Bank Lending BFC5914 Monash Business School Monash University Week 5 Reviews Corporate Lending Small Business Lending 1 Reviews 2 Corporate Lending 3 Small Business Lending Bank Lending 2 / 62 Reviews Corporate Lending Small Business Lending Reviews : The 5 Cs Character : the integrity of the borrower. Capacity : the cash flows to repay the loan. Capital : the borrowers contribution to the project. Collateral : the assets the borrower pledges. Conditions : internal and external conditions, and loan conditions or covenants. Bank Lending 3 / 62 Reviews Corporate Lending Small Business Lending Reviews : Credit Scoring Techniques How to build up your credit scoring system Advantages and Disadvantages Bank Lending 4 / 62 Reviews Corporate Lending Small Business Lending Reviews :Consumer Lending and Real Estate Lending Types of consumer loans Credit scoring system in consumer loans Real estate lending Valuation/ Application/ Precautions /Pricing / Structuring Bank Lending 5 / 62 Reviews Corporate Lending Small Business Lending Week 5 Corporate and Small Business Lending Reading : Sathye and Bartle Chapters 8 and 9 Bank Lending 6 / 62 Reviews Corporate Lending Small Business Lending Large Corporate Lending Bank Lending 7 / 62 Reviews Corporate Lending Small Business Lending Large Corporate Lending Learning Objective 1 Apply the principles of corporate lending Discuss the application of lending criteria Corporate loan structuring Manage loan portfolios Bank Lending 8 / 62 Reviews Corporate Lending Small Business Lending Large Corporate Lending Bank Lending 9 / 62 Reviews Corporate Lending Small Business Lending Large Corporate Lending Corporate Lending The core principles of personal lending also apply to corporate lending (CAMPARI or 5 Cs). The difference is that the information required to assess the feasibility of such proposals is more rigorous, complex and time consuming. However, the risks and the returns on such loans are also larger and therefore more attention is required. Bank Lending 10 / 62 Reviews Corporate Lending Small Business Lending Large Corporate Lending Three Overarching Principles 1 Safety - Ability to repay the loan 2 Suitability - Purpose and amount of loan, hurt money and repayment schedule 3 Profitability - Sufficient return on investment You have to be willing to say NO to loans that do not meet these criteria. Bank Lending 11 / 62 Reviews Corporate Lending Small Business Lending Large Corporate Lending Approach of Assessment 1 CAMPARI - Character ; Ability ; Margin ; Purpose ; Amount ; Repayment ; Insurance (Security) 2 5 Cs 3 PARSER - Personal element, Amount required, Repayment, Security, Expedience, Remuneration 4 Statistical methods (Z-Score, KMV, etc) Bank Lending 12 / 62 Reviews Corporate Lending Small Business Lending Large Corporate Lending The Lending Cycle - Origination - Funding - Monitoring Bank Lending 13 / 62 Reviews Corporate Lending Small Business Lending Large Corporate Lending Appraising a Business There two aspects to business appraisal (i) financial, and ; (ii) non-financial matters which are hard to quantify. Whilst the importance of the former is widely accepted and practiced, there is a tendency to give scant attention to the latter. - This is dangerous because aspects of this general appraisal hold the key to the success or failure of the business. Bank Lending 14 / 62 Reviews Corporate Lending Small Business Lending Large Corporate Lending Appraising a Business Some non-financial considerations are as follows : Markets and Products Competition Resources Management Bank Lending 15 / 62 Reviews Corporate Lending Small Business Lending Large Corporate Lending Appraising a Business Nearly all businesses are financed by a combination of proprietor’s capital and borrowed money (equity and debt). The relationship between the two is very important because a highly geared company (one with a high proportion of debt) is more vulnerable than a lowly geared one. The financial cost of debt (interest) has to be paid whether or not the company is making profits. Bank Lending 16 / 62 Reviews Corporate Lending Small Business Lending Large Corporate Lending Appraising a Business The financial cost of debt (interest) has to be paid whether or not the company is making profits. - This is a particular problem when interest rates are high. - A lender is going to be less happy with a highly geared company because of the potential strain placed on it to generate sufficient profits to cover the interest cost. - Further, owners of companies in which they have substantial equity (and therefore more to lose) are more likely to work hard to ensure the business is a success. Bank Lending 17 / 62 Reviews Corporate Lending Small Business Lending Large Corporate Lending Appraising a Business Financial structure Nearly all businesses are financed by a combination of proprietor’s capital and borrowed money (equity and debt). - Capital gearing - Interest cover Bank Lending 18 / 62 Reviews Corporate Lending Small Business Lending Large Corporate Lending Appraising a Business Liquidity and Efficiency The importance of a business’s liquidity position cannot be overstressed because it is an indicator of whether its liabilities can be met