divided by sales Operating expenses divided by sales
A potential trap with ratio analysiS is that it can end up being superfiCial if it focuses on the ratio values without going into what lies behind those values. Here are some ways in which to make your ratio analysis more in depth. 1. Refer to the source data
Relate your analysis of each ratio back to the underlying figures in the balance sheet or profit and loss statement used in the calculation of the ratio. Consider a longer term solvency ratio: shareholders' funds divided by total assets, for example, which has changed from 47 per cent to 40 per cent to 37 per cent over a three-year period. Why has this change in the ratio value occurred? Has it been due to a growth in total assets while shareholders' funds remain constant? Or, to some other combination of change in total assets and shareholders' funds? 2. Relate comments to the type of business concerned
Ratio analysis .should be nsed to say something about the business concerned. If the business is a boat builder, then the comments about stock turnover should relate to the stock typically held by a boat building business. As an example, what proportion of work-in-progress is contained in Boat Builders' stock figure 7 3. Make some conclusions about risks
Lenders are ultimately interested abont risks, 50 ratio analysis should be used to make conclusions about the risks that the lender to this business faces. If the liqnidity position of the business is poor, then what are risks to the lender?
Request for increased funding The directors of Boat Builders have requested the following increase in bank funding.
508 Part. 7: Case studies
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Overdraft
$110000
$300000
Increase in base limit (see discussion belo,,\")
Bill facility
$220000
$220000
Bill facility matures in Octobel- 2003. Facility is to be refinanced on an interest-only basis for three years.
Lease for boat lifter
nJa
$60000
To be purchased in October ~003
Lease faT metal fabrication machinery
nJa
$140000
To be installed in the new factory (October 2003)
nia Not applicable
The directors have provided a cashflow budget, with the following notes, to support their request for an increase in the overdraft limit in particular: 1. The $300 000 overdraft limit will be required only until June 2004. At that point, the limit will be returned back to $110 000. 2. The increase in the overdraft limit is to cover: t a taxation payment of $95 000 due in October 2003 construction costs of $220 000 which will be payable during October and November 2003 superannuation payments due in December 2003 the purchase of additional stock following a reduction in stock before the move to the new factory. 3. Since May 2003, Deep Sea Fishing Enterprises Ltd (DSFE) has owed $280 000 to Boat Builders. This debt relates to a boat that was built for use in a joint venture between DSFE and the Commonwealth Scientific and Industrial Research Organisation (CSIRO). DSFE is waiting for payment from its government partner. According to documents provided by DSFE, this payment will be made in four tranches as follows: October ($100000), November ($100000), December ($40000) and January ($40000). 4. The figure of $1615 000 for 'Sales' is made up of contracts with both DSFE (65 per cent) and other customers (35 per cent). Boat Builders expects that these sales will be paid within thirty days. You are asked to analyse the cashflow using the five-stage cashflow checklist outlined in table 9.7 (page 300). In particular, you are asked to concentrate on parts 4 and 5 of the checklist: analysing the validity of the underlying assmnptions and critically considering the issue of sensitivity analysis.
