Principles of Lending

MT KENYA UNIVERSITY
DEPARTMENT OF FINANCE &

ACCOUNTING
P.O. Box 342
THIKA, KENYA
Email: info@mku.ac.ke
Web: www.mku.ac.ke
Course Code: BAF3208
Course Title: Lending

Instructional materials for distance learning students
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CONTENTS
CONTENTS........................................................................................................................ 2
COURSE OUTLINE .......................................................................................................... 4
LESSON ONE: GENERAL PRINCIPLES OF LENDING .............................................. 5
1.1 Philosophy of Lending .................................................................................................. 5
1.2 Methodical Approach to Lending ................................................................................. 6
1.3 Principles / Canons of Lending..................................................................................... 8
1.4 Monitoring and Control .............................................................................................. 16
1.5 Review Questions ....................................................................................................... 18
LESSON TWO: BRIDGE OVER LOANS ...................................................................... 20
2.1 Introduction................................................................................................................. 20
2.2 Closed Ended Bridge Loan ......................................................................................... 20
2.3 Open Ended Bridge Loan............................................................................................ 21
2.4 General Considerations ............................................................................................... 21
2.5 Lending to Executors and Administrators................................................................... 27
2.6 Lending to Trustees ..................................................................................................... 28
2.7 Lending to Clubs and Associations............................................................................. 28
2.9 References................................................................................................................... 29
LESSON THREE: SECURITY FOR PERSONAL LENDING AND PERSONAL
BORROWERS IN DIFFICULTIES ................................................................................. 30
3.1 Bank Security.............................................................................................................. 30
3.2 Types of Security and Valuation ................................................................................. 30
3.3 Guarantees and Third Party Security .......................................................................... 31
3.4 Problematic Accounts ................................................................................................. 32
3.6 References................................................................................................................... 38
LESSON FOUR: LARGE BUSINESS LENDING.......................................................... 39
4.1 Introduction................................................................................................................. 39
4.2 Non-financial Appraisal of Business .......................................................................... 39
4.3 Assessment of Financial Information.......................................................................... 40
4.5 References................................................................................................................... 49
LESSON FIVE: SECURITY FOR CORPORATE LEMDING ....................................... 50
5.1 When should Security be taken? ................................................................................. 50
5.2 Assessment of Risk ..................................................................................................... 50
5.2 Gone concern break-up analysis ................................................................................. 51
5.3 Security and Margins .................................................................................................. 52
5.4 Debentures .................................................................................................................. 52
5.5 Summary of Lending Considerations ......................................................................... 55
5.6 Layout of Examination Answers................................................................................. 58
5.7 References................................................................................................................... 64
LESSON SIX: PROPLEMS WITH CORPORATE LENDING....................................... 65
6.1 How to Identify Problems Early ................................................................................. 65
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6.2 Danger Signs ............................................................................................................... 65
6.3 Action to be taken as soon as Possible........................................................................ 67
6.4 Remedial Action.......................................................................................................... 68
6.6 References................................................................................................................... 73
LESSON SEVEN: FINANCE FOR FARMERS .............................................................. 74
7.1 Appraisal of farming customers .................................................................................. 74
7.2 The Farmer’s Audited Accounts ................................................................................. 75
7.3 The Farmer’s Confidential Balance Sheet /Statement of Asset and Liabilities. ......... 76
7.4 Farmer’s Assets ........................................................................................................... 78
7.5 Rental Equivalent........................................................................................................ 79
7.6 Other Calculations to Aid Assessment ........................................................................ 82
7.7 Monitoring and Control of Farming Advances ........................................................... 83
7.8 Security for Farm Lending.......................................................................................... 83
7.10 References................................................................................................................. 89
LESSON EIGHT: TRADE FINANCE ............................................................................. 90
8.1 Finance for Exporters: Overdrafts / Loans.................................................................. 90
8.2 Other bank Finance for Exporters............................................................................... 90
8.4 References................................................................................................................... 97
LESSSON NINE: SPECIALIST SERVICES FOR BORROWERS ................................ 98
9.1 Services for Personal Borrowers................................................................................. 98
9.2 Services for Business Borrowers ................................................................................ 99
9.3 Factoring and Invoice Discounting ........................................................................... 105
9.4 Acceptance Credits.................................................................................................... 109
9.5 Review Questions ..................................................................................................... 109
9.6 References..................................................................................................................110
Sample Paper 1 ...............................................................................................................110
Sample Paper 1 ................................................................................................................111
Sample Paper 2 ................................................................................................................113
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COURSE OUTLINE
BAF3208 LENDING
Purpose
To introduce the learner to the principles and cannos of lending and other methods of
evaluating lending propositions from different types of borrowers.
Key objectives
A learner who passes this subject should be able to:-
i) Describe the principles of lending (CAMPARY).
ii) Evaluate different borrowing propositions from various borrowers
iii) Describe the procedure of recovering process from problematic accounts and
wake s remedial action.
Course outline
Week 1Introduction to principles of lending
Week 2-3 Evaluating personal loans salaried customers
Week 4 -5 evaluating small business loans (small enterprise)
Week 6 -7 evaluating appropriate borrowing proposals
Week 7 Sit in CAT
Week 8-9 Agricultural propositions
Week 10 -11Trade finance
Week 12 Specialized services offered by banks
Week 13 Tutorials
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LESSON ONE: GENERAL PRINCIPLES OF LENDING
Purpose: To introduce the learner to the general rules and technical knowledge of
lending.
Each lending case has to be treated on its own moment however these are a number of
general principles which should be applied in all cases.
Specific Objectives
By the end of the lesson the learner should be able to:
1.1 Philosophy of Lending

A lender “lends” money and does not give it away, he/she applies judgment that at some
future date repayment will take place. The lender needs to look into the future and ask the
question whether the customer will pay at agreed date. There will always be some risks
that the customer will be unable to repay. In assessing the risk of non-repayment the
lender needs to demonstrate both skill and judgment. The lender’s objectives are to assess
the extent of the risk and try to reduce amount of uncertainty that exist over the proposed
repayment period.
While there are guidelines to be followed there is no “magic” formula. The lender must
gather enough and relevant information and apply skills in making a judgment. The skills
applied in one the proposal may never apply in another that is why experienced lenders
describe lending as an “art” rather than a science. Lenders must seek to arrive at an
objective decision. The approach of true professionalism is to resist outside pressures and
insist on sufficient information and time in order to understand and evaluate the proposal.
A lender who is confident in his / her ability will apply the following:
i) Take time to reach a decision because detailed financial information requires time
to be absorbed.
ii) Get a second opinion from another experienced lender
iii) Get full information from customer and not to rush in making assumptions or “fill
in” missing details.
iv) Not to take customers statements at face value ask for evidence.
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v) Distinguish between facts, estimates and opinions when forming a judgment.
vi) Think again when “gut reaction” suggest caution even though factual assessments
look satisfactory.
1.2 Methodical Approach to Lending

There are five stages in analyzing a new lending proposition.
i) Introduction to the customer
ii) Application by the customer
iii) Review of application
iv) Evaluation
v) Monitoring and control
i) Introduction to the customer
Lenders can only do successful business with individual they know and feel comfortable
with. References are not taken only every occasion an account is opened. Nevertheless,
all the account opening procedures should be followed. Account opening procedures
must be followed to the latter to ensure that the customer is honest and trustworthy. This
is especially important when the customer wishes to borrow at a later stage. An important
source of new business to lenders is introduced from professional advisors such as
accountants and advocates. However this not to say banks are obliged to lend to
customers introduced in this way. The lender must treat each case on its merit.
ii) Application by the customer

This can take away many forms but should include a plan for repayment of borrowing
and an assessment of contingencies which might arise and how the borrower will deal
with each item. The application may be in a detailed written form or verbal. The lender
must draw out sufficient further information to enable risks in the application to be fully
assessed.
iii) Review of application

At this stage all relevant information which is required needs to be tested and other data
sought if necessary. Either formally or informally the lender applies the canons or
principles of lending. It is sometimes difficulty to remember all the points to cover during
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an interview and many lenders use a mnemonic as a check list. There are a number of
mnemonics in common use, but the most common are CCCPARTS (Character, Capital
Capacity, Purpose, Amount, Repayments, Terms, and Security), PARSER (Person,
Amount, Repayment, Terms, Security, Expediency, Remuneration) and CAMPARI
(Character, Ability, Margin, Purpose, Amount, Repayment, Insurance). CAMPARI is the
most popular of the mnemonics and will be discussed later.
iv) Evaluation
Once all available information has been assembled, an evaluation of proposal should be
made. It’s done in two stages:
a) An assessment of the feasibility of the borrowers plan for repayment. If the
proposal is not viable it’s pointless to continue.
b) A critical appraisal of what might go wrong. It involves likelihood of such events
occurring and the effect on bank’s position.
The aim of this evaluation is to establish risk involved. Listing the pros and cons of a
proposition is helpful more regard is placed on facts and evidence rather than estimates
and opinions. Once a lending has been made, the risk lies in the way the customer
handles any problem which might arise. The lenders evaluation concentrates on
understanding borrower’s risks and assessing the borrower ability the deal with them. In
cases where the lender feels that the risk is not bearable, and wishes to help a good
customer advice the customer to the ‘re-engineer’ it into a more acceptable form.
v) Monitoring and control

It’s highly unlikely that is a customer expectation will exactly go as planned. It’s
therefore necessary for lenders to review progress regularly. The earlier the problems are
identified the better will be the chances of controlling them and providing practical
advice to the customer which in turn protects lenders position. Regular monitoring of
corporate account can also enhance the lenders image on eyes of customer. This provides
evidence to the customer of a wish to understand the underlying business and to be
involved in solving future problems. A monitoring plan should be established at the
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beginning and where provision of regular information is necessary suitable arrangements
should be made and a follow-up.
1.3 Principles / Canons of Lending

C – Character
This can be deduced from past relationship with the customer to find out:
i) How reliable is customer words regarding details of proposition and the promise
of payment.
ii) If customer’s track record; was there any previous borrowing and if so was it
repaid without trouble.
iii) If customer is new, why is he approaching the lender?
iv) Can bank statement be seen to assess conduct of the account?
A – Ability
This relates to borrowers capacity in managing financial affairs and it’s similar to
character as far as personal customers are concerned. The following points relate to
business customers:
i) Is there a good spread of skills and experience among management team e.g.
production, marketing and finance?
ii) Does the management team hold relevant professional qualifications?
iii) Are they committed in making the business successful?
iv) If the funds are earmarked for specific activity do they have necessary skills and
experience in that area?
M-Margin
Refer to the relationship between amount to be borrowed and value of security being
offered as collateral. If the proposal is risky the bank requires the security value to be
almost equal to the money to lend. Margin also relate to interest, commission and other
fees. Collateral required and charges like interest and other fees should reflect the
inherent risk in the proposal.
P-Purpose
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The purpose should be legal and acceptable to bank policy. The facility should be the in
customers best interest and customers should be able to carry out the project successfully.
A-Amount
Evaluate whether the customer is asking too mush or too little. Establish the amount
required by the project and to cover other incidental expenses. The amount to be lent
should be in proportion with the customer’s resources and contribution. A reasonable
contribution by the customer in the project indicates commitment and acts as a buffer
against misuse of funds borrowed.
R-Repayment
The risk in lending is found in assessment of repayment proposals. It’s important that the
source of repayment is made clear by the customer and the lender must establish the
degree of certainty that the promised funds will be received. Where the source of income
/cashflow, the lender requirement projections to ensure that there are surplus funds to
cover repayment after meeting other commitments.
I- Insurance / Security
The cannons of lending should be satisfied irrespective of availability of security or
insurance. However, security is necessary in the event the repayment proposal fail to
materialize. It provides an alternative source of recovery or fall back position should the
promised source of repayments fails. It’s important that no advance is made until security
procedures have been completed or at least at a stage where the completion can take
place without the need to involve borrower.
Example 1.1
Jeremy has maintained an account at your branch for many years. You have very little
detailed information on file regarding him but you are aware he has business interests in
the city. He is a director of three companies and from time to time sits up board of
enquiry set by government.
No regular credits are seen in the account but over the past three years credits totaling
Ksh 250,000 have been received including six dividends warrant amounting Kshs75, 000.
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Nine months ago you wrote to him suggesting that the dividends should be mandated but
there was no response to his letter.
Over 2 years ago Jeremy wrote to you regarding the prestige card issued by your bank
card company. Subsequently a formal application was made and a card was issued. As
part of this facility an unsecured overdraft limit of 75,000 has been recorded on his
account.
Today you receive a letter from Jeremy enclosing a cheque of Kshs200, 000 in his favour
by a firm of Nairobi lawyers and three share certificates all in his name with a current
market value of 800,000. He explains that he is involved in a small syndicate of investors
they are about to complete the purchase of a significant investment in the US but at this
time he can give no details. He is therefore likely to issue a cheque over the next week for
Kshs 1,000,000 and asks you to increase his overdraft by 750,000. Set out in detail you
reply to Jeremy.
Solution
Apply CAMPARI in your analysis
Character connection and capital initial reaction
This is a relatively a long standing customer who has presumably operated the account
satisfactory. You would therefore wish to help if at all it’s possible especially because of
the customers standing. Furthermore you do not have any advanced information about
him. As a director of three companies and sitting on government board of enquiry shows
that he is a person with vast business operations and of high integrity.
There is evidence of capital from share certificate of Kshs.800, 000 and annual dividends
of Kshs.75, 000. He has also been issued a prestige card facilities unsecured. As far as
connections are concerned they exists (evidence by board of directorship in three
companies and sitting on government board of enquiries and the investment syndicate
group). However you must not let this description influence your judgment.
Ability
Jeremy has satisfactory serviced his Kshs 75,000 prestige card facility. As the same time
Jeremy could be having other account in other financial institutions. The bank needs to
get clarification from him, what other bank account he holds, other securities and
commitments and liabilities in order to evaluate his ability to repay the loan. Furthermore
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the source of repayment could also be from realizing investment from which the bank is
being asked to finance. This required to be clarified.
Margin
This is a speculative venture as Jeremy and his group want o engage in overseas
investment which he doesn’t have full information and even if he had all information the
bank cannot adequately ascertain its accuracy as the investment is to be undertaken far
away in the USA. The bank should charge interest at a premium adequate enough to
cover this high risk.
Purpose
This is not fully given and it’s presumably a speculative investment you need much
information as to the investment and the payback period.
Amount
The bank is being asked to provide additional borrowing of Kshs 750,000 making the
bank total exposure of 825,000 be fully utilized assuming he keeps the original limit of
Kshs 75,000 overdraft. However you need to check this information.
Repayment
The source of repayment is not given however if it is o come from realization of investor
he must provide cashflow projections which must be by the bank. It’s possible that
Jeremy is multi-bank and the bank must not have seen some of his income, its important
to find out from him which other bank account he hold and facilities he is enjoying at the
moment. The bank also needs to find out the duration of the loan (how long loan is
required.)
Insurance / security
This proposal seem to be a speculative venture therefore the risk is high the bank
therefore needs to be fully secured and although the share certificate current market value
of 800,000 a margin of 20% is required giving security value of 640,000 which may not
be enough to cover the borrowing.
Conclusion / decision
Despite Jeremy excellent credentials, the bank does not have sufficient information to
assess the risk attached to the proposal. A top businessman Jeremy should appreciate the
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need for further information if he really wants the bank to assist him. The proposal is
declined at the moment as it is.
Example 1.2
John Smith and his wife (both aged 50) have been customers of your branch for over 20
years. Their account is conducted impeccably. Mr. Smith is employed as the sales
manager of a local poultry processing company and Mrs. Smith works as a secretary for a
firm of’ solicitors. Their present financial situation is as follows:
£
John Smith’s salary 18,000
Mary Smith’s salary 5,900
House owned, in joint names, estimated value 90,000
Mortgage outstanding 8,100
Investments: Premium Savings Bonds 2,000
National Savings Certificate 5,000
Building society share account 1,500
On retirement Mr. Smith will receive a pension of some £ 100 per week, and he has been
given to understand that his employers are prepared to allow him to retire early, in six
months time, on full pension. It will not be possible for Mr. Smith to draw a ‘lump sum’.
Mrs. Smith’s employment is not pensionable.
Mr. and Mrs. Smith call to advice you that they wish to purchase a public house (The Red
Lion) in a village in a country district some fifty miles away. The Red Lion is not tied to a
brewery and therefore does not have to purchase all its supplies of alcohol beverages
from one company. The consideration is as follows:
£
Property 75,000
Fixtures and fittings 10,000
Goodwill 15,000
100,000
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In addition, stock will be purchased at valuation. There are six bedrooms for letting and
light meals are provided at the bar. Trading accounts for the existing owners (who are
retiring, age 68 and 62) are as follows:
£
Income 90,000
Cost of sales 72,000
Gross profit 18,000
Overheads £
Heating / lighting etc 5,000
Accountant’s fees 600
Rates 700
Motor expenses 1,000
Other expenses 2,500 9,800
Net profit 8,200
The Smiths are confident that sales can be increased by 10% during the first 12 months
following their taking over of the business.
They have been told that other buyers are interested in The Red Lion and whilst it may be
possible to defer completion of this purchase, they wish to make their offer today.
Therefore they require your immediate decision.
Summary of proposition
Amount requested: £ 100,000
Purpose: Purchase of Red Lion + Fixtures & fittings +
Good will
Repayment: Sale of house net £81,900 cash investment
£ 8,000
Net long-tern borrowing requested: £ 10,100
Security offered: None, but obviously ‘Red Lion’ plus normal
bridgeover facilities would be needed.
Capital / amount
There is no problem on this score as the Smiths’ state is well in excess of the bank’s.
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The bank would wish to assist if at all possible because the account has been trouble free
for 20 years.
You need to establish at the interview whether the Smiths are prepared for the complete
change in life style. They will be ‘on call’ seven days a week. Do they seem capable of
running the Red Lion? Could Mrs. Smith cope with the books from her work experience?
Purpose
If you are satisfied as to the bridgeover element, then a 10 year loan would be reasonable,
bearing in mind their age.
The Smiths must obtain a valuation from an independent professional valuer to see if the
asking price is reasonable.
Amount
In addition to the £ 10,000 calculated above, they need:
Red Lon legal fees (say 3%) £ 3,000
Stock (say 1 month) £ 6,000
Home sale fees (say 2%) £ 2,000
Thus, a total facility of £ 21,000 is needed, plus an overdraft facility for working capital.
Do they need to buy a motor vehicle? Is the hotel in good repair?
Repayment
a) Annual Installment \s on a £ 21,000 loan at 3% over base rate over 10 years are:
£3,465
b) In practice you would prefer the Enterprise Agency to help prepare budgets, and the
bank’s role would be to check the assumptions. However, in view of the urgency of
the request, the branch manager must complete the protections.
Profit budget using Smith’s figure (£):
Sales 99,000
Cost of sales (80%) 79,200
GP (20%) 19,800
Less overheads (add 5% for inflation) 10,290
Profit before drawings and depreciation 9,510
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c) £9510 - £3465 = £6045. This is very little different from the salary which rs. Smith
will forego if she retires.
d) In theory sales break even point looks reasonable:
10,290 x 100 = £ 51,450
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However, if you include bank repayments and drawings (which are not strictly profit
and loss items), you can see that break even point is say
19,200 x 100 = £ 95,000
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This leaves virtually no margin of safety.
e) In any event, you need to test the assumptions:
i) Why Smith confident he can increase sales?
ii) You must have independent confirmation that the trading accounts from the
present owners are accurate. (In practice balance sheets may not be available.)
iii) You need a breakdown of sales into bar, food and bedrooms.
iv) Are there any staff employed (other expenses?
On the face of it repayment would be difficult, and Smiths would suffer a reduced
standard of living.
f) Is the Smiths’ house worth £90,000 and will it sell quickly for that price?
Insurance
If the bank is happy about the bridgeover element, then security is not a problem. A legal
mortgage over the ‘Red Lion’ should suffice, provided the independent valuation shows it
is worth the asking price on the open market.
Services
Permanent health insurance would be a condition of granting the facility. The bank could
also insure the ‘Red Lion’ premises and provide public liability insurance. A 1% arra
ngement fee would be required.
Conclusion
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The bank is not at risk, but you would only lend if the Smiths could satisfy you that they
could generate sufficient profits to repay the bank and provide themselves with a good
standard of living. On the information provided, the bank must decline.
1.4 Monitoring and Control

