Credit Risks in Working Capital and Equipment Loans

1. Credit Risks in Working Capital and Equipment Loans Alexandru Cebotari

2. Working Capital – Why Is It So Important • The financial element of risk is defined as the inability of cash generation to: • Maintain working capital • Maintain productive assets • Meet debt service in schedule • Pay reasonable dividents • Maintain some borrowing power • Cash generation is defined as profits plus depreciation. Is it true? • Opreating expenses on the net income statement include depreciation expense, which does not require a cash outlay • Decrease in current assets, other then cash, have positive effects on cash flows, and increases in current assets have a negative effect. • An increase in the current liabilities has a positive effect, and a decrease in current liabilities has a negative effect.

3. Evaluating Historical Performance Evaluating Business Plans Manage-ment Ability Current Assets Current Liabilities Current Creditor Commit- ments Volume Liquidity Needs Servicing Environ-mental Coditions Deficiency? Reserve? Change in W/C Long-Term Creditor Commit- ments Long-Term Debt Servicing Operating Practices Income Statement Non-Current Assets Sources and Uses of Funds Deficiency? Equity Reserve? Funds Adequacy Profitability? Return on Equity?

4. Role of Working Capital Current Assets Current Liabilities Short-Term Creditors’ Commitments W/C Long-Term Debt Long-Term Creditors’ Commitments W/C Non-Current Assets Equity

5. Asset Conversion Cycle • The Asset Conversion Cycle represents the number of days it takes a company to puchase raw materials, convert them into finished goods, sell the finished product to a custmer and receive payment for the product

6. The ACC has three components: • Days Receivables Outstanding Measures the average number of days from the sale of goods to the collection of receivables (Average Accounts Receivables/Sales)*365 days • Days Inventory Held Measures the average length of time between acquisition and sale of merchandise (Average Inventories/Cost of Goods Sold)*365 • Days Accounts Payable Outstanding Measures the average length of time between the purchase of goods and payment for them (Average Accounts Payable/Purchases)*365, where Purchases = Cost of Goods Sold+Ending Inventory–Beginning Inventory

7. Cash Cycle Illustration

8. Cash Flow Quality

9. Servicing Current Liabilities • Sales volume, the rate of turnover of current assets, working capital and current creditors’ terms are factors that determine how a firm services current debts • Assume that sales double, the firm operates with positive working capital position and the commitments from current creditors do not increase. What scenario do you foresee? • What does happen if the rate ot turnover of current assets slows to half its former rate? • What does happen if the firm operates with a deficit working capital requirement?

10. Overtrading? There are four elements of risk associated with overtrading: • Serious deplition of profit; • Organization failure associated with high volume; • Receivables losses; and • Inventory risks Rule of thumb: current assets should cover total debt at the seasonal low

11. Sustainable Growth • If a rapidly growing company can maintain a prudent balance between debt and equity sources, the reliance on external capital creates no problems • In too many instances, rapid sales growth, coupled with modest profit margins and an inability to sell new equity, forces the company to rely increasingly on bank credit • Rapid growth may lead to increasing debt ratios and increasing banker headaches • Two questions to be answered to when contemplating a loan to a rapidly expanding firm: • Is the applicant in balance? Given the company’s growth targets and financial policies, will the company be able to maintain a stable debt ratio over time? • When can the bank expect repayment of the loan? Is the requested amount sufficient or is the contemplated loan likely to be just the downpayment on a much larger commitment?