I Case study 2: Financial analysis of Boat Builders Ply Ltd
509
~
0
.." ~
,.,'" co
iii ro
~
c
= co· ~
Opening overdraft balance CASH INFLOWS DSFE Ltd Payments Sales TOTAL CASH INFLOWS COST OF SALES
ConsumabJes (welding) Drafting services Direct wages Eleclrici.ty Freight Repairs - plant Tools M~Jerial purchases
(mainly aluminium) Subcomractors CASH EXPENSES Accountant fees
Advertising Bank charges
Hire of equlinnent . Interest - overdraft .' Interest - term loan Motor vehide expenses Licences Postage Printing
Protective clolhing Ra tes and La;"{es Rent Staff training Superannu
10 000 -126870 -120416 -240175 -226845 -280191 -299155 -294510 -259014 100000
-54839 -107907 -1545957
100000
100 000 40000 140000
40000 110000 150 000
40000 130000 170000
120000 120 000
165 000 165 000
190000 190000
1545
1545
4918 20600 180 194 39 155
7869 4511 20600 288 309 62 247
8656 4963 20600 317 340 68 272
9050 5 IB8 20600 332 355 71 284
9050 5188 20600 332 355 71 284
20600 346 371 74 297
169 950 7725
106 605 12 360
117420 13 390
123600 14420
123 600 14 420
127720 14 420
31930
133 275 412 6180 511 1988
133 440 412
133 484 412
7571 133 506 412
133 528 412
511 1 988
511 1988
133 506 412 6180 511 1988
5ll 1988
5ll 1988
133 132 412 6180 5ll 1988
149 248 258
149
149
149 248
149
149 248 258
149
149
918
918
2820
13 596 103
2060
13 596 103
2060
5923
133 22 412
133 33 412
511 1988 206 149
511 1988
4120 918
149
258
220000 220 000
235000 235000
110 000 110000
105 000 105000
190000 190000
9443
2361 1353 20600 87 93 19 74
2754
7869
9443
1579
4511
5414
20600 101 108 22 87
20600 288 309. 62 247
20600 346 371 74 297
36050 4120
106090 12 360
127720 14 420
133 155 412
133 440 412
5ll 1988
511 1988
133 528 412 6 lS0 5ll 1988
149
149
5414
1545
4
no
248 258
1545
51500
Telephone Travel expenses Union fees OTHER CASH OUTFLOWS Taxation Construction costs TOTAL CASH OUTFLOWS Closing overdraft balance
-95885
185
1407 185
185 927
185
1407 185
185
185
1407 185
185
110 000 133 546
236870 269759 156670 173 346 183964 185355 184504 -126870 -120416 -240175 -226845 -280191 -299155 -294510 -259014
1407 185
185
74503 40941 233 192 2823 2805 56] 2243
1074 805 Hl 755 13493 1594 4048 4944 24720· 6131 23 855 206 1792 993 1030 4 no 2753' 3090· 51500 562B 2225
927
95000\ 110 000
185
280000 1615 000 1895000
71871 -95885
95000 220000 68953 158068 188771 2 Oll 678 -54839 -107907 -106678 -1662635
Discussion questions 1. Comment on the short-term liquidity, longer term solvency and business performance of Boat Builders based on your analysis of tlie ratios. Remember that you should be analysing the modified financial statements that you generated as part of case study 1. 2. Comment on what your analysis of the cashflow budget has revealed. Overall, do you see the cashflow budget as being pessimistic, optimistic or realistic? Do you think that Boat Builders' request for an increase in borrowing facilities is justified? In your opinion, will tbe business be able to reduce its overdraft to below $110 000 by July 2004? 3. Based on your ratio analysis of the statement of financial position and statement of financial performance, plus your analysis of the cashflow budget, do you consider that Boat Builders is in a strong position as a borrower? As the lender to Boat Builders, what are the major risks that you face?