Reasons for monitoring account
i) To be fully aware of update situation on an account.
ii) To ensure any borrowing which has been granted remain within the customer’s
capacity to repay.
iii) To observe any adverse trends so that an easily action can be taken.
iv) To discover any irregular practices bank have recently been criticized for allowing
proceeds of claims to be laundered through account without sufficient enquiry.
v) To be informed about customers activities to credit worthiness for example
evidence of gambling.
vi) To ensure that the customer is using the account for agreed purpose.
vii) To confirm information provided by customer e.g. amount of salary and monthly
commitment.
Methods of Monitoring
It’s unrealistic to monitor every personal customer, concentrate effort of those accounts
which are likely to accuse for concern.
Bank branches have a lot of information can be categorized into 3 main types:
i) Computer print outs.
ii) Customer statement sheets
iii) Entry vouchers
Computer print outs
Different banks have different computers systems and produce different printouts.
However all of them have the capacity to supply historical information of the trend on
individual customers’ accounts. When looking at this information the main questions
which should be asked are:-
i) What is the worst balance trend?
ii) What is the best balance trend is there any evidence of a hardcore developing?
iii) Is the average balance figure worsening?
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iv) Is the turnover through the account out of line with what might have been
expected?
v) Has there been a change in the run of account compared to previous years.
An adverse trend in one of this need not to be a cause of concern but when deterioration
is evident in more than one then some action maybe necessary even if its limited to
keeping the account under more regular review.
Customer statements sheets
Customer statement information tends to be standard among banks. The information
given / produced is to give the customer an account of individual debits and credits and is
not therefore an ideal form for bank monitoring purposes. Specifically produced
computers printouts maybe more user friendly. The question which an examination of
statements will help answer includes:
i) Is there any pressure on an overdraft limit? Or is the account working satisfactory
and showing healthy fluctuations?
ii) Does the balance give a true picture or it has been distorted by unusual amount?
iii) Is the turnover through the account rising sharply this might be evident of cross
firing?
iv) When are credits received? Is the monthly salary been received regularly?
v) To whom are regular payments out of account paid?
vi) Is there any change in character of the account?
vii) Are there any unusual items passing through the accounts?
Entry vouchers
An examination of all debits and credit through a customers account may be time
consuming and lender needs to be selective, efforts should be concentrated on:
a) Those accounts which require special attentions.
b) Entries for large amounts
An examination of debit entry will show:-
a) Evidence of customer interest and financial activities e.g. borrowing – payment to
hire purchase company or other finance companies associates – membership fee
to clubs or payments to charitable organizations.
Thrifts – regular payment to saving institution and insurance companies.
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b) Whether borrowing is being used for purpose agreed.
This may not represent a problem but it gives evidence of customer truthfulness and
might be a cause of concern. An examination of credit will show:
a) Source of customers’ income, salary, divided.
b) Suspicious transactions. Can large cash receipts be explained?
c) Whether uncleared effect are possibly going to be a problem.
Methods of Control
Process can be split into two elements
i) Review
ii) Action
Review
The most common form of lending decision is that which involves the payment of a
cheque or where an overdraft limit exists or the limit which is marked is being exceeded.
Major banks have daily computers printouts which identify such cheques and debit on
daily basis. Items which are to be returned need to be dealt with before noon so period
available for decision is a quick review of the account has to be carried out using the
monitoring information discussed above and then applying cannons of lending.
The review of other types of personal lending can be a measured process with time set for
discussion with customer and ability to call for more information if necessary. Having
reached a decision its useful to make a sort of brief note which can quickly be referred to
in the future to avoid duplication of effort in any subsequent review. Action after review
has taken place of action has to be taken. The causes of action available to lenders when
things seriously go wrong will be discussed later.
1.5 Review Questions

1. Name the five stages to any analysis of a new lending proposition
2. Set out briefly the account opening procedures used by any bank near you to establish,
as far as possible, that a new customer is honest and trustworthy.
3. Set out the basic principles to be applied to lending proposal
4. Omollo has banked with us for four years. In the recent month you have noticed a
tendency for Omollo to anticipate his monthly salary which has averaged to Kshs.130,
000. Yesterday you received a telephone call from Omollo and you arranged an
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appointment with him for todays. In preparation for the meeting you gathered the
following regular monthly payments, building society Kshs.40,000, hire purchase
company Kshs25,000, TV/Video rentals Kshs3,000, clothing retailer Kshs5,000, council
tax Kshs10,000, gas Kshs5,000.
The account is overdrawn by Kshs 32,000 and a cheque of Kshs.8, 000 in favour of a
credit card company is in this morning clearing. Your customer salary is due to arrive in
the next few days. At your meeting Omollo apologizes for the overdrawn balance. He
explains that he went with his wife and 2 children to Mombasa a of couple months ago
and it costed more than he had expected. Consequently from a financial point of view he
was recovering slowly. During your discussion the following points emerged.
i) Omollo changed house 15 months ago and his new property cost Kshs.7 million
and the mortgage is Kshs.3.4 million.
ii) Anew car was purchased a year ago with the help of hire purchase agreement.
iii) Mrs. Omollo works part time and receives Kshs.4, 000 per week in wages hence
Omollo has to contribute Kshs.20, 000 per month for house keeping.
iv) Tax insurance of the car is now due amounting to Kshs.24, 000.
v) He has a pressing bill for house repairs amounting to Kshs.24, 000.
vi) Omollo is due to receive a salary increase of 3% in the next 2 months time.
Omollo asks for a loan of 200,000 repayable at Kshs.9, 000 per month.
Required:
Giving reasons explain how you respond to the request.
References
Peter C Mcgregor Lending Bankers Workbook Series 2nd Edition the Chartered Institute
of Bankers.
Rouse C N (1989), Bankers’ Lending Techniques British Library Cataloguing in
Publication Data
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LESSON TWO: BRIDGE OVER LOANS
Specific Objectives
i) Evaluate with confidence larger lending proposals from personal and
professional customers
ii) Explain the points to be borne in mind in bridging loans
iii) Describe the procedure for evaluating bridging loans proposals
2.1 Introduction
Abridging loan is an advance given to a borrower for the purpose of completing a
particular purchase with the source of repayment coming from the sale of another
property in the near future.
There are two types of bringing loan facilities:
i) Open ended bridge loan
ii) Closed ended bridge loan
2.2 Closed Ended Bridge Loan

This means that the borrower has already identified buyer a buyer for the existing
property which is the main source of repayment of the advance. Its one where contracts
have been exchanged with a clear completion date on the sale of an existing property
which represents the key source of repayment. Since such contracts are legally binding
the lending risks are lower now provided a lawyers oath / undertaking is obtained to
ensure sale proceeds are received by the bank. Exchange of contracts does not however
guarantee that a sale will take place and problems can still arise in the full circumstances.
i) The buyer may not have the finance to complete the purchase. However, a
reputable lawyer cannot allow contacts to be exchanged if the necessary resources
to complete the contract are not available but it can happen. Close liaison with
the lawyer / advocate is essential indirectly through buyer’s lawyers. It’s also
becoming common for buyer to deposit 10% of the value of property to be
purchased as a show of commitment to purchase the property.
ii) Completion of the contract maybe conditional. For example the buyer might have
an option to withdraw from a purchase of property being built / improved if works
20
are not finished on time. Alternatively completion maybe dependent the buyer
having a mortgage.
iii) Although fixtures and fittings maybe forming a significant part of the purchase
price, they may not form part of lenders security if things go wrong. A full
valuation of the property should be taken and if significant be included as part of
security. However such valuation is not always taken in a bridging situation
particularly if bridging appears to be closed.
iv) Collision between buyer and seller, they might mutually agree not to go ahead
with the transaction in such a situation there is nothing a lender can do to ensure
the transaction go ahead in such circumstances and care should be taken when its
known that the buyer and seller are related.
v) Fees and finance costs.
NB: The safest course of action when in doubt completion will take place is to treat the
facility as an open ended bridge loan.
2.3 Open Ended Bridge Loan

This occurs especially where contacts regarding the sale of an existing property which
represent source of repayment have not been signed for the loan to be advanced to
purchase a new property. A lender should not consider an open ended bridge loan unless:-
i) The property market in question is a buoyant and it looks like staying that way in
immediate future.
ii) An early sale of the existing property is in prospect i.e. a definite buyer has been
found although contact have not been signed.
iii) There is a substantial margin to cover all contingencies. The expected net sale
proceed should be able to pay the loan plus twelve month accrued interest and at
the same time allow for 20% reduction in the asking price.
2.4 General Considerations

i) The advance for property purchase must be made on a loan account in order for
any tax benefits to be claimed.
ii) Where the deposits only is being advanced its still necessary to access the
complete transaction incase problems arise.
21
iii) Written confirmation must be obtained from the borrower’s lawyer that contract
for both sale and purchase have been obtained.
iv) Lawyer undertaking or oath should be obtained in respects of monies due or deeds
to come. Consideration to be given to take formal charges over the property
especially if the bridge is open ended.
v) Where the source of repayment is a mortgage from another lender confirmation
are required of the amount and when it’s due together with an undertaking to send
money to the bank. If part of borrower’s contribution is to come from other
sources similar considerations may apply.
vi) If the loan is being provided to be to build properly ensure:-
a) Builders are reliable
b) The contract is either fixed price or reasonable terms.
c) Advances are only made against architect’s certificates at pre-determined
stages of development.
vii) Realistic valuation should place in property
viii) Full insurance cover is essential as soon as contracts are exchanged.
ix) Status enquiry is necessary for lawyers unknown to the bank.
Example 2.1
Mr. and Mrs. Smith have been customers of your branch for 15 years. A house they have
always liked has come on the market and they wish to buy it. The vendor is looking for a
quick sale and will sell to the first people who can exchange contracts. The Smiths wish
to offer the asking price of Kshs 8.5m. A local estate agent has suggested that their
present house is worth Kshs. 5m, there is a mortgage of Kshs 2.5m outstanding.
Smith is 40 years old and currently earns Kshs.2.3m per year. His wife is 38years old and
earns Kshs.500, 000 per year. Smith has approached his building society which has
agreed to lend him Kshs.5.5m to acquire the new property. You are aware that Smith has
just over Kshs 1m invested in the building society.
The estate agent will charge 2% of the sale value and the Smith lawyer has indicated that
he will charge Kshs 50,000 on the sale and Kshs 75,000 on the purchase.
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Assume stamp duty is 1% and base rate is expected to be 10% for foreseeable future. The
Smith wish to exchange contract for the purchase as soon as possible. They call to see
you and ask for a bringing loan.
Required:-
a) Identify the type of bringing loan
b) Set out advice will give to the Smiths and your decision giving reason for each.
Show in full calculations how you illustrate your reasoning.
c) Indicate what further steps you might take to help the Smiths achieve their dream.
d) List the conditions you wish to fulfilled to protect both Smiths and the bank
position if the loan was granted.
e) Ignore all costs except those mentioned above.
Solution
a) This is an open ended bridge loan
Reasons – buyers not identified
- The contracts have not been exchanged.
b) Apply CAMPARI
Initial reaction: character, connection and capital.
The bank has no adverse information concerning them. Someone earning 2.3m per year
is not a kind of customer can any lending institutions can wish away. There is evidence
that they have saved Kshs1m from their personal earnings. As far as connections are
concerned no information has been given. Because the Smith has banked with you for
15 years without problem, the bank should assist if at all possible. However this being
an open ended bridge the bank requires substantial margins between the anticipated
outgoings and the anticipated income to cover the following:-
i) 20% drop in the selling price of the existing house should a quick sale become
essential if the house stays for one year before being sold.
ii) Interest for 12 months in the bridging loan.
iii) If there are outside assets available or if there is sufficient income then the bank
required regarding margin can be relaxed
The margin is calculated as below:
Income Kshs
23
Sale of house 5,000,000
Less mortgage (2,500,000)
Net proceeds 2,500,000
New mortgage 5,500,000
8,000,000
Outgoings
New house 8,500,000
Stamp duty 1% x 8.5 85,000
Agents commission 2% x 8.5 170,000
Lawyers fee (50,000 + 75,000) 125,000
8,880,000
Less personal saving (1,000,000)
7,880,000
Margin = Kshs.8, 000,000 – Kshs.7, 880,000
= Kshs.120, 000 .This is too little to cover the following.
To cover:-
20% drop in the selling price
i) 20% x 5,000,000
= 1,000,000
ii) 12 months interest
10% x 4,880,000 (7,880,000 +2,500,000 – 5,500,000)
Kshs 1,000,000 + Kshs, 488,000
= Kshs.1, 488,000
The margin of 120,000 cannot cover 20% price and a 12 months interest which total to
1,488,000.
Decision
On the facts presented the bank must decline.
c) Remoulding the proposition
i) If the Smith were granted a mortgage of Kshs.7,000,000 this will cover both the
reduction of 1m and ones year interest of Kshs.488,000
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ii) The Smiths have saved Kshs.1m therefore showing ability to save from income.
They have already financed Kshs.2.5m without problems.
iii) The Kshs. 7m new mortgage should come with banks house purchase criteria as
regard salary and equity in the house.
d) Conditions
i) Ensure that the Smiths can meet the bank criteria for Kshs.7m mortgage.
ii) Ensure other commitments can be met e.g. food, clothing, entertainments etc.
iii) If the bank is satisfied on the above bank mortgage but give the Smith opportunity
to apply for larger mortgage from building society.
iv) Value existing house to ensure it can sell within a reasonable time for Kshs.5m.
Confirm amount outstanding on the present mortgage by sight of the building
society statements.
v) Professional relation of new property should be undertaken to meet mortgage
criteria.
vi) Pay off the Kshs.2.5m mortgage taking a legal charge over the deeds / land
certificates.
vii) Release the documents to Smith lawyer against his/her understanding in a
standard bank form to remit the net sale proceeds to the bank. Take a status report
on the lawyer if he/she is known by the bank.
viii) Lend the purchase balance of new property against the standard
undertaking so that the bank will obtain a mortgage assuming the bank has
provided a
ix) Insurance cover is required on new property from the date of exchange of
contract. The bank should facilitate insurance
x) Lend as follows:-
Ksh
Pay off old mortgage 2,500,000
Less own savings 1,000,000
1,500,000
Purchase deposit (10% x 8.5) 850,000
Purchase balance (8.5. - 0.850) 7,650,000
25
Stamp duty 85,000
Agents commission 170,000
Lawyers fee 125,000
10,380,000
Less new mortgage (building / bank) 7,000,000
3,380,000
The 3,380,000 will be cleared from sale proceed of 5m leaving a surplus before
interest of Kshs 5m – Kshs 3.380m = Kshs.620m
xi) The bank will lend on a separate loan account for ease of control and to enable
customer obtain tax relief.
xii) Other appropriate services offer insurance and other contents and appropriate
insurance to cover mortgage e.g. mortgage protection policy or endowment
policy.
Additional Risks in Open-ended Bridging loans

Consider
i) Delay in the sale; leading to
ii) Excessive interest accruing; leading to
iii) Seller reducing the selling price, thereby eroding the surplus needed to repay
the loan.
Generally, if you are assisting a customer with an open –ended bridge, allow a margin in
your calculations to cover a 20% drop in the sale price and 12 months’ interest at least. In
times of falling or static house prices or rising interest rates these figures should be
increased. Typically the security taken would consist of a first charge over the house
being purchased and a second charge over the house being sold, if it is not already
charged to the bank.
Before lending you must satisfy yourself that:
i) There are readily realizable assets to repay the advance quickly.
ii) The solicitors handling the estate are reliable and trustworthy
26
iii) The executors or administrators are of good integrity and financial standing
as bank is effectively lending to them.
2.5 Lending to Executors and Administrators

This is usually needed by the personal representatives of a deceased to:
 Settle estate debts prior to grant of probate or letters of administration.
 Pay inheritance tax to enable a grant of probate or letters of administration to be
obtained.
 Lend after receipt of grant of probate or administration to wind up the estate.
You will be lending entirely on the personal liability of the personal representatives who
must b e asked to sign the standard bank mandate, thereby accepting joint and several
liability on the account. Property previously charged by the deceased is not available for
new borrowing unless recharged by the personal representatives.
Banks normally agree to assist if they are satisfied that the:
 Personal representatives and the solicitor are of the highest integrity.
 Amount to be borrowed is justified and reasonable; and the
 Advance can be repaid quickly from the realization of liquid asses.
Probate / inheritance tax advances
If a customer dies and his estate is large enough (over £200,000 in the year 1996 / 7, but
this figure tends to increase with each Finance Act), then his executors may have to pay
any inheritance tax, currently at 40%, on the value of the estate, before probate or
authority to realize the estate assets is granted. Banks are often asked by the executors or
administration to assist a ‘catch 22’ situation exists. Without probate the executors cannot
sell estate assets to pay the inheritance tax, but they cannot usually afford to pay the
inheritance tax without realizing such assets.
In these circumstances good status replies from bankers are necessary. Furthermore you
will clearly wish to see the deceased‘s death certificate and will, if available. If there are
credit monies held by the bank in the name of the deceased, this is some comfort. If
he/she was in debit, the borrowing as well as the inheritance tax liability must be covered
by the liquid assets in the estate.
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Banks will be very conservative in their valuation of the estate assets, particularly where
property has to be sold on a weak market. If borrowing is requested to carry on a
business, you must check the will to ensure that the executors have the authority to do
this. Inheritance tax advances are taken on separate loan account in the joint names of the
executors / administrators. As security a ‘first proceeds form’ is signed by the executors
giving the bank right to repayment from the first proceeds realized.
2.6 Lending to Trustees

Trustees are similar to executors and administrators and they must be persons of high
integrity. A bank mandate specifying joint and several liability must be taken, otherwise
they are only jointly liable. You should lend on overdraft against personal liability of the
trustees or on loan account if the trustees are able to charge trust assets (as they have no
implied power to do this, so specific authority must be requested and checked).
2.7 Lending to Clubs and Associations

If these are not registered companies, thy do not have contractual powers and cannot be
sued for their debts. Their members are not personally liable and it seems that committee
members may not be either.
If lending, follow he normal canons of lending and ensure that personal liability is held,
usually by lending on a separate account to responsible officers or by taking their
guarantees if lending to the club itself. In the latter case, check that the club rules permit
it to borrow. Club property is held in names of trustees and if taken as security, specific
powers for the trustees to charge security and to borrow must be held and adequately
verified.

