Preparing credit proposals and memos

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Continuing with our previous post on credit culture and information gathering requirements we share our list of required information with Willy Whale.  Willy Whale sends us the following information.

• Exhibit One is the 5 year consolidated balance sheet
• Exhibit Two is the 5 year consolidated income statement

These are the latest audited figures. We also look up a third party company profile for Willy Whale which included industry specific credit report, supplier and trade references and a composite credit score. We also run selected ratios from your financial analysis software that takes financial statements and generates a pre-formatted financial analysis. An extra add in also generates estimated free cash flows and a comparative analysis and benchmark for each ratio with sector and industry databases.

We are now ready for preparing the credit proposal.

• Exhibit Three is the free cash flow calculation.
• Exhibit Four is the preformatted financial analysis

Exhibit One – Balance Sheet

Balance Sheet	1996	1997	1998	1999	2000
Cash & Marketable Securities	5	–	4	5	10
Accounts Receivables	25	34	44	43	51
Inventories	41	43	47	46	46
Other Current Assets	9	9	5	3	2
Total Current Assets	80	85	99	98	108
Plants, Equipment & Machine	60	57	54	57	59
Real Estate	40	64	51	57	55
Less: Accumulated Depreciation	20	26	27	29	32
Total Fixed Assets	80	94	77	84	82
Total Assets	160	179	177	181	191
Notes Payables	25	26	29	9	10
Current Maturities of Long Term Debt	2	3	3	9	10
Accounts Payable	24	30	29	24	23
Accrued Liabilities	11	9	11	9	17
Long Term Debt excl. current portion	22	43	49	72	76
Total Liabilities	84	109	119	122	135
Share Holder’s Equity	76	70	58	60	56
Liabilities & SH Equity	160	179	177	181	191

Exhibit Two – Income Statement

Income Statement	1996	1997	1998	1999	2000
Revenues	130	142	153	171	190
COGS	45	64	70	77	89
Gross Profit	85	78	83	94	101
Sales & Marketing	29	40	41	45	48
General & Administrative	19	21	24	22	27
Depreciation	20	6	2	4	3
Operating Profits	17	11	16	23	24
Interest Expense	2	4	5	9	11
Income before taxes	15	6	11	14	13
Taxes	11	3	5	6	5
Net Income	4	4	6	9	8

Exhibit Three – Free Cash Flows

Free Cash Flows	1997	1998	1999	2000
After Tax EBIT	6	10	14	14
Add back depreciation	6	2	4	3
plus changes in current liabilities	4	5	(28)	8
less changes in current assets	5	14	(2)	11
less Cap Ex	14	(17)	5	(2)
Free Cash Flows	(2)	20	(12)	16

Exhibit Four – Pre Formatted Financial Analysis

Ratio Analysis	1996	1997	1998	1999	2000
Return on Equity	5%	5%	13%	14%	15%
Profit Margin	3%	3%	5%	5%	4%
Asset Turnover	0.81	0.79	0.86	0.94	1.00
Liquidity
Current Ratio	1.29	1.28	1.38	1.97	1.84
Acid Test	0.63	0.64	0.72	1.03	1.06
Turnover Ratios
Inventory Turns	3.17	3.33	3.23	3.70	4.17
Receivable Turns	5.20	4.17	3.45	4.00	3.70
Asset Turns	0.81	0.79	0.86	0.94	1.00
Leverage
Debt to Equity	29%	61%	85%	121%	137%
Debt to Assets	14%	24%	27%	40%	40%
Time Interest Earned	8.59	2.47	3.41	2.66	2.26
Average Collection Period	70.19	87.60	105.85	91.25	98.55
Average Payment Period	194.67	170.33	150.76	113.56	93.19

Preparing credit proposal – information processing 

There are two significant steps within the information processing

1. Information pre-processing
2. Preparation of Credit Memorandum or Credit proposal

Pre Processing

The first logical step is to sort the information out by quantitative and qualitative significance.  There is information that translates directly into numbers and there is information that leads to insights and requests for additional information. As you browse and sort through the material, impressions will also form.  If we go back to the initial reaction to Willy Whale, Inc, the first thoughts to cross the loan officer’s mind were:

• Inventory and receivables are available to secure the credit line.
• Against total assets of 181 million dollars, total debt (current as well as long term) stands at 114 million. Almost 50% of the assets are current assets, split almost equally between receivables and inventory.
• The cyclicality of cash flows. Do we have enough history and data to be sure that the next year is going to be positive cash flow year?
• Between the inventory & receivable balances you have two potential sources to pay back the loan. You are not sure how liquid the inventory is or the break up between materials and finished goods
• The most attractive as well as the most worrying feature is the two existing loans. You are very positive that it would be possible for your bank to refinance both the loans at much lower rates, resulting in substantial savings for Willy Whale as well as substantial new business and fee income for your bank. The credit line may be a good starting point for a relationship with this customer. However, the question is why has the firm not looked for better terms and why are the two loans not on the table for discussion.
• The bank’s biggest customers are the regional retail chains. Willy Whale would be the first significant customer on the supply side for the bank. You are quite excited about the possibilities of expanding your customer base into non-retail segments.

These impressions are another line of investigation that you would want to follow up. As we move forward we will come back to these impressions again and see what available information can tell us about these questions? The highlighted items identify the steps in each category.

Business risk and financial risk analysis

a. Identification of Value Drivers

There are three key value drivers for Willy Whale Inc business

• Relationships with local, regional and international suppliers
• Production facilities, storage & distribution warehouses
• Relationships with retail chains

b. Historical Crisis and reasons

It is not surprising that historically speaking all the major crisis Willy Whale suffered were in two main categories

• Pricing or supply problems with international suppliers – leading to product shortages (missing projected revenues & profitability targets)
• Demand problems at the retail chain level because of economic conditions (missing revenues & profitability targets)

c. Classification of Business (Financial Structure, Profitability, Impact of recession)

Because of Willy’s profitability situation, highly leverage financial & fixed cost structure, supply or demand problems have a dramatic impact on Willy’s bottom line. The health of Willy Whale is directly related to retail store sales. During economic slowdowns, Willy takes a direct hit as store sales shrink. Seasonality in sales, dependence on economic cycles, limited profitability are the big reason why Willy has been reliant on debt to grow its business.

d. Examination of projected financial statements & assumptions

Projections of financial statements (income statement, balance sheet and cash flow statement) for the coming years. The number of years for which projections are made is totally dependent on the bank’s policy; the usual duration is 3 to 5 years.

Willy is a highly leveraged (financially and operationally) business.  Over the past five years, management has made significant progress is growing sales, improving the cost structure, employing effective controls for reducing working capital per unit of sale and increasing returns to shareholders.  The programs have just started taking effects (evident in the last two years of financials) and as sales grow will significantly improve Willy’s profitability, return to shareholders, leverage & coverage ratios

Willy plans to grow at 8% – 12% for the next three years. Besides additional interest payments, there are no projected increases in the fixed cost structure of the firm. Projected financials for the next three years have not been submitted as yet but are expected to arrive in the next two weeks at the bank.

e. Leverage, Collateral and Ownership interest

Detailed analysis of the ratio of capital to debt, that is has the capital structure changed over the years? Have owners reduced (or increased) their stake in the business? Has the firm merged with any other business over its lifetime? Have there been any acquisitions? Has the firm’s growth pattern been appropriate considering the state of the economy and industry?

Although Willy’s balance sheet still has space to support additional debt, at this point the business is a borderline credit risk.  Coverage ratios are still healthy but they have fallen significantly from their high five years ago. In the same period LTD has increased by more than 50 Million dollars to a level where Long Term Debt finances 40% of all assets.  This is a little higher than the industry average of 28%. However, the firm has put the capital to good use.

In the past three years, there have been two dividend distributions to existing shareholders, further exacerbating the leverage situation. Since sales growth is dependent on the state of the economy a recession can have a serious effect on Willy Whale’s projected growth, profitability and leverage situation.

Existing debt, as of 31 December 2000, including the current portion stands at 86 million dollars secured by current production plants, storage and distribution warehouses (book value of assets is 82 million dollars; most recent market value appraisal is 97 million dollars).  The non-current portion is 76 Million dollars. Interest expense in 2000 was 11 million dollars.