[ Case study 2: Financial analysis of Boat Builders Pty Ltd 511 [
Case study 3 - Orbital Engine Corporation Ud* Learning objectives After completing this case study, you should be able to: 1. demoustrate a familiarity of the format of general-purpose financial accounts for a listed company 2. demonstrate an understanding of the impact of company structures (that is, company accounts versus consolidated accounts) on the analysis of first and second ways out of the proposed loan 3. conduct a detailed analysis of the first and second ways out for a loan to a listed company 4. produce a lending submission for the proposed loan (according to the pro-forma provided) which clearly identifies the risks and risk mitigants associated with the deaL
Introduction This case study on Orbital Engine Corporation Ltd poses interesting challenges for a lender. As a listed company on the Australian Stock Exchange, Orbital produces detailed financials as part of its annual reports. Compared with Veterinary Clinic Pty Ltd (case study 4), Orbital offers an abundance of information. For those relatively new to the experience of lending, it is easy to become swamped by all this information. We suggest that if you start to feel overwhelmed by the quantity of information, you should go back to basics and ask the question: what are the first and second ways out for this loan? This case study on Orbital Engine Corporation Ltd is different from other case studies in this book in that it involves an actual business. The request for funding, however, is hypotheticaL
Orbital Engine Corporation ltd Date: Tuesday, 30 October 2001 Background
Your are working as a corporate lending manager in a major bank The board of the bank decided at the start of the year that it wanted to increase the amount of corporate lending business on its balance sheet (that is, its statement of financial position). As part of the implementation of that decision, you and the other corporate lending managers have been given ambitious monthly lending targets to meet. You have been directed to meet your monthly targets by increasing both your lending to your existing customers and your lending to new corporte customers. Part of your typical week involves trying to identify existing and new companies * Disclaimer: The lending proposition [or Orbital in this case study is entirely hypothetical.
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to which you can make new laons. Orbital is one of the new companies that you have identified as prospective customers. A school friend, who went on to do study engineering, is currently working with Orbital. Through him, you have learned that Orbital has successfully granted licence rights to manufacture products incorporating Orbital technology to some of the major automotive, marine and motorcycle manufacturers in the world. Manufacturers that currently sell products with Orbital technology include Mercury Marine, Tohatsu, Bombardier and Aprilia. Orbital Engine Corporation Ltd is a company that was first listed Cas Sarich Technologies) on the Australian Stock Exchange in 1984. Orbital has described itself as: ... an intellectual property company that has developed world leading direct fuel injection, combustion and control system technologies collectively termed the Orbital Combustion Process (OCPTM). When applied to either 2-stroke or 4-stroke internal combustion engines, OCPTM achieves a superior combination of fuel economy impt9vement and emissions reduction and is suitable for automotive, marine, recreational, motorcycle and scooter applications ... (www.orbeng.com.au/
orbitaVaboutOrbitaVaboutOrbital.htm, 19 October 2001)
lending proposition Your brief reading of the Orbital annual report has identified that Orbital is effectively 100 per cent equity funded. AVOiding debt funding has been a deliberate decision of the Orbital board. Your thinking, however, is that while pure equity funding might have been appropriate while Orbital developed its technology, it rriay not be as appropriate now, given the company's new phase of granting licence rights to major manufacturers. You have decided to expolore the possibility of putting a proposal to Orbital to take on some debt funding. You have in mind that a $5 million five-year multi-option facility may be appropriate. This facility would allow Orbital to drawdown up to $5 million in different forms (including commercial bills, cash advances and so on). Before you put the proposal to Orbital, you need to do some detailed credit analysis of the posposed $5 million exposure. You know'ihere will be both strengths and weaknesses associated with the proposed Orbital exposures, as with any lending. Your task is to see whether there is a way of structuring the deal to ensure the bank mitigates against the deal's weaknesses (or risks). You may not be able to find such a way, but at least you should do as much thinking and analysis as you can to see whether a viable loan can be structured. The following information is relevant to your analysis of the proposed Orbital exposure: • The Orbital website (http://www.orbeng.com.aulorbitallhomelhome.htm) has a copy of the recently released 2001 Annual Report. The format of this annual report is typical for a listed company, in that it provides an overview of the company's operations, then detailed financial statements. • A cashflow budget for 2002 is not available to you as part of your analysis.