1. Up to what multiple of salary will the bank your bank with lend for home loan
2. What percentage of cost or valuation will your bank lend on home loan?
3. What extra costs or valuation will your bank lend on home loans?
4. Name and briefly describe four different types of mortgage
5. What security at least is taken by a bank offering bridge over facilities?
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6. Mr. Ernest Mwai an executive and a valuable customer of your bank has between
promoted to a new branch. The new branch is at a new location and he wishes to move
houses immediately. His present income is Kshs.3.6m per year. He has an outstanding
mortgage Kshs.1.350m he has so far identified a house near his new office which is being
offered at Kshs.2.7m and a mortgage co’ has agreed to a new mortgage of Kshs1.8m. The
completion of his purchase for 3month contracts were exchanged after Mwai made a 10%
deposit from his own resources. His present house has been on the market for a short time
and no firm offers have a short time and no firm offers have been received. He assures
you that similar rises are being sold about same price of Kshs.2.7m and he does not
envisage any undue delays in the sale.
Other charges applicable to translation are
Lawyer fee Kshs 99,000
Estate agent Kshs.63, 000
Stamp duty 4%
Bank charges interest 20% per year
Mr. Mwai asks for assistance to finance the transactions.
Required
a) Explain the type of bringing facility required.
b) Appraise request
c) Assuming the bank agrees to assist outline the measures it will take to protect its
position.
2.9 References
of Bankers.
Publication Data
29
LESSON THREE: SECURITY FOR PERSONAL LENDING AND PERSONAL
BORROWERS IN DIFFICULTIES
Specific Objectives
At the end of the lesson the learner should be able to:
i) Decide when to seek security to cover personal lending
ii) Explain the value to be placed on various forms of security available from personal
customers
iii) Explain methods available for monitoring, control and recovery of personal
borrowing if difficulties arise
3.1 Bank Security

Security is a cover taken by a lender to cushion the institution from complete non-
recovery of a borrowing should the promised source of repayment fail to materialize of
does not cover the full advance with interest.
When to take Security
a) If loans are granted for the purchase of an asset, then, practicable the asset should
be taken as security.
b) Where the purpose of the advance is to acquire a specific asset, e.g., a home loan
c) If it seems possible that repayment from an expected source is not forthcoming,
and no viable alternative source of repayment can be seen, then security should be
looked for.
d) Security acts as collateral or as an additional cushion should the promised source
of repayment fail to materialize in future.
e) Where the risks and consequences of the expected source of repayment failing are
such as to make it necessary to have a clearly defined and controlled alternative
source.
3.2 Types of Security and Valuation

As tangible security for personal borrowing land and property, life policies or stocks and
shares are used as security. Banks will not normally rely on 100% of the value of the
security because values can fall, and accrued interest and realization costs can be high.
Bank security margins vary, but the following are typical of the maximum percentages
they will lend against various form s of security.
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 Domestic land and property 80%
 Life policies 95% of surrender
 Investments 80% - 100%
Obviously much depends on volatility and the lender’s view of the market and in some
cases the above figures would differ greatly. Common sense and a realistic view of the
present economic situation are great aids in the valuation process. In many cases bankers
have been surprised at how security valuations can be eroded, particularly where a forced
sale is necessary in tough market conditions. Needless to say regular revaluations of the
security should be carried out, either professionally or by the bank manager (depending
on the asset and amount borrowed) at appropriate intervals.
Stocks and shares should be revalued quarterly (more often if the market shows signs of
volatility), and property at least every three years. Life policies tend to increase in value
each year as long as premiums are paid, so it is only necessary to obtain new surrender
values every five years or so.
If you are offered a second charge over property as security, a valuation of the property
would first be carried out by the branch manager or, more likely a professional valuer.
This valuation would then be reduce d by the margin stated above, and from the resulting
figure the amounts outstanding on any prior mortgages would be reduce d to give the
value of the security to the bank. At an early stage, you must confirm the amount owing
to the first mortgage.
Why is a margin required?
a) To cover any fall in value between the date of the advance and the sale of an asset.
For a long term lending, the uncertainty of realizable value may be greater
therefore a wider margin may be required.
b) The costs of sale and other necessary costs relating to the need to keep the asset
saleable, such as security, insurance and maintenance costs on a property
c) The role up of interest since the last charging date.
3.3 Guarantees and Third Party Security

A guarantee is an agreement where one party agrees to be collaterally responsible for non
payment of an advance by the borrower. The guarantor can take oath of personally
meeting the repayments from personal income or by pledging personal assets. The
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guarantor undertakes that in the event the borrower fails to meet obligations under the
contract, will be responsible for the miscarriage.
Bankers are reluctant to take guarantees as security for personal borrowing. If they do
they must ensure that:
 The guarantor fully understands the nature and extent of the liability – if an ‘all
monies’ charge form is used the guarantor must be made aware of the implications of
this clause.
 The guarantor is given the opportunity to take or actually receives, independent legal
advice, particularly if there is any chance of ‘undue influence’ being exerted – indeed,
many banks now positively insist on independent legal advice being taken by all
givers of third party security.
 If security forms are to be signed at another branch, that the nature of the liability is
fully explained.
 Supporting tangible security is provided if you are relying on a large guarantee.
 The wrongful trading provisions of the Insolvency Act 1986 are unlikely to apply.
Under these a director giving an unsupported guarantee for a company’s liabilities
could later incur full liability for the company’ s debts to the detriment of the bank’s
position if wrongly trading occurred. This would include continuing to trade knowing
the company to e insolvent.
3.4 Problematic Accounts

The lender should take a sort of action when dealing with personal borrowers who get
into difficulties. The following aspects should be considered:
a) Identifying problem accounts
b) Dealing with problem accounts
c) Rescheduling a debt
d) Recovery procedures
e) Legal proceedings
The first step is to identify possible problem accounts.
Warning signs
Look for:
a) Account(s) are over limit or overdrawn without a limit.
32
b) Dishonour of cheques paid into the account (possible cross-firing)
c) Overdraft not repaid on time, or loan repayments delayed.
d) Previously dormant accounts e.g. salary credits.
e) Rising trend of overdrafts.
f) Mails returned marked ‘gone away’.
Do not jump to premature conclusions, however, or overreact where relatively small
amounts are involved, but any of the above should prompt you to examine the situation
more closely. If your investigations confirm that there are problems, what do you do net?
The second step is to take a sort of action
You should
 Contact the customer to discuss the situation.
 Return cheques and direct debits or recall standing orders (under advice to be
customer, at least on the first occasion).
 Cancel any unadvised (control) limit and replace with a low limit, so that the account
will be referred earlier.
 Ask for the return of cheque books and plastic cards and ensure they neither are nor
renewed. If possible inhibit ATM withdrawals by ‘hot carding’, place on the counter
reference lists.
 Cancel any credit open arrangements.
 Search with a Credit Reference Agency
The lender must avoid sending a steadily increasing number of threatening letters but
then doing nothing. The persistent debtor will quickly become used to receiving them and
will be logical for him/her to simply ignore them.
Telephone contact
Where letters are being ignored or more urgent contact with the customer is needed,
contact by telephoning is the best course. General experience suggests that telephoning
produces a better response than sending letters. The reason for this is obvious, on the
telephone there is the ability to have a two way contact which leads to a greater
understanding of the customer’s problem and a commitment to do something about it.
The telephone call should not be made in a haphazard manner. The objectives of the call
must be clear before the call is made. The objectives will usually be:
33
a) To establish contact and check the customer’s address in case a previous letter
has not been received and provides the basis for future action.
b) To obtain a commitment to correct the overdraft, or rectify the position on a loan
account, etc., or to establish a realistic repayment programme.
c) If adjustment is not possible to establish why this is so
d) To inform a customer of the consequences should he/she fail to meet the lender’s
request. Great care should be taken to avoid accusations of harassment.
e) To obtain an up to date picture of the customer’s general financial circumstances
including details of employment, assets, liabilities, income and expenditure.
To achieve the above objectives good preparation is essential. A meaningful dialogue
will not be possible if the facts of the customer’s situation become a matter of
dispute. The lender must be in a position to answer any questions relating to the
recent history of the account.
The third step is to reschedule the debt
The discussions with a customer may show that he or she will not be able to repay the
borrowing as originally envisaged. The customer may request a longer period to pay and
also suggest that the lender takes on other debts where creditors are pressing. If you have
to reschedule a customer’s borrowing, i.e. to increase a loan account, extend the loan
period, reduce repayments, the bank’s exposure to risk is usually increased. Greater care
should be taken here to:
 Ascertain income and outgoing, future prospects and explore how the former may
be increased or the latter reduced.
 Enquire if moneys can be raised from family, friends or sale of assets in the short
term.
 Consider amalgamating bank borrowings and external liabilities in one amount over
a longer term and/or at a lower rate of interest to reduce outgoings; if possible,
security should be sought and the customer advised that this is a ‘last resort’
situation.
 Take the borrowing on loan account and the current account kept in credit, even if it
means canceling plastic cards. Carry out regular monitoring with a view to increase
repayments as soon as the customer’s financial circumstances improve.
34
The forth step is to institute Recovery procedures
If all else fails and no agreement can be reached on repayments, then you must have
formalized recovery procedures as legal proceedings may eventually be necessary and
you do not wish to jeopardize your case by any irregular treatment of the debtor. Most
banks’ procedures are strictly laid down, with the aim being to return the initiative and
obtain repayment of as much as possible at the least cost. After taking into account any
mitigating circumstances actions must be instigated and carried out as threatened. For
example, the following steps must be followed before legal proceedings can be taken.
 Check that security (if held) is complete and can be realized.
 Make every effort to contact the customer, trying his/her last known place of work
as well as his home address.
 Try to visit him/her at home or work (if feasible) – to avoid allegations of ‘duress’,
take a witness with you from the bank.
 Make a formal demand by letter, or as specified in the Consumer Credit Act 1974 if
the borrowing is regulated.
 In appropriate cases, pass the matter to a tracing or debt collecting agency for a
percentage of the amount collected, say 27% they will visit regularly and collect
payment on behalf of the banks.
In view of the cost of the above, most banks will write off small bad debts without further
ado. Each bank has its own internal instructions which you should refer to and follow
closely.
Legal proceedings
If there is no response from the borrower to the action taken so far, then the following
legal steps can be taken. Customers often respond at this stage, but beware of those who
make repayment promises which they have no intention of keeping in order to delay
proceedings.
Solicitor’s letter
A solicitor writes on behalf of the bank giving two weeks to respond to avoid legal
action. These can be expensive unless you have your own in house solicitor. Even so,
they are cheaper than litigation and can be effective in focusing customers’ minds.
Sworn statement of affairs
35
A statement from the debtor under oath giving details of his financial affairs must be
taken in the presence of a solicitor or commissioner for oaths. How ever this does not
necessary mean that the debtor is telling the truth.
Mareva injunction
This is a court order freezing the debtor’s assets (if any), preventing their removal from
the court’s jurisdiction, until judgment on the debt can be obtained.
Judgment
Your solicitor issues a default summons if the debtor does not respond to a letter of
demand. The country court or High Court (as appropriate) will then issue judgment
against the debtor for not responding to a formal demand for repayment. Judgments are
registered against the debtor with credit reference agencies, acting as a warning to future
prospective lenders.
Installment order
A debtor can apply to court to repay a judgment debt by installments. The court will
usually accept offers of very small amounts if the debtor is highly committed and on low
pay, and the lender must accept whatever is offered.
Oral examination
This is a questioning by the court after judgment about the debtor’s financial
circumstances. It can be useful in revealing the debtor’s previously unknown assets.
Often the threat of this can persuade the debtor to offer repayments before the court
hearing.
Enforcing the judgment
When judgment has been made in the bank’s favour, the bank can use various methods to
recover the debt, depending on individual circumstances.
Attachment of earnings order.
This is a county court order to the debtor’s employer to deduct regular repayments from
his wages or salary to be paid into court. This is only possible if the debtor continues in
full time employment and his earnings exceed a minimum figure laid down by the court.
Charging order
36
This enables the bank to obtain an equitable charge over land or stock exchange
investments held by the debtor. The bank cannot sell the asset, but if the debtor sells it,
the bank will receive the proceeds, subject to any prior charges.
Receiver by way of equitable execution
Similar to a charging order, but it covers assets a charging order cannot touch, for
example, a life policy.
Garnishee order
This can attach funds owed by a third party to the debtor, and have them paid into court
for the bank’s benefit. This is useful when the debtor is known to have savings elsewhere,
which can be located and identified.
Levying execution
This is a court warrant enabling the bailiff or sheriff to seize the debtor’s good s and sell
them to repay the debt. This is only useful where you are sure the goods are in the
debtor’s name and not for example, bought on hire purchase.
Bankruptcy
This is a final step, but a dangerous course of action. It means that whatever assets can be
realized go to benefit all creditors, unless the bank had taken security, which gives the
bank priority over other creditors, or has taken steps to attach any identifiable assets
beforehand.
Insolvency proceedings are costly and bank tend to resort to them only in exceptional
circumstances e.g. where they suspect a customer of dishonest or they consider there is a
real risk that assets may be dissipated.
Voluntary arrangements
Under the Insolvency Act 1986, proposals for the partial settlement of debts, or payment
over time, can be put to the creditors. Three quarters by value of the creditors must agree
for such proposals to be sanctioned.

1. Under what circumstances should security for personal borrowing be taken?
2. Give examples of the security margins banks will normally attach to tangible personal
security. If you are aware of your own bank’s figures, give these.
37
3. What precautions should be taken if you are offered a guarantee as third party security?
4. What warning signs may alert you to a problem personal account?
5. What action should be taken if a customer fails to respond to correspondence about
proble borrowing?
6. What steps should be taken before instigating legal proceedings for recovery of
personal debt?
7. Outline the main legal steps that a bank can take if a customer ignores a formal
demand for repayment of a dent?
8. Describe the various methods of enforcing a judgment, and briefly explain when each
method may be most appropriate.
3.6 References
of Bankers.
Publication Data
38
LESSON FOUR: LARGE BUSINESS LENDING
Specific objectives
a) Assess larger business lending where good quality financial accounting
information is available;
b) Demonstrate the use of both non-financial and financial information, in appraising
lending.
c) Apply various financial ratios to assess a lending proposal.
4.1 Introduction
To deal adequately with lending at this level, you must ensure that you are up to date with
your accountancy studies, particularly the principles of management accounting and
accounting ratios.
4.2 Non-financial Appraisal of Business

Markets and products
In most businesses sales are the main source of income and profit and it is therefore
essential to confirm that the company’s products are appropriate for its markets, and will
continue to be so, compared with its competitors. Ant drop in sales is worrying and, for
some businesses, can be fatal. You must keep yourself up to date on the business
environment at a national and local level. In the light of your knowledge you should
check that your business borrowers are fully aware of the strengths and weaknesses of
their own products and of the opportunities and threats existing in their markets. For
example they should have considered:
Products – Position in product life cycle (new, mature, and declining), profitability, new
developments, market segmentation, spread of customers, share of total market?
Competition – Local, national, regional, international, comparative prices?
Supply / demand – Availability of alternative e suppliers, volatility of demand, exposure
to currency risks, skilled workforce / personnel, new technologies, fashion, buying
habits?
39
Research of markets – Where are tomorrow’s customers / products? Are today’s
markets declining, static, expending?
Resources
If a company is to supply the right products t the right markets at the right price, then it
has to have the appropriate production resources in place exactly when needed i.e. the
company needs to monitor the present and continued availability and quality of its
premises, machinery, vehicles and labour force. It must plan ahead carefully in all these
aspects if its production is not to be adversely affected at a time when the company can ill
afford it.
Management
If a bank is to lead to a company, it must have complete confidence in the character and
ability of the management; these qualities must be objectively assessed. Qualifications,
experience, age, health, personal and financial commitment must be confirmed. The
company must have a good mix of qualities spread amongst the management team with,
as a minimum, production, marketing and financial skills. It is helpful if there is a
training and succession plan to reduce the management on retirement or promotion.
A visit to the business to meet all directors and managers is essential, at which time the
resources can also be examined.
4.3 Assessment of Financial Information

By financial information it means primary the latest audited accounts, including income
statement, cashflow and financial position statement (balance sheet). These figures are
usually several months out of date by the time the bank receives them, but larger
businesses are able to supply the bank with up to date interim figures which will be
audited. The following are the key ratios to be considered when dealing with financial
information.
Financial ratios
Current ratio % = Current assets x 100
Current liabilities
Acid test % = Current assets stock x 100

Current Liabilities
40
Credit given (days) = Debtors x 100
Sales
Credit taken (days) = Creditors x 100

Purchases
Stock turnover (days) = Stock x 365

Sales – Gross profit (cost of goods sold)
Gross margin % = Gross profit x 100

Sales
Net margin = Net Profit (before tax & extraordinary items)

Sales
Interest cover (times) = Profits (Before interest and tax)

Interest payable
Net gearing % = Bank overdraft + long-term external borrowing x 100

Net worth
Net working assets to sales % = Stock + debtors – creditors x 100

Sales
(Working capital needed to finance extra sales)
Retained profits to sales % = Annual increase in profit & loss A/C x 100
Sales
Return on capital employed % = Profit before interest x 100

Net capital resource
Notes:
Where figures are altering significantly from year to year, it is possible to take an average
of two years’ balance sheet figures, rather than simply the latest year end figure.
However, this approach is rare.
Be careful where the time span covered by the figures being compared varies i.e. a full
year’s audited figures against six months management figures, particularly where trade is
seasonal, and sales or purchases may be concentrated in one part of the year.
Example 4.1
Mining Equipment Ltd. currently banks with one of your competitors and has been a
long-standing marketing target for your branch. The company was founded over 30 years
41
ago and has been with its present bankers for most of that tome. It manufactures, in
factory in a development area in the north of England, machinery used in the mining
industry. By far its largest customer is British Coal.
Following the year long strike in the British coal mining industry which ended in 2005,
British Coal has been closing coal mines. Your Economics Department considers that this
trend is likely to continue in the UK although overseas mining markets may be more
buoyant.
Mining Equipment Ltd has not found trading conditions easy since the end of the mining
strike, and last year the directors decided to stop producing certain loss-making products.
This involved closing down a department of the factory and making a number of
employees redundant. After taking these steps the directors are confident the business
will have a healthy future.
The company currently enjoys an over draft limit of £ 400,000 together with a medium-
term loan of which the present balance is £255,000 with seven years of its term to run.
These facilities are secured by a mortgage over the company’s freehold and leasehold
properties.
The directors have recently had their annual review meeting with their present bank, at
which they produced their latest audited accounts, projections for the current financial
year and management accounts for the first quarter of the current financial year. These
management accounts show sales on target but also reveal a loss of £25,000 which the
directors put down to temporary production difficulties following on from the
rationalization at the factory. They still expect to be able to meet their profit target for the
full year despite this setback.
Their bank has agreed to renew the limits, but is insisting on having additional security in
the form of a debenture and personal guarantees from the directors.
The directors consider that their present bank’s stance is unreasonable and approach you
to take over the company’s account without the benefit of the additional security.
Required
Set out in note form your analysis of the company’s present financial position.
Indicate with reasons, the response you would make to the company’s request.
42
Mining Equipment Ltd
Balance Sheets
31.12.05 31.12.06 31.12.07

£ £ £ £ £ £
Current assets
Cash 300 200 900
Debtors 411,100 464,700 361,900
Stock 539,100 950,500 609,300 1,074,200 548,800 911,600
Current liabilities
Creditors 354,400 419,100 308,200
Bank 147,000 164,900 280,800
Current taxation 27,100 18,900 23,000
Dividends 22,900 551,400 24,800 627,700 13,400 625,400
Net current assets 399,100 446,500 286,200
Fixed assets
Freehold & leasehold
deeds 194,700 187,000 171,300
Plant & machinery 374,400 569,100 387,500 574,500 355,200 526,500
Total assets less

Current liabilities 968,200 1,021,00 812,700
Term & other liabilities

Medium-term loans 275,200 293,500 267,000
Deferred taxation 20,000 295,200 19,200 312,700 6,600 273,600
Net assets 673,000 708,300 539,100
Financed by
Share capital 300,000 300,000 300,000
Profit & loss Account 373,000 408,300 239,100
Share holders’ funds 673,000 708,300 539,100
Profit and Loss Account Figures
2005 2006 2007 Forecast

2008
£ £ £ £
Sales 1,584,100 2,069,800 1,932,900 1,987,100
Inc. export 487,000 446,100 391,200 362,000
Cost of sales 1,156,400 1,345,400 1,333,700 1,232,000
Inc. purchases 631,000 696,800 519,300 601,200
Gross profit 427,700 724,400 599,200 755,100
Interest 46,700 50,600 47,700 62,600
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Profit before tax and
extraordinary items (67,000) 142,000 73,400 164,800
Extraordinary items
(restructuring and redundancy
costs) - - 187,400 -
An extract of the financial information regarding ‘Mining Equipment’ is shown in the

question. The following information shows how the examiner calculated the ratios from
the 2007 accounts.
i) Net gearing
Cash borrowed x 100 = 547,800 x 100 = 101%

Shareholders funds 539,100
Note: Take care to ensure that any hidden reserve and directors loans are included in
the shareholders funds figure.
ii) Interest cover
Profit before tax and interest

Interest
= 73,400 + 47,700 = 2.5

47,700
iii) Credit given (days)
Debtors x 365 = 316,900 x 365 = 68 days

Sales 1,932,900
Note: If the accounting period is below one year, then multiply by the appropriate
number of days, instead of using 365.
iv) Credit taken (days)
Trade creditors x 365 = 308,200 x 365 = 190

Purchases 591,300
v) Stock turnover
Stock x 365 = 548,400 x 365 = 150

Cost of goods sold 1,333,700
Note: If the examiner chooses not to give you the cost of goods sold figure, then he will
use the sales figure. However, the method of calculation is irrelevant; it is the trend which
matters.
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vi) Current ratio
Current assets = 911,600 = 1.46:1

