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Credit Process: Credit Culture and Information Gathering Foundations

Credit Culture.

Organizations have formal and informal processes in place for getting things done. Credit culture refers to the comfort level developed within a lending institution, over the years with a number of issues and factors.

  • What policies does the bank have (in writing or otherwise) with respect to lending?
  • Does the organization prefer lending to small businesses or large ones?
  • What kind of industries and businesses does the institution lends to? What segments of the market (which industries) does the bank target actively for its loans?
  • What is the maximum limit for a bank-only loan? For a syndicated loan?
  • What factors are loan officer expected to consider while studying each individual application?
  • What process does the bank have in place to ensure a scientific / objective assessment of potential borrowers’ creditworthiness?
  • What are the inherent characteristics of the applicant’s business and industry? Has the bank done business with the applicant’s firm before or will this be the first experience?
  • How risky would it be for the bank to lend to a certain business? Is the bank aggressive (risk-seeker) or conservative (risk-averse)? Each lending institution has a comfort zone with respect to risk. What and where is that comfort zone?
  • What would the rewards or returns be if a loan is approved? Can the bank measure the value created? Is the bank interested in the value created by the approval? What is the ratio of risk to returns? Is that ratio in line with what the bank has been following in the past?

Getting comfortable with this “credit culture” is the first thing you need to do as a loan officer. Let’s see if we can help with an example.

The Regional National Bank is a 30-year-old small community bank with 250 Million dollars in assets. The bank has 200 million dollars in customer deposits and another 50 million dollars in capital /equity. It specializes in working with small to mid sized businesses that do not have the credit profile required by some of the larger national banks. The bank has relationship officers that work with new customers from the point they step in a branch as an applicant. The bank takes great prides in being a partner in its customer’s success by providing financial solutions, products, services and support and has been the recipient of numerous regional, state and industry awards for its commitment and service to small businesses. As of 31st December 2000, Regional National Bank had 1,100 commercial customers with an average outstanding loan balance of 200,000 dollars. Besides financial services, the bank also provided optional legal, trust, insurance, employee benefits, payroll processing & mortgage solutions to these 1,100 customers in collaboration with a number of independent regional service providers. The Bank earned substantial referral fees and commissions on these transactions.

Here is some selected data from the bank’s lending and employee-training manual that answer some of the questions asked above.

  1. What policies does the bank have (in writing or otherwise) with respect to lending?
    • Profitable growth working with customers in targeted segments
    • Geographic diversification within the five neighboring states (NY, NJ, CT, PA, MA)
    • Emphasis on managing & growing existing relationships
    • Extensive use of technology and information resources in the information gathering & processing stages
    • Final credit decision made by relationship officer after review by credit committee
  2. Does the organization prefer lending to small businesses or large ones?
    • Small businesses (between 1 Million – 10 Million dollars in annual revenues)
    • Profitable, at breakeven or close to breakeven
  3. What kind of industries and businesses does the institution lends to? What segments of the market (which industries) does the bank target actively for its loans?
    • Traders, whole sellers and distributors in the health care sector
    • Clinics, Private practices & Physician Partnerships
    • Professional services businesses (law, insurance, accounting, consulting & technology)
  4. What is the maximum limit for a bank-only loan? For a syndicated loan?
    • $500,000 or 1% of capital base, whichever is higher
    • Limits for syndicated loans are determined on a loan by loan basis
  5. What factors are you, as a loan officer, expected to consider while studying each individual application?
    • Relationship
    • Profitability of underlying business
    • Competence of management team
    • Supplier and customer references
    • Professional, personal and credit profile of owners
    • Collateral Free cash flows
  6. What process does the bank have in place to ensure a scientific / objective assessment of potential borrowers’ creditworthiness?
    • State of the art credit scoring, financial analysis and probability of default solution from industry leaders. Supplemented by best practices checklist, annual profitability review & target customer profile
  7. What are the inherent characteristics of the applicant’s business and industry? Has the bank done business with the applicant’s firm before or will this be the first experience?
    • 30 years of experience in dealing with professional services firms and physician practices. Bank has expanded to the health care sector distributors on one side and similar professional services segments on the other side. Prefer to work with customers from these three segments.
  8. How risky would it be for the bank to lend to a certain business? Is the bank aggressive (risk-seeker) or conservative (risk-averse)? Each lending institution has a comfort zone with respect to risk. What and where is that comfort zone?
    • Conservative. Will only lend to businesses in the target industry that meet the acceptable customer profile.
    • Aggressive use of collateral, personal guarantees, references, relationship management & monitoring tools to lower risk of default.
    • Extremely active in Asset backed lending, Leasing & Real Estate Mortgage products area. In last two categories role limited to collection of origination & servicing fees.
  9. What would the rewards or returns be if a loan is approved? Can the bank measure the value created? Is the bank interested in the value created by the approval? What is the ratio of risk to returns? Is that ratio in line with what the bank has been following in the past?
    • Work with owners and managers to determine cost of capital and value created by application of proceeds. Establish the basis of relationship as a financial partner and advisor – not just a lender.
    • Will not fund or finance negative NPV or value destroying projects.

