Topic 2 - Principles Of Lending Flashcards
Key principles of lending
- profile of the customer - assess their character
- determine the lending criteria and purpose
- ability to repay - sufficient capital. Repayment profile consistent with cash flow projections
- suitable term
- security
- pricing to reflect the risk
Person -what 3 C’s should be considered?
Character
Capacity
Commitment / Capital - how much assets do they have?
CAMPARI
Character Ability Margin Purpose Amount Repayment Insurance - security
PARSERS
Person (3C’s) Amount Repayment Security Expenditure Remuneration Services
PARTS
Purpose Amount Repayment Term Security
5 C’s - the most important one!
Character - verify their identity; key characteristics - respectable; trustworthy; honest; dependable; high integrity.
Capacity - age (borrowing repaid before retire?); experience with this venture; reputation (for previous loans).
Commitment - skin in the game - higher contribution the greater the chances of our borrowing being repaid
Conditions
Collateral
Factors to consider to assess the character of an existing customer?
- how long have they been customer of the bank
- reputation and track record
- account handled in a satisfactory manner with previous borrowing repaid on time?
- regular lodgements on the account
- understand flows (min/max/average) over the last 3 yrs
- any charges applied re unauthorised overdrafts - evidence of item having returned unpaid for lack of funds?
Assessing character of a new customer
- previous bank and why did they leave?
- unhappy with service/high charges/ decline ?
- talk to people and meet the new customer at their premises
Profile of the customer - questions to consider
- financial acumen
- qualifications and experience
- age
- integrity and reliability
- organisational ability and efficiency
Do they understand their own business’s cost and capital structure
Character of the business - key issues to consider
- Capacity if the mgmt, business and industry
- how does the business compare with industry norms
- premises - owned vs leased? Terms of the lease? Does the business make enough to keep up with int payments? Sufficient space for business to expand? Next rent review?
- seasonality - retain profits
- management - relate well to each other? Identify with common goals and objectives? How is ownership and control distributed in the business
- plant and equipment -machinery owned or leased? How old and when does it need to be replaced?
Key issues to assess people and character
PESTLE - external - legal issues, industry and business sector, political issues, maker, economy, changes in taxation, competitors, technology and its impact on the product, supply chain.
Internal - cost structure, staff, succession planning, profitability, service levels.
Purpose of the loan - what to consider?
Is the purpose of the loan legal? Impact on reputation risk? Consider banks policy on lending to particular types of customer? Credit controls imposed by regulations? FCA’s guidelines - one customer cannot account for >10% capital base.
LTV
Loan to value - the ratio of the size of the borrrowing compared to the value of the asset being purchased; measure of risk for a lender. High LTV - high risk - high margin applied.
How does the term of the borrowing link to the purpose?
Depending on what the purpose of the loan will be, the repayment and term of the loan should be structured accordingly. The longer the borrowing term, the lower the monthly payments.
Commons reasons why the business borrows?
1) working capital - finance operating costs, variable costs, and fixed costs until trade debtors are converted into cash;
2) working capital - to finance stocks until they are converted to finished goods and sold and the debtors turn into cash;
3) long term debt with repayment from future cash flows - finance the purchase or refurb of PPE until used over many trading cycles in producing output which is converted to sales and then to cash;
4) growth -finance a whole range of asses and pay additional operating costs to support rapid growth;
5) Change in company’s ownership - e.g management buyout;
6) to finance one-off projects such as property development;
7) to finance survival - turnaround - to resolve cash leakage, insufficient profits or to recover losses. Risky!
Main stages of a trading cycle
Buys raw materials - starts producing goods - goods production complete - sell goods to consumers - collect cash from customers - use this to pay suppliers and expenses - buy new raw material again…
Why doesn’t increase in sale generate extra cash in all case?
- there is an optimum level where growth can be funded through profits
Therefore important to distinguish where customer is borrowing due to sales growth or due to slowdown in trading cycle.
Sources of repayment?
Refinance
Income - expenses (ensure this is a realistic projection and in line with other customers)
Typical items to use as security
- legal mortgages over property (standard securities in Scotland)
- floating charges from companies
- guarantees
- life policies
- stocks and shares
Covenants
Obligations on the borrower such as provision of info to the bank and adherence by the customer to financial covenants such as interest cover or gearing ratio. Ensures risk profile of the loans is maintain during its tenor.
What should a good business plan have?
- contact details
- synopsis
- business background
- products or services
- process
- market analysis
- marketing strategy
- proposal
- property
- management or staff
- financial information
- risk assessment
- PPE
- skin in the game
Loan suitable for an asset purchase
Term loans or asset finance product
3 factors to consider in relation to Security?
- simplicity of title - quick, cheap and easy to arrange, discharge - realise and release - e.g gov bonds
- stability of value - shouldn’t fluactuate too much. E.g quoted investments. Commercial property too hard to value.
- realisability - how quickly can the security turn into cash with minimal formalities as any delays can increase losses from the principal debt and interest.
How does a bank make money?
- net interest margin between lending and deposit rates
- loan arrangement fees
- charges for services provided by the bank
- commission and payments received from outside agencies for referring clients