Willy Whale is in the market for better terms on both the loans but prefers to start the relationships with the revolving credit line

Although Willy’s current and quick ratios have improved significantly over the past five years, quality of receivables has actually declined. Receivables days outstanding stood at 70 days in 1996 and stands at 99 days at year end 2000. Aging analysis shows that more than 80% of receivables lie in the 60 – 90 days outstanding bracket. Willy explanation is the extended credit terms most retail chains demand from their suppliers

Interestingly enough Inventory rationalization over the same period has reduced Inventory outstanding from 115 days in 1996 to 88 days by year-end 2000. Break up of inventory between materials and finished good is 60 – 40 (60% materials, 40% finished goods). Finished goods are reasonably marketable and include packaged stuffed toys, printed greeting cards & large custom printing orders.

f. Cash Flow Analysis – Break down by major heads, proceeds and applications

Working capital has been the biggest consumer of cash flows over the last five years. The only other significant outflows have been the two dividend distributions to shareholders in 1998 and 2000. Capital expenses had been significant in the first two years of historical statements but compared to the first two items are not significant anymore.

g. Ratio Analysis

Financial statement analysis through ratios.  The number of ratios that can be calculated is endless.  It is up to you to decide which ratios best suit your needs and provide meaningful information. The idea here it to not quote numbers and percentages but to make an attempt at interpreting the same.

Interpretation of Ratios

In Willy’s case, there has been a gradual and consistent improvement in Productivity, Profitability and Liquidity ratios over the last five years. The only red flag has been the increasing amount of leverage utilised by Willy Whale over the same period.  At the same time the increasing long-term leverage is a result of Willy’s move away from short term financing to more stable long-term financing relationships. This will have a significant impact on Willy’s cost of financing and its relationships with its suppliers. One visible sign is the reduction of Accounts Payable outstanding from 194 days to 93 days.

Preparation of Credit Memorandum

At this point, you should have a very good idea about the underlying business, its overall strategy and prospects, depth of its management team and your own personal impression (lend, do not lend).  A credit memorandum organizes information in a standard and presentable form for use by credit officers, credit committees and/or syndicate members. It includes:

1. Background information about the business
2. Projections and financial expectations for the next few years. The loan officer prepares projections of the future of the firm. These projections or expectations are stated both for the short-term (less than a year) and for the long-term (1 to 5 years)
3. A summarized report covering the analysis performed and its conclusions. Qualitative arguments that highlight the strong and weak aspects of the firm are also included
4. Recommendations (lend, don’t lend)
5. Other relevant factors that should be considered while making the decision are also mentioned.

The sections below identify some of the information that you should have at this point to prepare the document

a. Summarizing Sheet / Front Sheet / Review

Data Required

• Company (Industry code, risk factors, revenues, earnings, working capital, key contacts)
• Owners & guarantor information
• Existing loans (approved & outstanding balances, interest rates, expiry, secured, credit ranking)
• Collateral (original & current condition)
• Guarantor information
• Relationship

Presented in a one page concise format

b. Application and Repayment Section

Data Required

• Application of proceeds
• Sources of repayment
• Interest rate and term of loan
• Collateral (if secured loan)

c. Collateral

Data Required

• Accounts Receivables (concentration, break down by age & % change over 2 – 4 quarters)
• Inventory (sales turnover, classification by turnover, classification by liquidation value or marketability)
• Real Estate (description of property, location, original appraisal, current appraisal, value of improvements)
• Others (description of collateral, appraisal of current value, liquidation value & marketability)

d. Terms & Conditions

Data Required

• Loan Terms
• Covenants
• Related Financial Data

e. Company & Management Background

• Business History
• Industry overview
• Products
• Markets
• Competition
• Quality, depth & competence of current management
• Incentives & ownership structure
• Track record (prior to as well as including current assignment)

f. Financial Analysis

• Growth
• Productivity
• Profitability
• Liquidity
• Leverage
• Coverage
• Operational Cash Flows

g. Business Plan & Financial Projections

• Validity of assumptions
• Growth
• Productivity
• Profitability
• Liquidity
• Leverage
• Coverage
• Operational Cash Flows

h. Credit Management

• Monitoring strategy, exceptions & significant event
• Point of no return
• Exit strategy

i. Relationship & Issues

• Reasons to lend
• Reasons not to lend

j. Comments

k. Exhibits

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