when they fall due. - For example how close are assets to being converted to cash. - The following are a list of financial ratios relevant to liquidity : Debtors turnover, stock turnover, creditors turnover, HP/leasing, short-term vs. long-term loans, Inter-company debt, loans from/to directors, dividends, taxation, working capital, operating cash flow, capital expenditure, current ratio and acid-test ratio. Bank Lending 19 / 62 Reviews Corporate Lending Small Business Lending Large Corporate Lending Appraising a Business Profitability The lender should concentrate on these questions : - Are profits increasing with sales ? - What is the quality of profits ? - Are they the direct result of trading or is there an extraordinary element in them ? - Are profits being retained in the business ? - If a loss has been made, has the cause been identified and remedial action taken ? - Are there any changes in the return earned on capital employed ? Trends in profitability can be analysed through the examination of a number of ratios. - Gross margin - Net profit margin Bank Lending 20 / 62 Reviews Corporate Lending Small Business Lending Large Corporate Lending Structuring The Loan Proposal It should address the following questions Is loan amount sufficient for task ? Is cash available and repayment identifiable ? Is term of debt long (>12 months) or short-term ? Bank Lending 21 / 62 Reviews Corporate Lending Small Business Lending Large Corporate Lending Structuring The Loan Proposal If long-term, will cashflow projections support repayment and does purpose match term ? If short-term, does asset conversion cycle and working capital allow repayment ? Does the borrower have seasonal funding requirements or is it ’hard-core’ debt ? Bank Lending 22 / 62 Reviews Corporate Lending Small Business Lending Large Corporate Lending Product Structure and Application High end products : more complex product suited to larger corporates and NOT small business. Note that in times of financial difficulty / financial distress such products are quickly drawn down to their limits. Popular high-end products include - Revolving Credit : Flexible facility with a limit that may be drawn, repaid and used again - Standby Lines : Funds that may be drawn down when required with guaranteed access Bank Lending 23 / 62 Reviews Corporate Lending Small Business Lending Large Corporate Lending Product Structure and Application - Revolving underwriting facilities : Funds available on demand and reinstated on repayment - Syndicated facilities : Mixture of product offerings shared by multiple lending firms - Project finance : Specific funding for single large-scale projects Bank Lending 24 / 62 Reviews Corporate Lending Small Business Lending Large Corporate Lending Credit Rating Agencies Credit rating is a formal credit opinion provided by rating agency for financial markets Generally for large corporates and sovereign borrowers Ratings used in conjunction with other credit criteria. Bank Lending 25 / 62 Reviews Corporate Lending Small Business Lending Large Corporate Lending Managing the Loan Portfolio What can go wrong ? - 30% of bad loans were unsound when loan made - facts missed or analysis was faulty - Much greater risk of errors in loan approval process than fraud - Risks are : 1 External : Changes to regulations/legislation, technological, globalisation, economic, etc. 2 Internal : Poor planning, organisation, profit planning/cost control and resource. management Bank Lending 26 / 62 Reviews Corporate Lending Small Business Lending Large Corporate Lending Skills Required of The Loan Officer Understanding loan portfolio complexity Subjective and objective in risk assessment Sound credit administration and record-keeping Strong focus on loan monitoring and credit judgment Technologically competent / Technically competent Clear thinker who is good at early problem recognition and decisive solution-finding Bank Lending 27 / 62 Reviews Corporate Lending Small Business Lending Bank Lending 28 / 62 Reviews Corporate Lending Small Business Lending Learning Objective 2 Define small business Describe the distinctive risk of small business Appraising the business Tips from the past Bank Lending 29 / 62 Reviews Corporate Lending Small Business Lending Small Businesses SME represent 99% of all business SMEs contributes 57% to GDP SMEs employ over 7million people (67% of total employment) www.asbfeo.gov.au Report 2019 - Guy Debelle (2017) RBA speech ”It is not the absence of entrepreneurial spirit, it’s the absence of entrepreneurial finance that’s been the main factor holding that part (small business) of the economy back. ” - One SME born every 2 minutes. Bank Lending 30 / 62 Reviews Corporate Lending Small Business Lending Problem of Collateral for SMEs where Owner is Young Banks lend on average $100,000 with mortgage collateral up to 3 years to SMEs. Fintechs will offer smaller loans (up to 18 months) with back up collateral based on the business assets - but at a higher interest rate. Home ownership for 25-34 year olds down 30% (compared to last 25 year average). What to use as collateral ? Lack of competition - major 4 banks held 83% share of SME finance (RBA, 2017). www.asbfeo.gov.au Bank