Assessment of Customers Financing Requirements

Credential Investigation: The numerous and varied risks in lending stem from the many factors can lead to the non payment of obligations when they come due. Losses some times results from acts of God such as storms, fires, earthquakes, and floods. Changes in consumer demand or in the technology of an industry may alter drastically the fortunes of the business firms and place a once profitable borrower in a loss position.A prolonged strike, competitive price cutting, loss of key management personnel can seriously impair a borrower ability to make payments. The swings of the business cycle and political situation can effect the re payment ability of the borrower.

In determining whether or not to grant a loan a banker must attempt to measure the risk of non payment. This risk is estimated trough a process referred to credential investigation/credit analysis. Objective of credential investigation: The principal purpose of credit analysis or investigation is to determine the ability and willingness of a borrower to repay a requested loan in accordance with the terms of loan contract. A bank must determine the degree of risk it is willing to assume in each case and the amount of credit that can be prudently extended in view of risk involved.

Some of the factors that affect the ability of a borrowers to repay a loan are very difficult, but they must be dealt with as realistically as possible in preparing financial projections. The work of credit analysis is basically the same in all banks, but certain functions may be emphasized to a greater extent in some banks than another.In general they include the collection of information that will have bearing on credit evaluation, the preparation and analysis of the information collected, assembling and retention of information for future use. Credit department will only make recommendations and decision will be made by the authority. Authority may be loan officer, loan committee etc.etc.
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Factors considered in credit analysis.

Five Cs

Character capacity Collateral Condition capital

Scope of credit investigation The scope of credit investigation will vary, depending on size and maturity of the loan, operating record of the business , security offered, and previous relations with the borrower. The objective is to accumulate information that can be used to evaluate the applicants character, assets, ability to create income, and probable economic environment In the investigation of business loan application, banks like to know something about the history of the business, the firm operating record, labor relations, experience in the development of and marketing of new products, and source of growth of sales and earnings.

Source of credit information 1. Interview of loan applicant. Interview is the source of data collection. In interview the lending officer will learn the reason for the loan and whether the loan request meets various requirements established in the loan policies of the bank. From interview of applicant the lending officer can also gets some idea as to an applicant honesty and ability and may form a opinion as to whether the security will be necessary. Information about history and growth of business, background of key personnel,the nature of product and services, source of raw material, competitive position and plan for the future can be obtained through the interview.
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2. Banks own record. A bank may maintain central file of all its depositors and borrowers from which credit information can be obtained.For example, it will show the payment record of previous loans, the balance carried in checking and saving accounts, and whether the applicant has a habit of over drawing his/her account.

External Source of credit information 1. Rating agencies like Dun & Bradstreet, Poor and Standard. 2. Inspection of applicant Places of business. 3. Financial Statements

Inspection of applicants place of business: During visit of applicant place of business ,loan officer will learn a significant amount of how productive and well managed business is? Financial Statement Three financial statement are evaluated. Balance sheet: Balance sheet is snapshot of financial strengthens of the business. Profit and loss is showing operating position of the business, while cash flow is showing cash inflow and out flow of the business. Lender will prefer the cash flow statement of the business for making loan decision.
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Evaluation of financial statements In evaluation of financial statements banker will give more preference to balance sheet if loan is for short period of time, while in case of long term loan preference is given to profit and loss account. Income statement will reveal the degree of stability in its operation and efficiency with which it is being managed.Common size statement is prepared in which all items are expressed in percentage of sales.The % figures can be easily compared with previous period and the percentage of other similar firms.

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Ratio Analysis Figures on the firm,s balance sheet and income statement are often much more informative when related to other figures on those statements or to averages for comparable firms in the same industry.Lending officers are interested in relationships that shed light on the direction in which a firm appears to be moving as well as on its current financial condition and recent profitability. The ratio that could be computed with figures in the firm financial statements are limitless, but logic and experience tell us that only handful are really useful.

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Ratios used in analysis 1. Short term solvency/liquidity ratios Current ratio: current ratios/current liabilities Quick ratio: Current assets-Inventory/current liabilitiesover draft 2. Long term solvency or financial leverage ratios Net debt/equity ratio: T.Financial debt-cash/total equityintangible. Debt/equity ratio: T.debt /t.equity 3; Assets utilization or turn over ratios Inventory turn over ratio: cost of goods sold/ inventory Days sales in inventory: 365 days/inventory turn over Receivable turn over: Sales/account receivable.
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4: Profitability ratios Profit margin: net profit/sales*100 ROE:net profit /t.equity*100 ROA: net profit/t.asset*100 5: Market value ratios:price earning ratios: price per share/earning per share

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Risk Risk mean Uncertainty. Payment of credits are made in future and future is uncertain so risk is there.There arte of two types of risk . 1. Systematic risk 2. Unsystematic risk

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Systematic risk that influence large number of asset also called market risk. Unsystematic risk mean a risk that affect at most a small number of assets.also called unique or asset specific asset risk

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1.Credit risk. Also default or counter party risk arise in the case of debt security from the possibility that future payment will not be made. 2. Market risk known also price risk arises from volatile market prices.

