Credit Skills Academy Credit Skills Academy Executive Briefing Unit 4: Business Lending and Security ! ! Keith Checkley & Associates ! ! Credit Skills Academy Unit 4 Business Lending and Security Objectives After studying this unit, you should be able to: · quantify the total risk exposure on business lending; · clarify when security should be taken; · consider the various forms of security available from business borrowers and the valuation discounts; · understand the concept of break-up analysis It is not intended to deal with the technicalities of charging security which are well covered in various Banking books. A lender should consider taking security, where the purpose of the advance is to acquire a specific asset, e.g. a medium term loan for the purchase of machinery, or a bridging loan for premises purchase or where the risks of repayment are assessed as to make it essential to have a controlled repayment alternative. If a business is unable to repay its debts, in order to assess the outcome of this event, it will be necessary to carry out a break-up analysis of the balance sheet. This will give a significantly different picture to the balance sheet as a going-concern. For example, many assets lose value as soon as trading ceases. Asset values need to be discounted by the banker to carry out this type of gone-concern approach to credit analysis. The discount factors to be applied will vary from business to business. For example, stock may be out-of-date, obsolete or include work-in- progress. THE ASSESSMENT OF RISK When assessing the risk to the bank, the full extent of the bank’s exposure to the customer must be understood. In addition to overdrafts and loans, the bank may well be asked to enter into many other types of contingent liability for the customer and it will be necessary to incorporate these additional risks into the overall risk ‘exposure’. ! ! Keith Checkley & Associates ! ! Credit Skills Academy Bank Risk Percentages for Contingent Liabilities The below figures are approximations. Precise views on the level of risk in these products vary from bank to bank. % Acceptances 100 Discounts (trade bills) 30 Discounts (accommodation paper) 100 Foreign bills negotiated 30 Forward currency contracts 20 Irrevocable letters of credit 100 Engagements:- - Guarantees 100 - Bid Bonds (tender bonds) 20 - Performance bonds 100 - Advance payment guarantees 100 - Bonds to HM Customs & Excise 200 - Indemnities re. freight irregularities in 10 shipping documents etc. CSA Member Activity 1 Identify the risk assessment criteria in your Bank. How do they compare with this table? Guidelines · Acceptances - 100% When the bank accepts a bill on behalf of a customer the customer then obtains possession of the underlying goods In exchange for the bill. At maturity the bank must honour the bill at face value. · Discounts (trade bills) - 30% When a bill is discounted the bank is, in effect, buying (with recourse) the underlying debt from its customer. On breaking-up a balance sheet you allow 70% for debtors and assuming you will obtain 70% value for the debt your uncovered risk is 30%. The bank may be able to secure a lien over the underlying goods if it feels the need. · Discounts (accommodation paper) - 100% An accommodation bill is a bill drawn by your customer on himself for a funding operation not linked to any underlying trading transaction and your customer will be expected to cover the bill at or before maturity. Thus, your customer is the ultimate debtor and our risk Is 100%. ! ! Keith Checkley & Associates ! ! Credit Skills Academy · Foreign bills negotiated - 30% Treat on the same basis as discounts (trade bills). · Forward currency contracts - 20% Loss could be sustained if the customer is unable to complete the contract. This would necessitate the bank having to buy or sell the currency at spot rate in order to complete. Your risk is dependent upon movements in the exchange rate and for practical purposes you adopt a risk factor of 20% (some banks are as 16w as 10%). · Irrevocable letters of credit - 100% In establishing a credit we undertake to make payment in accordance with the terms thereof. Thus, this risk is assessed at 100%. · Guarantees - 100% Where you have detailed knowledge of the finances of the individual or company being guaranteed (the principal debtor), e.g. recent balance sheet, the risk is capable of accurate assessment. Where you do not, this risk must be 100%. Some banks automatically weight such guarantees at 100% risk. · Bid bonds (tender bonds) - usually 20% In effect, this is an assurance by the bank that a customer's tender for a contract is not of a frivolous nature, i.e. in the event of the contract being awarded to the tenderer, that he will not withdraw, thereby leaving the beneficiary to recommence tender procedure. The bond itself will only be outstanding until a contract is awarded, at which stage it will be cancelled (if the customer has not been awarded the contract) or replaced by a performance bond. The risk factor is therefore 100%, but because the bonds are short term and because many underlying tenders will not be accepted, some banks adopt a 20% risk factor. · Performance bond - 100% Default under a performance bond could arise through your customer's: - Inability to fulfil the contract; or - Withdrawal from the contract. The former case is only likely to arise from insolvency because contractors are highly unlikely to withdraw once the bond has been given. A performance bond is essentially an insolvency bond which generates no cash flow whatsoever. It merely has the effect of placing the contractor in the position that he can go ahead with the contract which in itself may or may not generate cash flow. If and when default occurs you are still not able to quantify your risk at less than the full amount, because it is possible that the whole of the bonded amount will be required to rectify the shortcomings of the contract. Also remember that you are In the beneficiary's hands in that he holds an 'on demand' guarantee and you must pay in full when called upon to do so. Thus, the risk factor is 100%. ! ! Keith Checkley & Associates ! ! Credit Skills Academy · Advance payment guarantee - 100% When a bank's customer is paid In advance for goods not yet delivered, the purchaser may demand in exchange a guarantee of repayment in case of non delivery. As with a performance bond this is, In effect, an insolvency bond which is not capable of quantification at less than the full amount. Customers' balance sheets may show these advance payments in different ways. In some cases the amount of the advance payment is shown as a liability whilst in others it can be shown as a deduction from work in progress. · Bonds to HM Customs & Excise - 200% These are mainly guarantees for deferred VAT and import duty. The bonds normally specify a maximum figure per month, but Customs and Excise could wait until two months' payments are In arrears before claiming. · Indemnities re missing bills of lading, Irregularities in shipping documents etc - 10% It is highly improbable that any customer will ask you to assist him (through the Issue of an indemnity) to procure goods that are not intended for delivery to him. Irregularities in shipping documents are invariably clerical discrepancies and your action In giving indemnities against discrepancies merely oils the wheels of commerce. It is, therefore, considered that the risk factor in these instances is notional at 10%. Indeed, some banks take the view that for an established, reputable customer there is nil risk. BREAK-UP ANALYSIS (The Gone-Concern Approach) If a business goes into insolvency, you need to be able to assess the risk of any loss on your lending by analysing the business’ assets on a ‘gone concern’ basis. Break-up values can be calculated from the latest audited (or interim) figures. Experience has shown that amounts recovered in asset realisations are almost always far less than expected. If there is a general recession hitting trade or area, the market for the assets will be depressed and also when a business fails, many debtors will look for reasons not to pay. ! ! Keith Checkley & Associates ! ! Credit Skills Academy Suggested percentages for asset realisation values (‘Gone-Concern’ basis) % Marketable Investments 80 of current market value Debtors 50-70 Depending on age, spread, quality HP Debtors 60 Stock 15-40 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 manger’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 specialised 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 Deadstock - feed Nil Tillages - preparation 50 Note: These percentages are not regarded as rigid. If it is felt necessary to include a different valuation, the reason should be stated in your reports. ! ! Keith Checkley & Associates ! ! Credit Skills Academy DEBENTURES When the bank has a debenture charge, then monthly figures (as well as monitoring business performance through ratio analysis, cash flow and management information) can be called for to help monitor the bank advance. After considering the nature of the debenture charge in general, we will look at the type of monitoring that can be used. Bankers will frequently encounter situations where a company customer has executed a debenture charge to the bank.