Lending 31 / 62 Reviews Corporate Lending Small Business Lending Bank Lending 32 / 62 Reviews Corporate Lending Small Business Lending Overview of Small Business Lending Small business lending is a specialized area of lending Small business lending is gaining increased theoretical support Two main approaches : Relationship Management approach ; Credit Scoring approach Bank Lending 33 / 62 Reviews Corporate Lending Small Business Lending Small Corporate Lending Distinctions between large and small businesses are usually based upon number of employees, size of sales turnover, size of capital base, etc. - Note that these different definitions can yield different outcomes and are different across nations (e.g. a small number of employees in Australia vs China). For the lender these distinctions are not as important as the fact that many ’small’ businesses either cannot or will not produce good quality management information or projections which are generally available from larger ones. Small business in the economy - 2m+ small businesses in Australia in 2016 Bank Lending 34 / 62 Reviews Corporate Lending Small Business Lending Small Corporate Lending Ideally, small businesses would have efficient systems for collecting together information and for forecasting so that they would be able to keep themselves and the lender up to date with their present financial position and prospects. Unfortunately, in practice, such arrangements tend to be the exception rather than the rule. - Thus, the existence of decent information management systems in a small business is a positive sign in itself. Bank Lending 35 / 62 Reviews Corporate Lending Small Business Lending Small Corporate Lending When pressed to do so, small businesses will produce formal budgets and cash flow forecasts. Where they cannot do this for themselves they will have no difficulty in enlisting the help of an outside accountant. - The accountant will be working for the customer, and NOT the bank, and will therefore wish to keep the customer, rather than the bank, happy. - Such forecasts will tend to show that the facility being requested is needed and that it can be repaid. Bank Lending 36 / 62 Reviews Corporate Lending Small Business Lending Small Corporate Lending It is not unreasonable for the lender to treat with suspicion cash flow forecasts and budgets which have been prepared by, or at the request of, businesses which would not usually undertake any form of financial planning. Sales forecasts in such projections are often over-optimistic and the lender cannot expect outside accountants to concur with the optimism of their clients (although that is not to say some good ones will not try). Bank Lending 37 / 62 Reviews Corporate Lending Small Business Lending Small Corporate Lending Cash flow forecasts which are drawn up to ’prove a point’ are easily prepared from the bottom line upwards so that the sales receipt line at the top shows what is necessary to produce the required result in terms of cash flow at the bottom. - Look for growth forecasts in excess of the higher of the rate of inflation or the general growth rate for that industry or region. - Unless a small firm is a special case it is unlikely to grow at a rate hugely in excess of the general environment factors. Bank Lending 38 / 62 Reviews Corporate Lending Small Business Lending Small Corporate Lending Finance to small business takes three main forms : Floating rate finance Fixed rate finance Bill finance Bank Lending 39 / 62 Reviews Corporate Lending Small Business Lending Small Corporate Lending Bank Lending 40 / 62 Reviews Corporate Lending Small Business Lending Appraising Business Proposals Without Good Quality Financial Information The decision to lend to small businesses when there is inadequate information is a task which even the most experienced of lenders finds demanding. In those situations where serious doubts exist about the viability of a proposition, it will usually be wise to seek a second opinion from a colleague whose judgment and objectivity is respected. In some cases you will need to know someone with a good knowledge of that industry. Large lending institutions often maintain a suite of such specialists. It is this issue that make lending as much art as science and it takes time and experience to develop a good ’nose’ for bad loan requests. Bank Lending 41 / 62 Reviews Corporate Lending Small Business Lending Appraising Business Proposals Without Good Quality Financial Information The areas which need to be examined are : the ability and integrity of the proprietors ; the availability of physical and production resources ; the present and potential profitability ; the impact of the proposition on future cash flow ; the adequacy of present and planned capital resources. Bank Lending 42 / 62 Reviews Corporate Lending Small Business Lending Uncertainty and Security Despite all the questions and analysis, it is still likely that significant doubts will remain concerning the viability of the plans. The assessment of the probability of a business meeting sales targets will be based on the lender’s own subjective judgment of the market rather than hard evidence. Whilst on balance a lender may feel that a plan