Current liabilities 625,400
Note: If directors loan are shown in the accounts under current liabilities, then they
should be deducted from the current liability total.
Directors loans are part of the capital base, as far as a lending banker is concerned,
provided these loans have been or will be postponed to the bank.
vii) Acid test
Current assets, other than stock

Current liabilities
= 362,800
625,400
= 0.58:1
viii) Gross profit margin
Gross profit x 100 = 599,200 x 100 = 31%

Sales 1,932,900
ix) Net profit margin
Net profit before tax and extraordinary items x 100

Sales
= 73,400 x 100 = 4%
1,932,900
Brief notes on the significance and / or derivation of various figures
Balance sheet items
i) Shareholders funds
This is calculated as
Share capital
+ profit and loss balance in balance sheet
+ reserves
+ directors loans if postponed
45
+ any hidden reserve in fixed assets*
- goodwill
* A hidden reserve arises when the question states that fixed assets are valued at a certain
figure, and this figure exceeds the balance sheet value.
Solution
Background and initial reaction

The company has been around for a reasonable length of time and has been profitable in
the past, but is coming to you from other bankers, and therefore you should take care in
your approach. It has had problems in the immediate past, but it appears to have taken
remedial action. However, it is locked into a market which at least in the foreseeable
future is going to be difficult.
It is heavily dependent on one major customer with the risks this entails of being
squeezed on price etc. Exports sales, where the market is likely to be more buoyant, are
declining and forecast to fall further.
Although the management has taken steps to rationalize the business it is arguable that
they have been slow to recognize the probable effects of pit closures in waiting for two
years after the strike. This brings in focus their management ability and experience. This
may not reflect well on their forecasts for the future against the background of adverse
independent opinion. The company is a long standing customer of its present bankers
and they will not have taken the step of requesting more security lightly. The signing why
their present bankers are requesting for security is a warning sign.
Capital structure
Gearing has increased and is now at an uncomfortable level for a manufacturing business
of this kind. It is projected to fall in 2008, but only marginally, and if profits are not made
the fall is unlikely to come about. Net worth has been up and down recently and there is
no steady trend of retained profits. There was a loss on trading in 2005 and a further loss
in 2007 as a result of restructuring. There is no steady trend in interest cover, but 2007 is
probably the most settled year to look at, and it appears thin for a business of this type.
Liquidity
46
Both the current ratio and acid test are declining and in absolute terms for this type of
business, are less than good.
Less credit is being given as the company has tried to keep its borrowing down. With a
major dominant customer this trend is surprising so are abnormal discounts being given
which will affect profits?
The company is able to obtain substantial credit from its suppliers. This would be
unlikely to continue if there were any doubts about the company’s future. The confidence
of the creditors may be dented by the granting of a debenture as it would suggest its
bankers are not confident of the future following the restructuring. If credit is cut back, a
higher borrowing requirement wills arrear.
Stock turnover is improving, suggesting that the company is improving its efficiency.
Profitability
Sales and profitability have been up and down. The 2005 figures have been adversely
affected by the miners’ strike whilst the 2006 improvement reflects British Coal’s
subsequent re-equipment needs and was therefore a one –off.
The 2007 figures are probably the best guide to future trends. The net margin is thin
whilst the gross margin is wide, suggesting that there is a heavy level of overheads which
may not be covered if sales targets are not met.
Projections
The effects of the rationalization will be reflected in the forecasts making comparison
with previous figures difficult. The projections, with a significant increase in both gross
and net profit margin over what has been seen previously, look depending, particularly
against the background of a difficult market place. The expected loss in the first quarter,
mo matter what the excuse, is not a good sign. Capital expenditure is planned to run
significantly ahead of the depreciation charge with a consequent cash drain if profits are
not made.
Security
It appears that a significant element of the deeds is in a development area. Such
properties are not likely to be easy to sell and may not therefore be good security. The
best asset in the balance sheet is undoubtedly the debtors, with a large portion due from
British Coal. The stock and plant and machinery would probably not raise 50% of book
47
value on a break up and again are less than ideal security. What would personal
guarantees from the directors be worth? What personal assets do the directors have?
Decision
The company faces an uncertain future. Its market appears to be declining and it is now
heavily borrowed so that any option for diversification which requires cash will be
limited.
The management seems to have been slow to react to the situation which was probably
foreseeable and there is a question mark against them. The company’s own bankers are
in the best position to assess the directors’ performance and if they want more security
this is a warning sign.
Against this background a debenture would appear to be essential security to pick up the
debtors. Even so, debtor cover would be thin with the other assets in the balance sheet of
questionable value. However, this could have an adverse effect on the raise the overall
borrowing requirement to an-unacceptable level.
Personal guarantees also appear essential to back the directors’ expressions of confidence
for the business’s future.
On the terms offered, taking the company’s account is not an attractive proposition. Even
with a debenture there are plenty of potential problems with the company which suggests
that this is not a good time to acquire the account in any circumstances.

1. Name and briefly explain the non-financial areas of a business to be considered by a
prospective lender. Give a brief summary of the points to be covered in each area.
2. Set out ratios used to assess a business financial position and ability
3. Maridadi Hotel, a 3- star hotel in the city centre, has maintained a banking relationship
with you for the last 23 years. Recent development in the tourism industry has caused a
slump in business for most hotels in the country. Maridadi has enjoyed banking facilities
with you for the last 7 years with an exiting overdraft limit of Ksh. 2.5 million. The
facility falls due for renewal in the next 3 months. The directors have submitted their
audited accounts along with a request to increase the limit to Ksh. 3.0 million citing
pressure on overheads as the reason for increased overdraft. The accounts of the hotel are
given below.
48
Maridadi Hotels Ltd
Balance Sheet As At 31st December
2008 2009
Ksh. ‘000’ Kshs ‘000’

Fixed Assets
Building 1,800 2,000
Furniture and equipment 3,800 3,400
5,600 5,400
Current Assets
Cash 500 200
Debtors 2,750 1,500
Stock 4,050 5,500
7,300 7,200
Current liabilities
Creditors 4,200 5,200
Overdraft 1,250 2,900
Tax 190 240
Bills payable - 150
5,640 8,400
Net Current Assets 1,660 (1,290)
Total Net Assets 7,260 4,160
Financed by:
Share capital 3,000 3,000
Profit and loss 3,320 140
Term loan 940 1,020
7,260 4,160
Required: Appraise the request and give your recommendations
4.5 References
of Bankers.
Publication Data
49
LESSON FIVE: SECURITY FOR CORPORATE LEMDING
Specific objectives
a) Quantify the risks taken by banks when granting various facilities to corporate
borrowers
b) Clarify when security should be taken for corporate lending
c) Consider the various forms of security available from corporate borrowers and the
valuation thereof
5.1 When should Security be taken?

No amount of security will make a poor lending proposition viable. Banks are not
pawnbrokers, who lend against the pledge of an asset. Banks wish to know that a
customer’s borrowing plans are viable, particularly those concerning repayment of the
borrowing. Where loans are granted to purchase a specific asset, e.g. a building, the
lender would clearly look to the security of that asset. Similarly, when a bank is lending
pending repayment from sale of an asset, e.g. bridging finance, then a charge over the
asset to be sold would be expected. Other cases where security may be sought are treated
on their own merits. If the source of repayment is not, in the lender’s eyes, fully certain,
and there is no readily available alternative source, then it is better to ask for security.
5.2 Assessment of Risk

The decision whether to take security or not should be based on risk; ask whether;
Budgets and forecasts are in line with what has gone before?
Projected sales are supported by firm orders?
The figures stand up to sensitivity analysis of possible falls in sales volumes or
increases in costs/
Gearing is high (above 70% say) or interest cover below 3x?
The bank has had good experience of previous management forecasts?
50
5.2 Gone concern break-up analysis
If a business is forced into insolvency, you need to be able to assess the risk of any loss
on your lending by analysis the business’s assets on a ‘gone concern’ basis before
lending. If there is likely to be a shortfall of assets over liabilities on this basic, then it is
an indication that you should take security to cover it.
Break-up values can be calculated from the latest audited (or reliable interim) figures and
the balance sheet figures may be substantially reduced by this exercise. Below is
suggested percentage values of balance sheet figures to be used but, here again, these will
vary from bank to bank, and depend on individual circumstances. Experience shows,
however that amounts raised in realizations are almost always far less than expected.
Some of the reasons for this are that:
a) If trading ceases, assets lose value i.e. work in progress is worth little if
unfinished, and finished goods are difficult to dispose of once it is known that the
business is likely to close. Many small traders make a good living buying
‘bankrupt stock’ at rock bottom prices for resale on market stalls.
b) The book values of the assets will be historical, and they have probably not been
amended in line with market conditions.
c) The book value of fixed assets assumes that they have no other use. In addition,
land and buildings may need planning permission for any change of use.
d) If a business is short of cash, it is unlikely to maintain its fixed assets in good
condition, e.g. vehicles may not have been serviced, premises may not have
serviced, and premises may not have decorated.
e) If there is a general recession hitting the trade or area, the market for the assets
will be well depressed. Short leases, particularly, may well be worthless or
contain insolvency clauses enabling the lessor to regain possession.
f) When a business fails, its debtors look for reasons not to pay. These include
breach of contact, poor quality, denial of receipt of goods, contra items and
perhaps, set off-the last of course being perfectly legitimate.
Suggested percentages for asset realization values (‘gone concern’ basic)
%
Marketable investments 80 (of current market value)
Debtors 50 – 70 Depending on age, spread, quality
51
HP debtors 60
Stock 15 – 60
Work in progress 20
Property – freehold 40 of balance sheet or manager’s valuation
with vacant possession
Or
60 of recent professional valuation
Long leasehold (30 years plus) 33 1/3 of manager’s valuation or recent
professional valuation
Private dwelling house – freehold or 66 2/3 of manager’s valuation with vacant
leasehold possession
Plant and machinery etc 10 -20 Depending on how specialized
Vehicles 20
Office furniture tools etc 10
Payments in advance Nil
Ships 50 of recent professional valuation
FARMING Cattle and livestock 60
Harvested crops 50
Dead stock – feed Nil
Tillages – preparation 50
Note: Whilst it is the intention that these percentages are to be adopted in the majority of
cases, they are not regarded as rigid. If it is felt necessary to include a different valuation,
the percentage and the reason should be stated.
Check the percentages used by your bank lending managers when allocating values to
balance sheets assets on a ‘gone concern’ basis. Compare them with the above figures.
5.3 Security and Margins

It is unlikely that in most cases realization of security will produce 100% of the valuation.
The longer the period between taking the security and the bank’s sale of it, the more the
divergence in valuation will be. In addition, costs of sale (including insurance and
maintenance) and unpaid interest will eat into the net proceeds available to repay the
original borrowing. Banks therefore try to leave a margin between the value of the
security and the maximum amount they will lend to cover such contingencies to ensure
that sufficient funds will remain to repay them if the borrower fails.
5.4 Debentures
A modern bank debenture will normally be secured by:
52
a) A legal first charge over freehold and leasehold property including building and
trade fixtures and plant and machinery fixed to the floor. (Do not confuse these
with fixed assets in the balance sheet which also include movable assets.)
b) An equitable first charge on all future freehold and leasehold property including
fixtures.
c) A legal first charge over all book debts and other debts now and from time to
time owing and over goodwill and uncalled capital.
d) A floating charge over all other assets both present and future, typically stock,
movable plant and machinery and motor vehicles.
e) A floating charge over intellectual property rights.
A floating charge should be taken while the company can still be proved to be solvent,
otherwise the charge will be set aside under s. 245. Insolvency Act 1986 if the company
becomes insolvent within 12 months of the charge being granted or as a consequence of it
being granted. More commonly, sufficient credit turnover should have passed through the
account to cover the debit balance on the date the charge was created (Clayton’s case).
Perhaps the most important reason for taking a floating charge over all or substantially
all of the company’s assets is that it enables the floating charge holder to appoint an
administrative receiver and thereby effectively control the company’s liquidation.
In a company winding up, the order of priority of payments from asset sales is:
(i) The expenses of the winding up.
(ii) Holders of fixed charges – from the sale of the assets charged.
(iii) Preferential creditors
(iv) Holders of floating charges
(v) Unsecured creditors.
(vi) Shareholders
You should be aware of the probability of retention of title clauses (Romalpa clauses)
enabling a supplier to retain title of goods supplied until he is paid in full. If a substantial
proportion of the assets consists of stock and debtors, then the terms of trade and
purchase involves need to be examined for retention of title clauses before giving any
53
value to those assets. As general guidance (in a difficult legal area) Romalpa problems
usually only arise where the goods supplied can be identified and remain in their original
supplied state and have not been combined with other goods during manufacturing. Also
watch for ‘all monies’ retention entitlements, i.e. applying to all sums owing to the
supplier and not just sums owed on the particular contract of supply. Remember, too, that
Romalpa can work both ways, and your customer may be imposing such term s on his
customers.
Valuation of debentures
Below is the examiner’s own example of an actual debenture valuation, showing that
despite total assets of £ 2.32 million against borrowing of £ 1million the bank as
debenture holder still finished up with a £ 270,000 loss. It is based on a real and typical
case and shows the impact of applying discount factors to book values.
Assets covered by floating Book Value Realization Estimate to
charge £ 000 % realize £000
Stock 400 15 60
Plant, vehicles & equipment 240 30 72
640 132
Assets covered by floating charge
Freehold & leasehold premises 800 40 320
Debtors 600 67 400
Fixed plant & equipment 280 20 56
2330 776
Due to bank 1000
Add cost of receivership (5% of 46 1046
realizations)
Deficiency under fixed charge (270)
Preferential creditors
PAYE/NI 40
VAT 150
Holiday pay 10
Employees 40 240
Deficiency after preferential (108)
claims
Deficiency as regards debenture (207)
holder
In this example a loss of £ 270,000 was incurred despite apparently being more than
twice covered by total assets on book values. It illustrates two import ant lessons.
A floating charge often has only limited value.
54
The need for a strong debenture formula if this is the bank’s prime security.
5.5 Summary of Lending Considerations

Before moving on to look at various specialist aspects of lending, recap the areas you
need to consider when analyzing lending propositions and take a brief look at how the
examiner likes a candidate’s answer to be set out.
Lending considerations review
The customer
 How long has he/she been known to you and what is the worth of the relationship?
 Does he/she live locally? The business will be easier to monitor if so.
 Who exactly are you lending to? Take particular care in group situations. Satisfying
yourself that you are clear on this matter.
The business
Consider:
 The type of business involved
 What opportunities or threats face businesses in this line?
 How does your customer compare with others in the same sector?
 Ensure that the supplier / customer bases are well spread and sound and the
geographical, market and product spreads are well diversified.
The management
Consider
 Is there a good spread of management expertise in all areas such as production,
marketing and financial skills with a sufficient background of relevant experience?
 Are management and business objectives clearly defined?
 Is there evidence of good internal financial control?
 Ensure that the business is not over-reliant on one man (consider keyman insurance)
and that suitable deputies / successors have been trained to step in if needed.
The lending proposition
Consider
 The borrowing requested should be sufficient, realistic and of the correct type for
the purpose, which should be properly defined.
55
 The term requested should match the purpose and the resulting repayment
requirements should be well within the customer’s ability. Consider whether a
capital repayment holiday is appropriate.
 Be clear about what the borrower is contributing to the proposition and ensure it is
already in place or definitely available when required.
The financial information
Consider
 How reliable are the accounts presented to you? If not audited by reputable
accountants (and unqualified) have you good reason based on past experience, to
trust unaudited or internally prepared interim or management figures?
 The last three years’ audited accounts should be available and copies should be
produced promptly to you as soon as available. Check for any unusual accounting
practices by reading the notes to the accounts.
 Compare and contrast the usual ratios and examine the underlying figures if sudden
changes occur.
 Up-to-date management accounts including balance sheet profit and loss account,
cash flow analysis and debenture figures should be the minimum provided in most
cases.
 Watch for deterioration in quality if internal systems or personnel change.
 Diarize for receipt of regular future figures.
 How well do management accounts compare with eventual audited accounts when
received?
 Are forecast figures realistic in terms of past performance market place,
competition, economic situation and any other relevant factors? Monitor them with
actual figures when available.
Security
Consider
 Is security sensibly valued standard security margin formulae are helpful as guide,
but use common sense to assess actual worth?
56
 Do not allow drawdown of borrowing until the security agreed is deposited and all
necessary formalities are complete. If in doubt about the worth of the security held,
seek professional valuations from reputable valuers and update regularly.
 Where debentures / fixed and floating charges are held, you will need to insist on
regularly updated internal management figures for the underlying assets to enable
regularly.
 Ensure covenants are fully compiled with.
 Ensure all assets charged to the bank are fully insured.
 When lending to groups of companies, full cross-guarantees tying in all group
members should be taken.
 If possible take charges over security to support guarantees, which otherwise should
not be relied upon.
Other lending relationships
Consider
 Is there evidence in the balance sheets of the customer enjoying facilities from other
providers of finance and consider how your security may be affected b charges held
by them.
 Get full details of other financial facilities from the customer, supported by
documentation if possible.
Remuneration
Consider
 Agree on interest, commission, fee and securities charges.
 Interest rates and fees for contingent liabilities should reflect the risk involved to the
lender.
Other issues
Consider
 The quality of the borrower’s financial advisers. As businesses grow they can, for
example, outgrow their accountants.
 What are the implications of getting involve d with environmentally unsound or
politically incorrect customers.
57
5.6 Layout of Examination Answers
The examiner’s preferred lending application format is shown below.
1. Introduction
a) Nature and history of the business.
b) Purpose / amount / period
2. Market and products
3. Physical and production resources
4. Assessment of management
5. Trading performance
6. Projected financial position
7. Management information and controls
8. Security and conditions
9. Remuneration
10. Summary and recommendations
Example 5.1
Castle Foods Ltd is an old family business which was established over 75 years ago. It
has banked with your bank for all that time. It manufactures specialty biscuits which it
sells through retail grocers and supermarkets.
Three years ago a new generation of the family took over the running of the business. The
new directors considered that the company’s product range lacked growth prospects
because the large supermarket chains were not prepared to stock more than a few items of
the company’s wide range of products.
The business has always been cyclical, with the pre-Christmas sales production the bulk
of the bulk of the profits. To counter the cyclical trading pattern and the problem of
declining products, a new product was introduced at the end of 2008. This product, an
aerosol Chocolate foam, is imported from France, with the company acting as Sole UK
distributor.
At the time the company introduced the new product, the directors injected £ 100,000 of
new capital, and you agreed to transfer the hard core in the company’s overdraft on to a
medium-term loan repayable over seven years, with a two year capital repayment holiday.
58
The company’s overdraft limit was reduced to £170,000 and a debenture taken as security
with a debtor formula of 1.5 times cover for all bank borrowing. Subsequently, the
overdraft limit has been increased to £ 220,000.
The facilities are now due for their annual review. These have recently been excesses
over the overdraft limit and the debenture formula has not always been met.
You are aware that the directors are going to seek an increase in the overdraft limit of
£300,000 and a relaxation of the debenture formula to 1.25 times debtors.
Consider the following statements and then answer the questions which follow.
Castle Foods Ltd
Balance Sheets as at 31 December
2007 2008 2009 2010

£ £ £ £
Current assets
Cash 6,002 2,598 2,800 10,052
Debtors 335,408 475,132 452,474 58,1988
Stock 386,054 737,464 248,462 726,192 435,188 890,462 44,3056 1,035,096
Current
liabilities
Creditors 404,104 334,552 443,732 509,322
Hire purchase - 4,432 18,498 65,360
Bank 263,762 (667,866) 120,826 (459,810) 169,888 (632,118) 279,014 (853,696)
Net current 69,598 266,232 258,344 181,400
assets
Fixed assets
Machinery, 78,264 53,732 75390 151,810
vehicle
Tem liabilities
Medium term - (100000) (100,000) (93,344)
loan
Net assets 147,862 220,114 233,734 234,786
Financed by
Share capital 100,000 200,000 200,000 200,000
Profit & loss 47,862 20,144 33,734 34,876
a/c
147,862 220,144 233,734 234,876
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Profit & Loss summary (12 months to 31 December)
2007 2008 2009 2010 2011