Information Gathering – Foundations

Remember Willy Whale from the session on why firms borrow money. Well let’s work with Willy Whale Inc. again and see if it can help us understand the informational needs of a lender.

Here is a recap of Willy’s profile and our initial assessment from above.

Willy Whale is a 10-year old firm in the stuffed toys & franchising business that has applied for a credit line of $18,000,000. Willy’s sales are very seasonal with 90% of revenues generated between October and March, while the rest of the year remains very flat. Willy Whale uses the quiet period to produce inventory and close orders with major retail chains.

As a loan officer has gone through Willy Whale’s Cash Flow Statement. The statement shows that in 1997, 1998 and 1999, Willy had the following cash flows (all figures in ‘000’s):

Willy Whale Inc.199719981999
Annual Cash Flow$(8,000)$17,000$(11,000)

On the most recent balance sheet as of 31 Dec 1999, the biggest items were:

Willy Whale Inc.1999
Cash & Marketable securities$5,000
Receivables$43,000
Inventory$46,000
Other Current Assets$3,000
Plant & Machinery$57,000
Warehouses & Real Estate$57,000
Accumulated Depreciation$29,000
Total Assets$181,000

On the liabilities side, Willy already has two outstanding commercial loans with current balances of $72,000,000, with a competing bank. Existing plant, machinery & warehouses serve as collateral for the two loans. Annual debt servicing for the two loans is 9,000,000 and is expected to stay at that level. Willy Whale account’s payable balance as of 31 December 1999 was $24,000,000.

Willy Whale needs the loan to pay suppliers and cover operating expenses from April to November. During your initial assessment, the following things jump out at you

  • 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 one thing that does bother you is 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.

Before you present your case to the credit committee there is a lot of groundwork that needs to be done. You have received some information from the customer but a detailed credit application needs to be filled out by Willy Whale Inc. You also need to prepare the credit memorandum that summarizes your analysis and recommendations. Where do you start? By gathering information! Let’s look at an initial checklist

  1. Business – Need, Analysis & Risk
  2. Repayment sources
  3. Industry profile
  4. Management
  5. Track record

Business – Need & Risk

  • What is the financial structure of the firm?
  • What clues do financial statements of the past five years give?
  • How much capital investment has been made? What is the existing leverage situation of the firm?
  • Is the firm privately owned or is it listed on any stock exchange?
  • What strategy is the firm pursuing and has it made the firm successful?
  • What are the characteristics of the business (in terms of location, size of firm, number of employees etc)?
  • What, if any, ratings have other lending institutions and credit rating agencies provided for the firm?
  • What information (credit history) is available with other firms about this business?
  • Has the firm undertaken the activities for which it now requires funding in the past? If yes, how was that activity funded? Has it resulted in favorable results?
  • What will the money be used for?

Repayment Sources

  • Existing loans, covenants & collateral
  • Details of collateral held on existing loans including loan to value ratios
  • Available assets for future secured loans
  • If receivables are available, aging summary of receivables and payables
  • Accounting firm opinion on accounting, collection and book keeping procedures

Industry Profile

  • Industry structure (customers, suppliers, substitutes, competitive interaction)
  • Value Drivers
  • Economic profile, historical performance and future outlook

Management & Track Record

  • Management Team (Background, credit, personal and professional references)
  • Board of Directors (Background, credit, personal and professional references)
  • Historical performance (Compensation, ROE, ROA, Productivity, Profitability & Value Added)
  • Comparison with industry benchmarks

The idea is to create two lists – one for reasons to lend, the other for reasons not to lend. Some pieces of information will raise additional questions or insights that would need yet more information. Besides secondary or published data, you would need to go out and do some research on your own including conversations with industry professionals, the management team & key employees. With each new piece of information you get your hands on, stop and think about if you have enough reasons or not (for the two lists above).

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