12. Sustainable Growth Rate (1) • Sustainable growth rate – the annual percentage invcrease in sales which is consistent with a stable capital structure Sustainable Growth Target Debt Ratio Profit Margin Target Payout Ratio Capital-Output Ratio

13. Sustainable Growth Rate (2) p = profit margin on sales d = the target divident payout ratio => (1-d) is the target retention ratio L = the target debt-to-equity ratio t = the capital-output ratio defined as totral assets devided by net sales s = sales at the beginning of the period Δs = the increase in sales during the year Liabilities and owners’ Equity at beginning of year Assets at the beginning of year Additions to liabilities p(s+Δs)(1-d)L New assets needed to support increased sales Δs(t) Additions to Retained Earnings p(s+Δs)(1-d)

14. Example: Sustainable Growth Rate in Loan Appraisal p = .06, L = 1.20, t = 1.20 d = .10 • President of Radar contacts the loan officer at the bank to secure a term loan of $500,000 • Radar’s target sales growth rate is 20% per year • Loan officer fears that the company’s debt ratio will rise steadily in future years and could jeopardize the bank’s position

15. Short-term lending: What does short-term mean? • Under short-term lending, the lender can get paid in the ordinary course of events in the short-term (such as within a year) • The lender is required to have a clear understanding of the working capital adequacy – if permanent working capital is inadequate, slow payment of continuous refinancing beyond a year should be anticipated • The elements of appropriate short-term lending include: • Understanding the specific purpose • Structuring the maturity in line with the primary source of repayment • Identifying the certainty of secondary sources of repayment implicit in the purpose • Evaluating alternative protection available from the balance sheet; and possibly • Ensuring access to secondary protection by taking security

16. Characteristics of working capital loans • Seasonal versus Permanent Working Capital Needs • All firms need some minimum level of current assets and current liabilities • The amount of current assets and current liabilities will vary with seasonal patterns • Permanent Working Capital • The minimum level of current assets minus the minimum level of adjusted current liabilities Adjusted Current Liabilities • Current liabilities net of short-term bank credit and current maturities of long-term debt • Seasonal Working Capital • Difference in total current assets and adjusted current liabilities

17. Total Current Assets Minimum Current Assets Total Current Liabilities Minimum Current Liabilities Total = Permanent Working Capital Needs Dollars + Seasonal Working Capital Needs Seasonal Working Capital Needs Permanent Working Capital Needs q Time Dollars

18. Short-Term Commercial Loans (1) • Open Credit Lines • Loan is seasonal if the need arises on a regular basis and if the cycle completes itself with one year • Used to purchase raw materials and build up inventories of finished goods in anticipation of later sales • It is self-liquidating in the sense that repayment derives from the sale of finished goods that are financed

19. Short-Term Commercial Loans (2) • Open Credit Lines • The bank makes a certain amount of funds available to a borrower for a set period of time • Often used for seasonal loans • The customer determines the timing of the actual borrowings (“takedowns”) • Borrowings increase with inventory buildup and decline with the collection of receivables

20. Short-Term Commercial Loans (3) • Open Credit Lines • Typically require that the loan be fully repaid at least once during each year to confirm that the needs are seasonal • Commitment Fee • A fee, in addition to interest, for making credit available • May be based on the entire credit line or on the unborrowed balance

21. Short-Term Commercial Loans (4) • Asset-Based Loans • Loans Secured by Inventories • The security consists of raw materials, goods in process, and finished products. • The value of the inventory depends on the marketability of each component if the borrower goes out of business. • Banks will lend from 40 to 60 percent against raw materials that are common among businesses and finished goods that are marketable, and nothing against unfinished inventory

22. Short-Term Commercial Loans (5) • Asset-Based Loans • Loans Secured by Accounts Receivable • The security consists of paper assets that presumably represent sales • The quality of the collateral depends on the borrower’s integrity in reporting actual sales and the credibility of billings

23. Short-Term Commercial Loans (6) • Asset-Based Loans • Loans Secured by Accounts Receivable • Accounts Receivable Aging Schedule • List of A/Rs grouped according to the month in which the invoice is dated • Lockbox • Customer’s mail payments go directly to a P.O. Box controlled by the bank • The bank processes the payments and reduces the borrower’s balance but charges the borrower for handling the items

24. Short-Term Commercial Loans (7) • Revolving Credits • A hybrid of short-term working capital loans and term loans • Typically involves the commitment of funds for 1 – 5 years • At the end of some interim period, the outstanding principal converts to a term loan • During the interim period, the borrower determines how much credit to use • Mandatory principal payments begin once the revolver is converted to a term loan