£ £ £ £ (4 months to 30 April) £
Sales 1588828 1510008 1764432 2253338 550401
Gross profit 540202 573803 688093 811202 220160
Net profit (loss) 17886 (72748) 13620 1142 (82240)
before tax
Ratios
2007 2008 2009 2010 to April

2011
Net gearing 174% 10% 123% 184% -
Interest cover (times) 1.3 - 1.4 1.0 -
Credit given (days) 79 115 94 94 -
Credit taken (days) 58 163 170 172 -
Stock turnover (days) 134 97 148 112 -
Current ratio 1.1:1 1.6:1 1.4:1 1.2:1 -
Acid test 0.5:1 1:1 0.7:1 0.7:1 -
Gross profit margin 34% 38% 39% 36% 40%
Net profit margin 1.1% - 0.8% 0.1% -
2011 Budget: Summary of key points
Sales Net profit Closing bank

(£000) balance (debit)
January 102 (32) 226 Dr
February 136 (18) 236 Dr
March 200 - 240 Dr
April 194 (4) 260 Dr
May 222 4 258 Dr
June 216 6 270 Dr
July 234 6 316 Dr
August 222 2 320 Dr
September 300 28 340 Dr
October 372 50 322 Dr
November 398 62 298 Dr
December 214 (2) 272 Dr
2,810 102, (3.6%)
a) What do you think of the management here?

b) Assess the trends of the given ratios.
60
c) How is the bank account operating?
d) Is the bank adequately secured?
e) Is the amount requested sufficient?
f) Would you lend as requested?
g) If you are unhappy with the proposal, what would you do to take matters forward?
Solution
Background and initial reaction
Long –standing good customer whom you would wish to help.
The company has good products which sell well. New management who may be
relatively in experimented. But they have been prepared to take action to tackle perceived
weaknesses in the company’s product range. The excess and debentures formula breaches
are evidence of poor financial control. Injection of capital in 2008 showed directors’
commitment.
Financial appraisal
Gearing is too high and is rising.
Interest cover is unacceptably thin and will not get much better in the immediate future.
Credits given and taken are stable but given the nature of the company’s customers, there
will be little to reduce borrowing from these sources.
Stock turnover is high-reflecting the seasonality of some of the products.
It probably ought to have improved more than it has from the introduction of the
chocolate foam for which the company is only a distributor.
Both the current ratio and acid test are worsening steadily.
The 2007 – 2008 improvement is cosmetic – due to the switch in hard-core borrowing to
loan.
Sales growth has been good recently – up 28% 2009 – 2010.
Sales performance in the first four months of this year is below budget (£ 550,401 against
budget £ 632,000).
This need not be significant given the still seasonal nature of the business indicated by
the projections and the overall 1996 projection may be achievable.
Gross margin is health and is looking good for the first four months.
Although some care is needed concerning the relative product mix within sales.
61
The gross margin has not reduced as much as might have been expected with the
introduction of the new product.
Given the overheads on the foam will probably be less than on the biscuits (which need a
factory, etc to manufacture them), it is probably a strong profit earner.
The net margin is awful and even if the 2006 projection was achieved is not acceptable.
Unless it can be radically improved, the company does not have a long-term future.
Given the good sales and gross margin, the problem must lie in control of overheads.
Security
A reduction in the debenture formula is the same as releasing security not payable given
the trading performance. But, the debtors are good security – major supermarkets etc.
The products seem reliable and there is good demand so returns by retailers on
liquidation ate not likely. One and a quarter times cover in this instance is probably
acceptable.
However, against the trading background, directors’ guarantees may also be appropriate.
No deeds in balance sheet – is there a property outside the company which could provide
extra security?
Conclusion and decision
The request to increase the overdraft will be unwelcome but increased facilities look
necessary in the short term. The likely request for £ 300,000 may not be enough given
the projections peak at £ 340,000. In any event, there is a new hard-core borrowing and
no apparent source of repayment. But the business ought not to be beyond redemption –
sales and gross margin are good, so why the poor profitability, which is the fundamental
problem?
A detailed investigation is needed using Business Advisory Service / outside consultants.
Pending the results of this, an increase to say £ 275,000 in the limit will be necessary.
If possible, the existing debenture formula should be maintained accepting short-term
breaches not below 1 ¼ times debtors.
Services
Your bank’s own Business Advisory Service should be used for the initial investigation.
Cash flow may be improved by using factoring or invoice discounting, but if so, the
62
implications on your security should be considered as the factoring company would need
a charge over book debts, thus reducing the value of your debenture.

1. When should security be taken for corporate lending?
2. Quote reasons why amounts raised in realizations may not be high as expected.
3. Describe fully the cover offered by a modern bank debenture?
4. Set out the priority of payment from asset sales in a winding up.
5. Matangi Limited manufacturers metal containers. The company has banked with you
for over 30 years and has always been profitable. Two years ago, there was a sudden drop
in the market for metal containers. The directors of Matangi Ltd. Expected this drop to be
temporary, but market conditions has continued to worsen. An article in the ‘Market
Intelligence’ has speculated that the market for metal containers will reduce by a further
20%. The company currently has an overdraft limit of Ksh250 million. Last year, as a
condition for renewing the facility, you took a debenture as security with a formula of 1
½ times cover of the overdraft by debtors, and 2 ½ times by debtors and stock. Recently,
there has been pressures on the limit, excesses have occurred and the debenture formula
has been breached. You wish to review the limit and called the directors for a meeting.
The directors tell you that:
i) They require an increased overdraft limit to Ksh300 million
ii) Their creditors are of the opinion that they should write down the
value of stocks by Ksh 150 million.
iii) They with the debenture formula reduced to debtors figure, and
stocks plus debtors figures.
iv) They provide the following audited accounts in support of their
request.
Matangi Limited
Balance Sheet As At 31st December
2008 2009 2010
Ksh ‘000’ Ksh ‘000’ Ksh ‘000’
Current Assets
Cash 1,061 1,070 967
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Debtors 324,187 334,640 295,847
Stock 426,460 383,223 423,038
751,708 718,933 719,852
Current liabilities
Creditors 249,497 246,479 228,758
Bank 164,771 138,910 220,013
79,499 59,488 55,779
493,767 444,877 504,550
Net current assets:
Fixed assets:
Leaseholds 271,167 40,472 51,281
Plant and machinery 150,900 190,837 195,356
178,067 231,309 246,637
Net assets 436,008 505,365 461,939
Financed by:
Share capital 75,000 75,000 75,000
Profit & loss account 361,008 430,365 386,939
436,008 505,365 461,939
Profit & loss Account summary:
Sales 1,303,816 1,406,408 1,124,685
Gross profit 144,273 206,515 71,374
Net profit / loss 71,514 25,197 (39,732)
Accounting ratios
Current ratio 1.52:1 1.62:1 1.43:1
Acid test 0.66:1 0.75:1 0.59:1

Credit given (days) 91 87 96
Credit taken (days) 170 169 192
Stock turnover (days) 134 117 147
Gross margin % 11.1 14.7 6.3
Net margin % 5.5 8.9 (3.5)
Net gearing % 36 27 47
Interest cover 3.8 4.3 -
Required
Appraise the request and give your recommendations.
5.7 References
of Bankers.
Publication Data
64
LESSON SIX: PROPLEMS WITH CORPORATE LENDING
Specific objectives
a) Identify problems with corporate lending at an early stage
b) Define what action to take when problems arise
c) Know what action to take to minimize loss on problem accounts
6.1 How to Identify Problems Early

Unlike most retailers, lending bankers cannot sit back and relax once the product has
been sold. The risk continues until the borrowing is fully repaid, and regular monitoring
of the accounts is necessary to spot the vital early warning signs which may indicate that
a formerly profitable account is about to turn into an expensive write-off. The earlier
problems are identified, the sooner corrective action can be taken. It should be obvious
that the bank must automatically monitor the customer’s actual performance against his
budget and cash flow forecast. To this end a condition of lending is often that up-to-date
management figures be produced to the bank within a certain period. At the same time
assessments of debenture values should be updated, and formulae monitored. Any
excesses over agreed limits must also be invested promptly. But what other areas can you
keep an eye on to help avoid unpleasant surprises?
6.2 Danger Signs

You need to watch the following areas. If any of the signs appear it does not
automatically signify problems but could do, particularly if several appear close together.
Internal records
Look for:
 Unauthorized excesses.
 Turnover increasing or decreasing unusually
 Hard-core borrowing appearing on current accounts
 Unpaid cheques in and out;
 Cheques for round amounts
 Uncleared effects – possible cross firing.
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 Special collections in or out
 Status enquiries in or out
 County court judgment.
 New standing orders / direct debits to finance companies.
 Stopped cheques in and out
 Unusual cash withdraws
 Local news, rumour, information from staff about problems.
Visits or interviews
Look for:
 Difficulties in getting hold of directors
 Lack of long-term plans
 Failure to meet orders
 Reliance on one supplier or customer
 Buying goods offered cheaply without forward planning
 Diversification
 Delays in cash coming in
 Request for release of security (particularly third party)
 Changes in terms of trade.
 Idle assets (effect on return on capital employed)
 Dead stock
 Pressure from creditors
 Management changes, succession, balance, ability to react to changes.
 Changes in attitude since last meeting
Audited accounts
Look for
 Evidence of new borrowing elsewhere
 High gearing
 Small surplus or losses
 Accounts late or only draft
 Two sets of accounts
 Auditors changes or unusually high audit fee
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 Auditors’ certificate qualified
 Other bankers
 Revalued assets
 Figures not tying in with management accounts or debenture figures
Management accounts
Look for
 Late, non-existent or sketchy accounts
 i) Debenture formula breached
 ii) Figures not tying in with previous figures or with last audited accounts
 Increase in preferential creditors
 Targets not met
 No assumptions with forecast
 Losses
 Margins of safety small or reducing
 Customers lost or not well spread
 Pricing by guesswork
 Arithmetic wrong
6.3 Action to be taken as soon as Possible

If the above monitoring confirms that there is cause for concern, then you must take
prompt and positive action on the following lines.
 Discuss matters with the customer. Very occasionally warning signs can mislead
and you will find that there is no problem.
 Collect as much information as possible
 Consider what is known – do you need to know more?
 Check your existing security – is it compete and effective?
 Set objectives for the way forward. At this stage you may have to decide t accept
some eventual loss.
 Obtain the borrower’s understanding of, and commitment to, any plans for
repayment, particularly timing and amounts. Get agreement in writing if possible.
67
 Take firm control of the position. If agreements are not carried out by he customer,
take speedy and firm action. Do not make threats you cannot or will not carry out if
needs be.
 Keep your superiors/head office advised of the situation, taking care to obtain their
permission (if required) for any legal action.
6.4 Remedial Action

Financial difficulties in businesses usually arise in the first instance through lack of
cashflow rather than lack of profits and in the long, running out of cash is the most
common cause of insolvency. If a company is having problems, then it needs first of all
to improve its cashflow by improving profit margins or fully utilizing business assets. A
good way to examine the possibilities is to take a close at the main constituents of the
balance sheet and profit and loss account to see where improvements can be made.
Example 6.1
Spinster Wools Ltd manufacture hand knitting wool yarns mainly sold direct to retailers.
They have banked with you for over 30 years and until recently have always been
profitable; despite periods when had knitting has gone out of fashion.
Two years ago there was a sudden drop in the market for hand knitting wools. The
directors of Spinster expected this drop to be temporary, but market conditions have
continued to worsen. A recent article in the Financial Times has speculated that the
market for hand knitting wool might reduce by a further 20% before any recovery takes
place.
The company currently has an overdraft limit of £500,000. Last year, as a condition of
continuing the facility, you took a debenture as security with a formula of 1.5 times cover
of the overdraft by debtors and 2.5 times debtors and stock. Recently there has been
pressure on the limit, excesses have occurred and the debenture formula has been
breached.
The directors have sent you copy of draft accounts for 2006. They now call and tell you:
a) They require an increased overdraft limit of £600,000 to see the company over the
traditionally poor summer sales period.
68
b) Their auditors are of the opinion that they should write down the value of stocks
by £300,000.
c) They will be unable to restore the debtor element of the debenture formula and, if
the stock write down takes place, will not be able to be reduced to 1 times debtors
and 2 times debtors and 2 times debtors and stock.
Set out, with reasons, the response you would make to the directors of Spinster Wools Ltd
and also your immediate action plan.
To do this you must have a clear understanding of ratio analysis and a deal of common
sense. You should address the following issues – but remember, the list is a prompt, not
an exhaustive summary.
 The company’s previous history.
 The market within which the company now operates.
 The quality of its management.
 The nature of its stock.
 An assessment of the ratios you are given.
 Which ratios will be affected by the stock write-off?
 The nature of the company’s debtor book
 What is the effect of relaxing the debenture formula?
 How safe is the bank at the present limit?
 How safe will the bank be at the requested limit?
 Would you agree to help as requested? If not, what?
Ratios
2003 2004 2005 Draft 2006

Current ratio 1.52:1 1.62:1 1.43:3 1.31:1
Acid test 0.66:1 0.75:1 0.59:1 0.55:1
Credit given (days) 91 87 96 101
Credit taken (days) 170 169 192 222
Stock turnover (days) 134 117 147 148
Gross margin (%) 11.1 14.7 6.3 4.6
Net margin (%) 5.5 8.9 (3.5 (6.9)
Net gearing (%) 36 27 47 64
Interest cover (times) 3.8 4.3 - -
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Debentures Figures (2005 (£000)
Jan Feb Mar Apr

Debtors 623 614 595 582
Stock 798 805 821 840
1421 1419 1416 1422
Bank overdraft 470 511 505 499
Creditors 621 601 616 642
Liquid Surplus 330 307 295 281
Net capital expenditure since last - 2 - -
report
Spinster Wools Ltd.

Balance Sheet at 31 December
2003 2004 2005 Draft

2006
Current Assets 2112 2139 1933 1290
Debtors 648374 669281 591695 588071
Stock 852919 1503415 766446 1437866 846077 1439705 818302 1407663
Current liabilities
Creditors 498993 492958 457516 572078
Bank overdraft 329541 277820 440027 498847
Current tax 90915 29895 54737 -
Future tax 68083 987532 89080 889753 56821 1009101 - 1070925
Net current assets 515883 548113 430604 336738
Fixed assets
Leasehold 54334 80944 102561 98732
improvements
Plant & machinery 301800 356134 381634 462618 390713 493274 342710 441442
Net assets 872017 1010731 923878 778180
Financed by
Issue share capital 150000 150000 150000 150000
Profit & loss 722017 860731 773878 638180
account
872017 1010731 928878 778180
Profit & Loss account summary
12 months to 31 2003 2004 2005 2006

December £ £ £ £
70
Sales 2607632 2812816 2249371 2122381
Gross profit 288546 413030 142748 973633
Net profit (loss) before 143028 250393 (74464) (145698
tax
Solution
Background information
This is a long-standing customer whom you would wish to help if possible. The business
has a track record of good performance and profitability. But, it is a one-product company
trapped in a declined market. Market conditions are unlikely to improve in the immediate
future. The management do not appear to be doing very much about the situation i.e. no
redundancy programme etc.
Financial analysis
Capital structure
Gearing is at acceptable levels but is deteriorating and after the stock write-off is likely to
get worse. Capital expenditure appears to have been financed by short-term borrowing.
There will be a further reduction in Net Total Assets (NTAs) if the stock write-off takes
place which it obviously should). The true NTA figure has probably been overstated in
the recent past if the stock has been overvalued.
Liquidity
Current ratio and acid test are deteriorating steadily but on the audited figures are still just
about at acceptance levels. However, the debentures figures indicate that this will not be
the case after the stock write-off. Credit given is rising: this is a surprising trend given the
company’s need for cash. Are all the debtors good?
Stock taken is rising to uncomfortable levels and there is probably creditor pressure.
Stock turnover is poor, reflecting the unsaleable stocks identified by the auditors.
Profitability
The gross margin has deteriorated steadily suggesting increasing pressure on prices in the
poor market. The net losses are getting worse as sales fall and margins are squeezed. The
debenture figures indicate further losses despite the winter being the ‘good reason’. With
the predicted further market fall and the advert of the poorer summer season things are
going to get worse rather than better.
Bank account
71
The pressure on the limit and the excesses suggest creditor pressure.
The debenture figures show a hard-core not far short of the limit.
The increased limit is needed to meet the cash shortfall but there ought to be some
detailed projections made.
Security
The debenture formula has been breached (the debtor element) for some months and it is
arguable that the bank has been slow to react. There is no way the formula can be
maintained in the foreseeable future but would the bank be safe if it was relaxed as
requested?
The debtors are the best asset but small wool shops are probably having a hard time as
well. Are they good? You need a detailed analysis.
A break-even would look something like this:
£ ‘000
Debtors: 60% of April deb. figure 349
Stock: 20% of April deb. figure 168
Plant & machinery: 20% of draft a/c figure 78
595
After receivership expenses, preferential etc, you are probably only just covered now.
Would other security be available, e.g. directors’ guarantees?
Decision
There is a dearth of good management data on which reach a conclusion where more
information is needed. Losses are likely to continue so the bank’s risk will increase
further if nothing is done. Relaxing the debenture formula is the same as releasing
security at a time when risk is increasing and would be agreed with great reluctance. A
thorough investigation of the company is required, investigating accountants should be
appointed. Overall it is difficult to see how receivership can be avoided.
Services
In this situation, it is that any services would be marked. This question requires an
appreciation of the risks of rapidly expanding an under capitalized business, the risks in
documentary credit liabilities and the problems of high fashion goods as security.