is attainable, confidence in that judgment may not be great and there will remain a significant possibility of things going wrong. Bank Lending 43 / 62 Reviews Corporate Lending Small Business Lending Uncertainty and Security Fundamentally, it will be difficult to be sure that repayment will be achieved. Small businesses are often vulnerable to events outside their control, many of which can lie difficult to foresee. - E.g. technological change destroying an industry ; council road works causing cash flow catastrophes. It will be more by good luck than good judgment that a lender will cover such factors in the evaluation of the proposition. Bank Lending 44 / 62 Reviews Corporate Lending Small Business Lending Monitoring and Control Lending facilities should be structured to assist a lender in controlling the advance while also helping the borrower maintain financial discipline. - The obligation to provide regular reports to the lender can instill financial discipline upon managers. As far as possible, lending should be by way of loans rather than lines of credit. - It establishes an automatic mechanism for monitoring repayment. - Allows the lender to ensure that the facility is used only for the purpose for which it was granted. - For working capital purposes a line of credit is appropriate, but should be monitored to ensure that it is not misused. - For capital expenditure purposes like purchasing of machinery and other fixed assets, a loan is appropriate. Bank Lending 45 / 62 Reviews Corporate Lending Small Business Lending Monitoring and Control Lenders need to avoid the trap of hoping for the best where small customers are concerned. Monitoring information can provide warning of adverse trends. - It is vital that the customer is questioned and any necessary action is taken. - The need to be objective where problems are apparent is paramount ; the borrower and the lender are both likely to be worse off if early remedial action is not taken. Bank Lending 46 / 62 Reviews Corporate Lending Small Business Lending A Theoretical Basis for Understanding Lending to SB While considerable emphasis on ratios, cashflow analysis, etc., many other issues to consider arise : A Theoretical Basis for Understanding Lending to SB Asymmetric Information : Borrower is much better informed about the firm than lender (also ’Informationally Opaque’ Credit Rationing : Loan price set too high - Adverse Selection : Better borrowers depart while poor borrowers remain - Moral Hazard :Seeking of riskier projects Relationship lending helps reduce asymmetries via two information types : - Hard : Verifiable financial information - Soft : Borrower’s character/reliability Bank Lending 47 / 62 Reviews Corporate Lending Small Business Lending General Tips Advice From the Past What are some of the key lessons from experienced credit managers ? Always try to work in a team for credit decisions Allow sufficient time for reasoned decisions Verify ALL facts and figures Segregate the selling and approval of loans Be firm with the client and don’t be forced into bad decisions Bank Lending 48 / 62 Reviews Corporate Lending Small Business Lending General Tips Advice From the Past Never promise what you cannot deliver Always consider client’s quantitative AND qualitative aspects Volume is not necessarily profit. The client must also add to profitability The purpose of the loan should also indicate the repayment ability Visiting client’s firms adds to your understanding and allows business creation Bank Lending 49 / 62 Reviews Corporate Lending Small Business Lending General Tips Advice From the Past Record all relevant facts as soon as possible, and not from memory, as files may become evidence Try to confine client dealings to professional matters only Timely and careful gathering of information Be proactive, not lazy and reactive All loans should provide at least two ways out - cashflows and security Bank Lending 50 / 62 Reviews Corporate Lending Small Business Lending General Tips Capital Investment Appraisal There are four main methods of assessing capital investment projects Payback -this involves the calculation of the time it will take to recover the initial outlay. Return on investment - this indicates the average annual percentage return on either the average or alternatively the total amount of the investment ; Yield (or internal rate of return) - this method uses the same principles as the net present value approach but with the objective of establishing the discount rate at which the present value of the cash inflows and outflows match. Bank Lending 51 / 62 Reviews Corporate Lending Small Business Lending General Tips Capital Investment Appraisal Net present value return on investment - this method of involves the discounting of future cash inflows from the project. It adjusts the return to allow for the time value of money (cash received now is more valuable than cash received in the future because it can be invested to earn an income in the intervening period). Bank Lending 52 / 62 Reviews Corporate Lending Small Business Lending General Tips Appraising Profitability Forecasts A company’s plans need to be incorporated in an operating budget, which should cover at least the