Credit

Question 1

What is Credit Risk?

Answer 1

The chance of not receiving money back in a timely manner and as agreed.

Evaluating credit risk is the process in lending that determines the acceptability of a proposed transaction based on the inherent risk of the opportunity and the lessor’s credit policies.

Question 2

What are the Five C’s of Credit?

Answer 2

*Character-Lessee’s reputation and performance on past obligations

*Cash Flow-Does the lessee have the capacity to repay the lease?

*Capital-Does the lessee have the ability to withstand a setback

*Collateral-What is the value of the asset securing the lease?

*Conditions-Terms of the contract, economic, industry

Question 3

What is Collateral?

Answer 3

What is the value of the asset securing the lease?

ex: When someone obtains a mortgage, the home serves as the collateral for the loan.

Question 4

What are the 4 parts of a Credit Process?

Answer 4

Receive request, collect data, analysis, decision

Question 5

What info is needed for a credit evaluation?

Answer 5

Time in business
Lessee’s industry
Type of equipment
Business credit reports
Owners/principals names & personal credit reports
Quality of the vendor
Structure of the lease
New/Used equipment
Equipment location

Question 6

What’s Needed for a Mid & Large Ticket Item?

Answer 6

Reports of outside agencies (e.g. AM Best/Public rating reports)

Review of lessee’s financial statements
- - 3 years of financial statements + interims

Bank agreements and covenant details

Projections

Question 7

Additional Questions to Wonder and Ask for Credit Evaluation

Answer 7

Why are they making the capital expenditure?

Quality of financial disclosure

Organizational structure (corporation type, partnership type, sole prop) **Org Chart!!

Question 8

What is the Origination Channel?

Answer 8

Direct Organization
– Ie. direct sales at FAEF
TPO
–Third party Originator, source of broker is between the lender and lessee
Vendor
–Manufacturer or dealer sales rep is between the lender and the lessee
Indirect
–“Buy/sell” function, allows for a solution for the client without holding all of the exposure. Allows lender to balance portfolio risk. (ie. CNB)

Question 9

First C of Credit- Character

Answer 9

**Know your client!!
Identifying principals and owners of a business
Who is the authorized DM?
Bank owned institutions have more rigorous requirements
— Banks held accountable for ensuring they are not financing nefarious activities
Difficult to mitigate against Character

Question 10

Preventing Fraud

Answer 10

Know your client.
Know your vendor.
UCC search to determine if another lender has a lien on the equipment.
Perform background and public record searches

Question 11

What are some Credit Evaluation Tools?

Answer 11

Credit scores and bureaus (D&B, Consumer Bureau)
Non-Traditional Sources (social media, internet searches)
Risk Ratings and Scores (Agency ratings from S&P, Moody’s)
FSA Analysis (Ratios, spreading software)
Industry Peer Comparison (Available with D&B, Troys, Value Line)

Question 12

Balance Sheet

Answer 12

Presentation of assets (what is owned), liabilities (what is owed) and the net worth (the difference between the two)

Captures the picture at the close of business one day in time
**(a snapshot in time)

The two sides must equal: Assets = Liabilities + Owners Equity

Left Side- Assets
Current Assets- either cash available or convertible to cash within 12 months
**Liquidity (Cash First)

Right Side- Liabilities followed by Owner’s Equity
Listed in order if who gets paid first- lenders get paid before owners
Current liabilities- due within 12 months

Question 13

Income Statement

(aka- “Consolidated Statements of Operations”)

Answer 13

Presentation of revenues and expenses for a specified period of time
Most common are yearly, semi-annually and quarterly

Revenues:
–cost of goods sold
– gross margin
–operating expenses
–other income/expense
–net income

Question 14

Statement of Cash Flows

Answer 14

In accordance with FASB95, required in the annual report-

**Shows a company’s cash receipts and payments during a specific accounting period
**Reflects a reconciliation of cash; does not provide a credit view of cash flow
**Non-cash items that may appear; depreciation, amortization, bad debt provision, impairment of goodwill

Question 15

Accountant’s Notes

Answer 15

Will see in audited and reviewed statements-

Listing of significant points regarding specific balance sheet or income statement accounts that need to be understood such as:
–Accounting methods used to evaluate inventory
–Notes regarding debt obligations

Many analysts read the notes first to identify red flags such as:
–Mention of going concern, liquidity issues
–History of covenant violations
–Contingent liabilities

Question 16

Financial Statement Analysis

Answer 16

*Earnings stability
*Liquidity
*Debt
–Maturities-Size and spacing over time (balloon payments)
–Purpose of debt and whether it matches outcome
–Contingent and off-balance sheet liabilities
*Capital structure and solvency
*Cash flow coverage

Question 17

Financial Ratios

Answer 17

Five Areas of Focus:

Profitability
Activity
Liquidity
Leverage
Cash Flow Coverage

Question 18

Financial Ratios

Gross Profit on Sales (Profitability)

Answer 18

Gross Profit/Total Sales(Revenue)

Represents the percent of total sales revenue that the company retains after incurring the direct costs associated with goods and services sold (Cost of Goods Sold or COGS)

Also referred to as Gross Margin

Higher percentage is good
–Company is retaining more on each dollar of Sales

Question 19

Sample Income Statement

Answer:

Answer 19

Sales: $1,000,000
Cost of Goods Sold: $900,000
Operating Expenses: (excluding D&A below) $40,000
Depreciation & Amortization: $5,000
Taxes: $1,000
Net Profit: $54,000

