Beruflich Dokumente
Kultur Dokumente
Sathye, M., Bartle, J., Vincent, M., Boffey, R. (2003) Credit Analysis & Lending
Management , John Wiley & Sons, Milton, Australia.
332.7
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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
Part 7
Case studies
Case study 1 - Boat Builders Pty Ltd
499
5. Consumer lending
137
174
Part 4
Corporate and business lending
241
516
413
Part 3
Consumer lending
8. Corporate 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
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
Part 1: Overview
,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
="'."
,,<p
'l'Y-:;;!'?f.;l?:,:.;-~~~:
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:
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.
10
Part 1: Overview
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.
Lenderslook 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
'
;;;~;2!'~~~~~~~~~~~~~~'~~~;1
to
50-basis-point increase in
lenders to business are
they will have little scoP.". to
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
"
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. '
'
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.
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.
"'/-
.<
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
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
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.
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.
52
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.)
Formula
70.1
10.6
= 6.11
2002
62.3
9.12
= 6.83.
.
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.
54
2002
9.76
S6 d
ays.
62.3 -;- 365 =
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.
2003
~~:i
= 0.21, or 21 %
2002
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
I 56
2002
= 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.
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.
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.
58
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.
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.
90
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.
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.
.
I 92
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.
94
1. Population difference
Impractical' or unsound
mixtures of population are
not sampled.
2. Definition of
creditworthiness
,TopiC',
,
0,
,",'
",:,,:
-;"'4-:
,'o ,'SI~liSlic8lSCO!ing~
"
",
,Jud~m~nta(sillring"
'
6. Validity of characteristics
and interrelationships
7.
9. Improved calculations
and,expected results
tt is difficult to tighten or
ease credit policy withou t
causing an overreaction or
underreaction.
Use of applicant
- -informarion
!.';
':,
Source: Adapted from L C. Thomas, J. N. Crook & D. B. Edelman 1992, Credit Scoring and Credit
Control, Oxford Press, Oxford.
-"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.
I 96
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
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
I 110
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
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
I 112
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.
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.
I 146
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.
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.
1150
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.
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.
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.
I 152
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.
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.
I 154
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.
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.
/
I 156
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
1. CustoH'Iers occupation,
or line ofworh
10
8
7
5
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
No
7. Number of dependants reported by customer
None
One
3
3
Two
Three
More than three
8. Bank aaounts held
Both cheque and savings
Savings account only
Cheque account only
None
Credit decision
4
3
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 .
. ;r
material is a bare
of the legislation
not intended as, and
a substitute for a
or the advice of
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.
I 212
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
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.
I 214
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,
I 242
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.
I 244
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.
I 246
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?
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.
.'
_
~_
(%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
44
na
na
12
36
28
68
24
69
13
55
31
43
40
21
30
44
47
57
19
40
77
1175
na
na
46
15
52
30
71
18
43
39
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.
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
1999-2000
542.2
365.7
167.1
1075.0
Source: Australian Bureau of Statistics 2001, Small Business in Australia, cat. no. 1321.0.55.001,
Canberra.
./ -
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.
.<, ...
. i\
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.
,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
'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.
.1
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 shortterm 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
-.'/
Conditions imposed on a borrower where the borrower is funding the business with loans
rather than with capital
Not applicable
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
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
1. The origins of
the cashflow
What were the relative inputs of the customer and the accountant in
point of the
cashflow
3. Internal
numerical
consistency
4. Validity of the
und~;lying
assumptions
5. Critical
consideration Of .
senSitivity
analysis
300
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.
I 302
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.
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
I 304
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-
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.
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.
Case study 1 -
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 criticalmindset 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.
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.
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
I 500
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
Factory equipment
n/a
-$21841
Land
nla
-$58778
$220000
-$220000
Bill facility
Construction costs
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
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
Bill facility
$220 000
$220000
nJa
$60000
nJa
$140000
To be purchased in October
2003
To be installed in the new
factory (October 2003)
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.
I 5D2
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
Consumables (welding)
37261
Drafting services
257229
Direct wages
17481
123424
2502
Electricity
2670
Freight
10646
40275
53828
637
2176
879402
Aluminium purchases
101861
Subcontractors
1405299.
287239
2188
509
54877
8114
257514
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.
CURRENT ASSETS
Debtors
$ 35168
$ 35530
S[Ock
30000
30000
4978
Cash
1545
36026
600
CURR~NT
107717
TOTAL
103000
1545
66410
ASSETS
134085
NONCURRENT ASSETS
140803
(44469)
103000
Plant_.and equip'11e"u -
at cost
40450
(23062)
vVrilten-down value
,96334
66756
(19601)
47155
Motor vehides -
17388
31147
at cost
(17098)
Written-clown valUE
4353
(! 572)
2781
Office equipment -
14049
2964
at cost
(!
1m
Written-down value
480
(288)
1836
Amortised value
191
480
(19])
287
249461
136560
357178
TOTAL ASSETS
270645
CURRENT UABILITIES
(4000)
Overdraft
66875
7001
Creditors
35156
216780 '
Bank bill
219781
102031
NONCURRENT LIABILITIES
40916
43671
Loan -
19931
Loan-Bank
13832
22496
fa~tory
60048
land
equipment
7869
83205
123460
168509
343241
TOTAL LIABILITIES
270540
SHAREHOLDERS' FUNDS
Paid-up capital
13935
Retained earnings
103
13937
105
357178
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.
'j
EXPENDITURE
$
6298
Accounting
1438
Advertising
3677
Ba-r;k charges
96
21408
5432
444
2060
4723
719
1067
BOIiowing costs
96
Conference fees
345
4140
5002
414
Donations
157
179
Fines
335
3556
General insurance
4001
9340
11198,
3289
838
12224
WorkCare insurance
.'.
28186
3289
U500
1018
Legal costs
1134
lil03
Petrol and oH
\
\BEpairs and maintenance]
9.JI31
7358
2923
1415
(7181)
57
1605
887
79
3706
11021
, 53
1043
35922
1646
583
Postage
Printing and stationery
293
1085
3032
Rent
9899
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
35681
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.
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.
I 506
Part 7: Cassstudies
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.
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
Debtors turnover
(continued)
"* Disclaimer: This case study is hypothetical. Any resemblance to actual evenLS, locales, entities or persons is
entirely coincidenlal.
507
Stock turnover
Creditors turnover
Gross margin
Net margin
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?
Overdraft
$110000
$300000
Bill facility
$220000
$220000
nJa
$60000
nJa
$140000
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.
509
.."
~
,.,'"
co
iii
ro
=
co
~
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<!'l-i:811
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
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?
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
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.
I 512
Part 7: Casestudies
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/
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.
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<ll, then who
. 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
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.
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
covenants
I 514
Part 7: Gasestudies
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
Appendix 3
Note: Orbital calls its statement of financial position a balance sheet, and it calls its statement of financial per-
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?