next 12 months. Ideally, the operating budget should represent the current year portion of a longer term financial plan. The management should not only be committed to meeting their budgeted figures. They should be prepared to use them as a means of controlling and monitoring their business. A lender should always be wary of any budget which appears to have been put together solely because he asked for it. Bank Lending 53 / 62 Reviews Corporate Lending Small Business Lending General Tips Monitoring and Control The bank lender has a number of aids to assist in monitoring his customer : Internal records Visits and interviews Audited accounts Management accounts Bank Lending 54 / 62 Reviews Corporate Lending Small Business Lending General Tips Corporate Lending and Security The main considerations are the same as for personal borrowers. A lender should consider taking security in the following situations : Where the realisation of specific assets represents the source of repayment, e.g. a bridging loan. Where the purpose of the advance is to acquire a specific asset e.g. a medium term loan for the purchase of machinery. Where the risks and consequences of the expected source of repayment failing are such as to make it necessary to have clearly defined and controlled alternative source. (Look for at least 2 exit strategies) Bank Lending 55 / 62 Reviews Corporate Lending Small Business Lending General Tips When Should Security be Taken ? For a lender to be fully secured, the security margin should include a reasonable estimate of the effect of these elements on the security value. The margin is excess of property value over the loan size, it is the owner’s equity in the project. The absence of an adequate margin means that the advance may not be fully repaid from the sale of the security and it needs to be recognised that such a lending is only partially secured, even though the face value of the security is greater than the lending. Bank Lending 56 / 62 Reviews Corporate Lending Small Business Lending General Tips Second Mortgages Second and subsequent mortgages over land are one of the most common forms of security taken by lending institutions. There is a tendency to regard all second charges as being of a similar quality but this is incorrect as some represent better security than others. Of crucial importance when assessing the value of a second charge is the relationship between the amount of the prior charges and the size of the equity available to the lender. In order to realise the security, a lender would have to pay off prior mortgages. Note that the holder of prior mortgages only wish to be fully paid out ; the second (and subsequent) mortgage(s) is (are) not their problem. Bank Lending 57 / 62 Reviews Corporate Lending Small Business Lending General Tips Guarantees and Other Third Party Security Whether a company can validly give a guarantee or any other third party charge depends on its ability. To establish whether this is possible, the company’s Memorandum of Association should expressly deal with the giving of guarantees/third party charges. If there is a specific paragraph in the Memorandum, a distinction still has to be made between the ’main objects’ of the company and those provisions in its objects clause which empower the company to enter into transactions in furtherance of its main objects. Bank Lending 58 / 62 Reviews Corporate Lending Small Business Lending General Tips Authority of the Directors Having established the company’s capacity to give a guarantee, it is then necessary to determine whether the transaction is within the authority of the directors. They are agents of the company and have an obligation to exercise the company’s powers in a proper manner. In order for the guarantee to be valid ; the directors must have : - given actual consideration to the position of the company in giving the proposed guarantee ; - been satisfied that the transaction was in the interests of the company itself (not some third party) ; and - acted in good faith in reaching their decision. Bank Lending 59 / 62 Reviews Corporate Lending Small Business Lending General Tips Intra-group Guarantees Many of the corporate guarantees which a lender takes are to support facilities granted to other limited companies within a group. Bank Lending 60 / 62 Reviews Corporate Lending Small Business Lending General Tips Parent Company Guarantees Benefit can be assumed in all cases where a parent company guarantees a subsidiary. Bank Lending 61 / 62 Reviews Corporate Lending Small Business Lending General Tips Lecture Recording Lectures are recorded and available online. Copyright c (2021). NOT FOR RESALE. All materials produced for this course of study are reproduced under Part VB of the Copyright Act 1968, or with permission of the copyright owner or under terms of database agreements. These materials are protected by copyright. Monash students are permitted to use these materials for personal study and research only. Use of these materials for any other purposes, including copying or resale, without express permission of the copyright owner, may infringe copyright. The copyright owner may take action against you for infringement. Bank Lending 62 / 62