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3.Interest rate risk. Risk posed by unexpected movement in interest rate. Faced by both borrower and lenders. 4: Financial risk mean that borrowers earnings will not cover the its interest and loans.

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5: Settlement risk; The risk that individual payment will not be made is referred to a settlement risk 6: Contagion risk, the risk that could spread over in total financial system is called contagion risk

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7: Political Risk 8. Foreign exchange risk

9: Economic policy risk 10 : Country risk

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Credit Limits and risk categories.

When all available information on the prospective customer has been assembled, the decision regarding the amount and terms of credit will have to be taken. It is common practice for a financial credit line or limit to be established which attempts to reflect simultaneously the over all level of confidence in the customer capacity and
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intention to meet his obligation, and also the amount of credit which,taking into account the payment terms, may have to be extended in order to accommodate the orders likely to be placed.At times these two considerations can conflict, so that either is satisfied. The better course is to classify each account, dependent upon the over all assessment , into risk category which should be quite independent of the actual amount of credit to be granted.
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This procedure has the following advantages: 1. Credit limit can be fixed initially, and if
necessary be subsequently changed according to the needs of the sales, and to the amount which the selling co is prepared to have outstanding in the various risk categories from time to time. No change in credit limit need , however denote an increase or diminution of the risk factor.

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2. By establishing a range of risk categories according to various definitions, the different levels of risk recognized by the company are clearly codified and may be easily understood by any one familiar with the system. 3. The identification of different levels of risk by means of a series of single digits or letters means that information can be easily stored in computer files both for record purposes and to facilitate selective reporting.

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4. Account representing different level of risk demand different follow up and control procedure. It is convenient to establish a standard procedure for each risk category.

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Risk Categories In order for the system to be effective, there must be sufficient categories t6o allow an adequate grading of risk, but not so many that the distinction between one level of risk and another becomes unclear.In practice there will be not fewer then three risk categories and not more then five, unless for some reason it is desired to sub divided one category in to two or more parts. The followings are the suggested range of categories with the definition of each.

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1.

First category (1 or A) Negligible or zero risk All those organizations, firms owned by the government,semi government, fully financed from public funds are considered risk free. Nationalized industries, public universities and hospitals are fully financed from public fund. Government is behind these organization and borrowing of these organizations are considered government borrowing. Credit worthiness of government is considered risk free, undoubted credit standing and financial strength.
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However, all other limited companies must be regarded as normal business risks and be evaluated for credit purposes on the usual credit criteria.They have no guarantee of perpetual solvency. Blue chips business units are also considered in the list of zero risk category.

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2. Category (2 or b) ordinary trade risk Companies. partnership or sole traders of good reputation and financial status , having no known record of payment delinquency with suppliers.This category will in most businesses , probably encompass at least 50% of all customers. No body knows future trade results. Co suffering with losses can change in profit and vice versa. Such type of companies /firms are treated under second category of risk, which is called ordinary trade risk.

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3. Third category (3 or c) Potentially slow payer Customer believed financially sound but with a known history of slow payments, either with same bank or any other bank in past carrying assessment. It is sometimes thought that type of customer, by definition financially as sound as those in the second category , does not for this reason represent higher degree of risk. However the additional risk lies in the probability will ,if permitted to do so,allow his account to assume a more or less permanently, overdue condition, with a consequently higher balance outstanding then if payment is made on time.
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4. Category ( 4 or D)significant or high risk Customers of known or suspected financial weakness will considered significant or high risk category. This is the area of receivables from which the majority of bad debt losses may be expected to arise, and as such it deserves special attention.

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5.category (5 or E) unacceptable risk cash terms only. This category embraces the outer fringe of customers who are so financially weak, or so chronically unreliable in payment habits,that there is no option but to payment terms and control procedure sufficiently watertight to ensure that no order is executed until payment has been received.

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First category Second category}= Average to minimum risk Third and fourth category }= above average risk Fifth category}= unacceptable risk cash terms only.

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Factors which must consider by banker while assessing credit risk in Pakistan: Lending Proposal- inherent risk: WHAT IS THE LOAN FOR AND HOW THE LOAN WILL BE REPAID is the crucial question to ask, before the credit officer sets about to go any further towards risk evaluation. One of the primary fault in credit proposals is a failure, on the part of the lending banker, to detail what the money is to be used for and how it will be repaid.

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It is imperative to know that the source of repayment for any loan, will largely depend on the type of finance being extended.Three major type of finance commonly used in Pakistan, are the following. Working capital Trade financing Project financing.