1. In what areas should danger signs be sought?
72
2. Once danger signs have been identified, what aspects should be monitored monthly, so
that early action can be taken if necessary?
3. Once you are sure that there is cause for concern, what actions should be taken?
4. At what stage should unsatisfactory accounts be got rid of?
6.6 References
of Bankers.
Publication Data
73
LESSON SEVEN: FINANCE FOR FARMERS
Specific objectives
a) Explain the differing needs for various types of farming customer
b) Appraise and assess requests for borrowing from farmers
c) Describe what security available to cover such borrowing
7.1 Appraisal of farming customers

The financial statements of a farming business
These consist of:
 Audited accounts for the past three years.
 A specially formulated ‘farmers balance sheet’ or ‘statement of assets or liabilities’,
usually on the bank’s standard forms.
 A cash flow forecast (supported by operational and capital budgets).
 Gross margin budgets.
 A calculation of the ‘rental equivalent’ of the business – this can be expressed as a
cost per effective ace or as a percentage of gross output.
We examine each of these in due course.
Before lending to a f arming customer, you will wish to take a close look at the far m
and the farmer and a visit to the far m is essential to investigate the:
 Effective acreage of the farm, ignoring nonproductive areas of building,
woodland, water etc.
 Quality of stocking and cropping on the farm.
 Layout of the farm – accessibility of fields for milking, convenience for
ploughing etc.
 Capacity and condition of buildings – housing for animals and storage for crops/
 Farmer’s experience and management ability.
 How close is the farmer to the business? If not very close, has he good quality
staff and communications in places?
 What succession plans has the farmer put into operation – family managers/
74
 Check budgets against past performance!
7.2 The Farmer’s Audited Accounts

The accounts may well be historic but it is well worth looking at the balance sheet The
following simplified balance sheet illustrates what can be revealed and whether certain
items might require further investigation.
Liabilities £ Assets £
Rent outstanding 3500 Debtors 2000
Bank 14400 Stock 40320
Creditors 3150 Tenant right 5000
21050 (b) 47320 (d)
Capital net worth 30070 (c) Farm machinery 3800
51120 51120 (a)
i) Total assets (a) – are there any intangibles or fictitious assets?

ii) Total debts (b) – debt structure long / short-term?
iii) Total assets (a) : total debts (b) – debts should be well covered.
iv) Net worth (c), i.e. total debts minus total debts. This is the margin or buffer for the
business. (This could well be understated).
v) Total assets (a) current assets (d) – what is the proportion of quickly realizable
assets?
vi) Current assets (d): total debts (b) – this represents the liquidity of the business.
Can current debts be repaid without resorting to sale of fixed assets?
Then after examining the trading and profit and loss account record:
 Stock: sales turnover – dependent on type of farm enterprises.
 Debtors: sales – debtors figure in farming should be well covered.
 Profits – are they being earned and retained? Look at the resulting profit and loss
account balance.
Then the bank lending
 Net worth: bank lending
 Net worth: total liabilities – is the balance being maintained or deteriorating?
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All these ratios become more meaningful when you compare trends over several years’
balance sheets, It is dangerous to make a judgment on the year’s figures in isolation.
Limitations of audited accounts
Some of the limitations are:
 Purpose. The accounts are often prepared for taxation purposes only. They may
therefore not give a true indication of the net worth of the business.
a) Land, building an machinery may well be undervalued on a cost less depreciation
basis.
b) Stock may be undervalued and the accountant could accept the farmer’s valuation
without verifying this.
c) Sales involves could be carried forward into the next accounting period, therefore
reducing profits earned.
 There may be long delays between the date of audit and the date to which the
accounts refer. They may well be 12 – 18 months out of date before you see them.
 Individual firms of accountants may apply different interpretations to certain items
in the accounts.
 The basic of valuation of a number of items may differ from the current value.
However you could express these reservations about the accounts of many other
businesses.
7.3 The Farmer’s Confidential Balance Sheet /Statement of Asset and Liabilities.
This is a management document and not an audited financial statement which provides
an up to date statement of the:
 Assets and liabilities of the farmer’s business, at realistic market values; and
 Net worth of the business, which is the difference between total assets and total
liabilities, also at a realistic market value. The net worth of the business is the
value of the proprietor’s stake.
Specimen farmer’s balance sheet
Name: G Giles Bank: arm Bank plc
Farm address: Home farm, Kitale
Farm area: Owned Tenanted Rent
Crops 100 - £ per acre
Grass 150
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Other 0 - Landlord
250 -
Estimated effective acreage: 250

Livestock £
Cattle: Dairy cows 100 @ £ 400 40,000
Heifers 25 @ £ 360 9,000
Young stock 50 @ £ 140 7,000
Bulls 3 @ £ 1,500 4,500
Sheep - -
Pigs - -
60,500
Produce for own consumption: £
- tons corn
30 tons hay @ £ 40 1200
80 tons silage @ £ 15 1200
2400
Growing crops:
Acres Crop Total value (£)
40 Winter wheat @ £ 70 2,800
20 Spring barley @ £ 50 1,000
3,800
Stored produce for sale

Tons Crop Total value (£)
60 Barley @ £ 100 6,000
Farm machinery
Date of purchase Item Cost Market value (£)
19 x 3 milking equipt. 5,000 4,500
19 x 5 Tractor 8,000 10,000
19 x 7 Tractor 14,000 14,000
28,500
Balance sheet at 30 June 20 x 8
Liabilities £ Assets £
Bank overdraft 15000 Cash -
Bank loan 25000 Debtors 3000
Trade creditors 3500 Grants due -
Hire purchase -Stock livestock 60500
Produce for sale 6000
Mortgages (AMC)* 100000 Produce for own consumption 2,400
Private loan 10000 Seed/feed/fertilizer 2000
Sub total 153,500
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Valuation
Growing crop 3800
Tenant’s right -
Sub total 77700
Net worth (balance) at 30.6 x 8 452700 Land & building 250 acres @ 500000
2000
Machinery 28500
606200 606200
Other items
Contingent liabilities None
Leasing None
Non farming assets Endowment policy with a current surrender value of £ 4,800
*Agricultural Mortgage Corporation plc
In the case of dairy farmers it would be appropriate to note the amount of quota allocated
and its open market value.
Interpretation of farmer’s statement

A farmer’s balance sheet, if prepared annually, gives an indication of changes in the net
worth of the business over time. Increases in net worth would indicate either retained
profits or an increase in the valuation of fixed assets. The net worth of a business gives an
up to date market valuation of he farmer’s investment in his business.
Te farmer’s balance sheet also gives a picture of the asset structure of the business and
the value of assets per acre. Since freehold land is very expensive, it will be more useful
for comparing the assets of a farm against what is ‘normal’ to calculate the value per acre
of total assets less freehold land and building i.e. ‘tenant’s assets per acre’.
The normal ‘value’ will vary from region to region and between different f arming
activities (daily, arable etc). The value of tenant’s assets per acre of the farm under review
can be compared with that of other farmer customers.
7.4 Farmer’s Assets

The assets of a farm will depend on whether a farm is owned or tenanted and on the type
of farming undertaken.
Physical assets
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Note of the following physical assets shown in a farmer’s balance sheet.
 Land and building – if owner occupied, land will be the major item.
 Farm machinery
 Livestock
 Crops in process of growing – usually valued at cost of valuable inputs (seed,
fertilizer etc) consumed to get them to present state.
 Harvested crops not yet sold.
 Harvested crops kept for own consumption e.g. animal feed such as silage or hay.
 Stock of fertilizer, seed, purchased feed, pesticides etc.
The farmer’s balance sheet will of course also include such items as debtors, creditors,
cash or bank overdraft.
Hidden assets and farmland values
There may be a hidden reserve in the valuation of the farmland. This must be taken into
account when assessing the customer’s stake in a lending proposition. Examples are:
 The farmer owns the land, but the value in the audited accounts is below its current
market value.
 A tenant farmer buying land he currently rents will pay less than the open market
price with vacant possession, the landlord usually making allowance for the tenant’s
improvements to land and buildings.
7.5 Rental Equivalent

The most important financial statements for assessing the ability of the farmer to service
a loan are the budget and cash flow forecast. A rough and ready guide to help with
assessing the farmer’s ability to repay is an estimate of the farmer’s rent and finance
charges per annum, referred to as the ‘rental equivalent’ of the business.
The total rental equivalent per annum is then divided by the total acreage to obtain a
‘rental equivalent’ per acre. It is useful to discuss this with the farmer who usually has a
‘gut feeling’ as to the level of rental equivalent per acre that he can cope with
successfully.
The figure is calculated by including the following charges per annum.
£
79
a) Rent and rates X
b) Bank overdraft interest X
c) Bank loans interest and capital repayments X
d) Agricultural Mortgage Corporation - interest and capital repayment X
e) Hire purchase charges X
f) Leasing charges X
g) Merchant credit charges X
h) Private loans – interest and capital X
Total rental equivalent X
This total is then divided by the effective acreage. If the rental equivalent is high, you
might suspect that the farmer would struggle to meet his loan repayments. So what figure
is high? (Effective acreage is that which is used for agriculture, excluding roads, farm
steading, scrub and woodland).
The interpretation of this rental equivalent depends on the type of farm and farming
system. As a general guide, £ 50 per acre if often talked of as a figure below which
servicing could not be too difficult. Above £50 per ace needs a closer look. This is only a
general guideline – so be careful, more is said about this later.
The rental equivalent per acre is a cost per acre that does not take into account the value
of the income earned from the land. A further guideline for ‘serviceability’ is therefore
rent equivalent as a proportion of gross output where gross output is defined as total farm
returns plus the value of produce used for farm’s own consumption less purchases of
livestock and other products bought for resale.
The guidelines that might then be applied are that if the rental equivalent as a proportion
of gross output is:
 Less than 10% there should be little problem about servicing the loan
 Between 10% an d 15% - this is usual
 Between 15% and 20% - This is a little on high side and needs investigation
 More than 30% - this is high.
Rental equivalents: example
Worzel Gummidge farms 190 acres of land, half of which is rented and half owned. In the
year of 30 September 20 x 4, his costs included the following:
80
£
Rent and rates 4,200 (to rise to £ 4500 next year)
Agriculture Mortgage
Corporation interest:
£ 28,800 x 13% 3,744
Bank overdraft interest 1,156
Interest on a private loan 1,000
10,100
The AMC loan outstanding at 30 September 20 x 4 is £27,000. The interest rate on the
loan is 13%. Capital repayments on loan amount to £1,800 per annum. He would now
like to purchase a further 10 acres of land, and to borrow £9,000 from his to do so.
The bank would lend him money at 3% above base rate which is currently, say, 9% for a
term of 10 years. Interest on the bank loan in the first year would be 12% x £9,000 - £
1080 but this ignores capital repayments. The annual repayment on a loan will be
calculated approximately using the usual formulae or tables provided. In case it works out
at approximately £ 1,600 per annum. Of this, £1,080 will be interest in the first year and
£520 capital repayment.
Rental equivalent example: calculations
Mr. Gummidge therefore predicts his rent and rates and finance costs for the coming year,
with the bank loan to be:
£ £
Rent and rates 4,500
Agricultural Mortgage Corporation interest 3,500
(13% x £27,000)
Capital repayment 1,800
5,310
Bank loan interest 1,080
Capital repayment 520
1,600
Bank overdraft estimate 1,000
12,410
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(Note that whereas interest is charged against the farm’s profits, capital repayments are
not. The farm will need to generate sufficient cash flow out of profits plus depreciation
minus drawing, to make the capital repayments).
The rental equivalent per acre can now be calculated:
Year to 30 September
19X4 19X5
£1,800* + £10,000 £12,410
190 acres 200 acres
Rental equivalent £ 63 £62
*Capital payment to AMC
To decide whether or not these rental equivalents are high, you can:
 Express the total rental equivalent as a percentage of this gross output of the farm as
described above;
 Compare the rental equivalent per acre with ‘standard’ values for the rental
equivalent for Mr. Gummidge’s particular type of farming.
You cannot be expected to remember all typical ‘standard’ rental equivalents in the
examination room and so, as a very general guideline, it might help to assume that:
 Rental equivalent per acre if £50 – 60, this average:
 Rental equivalent per acre is £ 70 – 80; this is high and only a good farmer could
possible manage to bear such costs successfully.
In the example of Mr. Gummidge, the rental equivalent per acre will be about average,
perhaps and so bank would not reject his lending proposition on the basis of high rental
equivalent. As with all ratios, the trend should be studied.
7.6 Other Calculations to Aid Assessment

Net worth trends
On examining a farmer’s statement, check quickly that the up-to-date net worth figure is
in excess of 60% of total assets. Lower than this may be a danger sign, but the trend from
year to year is more important and any fall in this percentage figure requires explanation.
82
Asset structure: tenant’s assets / acre
Use this formula to check how efficiently the farmer is using his assets. To give good
comparisons with other farmers who may be tenants or owner-occupiers, you should
exclude the value of land and property so that you are comparing like with like. A rough
average figure is £400 worth of tenant’s assets per productive acre (£1000 per hectare
),but variations between £300 and £600 per acre are seen ,depending on type of farming,
with dairying being at the top end of the scale and livestock at the bottom. Too high a
figure suggests that assets are being wasted unproductively; too low, that the land could
perhaps produce more, given more tenant’s assets. Farming bankers can quickly build up
their own files of typical local assets/acre figures for different types of farm.
Gearing
This is the relationship between total borrowings (including all borrowed funds,
irrespective of length of credit allowed) and the net worth of the business. For tenant
Farmers a ratio approaching or exceeding 1:1 will be very difficult to cope with unless
very high productivity and profitability is present. Much depends on the make-up of the
assets and liabilities, and owner-occupied land values complicate the calculation and you
may disregard them if necessary for comparative purposes.
7.7 Monitoring and Control of Farming Advances

In the past, as long as they were fully secured, banks have tended not to worry about their
borrowing farmers. However, conditions have become more difficult for farmers, and
there has been an increase in the failure rate of farming enterprises since the fall in land
prices in the mid 1980s.Nowadays it is important to treat farming as any other business,
with less emphasis on security.
7.8 Security for Farm Lending

If the land is owner occupied a first or second mortgage over the land can be taken.
Some farms are operated by limited companies, in which case the usual fixed and floating
charge may be taken. However, most farmers operate as sole traders or partnerships and
in addition to the usual forms of security, the following special types of security for
farming advances should be considered:
a) Agricultural (floating) charge;
83
b) Charges over milk sales contracts;
c) Agricultural credit corporation guarantees
An agricultural (floating) charge
Such a charge covers all the farmer’s farming assets, including crops, animals and
farm machinery. It does not capture debts due to the farmer, or EC milk quotas, which
are a personal asset of the farmer, and are of particular value, nor does the charge
cover the land. Otherwise, similar rights to those under a limited company debenture
are obtained, including the power to appoint a receiver to take over and realise assets.
The disadvantages of an agricultural charge are that farmers try to resist giving them, in
the belief that registration will damage their standing in the farming community and
that if a receiver is eventually appointed the farm and stock ill already be run down and
landlords or bailiffs for other creditors may have seized stock already.
Charges over milk sales contracts

These are useful in controlling an important debtor not covered by the agricultural
charge. This ensures that milk proceeds come direct to the bank. Where farmers have
regular contracts to supply produce, then charges can also be sought over these contracts
Agricultural credit corporation guarantees

These are available sometimes from this government backed body to support a farmer’s
borrowing from a bank. It is similar to the small firms’ loan guarantee scheme in that it
tends to support farmers needing finance for viable plans. It is normally provided for
tenant farmers who cannot offer land as security
Example 7.1
You have recently been appointed manager at the branch, and you note that farmer
Brown’s overdraft facility of £15000 is due for renewal next month. You read the file and
find that the only information available is a balance sheet (audited) dated March 2006.
The figures are as follows:
Balance sheet at 31 March 2006
(Audited on historic account basis)
liabilities £ assets £
84
rent outstanding 3,500 Debtors 2,000
Bank 14,400 Stock 40,000
Creditors 3,150 Tenant right 5,000
Farm machinery 3,000
21,050
Capital/net worth 30,070
51,120 Total Assets 51,120
You arrange to visit the farm, and during your meeting farmer Brown gives the following
information relating to the farming enterprises on his tenanted farm of 345 acres-rent
payable£ 6,400 per annum: total gross output last year £103,500.
Dairy herd-100 cows, estimated market value £500 each

Young stock-60 heifers, estimated market value £300 each
Sheep-200 ewes, estimated market value £80 each
Lambs-180, estimated market value £25 each
Growing crops-20 acres winter wheat input costs £65 per acre
-12acres spring barley input costs £48 per acre
Farm machinery (tractors)-estimated market value £13,000
Current debtors £2,000
Creditors £2,150
Rent Outstanding £2,000
Bank £13,900DR
Farmer Brown then tells you that he has the opportunity to purchase 30 acres of land
(which he currently rents)
at a discounted price of £1,000 per acre. He asks if you will assist with the purchase
a) Evaluate the request for additional facilities.
b) What would be your decision? Give reasons.
Solution
Evaluation of request
(i) Gut reaction
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Farmers audited accounts are often out of date, so you need to complete an up to date
balance sheet on current market values. You know that farming is experiencing some
problems, but you wish to help Brown to obtain land at a discounted price.
(ii) Value of land
Has Brown obtained an independent professional valuation of the land to substantiate its
value and the ‘discounted price’? Farm land values vary throughout the country, but
speaking the minimum value is £1,200 per acre.
(iii) Gearing The farmer’s balance sheet would appear to be:
£ £
Rent 2,000 Cows 50,000
Bank 13,900 Heifers 18,000
Creditors 2,150 Lambs 4,500
18,050 Ewes 16,000
Capital 92,326 Crops 1,876
Tractors 13,000
Debtors 2,000
Tenant right 5,000
110,376 110,376
Check current prices of stock/crops in Farmers Weekly
Current gearing 15%
Proposed gearing (assuming overdraft to limit) 48%
But proposed gearing ignores any ‘hidden reserve’ in land
The proposed gearing level is reasonable
Farm assets per acre
103,376 = £300. Seems a little below the normal £400
345
(iv) Rent/finance charge per acre and as % of sales
Present Proposed
Loan repayments - 4,400
(15 year period if Brown is
young enough)
Overdraft interest 2,400 2,400

(15,000@16%)
Re nt 6,400 5,845 {6,400* 315}
345
Total rent/finance charge 8,800 12,645
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Total rent/finance charge per acre 8,800 = £26 12,645 = £37
345 345
Total rent/finance charge as % of sales 8,800*100 = 8.5% 12,645*100 =

12.21%
103,500 103,500
Rent /finance per acre and as % of sales are well within the normal maximum of £50 and
15% respectively. From the above, the proposition seems viable. Base rate taken at 13%
and the margin is 13% over base rate.
(b) Decision
Agree, subject to:
i) Professional valuation to support land value
ii) Mortgage of land
iii) Gross margin budget to support viability, together with cash budget
iv) Keyman insurance
v) Possibly pension linked mortgage
vi) Sell trust company services, to assist estate planning for inheritance
As you are lending £15,000 unsecured, you should presumably be happy if the land value
was sufficient to cover the loan account. If necessary take an agricultural floating charge.

1. What is a farmer’s statement or farmer’s balance sheet’ amd how does it duffer from
audited accounts. (Obtain and study a copy of your own bank’s form)
2. Give brief details of three types of security specifically appropriate for farmers
3. You are manager of a branch that serves a predominantly agricultural community. You
recently visited Mr. Kiptanui, a long standing customer, and during your conversation
you were able to confirm the request for an annual overdraft of KES 1 million pending
receipt of tea and coffee bonus payment. However, Mr. Kiptanui also enquired whether
your bank would be able to assist with a 10 years loan in connection with the purchase of
the farm. He tells you that his landlord died recently and the executors of the estate are
prepared to sell the farm at KES 100,000 per acre.
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Mr. Kiptanui is 60 years old, married and with two sons aged 12 and 17. At the moment,
he rents the 50 acre farm at KES 5,000 per acre annually. The firm is equally divided
between tea and coffee farming on one hand and dairy farming on the other. Currently, he
has 100 dairy cows. He always replaces his dairy cows from his own young calves but
bull calves are sold. Beef production is not part of the enterprise. Mr. Kiptanui enjoys a
good reputation in the local farming community. He has already raised KES 1.5 million
from his personal savings towards the purchase price. Mr. Kiptanui has also presented his
balance sheet to you as shown below.
Balance Sheet as at 31 December 2008
Bank KES’000
Trade creditors 1,200
Capital Account 300
10,350
11,850
Current Assets:
Stock 4,000
Plant &Machine 4,500
Tenant’s rights 2,500
KCC 550
KTDA 150
KPCU 150
11,850
Budget for 2009
Income KES’000
Milk Sales 6,600
Calf Sales 480
Coffee & Tea 1,080
8,160
Expense:
Personal Drawings 400
Labour 600
Rent & Rates 1,000
Fertilizer & Spray 600
Animal Feeds 2,350
Repairs & fuel 600
Interest 100
Depreciation 500
Net profit 2,110
Prepare a response to Mr. Kiptanui’s request.
b). Explain five disadvantages of agricultural charges
88
4. (i) Explain the following terms as used in agricultural lending
Rent equivalent, gross margins, farmer’s balance and keyman insurance
(ii) Describe the procedure for taking agricultural charges
7.10 References
of Bankers.