I
Case study 3: Orbital Engine Corporation Ltd 513
• The only assets available for security are those listed on the company's statement of financial position. Some of these assets have already been provided elsewhese as security. Details are provided in the notes to the financial statements. For the purpose of this case study, you are asked to structure your analysis in the form of a written lending submission. The submission will end with a recommendation on whether you wish to proceed with this proposed exposure. The format you will use for your lending submission is the standard format used by Excel Bank. This structure has a number of attractive features. One is that the analysis of the financials is done in the appendixes to the submission. This allows you to conduct this analysis before writing the submission. As a result, the submission tends to benefit from a sense of 'hindsight'. It also means less of a tendency for the submission to be clogged with numerical analysis, which is relegated to the appendixes. Your aim is for .the s,"bmission to contain, in the case of the financial analysis, only those issues that are absolutely central to the deaL Another attractive feature of the Excel Bank submission format is the clear focus on identifying the deal's key risks and how these key risks relate to the ultimate decision. Excel Bank format for a -lending submission
Backgr<:mnd detail
What is the name of the borrower? What is their address? Who are the major shareh~lders/unit holderslbeneficiaries?
What is the deal? How much is being borrol-ved? For what particular.Brief overview of . the facts of the deal purpose? Over what period of time? Overview of the borrower
. 'What ~re the current borrowings (if an existing borrower)? What is the hiStory of this borrower? If the borrower is not an indiviclu
. are the individuals behind the borrower? What does the borrower do to generate income? vVhat are some of the lzey characteristics of the business (number of employees, proqucts, location, number of competitors, management, -marketing and so on)? How has the "business changed over time? Industry analysis
A commentary on the industT)', ending with a 'statement abOllt the key success factors and key sensitivities of this industry
Financial analysis
The key credit issues to come out of the financial analysis in appencliX-es 2 and 3
Security
Identification of the key credit issues that corne out of the existing security structure, as per the analysis in appendix 1. A concluding comment should be made about the strength of the second way out.
Key strengths and weaknesses (risks) afthe deal
This section will draw on the analysis provided in the preceding sections and appendixes. Ways of mitigating risks should be identified where pOSSible. In both this section and the next, the strength of both the first and second ways out for the proposed bon:mving should be clearly noted as either a strength or weakness.
Recommendation
A clearly justified recomp:tendation, including a list of relevant
covenants
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Part 7: Gasestudies
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Appendix 1
The security position. This appendix should detail the different items of security and the lending margin that is available overall on this security.
Appendix 2
Analysis of the historical financials '(statement of financial position, statement of financial performance and cashflow statement). This analysis should always focus on the ultimate identification of risks (rather than on detailed quoting of numbers). Comments on the statement of financial position and statement o(financial performance should be made under the broad headings of 'short-term liquidity' > 'longer term solvency' and 'business perfonnance'. A cashflow statement, if not provided by the customer, may be generated by the lender and discussed in this appendix.
Appendix 3
Analysis of the projected financials (cashflow budget projections andlor statement of financial position and statement of financial performance). Two key issues that need to be addressed in this section include whether the amount sought is sufficient for the business's likely needs and whether the business has the capacity to service/repay the proposed borrowings. The five-stage cash flow checklist should be used in analysing the cashflow budget.
Note: Orbital calls its statement of financial position a balance sheet, and it calls its statement of financial per-
formance a profit and loss statement.
In researching information for your assignment, your main source should be Orbital's website at www.orbeng.com.au. There is also likely to be other information available on the web that provides analysis of the operations of OrbitaL For the purpose of this case study, your working date is Tuesday 30 October 2001. If you are searching for information on Orbital (particularly from the web), then you will need to restrict yourself to information that was publicly available as at Tuesday 30 October 2001. You are not to contact Orbital directly with any queries.
Discussion questions 1. Two sets of accounts are provided in Orbital's 2001 Annual Report: accounts for the company and accounts for the consolidated entity. In conceptual terms, why are there differences between these two sets of accounts? In practical terms, what are some of the major differences between the consolidated entit)' and the company? In analysing the proposed exposure to Orbital, which set of financials would you analyse? 2. Distinguish between the concepts of business risk and financial risk. Comment on the respective levels of business risk and financial risk. faced by Orbital. How do these two risk concepts relate to the board decision to be purely equity funded?
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Case study 3: Orbital Engine Corporation Ltd 515
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