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Various risk associated with each type of finance Working Capital Under such financing arrangements, repayment is expected to come from the general cash flow of the company. The lending institution should therefore, invariably insist on seeing a comprehensive cash flow statement/forecast for the co. The traditional ratio analysis of financial statement does not reveal the existence of the problem.If there is no net generation of cash internally then this characteristic itself is fair indication and an early sign of gathering problem.
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If a company that wishes to borrow working capital finance shows inability to supply cash flow forecast , then it must evidence very clearly to the credit officer that the co. itself is unsure of how the advance will be repaid.this situation obviously increases credit risk. In assessment of the general risk following factors require in-depth analysis

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1. Business Risk This essentially includes industry risk, market risk and supply risk a: industry risk: -concentration of sale on any one industry enhance risk -Product life cycle the shorter it is higher is the risk e.g. fashion-wear. -Existing and anticipating government policies/restrictions. -current level of competition can increase a risk of reduction in profit margin.
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B: Market risk -Concentration of sale on one single geographical area. -concentration of sale to a single buyer. -Reputation of buyer c: Supply Risk -concentration of purchases from any single geographic location. -concentration of purchases fro0m a single supplier. -Single currency exposure in respect of purchases. -Reputation of supplier
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2. Organizational risk -The quality of management and share holders and their track record in their line of business -Evaluate existence of any un-due reliance on one individual -Are all director resident-a non resident director may easily walk away from commitment. -Shareholders commitment to fund expansion of business.A continuous higher dividend policy is a danger signal. -Attitude of management conservative or speculative
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-The existence and quality of internal control system 3. Financial Risk -Interest and exchange rate sensitivity analysis to both assets and liabilities. -Balance sheet and capital structure examine closely gearing I,.e. debt equity ratio -In relation to industry standards check following ratios:* stock turn over ratio * Debtors turn over * Current ratio * Liquidity Ratio
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*Profitability Ratio * Quality of fixed asset and then ageing -Contingent liabilities -Quality of financial information - Assets suffering form charge -Financial discipline

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2: Trade Finance Trade finance is often believe to be less riskier then working capital finance and project finance, in view of its being short term and self liquidating. The successful culmination of the transaction become the source of debt repayment, and there is therefore no reliance on external or balance sheet sources

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The positive feature that attract lending bankers to finance of trade are:*The use of self liquidating paper * Availability of primary financing and refinancing through secondary market *Built in security * Off balance sheet financing. In practice however, trade finance require as much security and monitoring as any other type of finance, because of the following reasons:-

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-In many situation the bank does not retain control over goods right of the time it is paid. -A number of trade related transactions are in effect clean risk, e.g. pre shipment finance, export bill etc.where the underlying securities e.g. goods are not easily resalable nor the end use of fund can be properly monitored. Therefore, while assessing credit risk, in respect of trade transactions, the factors considered for working capital finance must be given equal consideration.Additionally following features must be evaluated.
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Control over goods import finance -Repayment is from sale of goods and hence credit risk is directly associated with degree of control over goods. The release of title documents on trust receipt is a weak security. -If the goods are transported by air, there is no title documents. In such cases, the bank should be the named consignee, to retain control over goods. -If the goods arrive before documents, bank may be asked to issue shipping guarantees. Whereby, the bank losses control over the goods. In such cases anything less then 100% cash margin only enhance risk.
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Salability of goods: Even though a bank may maintain full control over goods , yet these may not be re-salable easily. The goods may be perishable or to suit specific industry can create problem of resale. Therefore, price structure must be reviewed to see whether the goods can be sold at cost or above cost.This require importer track record, orders on hand the market demand and supply position.

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Export Finance. The decision of export finance is generally based on general credit status of the customers. The following points must be considered 1. Risk associated with importer -reputation and business risk of importer -Political risk, possibility of outbreak of war, social unrest etc. -Transfer risk

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2. Risk associated with importer banks: -credit worthiness of the bank itself -L/C terms and condition ..simple or complicated. 3. Pre-shipment finance: If given against L/C only. With out the support of further collateral then it is akin to clean finance. Most risky, since the end use of fund is out side the domain of check by the lending banker.

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Project finance: In assessing credit risk it must be borne in mind that repayment will come from the project cash flows, either through revenue stream or from the sale of completed project.the under mentioned factors need to be considered. 1. Viability of the project.This entails the detail review and analysis of the assumptions underlying the project cash flows. Including -anticipated revenue vs market supply

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-Pricing structure -inclusion of inflation factor -consistency with market , in the usage of interest and currency rates. A sensitivity analysis is imperative to be carried out on these assumptions to invoke the downside possibilities. 1. Availability of recourse. Bank must examine whether the company possess sufficient recourse to complete the project.

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2. Priority of repayment to ensure that there is no diversion of funds, bank must obtain priority in repayment. 3. External factors, such government legislation, political uncertainty. 4. Ability to monitor projects progress and use of funds.

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