Publication Data
89
LESSON EIGHT: TRADE FINANCE
Specific objectives
a) Identify various types of bank facility specifically designed to assist importers
and exporters
b) Highlight some of the unique dangers facing importing and exporting customers
8.1 Finance for Exporters: Overdrafts / Loans

In addition to usual secured or unsecured loans and overdrafts in sterling, the same
products can be made available to customers in foreign currencies. If non-sterling
facilities are taken, the exporter should ensure that he has income in the currency of the
borrowing with which to make repayments. If he has to use sterling income to repay
currency loans, then he exposes himself to possible adverse currency movements.
8.2 Other bank Finance for Exporters

Advances against bills of exchange / collections
Banks will lead up to 100% with resource against bills, or bills and documents sent on
collection basis. The bills will be hypothecated to the bank as security. In addition, the
bank will take prior status enquires on the drawees, ensure that the goods involved are of
a type suit ale for easy resale, and insist on assignment of the credit insurance on the
transaction.
Negotiation of foreign bills of exchange

Bills of Exchange can be bought by the bank, with resource, for up to 100% of the bill’s
face value. The bank then collects the bill on its own account to repay the loan.
Discounting bills of exchange

Banks will discount accepted bills of exchange up to 100% for customers. Usually the
acceptor will be a first class UK Bank which has accepted the bill under the terms of a
documentary credit for payment at a future date (usually 30, 60 or 90 days)
90
Beneficiary under documentary credits
A bank will lend to a good customer who is due to export under a documentary credit,
usually to enable him supply the goods for the export transaction. The bank must be
happy that the customer can comply with the terms of the credit in every respect.
Resource to the customer is maintained.
Smaller exports scheme
For customers with low export turnover (say £ 2m or less) banks will provide ‘non
resource’ finance under an umbrella policy held by the bank. The bank in effect,
negotiates bills drawn by customers for exports. Providing the customer has fully carried
out the export transaction, and then the bank’s policy will pay out if the bill is not paid. If
the customer has not complied with the commercial contract or policy rules, then the
bank reserves the right of eventual resource against the customer. The main issuer of
short-term (up to two years) exporter policies is now NCM Ltd. which took over from
ECGD in this field.
Short-term finance for exporters

This is similar to the smaller exports scheme, but for customers with larger turnover and
their own export credit policies. Buyers may benefit from credit terms up to two years.
Medium – term supplier credit

Where the supplier gives his customer credit for between two and five years (usually for
capital exports), ECGD will guarantee to refund the bank up to 85% of the transaction if
it provides finance. A 15% deposit from the buyer is taken in advance.
Example 8.1
Fatties Ltd manufactures and sells ladies clothing in larger sizes. The company has
banked with you for over 20 years.
The management of the business has until recently been in the hands of the two main
shareholders. Fred and Sidney Plump. Two years ago they decided to appoint a new
Marketing Director, Mrs. Stout, as they felt that the selling of their traditional garments
needed revamping. Mrs. Stout has identified an expanding market for higher fashion
outsize garments particularly through mail order companies.
91
The company did not have the manufacturing capacity to meet any significant extra
demand and the directors decided to import the additional garments from suppliers in
Hong Kong. The Hong Kong manufacturer were only prepared to supply Fatties and give
the company the 60 day credit terms it was seeking, on the basis that it established
irrevocable documentary credit limit. These have been of short duration and you have not
returned any cheques.
You are currently providing Fatties with an overdraft and /or documentary credit limit of
£250,000. As security you have been of short duration and you have not returned any
cheques.
The company shows its new designs to customers about six months in advance of the
expected delivery of the garments. It has just completed the showing to customers of its
spring 1997 designs. There has been a high level of interest I these from mail order
companies who have been a high level of interest in these from mail order companies
who have placed a better than expected level of preliminary orders.
The directors are forecasting sales of £1.3m for the next six months and expect to import
more from Hong Kong to meet demand. They call to see you to ask for an increase in the
combined facility to £450,000. They produce financial information, including
management accounts in the form of projected balance sheets covering the next six
months.
How would you respond to the directors’ request?
Fatties Ltd
Balance Sheets
31.3.04 £ 31.3.05 £ 31.3.06 £ Mngt £
£ £ £ Accts
30.9.06
£
Current assets
Cash 231 185 164 211
Debtors 144815 163454 216145 207672
Stock 233615 378661 234669 398308 298038 514347 311775 519658
Current liabilities
Creditors 109761 172401 163916 221731
Hire purchase 3422 2318 18046 20904
Bank 173253 120554 209887 189912
Directors’ loans 13369 13470 16414 16414
Current tax 330 300135 360 309103 14600 422863 14600 463561
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Net current assets 78526 89205 91484 56097
Fixed assets
Freehold b’dings 53037 53313 58814 73058
Plant & machinery 88637 141674 97050 150363 112529 171343 157712 230770
220200 239568 262837 286867
Long term
liabilities
Mortgage loan 18500 18500 18500 18500
Deferred taxation 39300 57800 41970 60470 41150 59650 41150 59650
Net assets 162400 179098 203177 227217
Financed by:
Share capital 1000 1000 1000 1000
Profit & loss a/c 161400 178098 202177 226217
S’ holders’ funds 162400 179098 203177 227217
31.3.04 31.3.05 31.3.06 6 mths to

£ £ £ 30.0.96 £
Sales 993520 1242218 1528531 1009327
Cost of goods sold 775510 974238 1249363 827822
Inc. purchases 325308 403835 853984 589887
Gross profit 218010 267980 279168 181505
Interest 10981 16661 18734 13928
Net profit before tax 38652 24967 37755 24040
Ratio and other information

31.3.04 31.3.05 31.3.06 30.9.06
Liquidity
Credit given (days) 53 48 52 38
Credit taken (days) 123 155 70 69
Stock turnover (days) 110 88 87 69
Current ratio 1.26:1 1.29:1 1.22:1 1.21:1
Acid test .48:1 .53:1 .51:1 .44:1
Profitability
Gross margin (%) 21.9 21.6 18.7 18.0
Net margin (%) 3.9 2.0 2.5 2.4
Financial structure
Gearing (%) 111 73 104 94
Directors’ loans as capital
Interest cover (times) 4.5 2.5 3.0 2.7
Fatties Ltd
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Bank Account
Highest debit Lowest debit Average
£ £ £
2005
October 55641 Dr 38527 Dr 48872 Dr
November 68998 Dr 40324 Dr 58483 Dr
December 152161 Dr 59770 Dr 121206 Dr
2006
January 181.161 Dr 107688 Dr 148599 Dr
February 220.820 Dr 128333 Dr 180168 Dr
March 164883 Dr 124262 Dr 152078 Dr
April 193673 Dr 142272 Dr 173934 Dr
May 221029 Dr 151146 Dr 194370 Dr
June 225230 Dr 173201 Dr 207741 Dr
July 204668 Dr 166101 Dr 184360 Dr
August 182233 Dr 142732 Dr 163271 Dr
September 161111 Dr 121817 Dr 139455 Dr
Turnover Average Balance

£ £
1985 831,047 50786
1986 1,081,717 74274
1987 1255253 81496
1988 to date 1267188 169708
Solution
This question requires an appreciation of the risks of rapidly expanding an under

capitalized business, the risks in documentary credit liabilities and the problems of high
fashion goods as security.
Initial reaction and assessment
The company has banked with you for over 20 years and you will want to help if
possible.
The management is experienced but the expansion strategy is by no means without risk.
Ratios
There is a seasonal aspect to the business and these needs to be borne in mind when
considering the ratios.
The bank account figures suggest March and September are near the low point in the
company’s liquidity cycle.
94
The change in the nature of the business in 1996 will affect the figures and make it
difficult to draw firm conclusions.
Liquidity
Both current ratio and acid test suggest a slow deterioration since the expansion
programme began.
The credit taken figures show a big reduction between 1995 and 1996 but this can be
explained by the change to importing a significant proportion of the garments. Credit
given is steady\: the September 1996 figures are not strictly comparable with the others.
Stock turnover is improving suggesting a possible rise in efficiency. However, this again
may reflect the change from manufacturing to buying a large portion of garments from
subcontractors.
Profitability
Gross margin is declining steadily; is the company buying sales?
Net margin is thin and the company is vulnerable if there is a problem, for example with
deliveries or quality which would affect sales.
There has been a steady pattern of retentions, albeit not at a level to sustain expansion
without a need for significantly increased limits.
Financial structure
There is no obvious trend in interest cover but anything below three times is thin for a
business of this type.
Gearing is high and there is no readily identifiable trend downwards.
The creditors are increasingly taking the working capital strain and a significant element
of this is effectively guaranteed by the bank through the documentary credit liabilities.
Bank account
There have been excess albeit of a temporary nature but there is pressure on the limit.
If seasonal factors are ignored, borrowing is increasing steadily and there is now a
significant hard-core. The projections suggest the worsening trend will continue.
Projections
The requested facility is obviously needed if the projections are correct.
From the balance sheet figures it can be deduced that profit before tax is forecast to be
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£ 107,000 for the next six months, with net profit margin at 8.4%. This looks
exceptionally optimistic compared to past performance.
Management accounts
These appear to be produced quickly so good monitoring information should be
available.
Security
There is a mortgage loan secured on the freehold deeds so that primary security for the
bank is the current assets.
At proposed peak exposure in January 1989 cover will be:
Debtor £ 265,000
Stock £ 580,000
£ 845,000
To cover liabilities:
Overdraft £ 252,000
Documentary credits £ 200,000
£ 452,000
There is therefore 187% cover by current assets including 59% cover by debtor.
The documentary credits have to be included in any security cover calculation as in the
case of difficult they will eventually turn into borrowing.
Security cover is thin. The stock is fashion garments which will probably not raise 25%
of book value on a break up.
Even though the debtors are ostensibly good names i.e. mail order companies, in all
receiverships there are refusals to pay because of disputes over quality etc. 75%
realization would probably be a realistic figure.
Using these figures, debtors would realize £199,000 at peak exposure whilst stock would
only realize £145,000. Ignoring preferential claims and retention of title problems, £
344,000 would be raised to cover exposure of £ 452,000.
Plant and machinery again generally does not realize large sums.
The second mortgage again generally does not realize large sums.
96
The joint and several guarantee of £50,000 from the directors is unsupported. What assets
do they have outside the business?
Analysis and conclusions
The bank’s main short-term risk lies in the company not realizing its sales targets having
invested heavily in high fashion stock.

1. Summaries the main types of bank facility available to exporters
2. What particular precautions should be taken before lending to exporters?
3. What are the main types of bank facility available for importers?
4. Briefly describe how you should control a produce loan
8.4 References
of Bankers.
Publication Data
97
LESSSON NINE: SPECIALIST SERVICES FOR BORROWERS
Specific objectives
a) Recognize where specialist services may appropriately be offered in lending
situations
b) Identify the importance of correctly assessing the needs of borrowing customers
for such services
c) Explain how the correct application of such services can reduce the risk of
lending propositions, both for the bank and the customer
9.1 Services for Personal Borrowers

Personal loan insurance
All banks now offer insurance s to customers for packaged personal lending. The types of
lending under consideration here are personal loans, budgets accounts, revolving credit
accounts, equity release loans and even credit card borrowing. A typical scheme may be
called a ‘loan protection plan’ and would consist of a special insurance package providing
cover against:
Death – loan (less arrears) repaid in full
Unemployment – repayments covered or up to 12 months.
Disability – repayments covered for the remaining period of the loan.
Premiums for the insurance may be paid from the borrower’s own cash resources or may
be added to the loan account and paid in installments. On revolving credit plans and
credit cards, premiums are often debited to the customer monthly based on a small
percentage of the outstanding borrowing.
Mortgage or home improvement loan protection plans
These policies offer protection against similar risks to those covered by package loan
insurances above. As these loans are secured by mortgage over property, the premiums
may be cheaper than that on unsecured loans.
All mortgages, of course, include insurance against death: with endowment mortgages,
the endowment policy offers death cover, with other mortgages the lender will insist on
98
low cost mortgage protection policy being taken out (premiums paid by the borrower) in
case of death during the term of the mortgage. With Pension Linked Mortgages, term
assurance is compulsory unless the borrower already has appropriate life assurance
policies he can charge to the bank in lieu.
Fixed rate mortgages
Mortgage lenders offer fixed rate or capped interest rates on mortgages, should customers
wish to protect themselves against increases in interest rates, which may affect their
ability to make repayments on the mortgages. Such mortgages are available for periods of
one to 10 years from most lenders at competitive rates. The borrower is guaranteed a
fixed or maximum interests rate, and therefore knows that his mortgage repayments will
not exceed certain figure. However, in the fixed rate mortgage, the borrower is tied in at a
certain interest rate, even if floating rates drop. There are no extra charges for fixed rate
mortgage, but the rates offered may well be slightly high than the current floating
mortgage interest rates.
Foreign currency mortgage

Borrowers with mortgages in foreign currency, taken out perhaps when UK interest rates
were high and continental rates mainly low, can take advantage of the various currency
hedging tools set out later in this section for use by exporters and importers. Such tools
enable the borrower to fix the exchange rate of his mortgage repayments against sterling.
However, it would be unwise for a customer to take out a foreign currency mortgage
without having income in that currency to cover the repayment. However, customers’
circumstances change and if such customers find themselves with income in a currency
other than that of the mortgage, use of such tools can reduce their exchange rate risk and
avoid a possible inability to meet increased (sterling equivalent) repayments.
9.2 Services for Business Borrowers

Income of assets
Most businesses are vulnerable to loss of assets by fire, accident or theft and such losses
could possibly so harm their cash flow as to put them out of the business. The bank has
an interest in this if it is lending to the business, particularly so if the bank has a charge
99
over the assets as security for borrowing. If the assets are lost, the customer’s sales may
well be interrupted, thereby reducing income. If this results in the business failing, the
assets on which the bank was relying for security may have reduced in value by the loss
and the bank borrowing may no longer be fully covered by the remaining security.
All banks have departments or subsidiaries which deal in asset insurance, and which are
only too pleased to arrange appropriate cover for customers. The banks will advice the
insurers of its interest in the insured assets (if it hold a charge over them) and if claims
need to be made on the policy, the bank will receive the proceeds. Various other
insurances are available to customers, for ex ample:
 Interruption of business (in case of fire, flooding etc)
 Keyman (loss of key directors, partners or employees.
 Bad dents (against non-payment by debtors, both domestic and foreign):
 Public liability (against claims from staff or customers)
 Employers liability (for accident, injury etc)
 Goods in transit e.g. shipping insurance
 Share protection (to buy out a partner’s or director’s share in a business if they die);
 Loan protection (as protection loan protection for the smaller business)
 Dread disease protection (particularly for sole traders).
Credit risk insurance

If the bank itself is unable to provide the necessary insurance cover, then most banks
have insurance broking or factoring subsidiaries who will be pleased to arrange the
necessary cover themselves or through outside insurers. Obviously, banks refer to sell
their own products (and take the profit on them) buy they are perfectly happy to take the
insurance commission on outside insurance.
An example of this is credit insurance, which consists of two main elements, the:
 Provision of insurance policies which ensure that the seller of goods or services
gets money back if the buyer defaults or fails to pay for reasons specified in the
policy.
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 Credit reference information on which decisions are based and from which risk
can be assessed.
Such insurance is available in the UK from commercial trade insurance companies such
as Trade Indemnity, though some banks are now offering similar cover in-house.
Similar cover for exporters, including country risk is available from specialist providers,
mainly NCM Ltd for short-term payment (under two years) or the Export Credit
Guarantee Department (ECGD) for deals with longer payment terms (two to five years
normally).
Country risk includes cover against loss of sales income due to:
 An overseas government moratorium banning payments in general or any specific
loan by the foreign government.
 Political, economic or legislative changes taking place overseas which delay or
prevent the payment.
 Loss arising from payment in foreign currency when payment should have been in
sterling.
 War, civil disturbances etc.
Here again, some banks offer their own similar insurance cover and you should be aware
of your own bank’s offerings.
ECGD also offer their Overseas Investments Insurance covering political risks for three
to 15 years on British investment overseas. Risks covered here include expropriation, war
and restrictions on remittances back to the UK.
Exchange rate risks

Every transaction in overseas trade involves an exchange risk. When a contract for import
or export is agreed, it will stipulate whether payment is to be made in the currency of the
buyer, or of the seller or in a third party currency. If the currency of the deal is that of the
buyer, the seller faces an exchange risk, because if the currency of the buyer falls in value
the seller will receive less of his own currency when the funds are received and
converted. If the currency is that of the seller, the buyer takes the risk. If the currency
neither that of the buyer nor the seller, then both are at risk of adverse exchange rate
fluctuation.
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You can offer ‘hedging tools’ to protect your customers against such risks, but they need
to be put in place at the time the contract is signed by your customer.
Within the scope of the syllabus for this subject it is probably only necessary for you to
be able to recognize the exchange rate risks involved, and in an answer to state that if the
bank was to lend to a customer involved in foreign trade, it would recommend (or
possibly insist) that the customer arrange suitable hedge-would recommend (or possibly
insist) that the customer arrange suitable hedging tools to protect himself against the
inherent exchange rate risk. Typical hedging tools available from most British banks
would be:
 Forward contracts
 Currency options
 Foreign exchange accounts
Forward contracts
There are irrevocable agreements between a bank and a customer for the purchase or sale
of a fixed amount of a foreign currency at a specific rate of exchange agreed now. ‘Fixed’
forward contracts may be used on fixed future dates. ‘Option’ forward contracts may be
used at any time between two future dates.
Remember that if the currency fluctuates in favour of your customer, he is obliged to deal
at the agreed rate, and may miss out on an extra profit opportunities, but at least he is
protected against any unexpected loss on the deal due to currency changes.
Currency options
These give a customer the right, but not the obligation, to deal in a certain amount of
currency at an agreed rate at or between certain future dates. It follows that if the
currency exchange rate moves in favour of the customer, he can choose to deal at the spot
rate, and is not obliged to deal at the agreed option rate. Currency options (not to be
confused with an ‘option’ forward contract) attract an up-front premium based on the
rate, period and currency of the option. The higher the perceived risk to the bank in
offering this option, the higher the premium. Banks do not normally charge for forward
contracts.
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Both forward contracts and currency options are available for periods up to one year and
often for longer periods, depending on the currently involved.
Foreign exchange accounts

It is possible in the UK for customers to hold bank accounts with their own banks in
major foreign currencies and overdraft, loan and other facilities may be made available in
specific foreign currencies, or a cocktail of several, e.g. £ +/ or US$ +/ or DM, so that the
customer can draw on his facility in the currency of his choice subject to the overall
lending limit.
If a customer is expecting income in a foreign currency, it may then pay him to borrow
from his bank in that currency (particularly if the interest rates for borrowing in that
currency are lower than those for sterling borrowing), and to repay it on receipt of the
foreign income. Similarly, a customer may wish to purchase foreign currency now to
cover an anticipated future debt, and invest it in a currency account (particularly if the
interest rate is higher than sterling) until needed. In both the above cases the exchange
rate for the foreign currency is fixed at an early stage for the customer, who can then
budget accordingly.
There are other forms of currently hedging tools, such as currently futures and swaps, but
for the purpose of this syllabus it is important that you know that currently exchange risks
can be covered to some extent, and the main methods available from banks.
Interest rate risks

As well as exchange rate risks, customers borrowing from banks will be vulnerable to
interest rate risk. A customer who has borrowed money at a floating rate, linked to base
rate of LIBOR for example, could face higher interest payments if interest rates generally
increase. At the least this is going to affect his budget and cash flow forecast for the
coming year and, of course, year end profit, but in some cases it could mean the
difference between survival and failure. Often banks are prepared to offer fixed rate
packaged loans, e.g. personal loans for personal customers or small business loans for
small businesses, with interest added to the loan up front and fixed repayment for the
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period of the loan. In addition banks are often prepared to offer fixed rate loan accounts
for usual business borrowing.
Some of the methods, available through banks, to fix or reduce interest rate risks are:
 Interest rate swaps
 Caps and collars
 Interest rate options
 Forward rate agreements.
Interest rate swaps

A payer (or receiver) of floating rate interest can agree (via a middleman, for example a
bank) to exchange his floating rate commitment for a fixed rate of interest. The
underlying loan is not touched – only the interest rate commitment changes.
Caps and collars

It is possible to purchase for a premium an interest rate cap, where the seller will
undertake to reimburse a borrower for any interest paid over an agreed limit for a certain
period of time. A cap and collar is a cheaper way of doing this whereby the borrower
purchases a cap, but agrees to pay over any interest saved if interest rates drop below a
certain rate. With a cap alone, the borrower keeps the benefit of any fall in interest rates,
however great, but he sacrifices some of this potential gain to benefit from a cap and
collar.
Interest rate options

Interest rate options giving the buyer the right but not the obligation to a fixed rate of
interest for a given borrowed sum for a certain period may be purchased in standardized
form from futures exchanges such as LIFE or tailor made to meet the buyer’s exact needs
by way of an OTC 9over counter) contract, usually from a bank.
Forward rate agreements

Forward rate agreements (FRAs) are a contract between two parties through which an
interest rate is fixed to apply to notional amount of borrowing for a specific period,
104
commencing on a stated future date. This enables interest rates to be fixed on borrowed
funds not yet drawn down.
Other interests rates hedging tools, such as financial futures or ‘forward forwards’ are
available through banks or specific future markets, but would usually be available for the
higher levels of borrowing. For this syllabus, you only need to know that such tools are
available and could be recommended or insisted upon when lending to customers who
may have problems if interest rates increase. It is particularly important to bear this in
mind when interest rates are low and the potential for increases is therefore greater..
9.3 Factoring and Invoice Discounting