Gross Profit on Sales:

–I only need my income statement
–Step 1-Subtract COGS from Sales = $100,000
–Step 2-Divide that result by Total Sales
–$100,000/$1,000,000=.10 or 10%

Question 20

Return on Equity (Profitability)

Answer 20

Net income/Equity
Should be steady or growing when compared with industry data
ROE increases combined with increasing leverage may not be a positive indicator

Question 21

**Know how to solve for “Return on Equity”

Question 22

Current Ratio (Liquidity)

Answer 22

Current Assets/Current Liabilities

Measures a company’s ability to pay its short term obligations

Higher ratio can mean slow receivable collection or excess inventory, but generally favorable

Generally, want a ratio of more than 1.25:1

Question 23

Solve for Current Ratio

Answer 23

I need my Balance Sheet to solve for this ratio, but, need to determine:
Current Assets (numerator) and Current Liabilities (denominator)

Current Assets include Cash, Accounts Receivable and Inventory
–$85,000
Current Liabilities are LOC Balance, CPLTD and Accounts Payable
–$51,000
Divide Current Assets/Current Liabilities
–$85,000/$51,000 = 1.67

Question 24

How to Solve for “Return on Equity”

Answer 24

I need my Income Statement and Balance Sheet to solve for this ratio

For the number, I need Net Profit from the Income Statement
–$54,000

For the denominator, I need Total Equity from the Balance Sheet
–Common Stock + Retained Earnings = $250,000

Divide $54,000/$250,000 = .22

Question 25

Quick Ratio (Liquidity)

Answer 25

Generally (Cash & Equivalents + A/R)/Current Liabilities
Over 1:1 is good
Indicates a company’s ability to pay its current liabilities
Also known as the ‘Acid Test’

Question 26

How to solve for: Quick Ratio ((Liquidity)

Answer 26

I need my Balance Sheet to solve for this ratio, but, need to determine the most liquid assets which are Cash and Accounts Receivable
$60,000
Current Liabilities was already calculated in the Current Ratio and is the denominator
$51,000
Divide $60,000/$51,000 = 1.18

Question 27

Inventory Turnover (Activity)

Answer 27

(Average Inventory/Cost of Goods Sold)*365

Higher number of days could be an indicator of:
–Mismanagement
–Overstocking
–Obsolescence

Question 28

Inventory Turnover

Answer 28

I need my Balance Sheet and Income Statement to Solve
Numerator is the balance of Inventory = $25,000
Denominator is Cost of Goods Sold = $900,000
Divide $25,000/$900,000 = .028
Multiply your answer by 365 = 10 (days)

Question 29

Debt to Equity (Leverage)

Answer 29

Total Liabilities /Total Equity (Net Worth)

Higher number means more debt in relation to invested capital and retained earnings

Higher debt levels reduce the possibility of a full payout to creditors in the event of a business liquidation

Question 30

Debt/Equity

Answer 30

I need my Balance Sheet to solve

The numerator is Total Liabilities (LOC, CPLTD, A/P & LTD) = $150,000

Denominator is Total Equity (Common Stock + Retained Earnings) = $250,000

Divide $150,000/$250,000 = .6

Question 31

Debt to EBITDA (Coverage)

Answer 31

Total Liabilities /EBITDA

Measure of a company’s ability to repay its debt obligations

EBITDA= Earnings before Interest, Taxes, Depreciation & Amortization

Question 32

Solve for: Debt/EBITDA

Answer 32

I need my Income Statement and Balance Sheet to solve

The numerator is Total Liabilities (LOC, CPLTD, A/P & LTD) = $150,000

Denominator is EBITDA = $60,000

Divide $150,000/$60,000 = 2.5

It would take the company 2.5 years to pay off its liabilities assuming no change in earnings and liabilities

Question 33

Cash Flow Analysis

Determination of a company’s ability to repay its debt obligations

Answer 33

Traditional Cash Flow-focuses on the income statement

Cash Throw Off-Combines Changes in the Income Statement and Balance Sheet

Considered a more sophisticated approach

Question 34

Cash Throw Off/Impact on Cash

Answer 34

Refer back to examples in slide deck (slide 53)

Question 35

PD

LGD

EAD

All Above= Expected Loss AIRB

Answer 35

Probability of Default is the likelihood a borrower will default.

Loss Given Default is the expected loss in the event of a default.

EAD is the exposure at default

Question 36

Solve For:
PD * LGD * EAD = Expected LossAIRB

Answer 36

PD= 2-L (.7%)
LGD=166 (40%)
EAD= 2,000,000
Expected Loss=5,600

Question 37

Examples of Common Risks/Challenges:

Answer 37

Deteriorating revenue base
Decreasing profitability
High risk industry
Insufficient cash flow
Tight liquidity
High leverage
Substantial distributions/unwillingness to guarantee
Structural risk
Requested term length not in line with financial strength of lessee

Question 38

Mitigants:

How do we mitigate that risk?

Answer 38

Shortening the lease term
Increase the number of advance payments
Addition of guarantors/co-lessees
Additional collateral
Security deposits

Question 39

Credit Scoring

Answer 39

Consistent Decisions

Efficient Process
–Speeds up turn times
–Allows credit team to focus on more complex transactions

Utilize
–Personal credit reports
–Business credit reports (Experian, D&B, Paynet)
–Custom credit scoring models (Fair Isaac)

What type of information is a client asked on an application?