What is involved in factoring?
The actual mechanics of factoring are simple. As soon as goods are delivered or services
completed, the company issues an invoice to its customer, requesting payment to be made
to the factor, sending a copy of the invoice to the factor. From that point on the factor
assumes responsibility for the collection of the invoiced debt, relieving the company of
the cost and administration of running a sales ledger and chasing up payments. If needed
the factor can, at this stage, make available to the seller up to 80% of the invoice value,
the balance being paid over soon as the factor receives payment from the debtor.
Factoring has maintained remarkable growth since the 1980s.
By using factoring, businesses can concentrate upon selling their products, leaving the
problems of collecting payments for completed orders to the bank’s specialist factoring
arm. Simply put, factoring allows the business to sell on open account terms and at the
same time gain 100% credit cover, thus eliminating risks of non-payment and spending
up inward cash flow.
If customers fail to pay after an agreed period, (say 90 days) past the invoice due date,
then the seller is paid by the factor, without having to substantiate the loss or show
compliance with bad debt insurance policies. Prior to the transactions, the factoring
company will have vetted the purchasers and will have reserved the right to refuse to
105
handle certain business. However, in general, it will wish to cover all a company’s sales
to get good spread of risks as it guarantees the seller against buyer insolvency up to an
agreed limit. The factor’s customer can therefore trade safe in the knowledge that he will
be free from bad debt losses. Factors normally expect to cover a minimum turnover of
£100,000 per annum. Each debtor will be given a credit limit, which must be respected.
Customer benefits of factoring
The following are the main benefits.
 The customer gets immediate access to working capital which may otherwise not be
received for two / three months.
 Finance available grows with turnover and therefore is available to fund rapid sales
growth.
 The administrative burden of collecting dents is lifted.
 Finance id without recourse to the seller, so he can be sure of payment.
 Particularly when exporting, it enables the seller to offer open account terms which
increases his competitiveness in the local market and protects him against exchange
risk if invoicing in currency.
 Cash flow can be easily predicted.
 Even if advances are not drawn from the factor by the seller, debtors will usually
pay promptly on invoice dates if they know they are dealing with a factoring
company, thus speeding up cash flow.
Cost of factoring
The cost of factoring includes two elements
 Interest on finance provided – comparable with most overdraft rates.
 Management fee for sales ledger administration, credit management and collection
of payments. This will vary depending on the number of accounts, the number of
invoices processed and the type of customers. The management fee, typically
between 1 -3% of turnover, has to be weighed against the time, resource and
financial savings offered.
Comparisons between factoring and invoice discounting
106
Factoring Invoice discounting
1. The bank’s customer sends his invoices to 1. The bank’s customer sends his copy
the factor. invoices to the factor (most factoring
companies offer invoice discounting
services.)
2. If required the factor will advance up to 2. The factor will advance up too 75% of the
80% of the invoice at once. The factor invoice value. The customer collects the
collects the debts. debts.
3. The debtor pays the factor. i.e. the person 3. The client’s debtor pays the client in the
who owes money to the seller receives an usual way.
invoice from the factor and sends his
remittances to the factor
4. The factor then pays over the balance to the 4. The client settles with the factor when the
seller, less interest and charges. debtor’s remittance is received.
5. The factor takes over the sales ledger 5. The seller is responsible for sales ledger
administration of the seller. administration.
6. Factoring is disclosed to the debtor. 6. Invoice discounting is not disclosed to the

debtor.
7. Charges are between 1% and 3% of turn
over, plus interest on any advances. 7. Interest is charged on amounts advanced.
The administration fee is relatively small,
because the factor is not involved in any
sales ledger administration.
Forfaiting
8. The factor will handle all the turnover. 8. The factor only deals with invoices against
Forfaiting is finance provided by buying bills of exchangewhichoranother financial
advance documents
is required.
without recourse to the seller. Note that this is incontrast to discounting
9. Invoice billsis of
discounting exchangewhen the
applicable
9. Factoring would be applicable if the seller
where
did the
notdiscounting bank does
have the personnel to have recourse
handle customer
sales to the seller if the wishes
draweeto continue
fails to pay.to handle sales
ledger. ledger administration himself.
10. Usually which

A business bad debts insurance
needs financeisfor
included 10. Usually
as deal involving
an export bad debt
capital goodsinsurance is included
can approach a as
part of the package. part of the package.
bank which offers forfaiting to obtain a quote for the relevant amount and time-scale.
Once the quote has been obtained, a price for the contract can be agreed with the buyer
and the level of the profit will be known in advance.
The characteristics of forfaiting

These are:
 Interest is at a fixed rate determined at the time the bills are bought.
107
 Transactions appropriate for forfaiting are normally for capital goods. (Bills must
relate to trade, and cannot be merely a means of raising finance.)
 The normal period covered by forfeiting arrangements is from a few months up to
about five years, sometimes as long as eight.
 The bills or promissory notes are usually in a series with maturity dates at regular
intervals e.g. every six months, expect where the full term of the arrangement is
very short.
 The costs to the customer are:
b) A commitment fee
c) Interest linked to rates in the Eurocurrency markets
d) A premium related to risk e.g. higher for unstable countries
 The financial documents used are ‘guranteed’ either because they are promissory
notes of a reputable financial institution or, if bills of exchange, because they are
‘avalised’ i.e. signed by a bank undertaking primary responsibility for payment
(rather stronger than merely endorsing a bill, which makes the bank liable alongside
any other endorsers).
Advantages for the customer
Forfaiting
 Improves liquidity because cash if brought in quickly.
 Helps cash flow management because he discounted amount of the package of bills
is received straightaway.
 Reduces need for other forms of credit.
 Reduces administrative work and the cost of collecting dents over a period of years.
 Can help with exchange risk by transferring it to the forfeiter as soon as paper is
discounted.
 Avoids credit risk because payment is guranteed as soon as paper is discounted.
 Ensures that default by the buyer has no effect because the facility is non recourse.
 Enables indication rates to be obtained if required.
 Enables finance costs to be accurately included in the contract price a business
quotes.
108
 Can eliminate interest rate risk (which is helpful if rates are volatile) because firm
quotes on rates are usually held for 48 hours.
 Encourages investing banks to take paper as there is a secondary market between
forfaitors to some extent.
 Offers a wide range of currencies possible (so forfeiting is suitable where ECGD
cover is available.
 Entails less documentation than for ECGD.
9.4 Acceptance Credits

For first class customers banks will often arrange, if needed an acceptance loan or
acceptance bill facility. The customers are allowed to draw bills of exchange on the bank,
up to an agreed total amount at any one time. Bills are usually drawn at three month
terms, and the maximum for each bill is £ 10 usually drawn at three month terms, and the
maximum for each bill is £10 million, though more than one bill may be drawn if within
the overall limit.

1. Suggest appropriate types of finance for the following business situations
a) Extra working capital needed to finance a large profitable one-of order, to be
manufactured, delivered and paid for within six months.
b) Purchase of extra production machinery with an expected life span of six
years
c) Purchase of a new factory unit, pending sale of old one.
d) Building of extra storage, workshop and office facilities to cope with
expanding business.
e) Extra working capital to finance a series of new ongoing orders for exports in
Swiss francs to a Zurich customer.
2. Outline briefly the workings of an acceptance credit facility
3. Summarize the advantages and disadvantages of financing fixed asset acquisition by
leasing or hire purchase, and outline the optimum circumstances for choosing each
service.
109
4. Setout a typical suitable case for offering factoring as a service. What difference would
persuade you to offer invoice discounting instead?
9.6 References
of Bankers.

Publication Data
110
Sample Paper 1
Mt Kenya University
UNIVERSITY EXAMINATIONS 2010/2011
SCHOOL OF BUSINESS & PUBLIC MANAGEMENT
DEPARTMENT OF FINANCE & ACCOUNTING
BACHELOR OF BUSINESS MANAGEMENT
BAF3208 LENDING MAIN EXAM
March 2011 Time: 2 hrs
Answer Question ONE which is COMPULSORY and any other TWO questions
QUESTION ONE
a) A new employee has reported to the bank’s credit department where you are the
officer in charge. Outline to the new employee the procedure for appraising an
application for term loan facilities for personal borrowers (15 marks)
b) Monitoring of bank account advances is as important to lending as the actual
lending. Explain how bank can effectively execute this function of monitoring
advances (9 marks)
c) Explain the meaning of the following terms and suggests an immediate solution
to each (i) Over trading
(ii) Hardcore borrowing (6 mark)
(30 marks)
QUESTION TWO
a) You are the branch manager in charge of the monitoring of loan port folios of
your corporate customers. Explain FIVE “warning” signs that a problem overdraft
account will show, highlighting the possible causes. (10 marks)
b) Explain reasons why a lender should obtain security (10 marks)
(20 marks)
QUESTION THREE
Brain Omollo has operated a current account at your branch for the last 7 years.
Through his account, an average monthly salary amounting to Kshs 126,000 is
received. You have arranged an appointment to discuss the account operation which is
usually overdrawn in anticipation of the monthly salary. On examination of his
account, you notice the following regular payments.
Kshs
House 8,000
Hire purchase 5,000
Electricity 800
Water 2,000
Petrol 2,500
111
The account is overdrawn by Kshs 64,000 and a cheque of Kshs 1,600 in favour of an
insurance company is in the day’s clearing. His salary is due in 4 days. At the meeting,
Mr. Omollo apologies for the overdrawn position and explains that he took his family for
a holiday in Mauritius which cost more than he anticipated. The holiday strained his
finances but he is now recovering slowly. The following also emerged from the
discussions.
i. He bought a new house two years ago which has an outstanding mortgage of Kshs
680,000.
ii. A new set of furniture was purchased a year ago through hire purchase
iii. He contributes Kshs 4,000 per month towards housekeeping.
iv. Road license for his car amounting to Kshs 4,800.
v. He is due to receive a salary increase of 5% in three month time.
Mr. Omollo is now asking for a loan of Kshs 400,000, repayable at Kshs 20,000 per
month:
Required: Respond to Mr. Omollo’s request. (20 marks)
QUESTION FOUR
a) Apart from bank advances explain five other sources of finance for business
(10 marks)
b) Explain reasons why lenders should lend 100% on the security value (10 marks)
(20 marks)
QUESTION FIVE
Earnest Mwai an executive with a, valuable customer of your bank, has been promoted to
head a new branch. The new branch is at a new location and he wishes to move house
immediately.
His present income is Kshs 3,600,000 per year. He has an outstanding mortgage of Kshs
1,350,000. He has since identified a house jnear his new office which is being offered at
Kshs 2,700,000 and the mortgage company ha agreed to a new mortgage of Kshs
1,800,000. Completion of its purchase is three months. Contracts were exchanged after
Mr. Mwai made a 10% deposit from his own resources.
His present house has been on the market for a short time and no firm offers have been
received. He assures you that similar houses have been sold for about the same price of
Kshs 2,700,000 and he does not envisage any ubdue delays in the sale. Other charges
applicable to the transaction are
Lawyers fee Kshs 99,000
Estate agent fee Kshs 63,000
Stamp duty is levied at 4% and the bank charges interest at 20% p.a.
Mr. Mwai asks for assistance to finance the transaction
Required:
i. Appraise the request (15 marks)
ii. Assuming that the bank agrees to assist, outline the measures it should take to
protect its security position. (5 marks)
(20 marks)
112
Sample Paper 2
Mt Kenya University
UNIVERSITY EXAMINATIONS 2010/2011
SCHOOL OF BUSINESS & PUBLIC MANAGEMENT
DEPARTMENT OF FINANCE & ACCOUNTING
BACHELOR OF BUSINESS MANAGEMENT
BFM323LENDING SUPPLIMENTARY/SPECIAL
March 2011 Time: 2 hrs
Answer Question ONE which is COMPULSORY and any other TWO questions
QUESTION ONE
a) You have been invited by the chamber of Commerce to give a talk on sources of
finance, other than the loans and overdrafts offered by financial institutions.
Advice the participants on the alternative forms of finance available to a local
borrower. (10 marks)
b) Explain methods that borrowing customers can use to effectively hedge against
interest rate risks. (10 marks)
c) Explain reasons why lenders should not lend 100% on the security value
(5 marks)
d) Briefly explain five principles of lending (5 marks)
(30 marks)
QUESTION TWO
Matangi Limited manufacturers metal containers. The company has banked with you for
over 30 years and has always been profitable. Two years ago, there was a sudden drop in
the market for metal containers. The directors of Matangi Ltd. Expected this drop to be
temporary, but market conditions has continued to worsen. An article in the ‘Market
Intelligence’ has speculated that the market for metal containers will reduce by a further
20%. The company currently has an overdraft limit of Ksh250 million. Last year, as a
condition for renewing the facility, you took a debenture as security with a formula of 1
½ times cover of the overdraft by debtors, and 2 ½ times by debtors and stock. Recently,
there has been pressure on the limit, excesses have occurred and the debenture formula
has been breached. You wish to review the limit and called the directors for a meeting.
The directors tell you that:
v) They require an increased overdraft limit to Ksh300 million
vi) Their creditors are of the opinion that they should write down the
value of stocks by Ksh 150 million.
vii) They with the debenture formula reduced to debtors figure, and
stocks plus debtors figures.
viii) They provide the following audited accounts in support of their
request.
113
MATANGI LIMITED
BALANCE SHEET AS AT 31ST DECEMBER
2002 2003 2004
Ksh ‘000’ Ksh ‘000’ Ksh ‘000’
Current Assets
Cash 1,061 1,070 967
Debtors 324,187 334,640 295,847
Stock 426,460 383,223 423,038
751,708 718,933 719,852
Current liabilities
Creditors 249,497 246,479 228,758
Bank 164,771 138,910 220,013
79,499 59,488 55,779
493,767 444,877 504,550
Net current assets:
Fixed assets:
Leaseholds 271,167 40,472 51,281
Plant and machinery 150,900 190,837 195,356
178,067 231,309 246,637
Net assets 436,008 505,365 461,939
Financed by:
Share capital 75,000 75,000 75,000
Profit & loss account 361,008 430,365 386,939
436,008 505,365 461,939
Profit & loss Account summary:
Sales 1,303,816 1,406,408 1,124,685
Gross profit 144,273 206,515 71,374
Net profit / loss 71,514 25,197 (39,732)
Accounting ratios
Current ratio 1.52:1 1.62:1 1.43:1
Acid test 0.66:1 0.75:1 0.59:1

Credit given (days) 91 87 96
Credit taken (days) 170 169 192
Stock turnover (days) 134 117 147
Gross margin % 11.1 14.7 6.3
Net margin % 5.5 8.9 (3.5)
Net gearing % 36 27 47
Interest cover 3.8 4.3 -
Required
Appraise the request and give your recommendations. (20 marks)
114
QUESTION THREE
e) Alpha Limited has been enjoying an unsecured overdraft facility at your branch
for a number of years. However, the previous two years, poor trading results have
necessitated the need to obtain some security. The company assets are not really
satisfactory for the purpose, but another company Beta Ltd, has agreed to give a
guarantee if you will continue the overdraft limit of Alpha Ltd. Beta Ltd who
bank with you are good supplies. They are a first class company with a very
satisfactory account. The two companies do not have any directors in common nor
are there any inter-company shareholdings required. Giving reasons, explain the
procedure that should be followed when perfecting the security. (10 marks)
f) Explain the meaning of the following terms and suggest a solution to each
situation.
i) Overtrading
ii) Hard-core borrowing (10 marks)
QUESTION FOUR
(a).Mr. Juma, the chief accountant of a leading insurance company, has maintained a
satisfactory account with your bank for the last 17 years. He has recently been promoted
to Branch Manager of their Eldoret Branch.
Mr. Juma services a mortgage, with a leading mortgage company, for a house in
Westlands where he has been living for the last 7 years. The amount outstanding on the
mortgage in Ksh. 2.6 million. The current market value of the house is Ksh. 7.8 million.
He has found a suitable house in Eldoret which he wishes to purchase and eventually
settle after retirement. He has negotiated the price to Ksh 5.8 million. Stamp Duty and
legal fees are estimated at 10% of the price.
He has approached you as his bank manager to assist in providing bridging finance in
order to enable him sign the sale agreement with the seller. He intends to sell the house in
Nairobi to pay-off the borrowed funds from your bank.
Required
i) Assuming the bank is willing to assist, assess the maximum amount the bank
would provide. (6marks)
ii) Explain other factors that need to be addressed in order to cover the risks involved
in this type of lending. (9 marks)
(b). Monitoring of bank advances is as important to lending bankers as the actual
lending. Explain how banks can effectively execute this function of monitoring
advances (5 marks)
(20 marks)
QUESTION FIVE
a) Explain the following terms as used in agricultural lending
(i) Rent equivalent (3 marks)
(ii) Gross margins (3 marks)
(iii) Farmer’s balance sheet (3 marks)
b) “The best way to avoid bad-debt is to avoid all situations that could lead to
delinquency in the first place”
115
You have been posted to the credit risk management department of your bank as
Credit risk Officer. From preliminary assessment and examination of records you
establish that:
(i) Companies put under receivership end up in liquidation and the bank
recovers very little for loan repayment]
(ii) Asset disposal under statutory right of sale are either incomplete or
realize minimal amounts
(iii) Bad debts portfolio is increasing by the day
In a recent discussion with you head of department, you agreed on a number of
recommendations, to the credit committee, that emphasize realistic appraisal, strict
monitoring and control.
Required:
Recommendations to the credit committee that include:
(i) Sources of customer information to assist in appraisal monitoring and control
(ii) Handling debtors and dealing with stocks (10 marks)
116

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MT KENYA UNIVERSITY

DEPARTMENT OF FINANCE &

Course Code: BAF3208

Course Title: Lending

1.1 Philosophy of Lending

1.2 Methodical Approach to Lending

ii) Application by the customer

iii) Review of application

v) Monitoring and control

1.3 Principles / Canons of Lending

1.4 Monitoring and Control

1.5 Review Questions

2.2 Closed Ended Bridge Loan

2.3 Open Ended Bridge Loan

2.4 General Considerations

Additional Risks in Open-ended Bridging loans

2.5 Lending to Executors and Administrators

2.6 Lending to Trustees

2.7 Lending to Clubs and Associations

2.8 Review Questions

3.1 Bank Security

3.2 Types of Security and Valuation

3.3 Guarantees and Third Party Security

3.4 Problematic Accounts

3.5 Review Questions

4.2 Non-financial Appraisal of Business

4.3 Assessment of Financial Information

Acid test % = Current assets stock x 100

Credit taken (days) = Creditors x 100

Stock turnover (days) = Stock x 365

Gross margin % = Gross profit x 100

Net margin = Net Profit (before tax & extraordinary items)

Interest cover (times) = Profits (Before interest and tax)

Net gearing % = Bank overdraft + long-term external borrowing x 100

Net working assets to sales % = Stock + debtors – creditors x 100

Return on capital employed % = Profit before interest x 100

31.12.05 31.12.06 31.12.07

Total assets less

Term & other liabilities

Profit and Loss Account Figures

2005 2006 2007 Forecast

An extract of the financial information regarding ‘Mining Equipment’ is shown in the

Cash borrowed x 100 = 547,800 x 100 = 101%

ii) Interest cover

Profit before tax and interest

= 73,400 + 47,700 = 2.5

iii) Credit given (days)

Debtors x 365 = 316,900 x 365 = 68 days

iv) Credit taken (days)

Trade creditors x 365 = 308,200 x 365 = 190

Stock x 365 = 548,400 x 365 = 150

Current assets = 911,600 = 1.46:1

vii) Acid test

Current assets, other than stock

viii) Gross profit margin

Gross profit x 100 = 599,200 x 100 = 31%

ix) Net profit margin

Net profit before tax and extraordinary items x 100

Background and initial reaction

4.4 Review Questions

Ksh. ‘000’ Kshs ‘000’

Net Current Assets 1,660 (1,290)

Total Net Assets 7,260 4,160

Total rent/finance charge as % of sales 8,800100 = 8.5% 12,645100 =