Credit Terminology continued.
Equity is what the original owners of the firm have put in the company. In other words, equity represents what the owners of the firm contribute towards financing the business. Equity is the cumulative value of the following:
- Common stock
- Preferred stock
- Retained earnings
Bankruptcy, reorganization and workout.
A firm is bankrupt when there is nothing (or a negative balance) left after subtracting total liabilities from total assets or when assets may be more than liabilities but after converting all assets into cash the generated amount may not be enough pay off the business’ obligations.
The probability that the firm will be able to meet its financial obligations declines as its debt and liabilities increase. High level of debt requires greater payouts for interest payments and principal repayments. When a firm crosses the threshold from being solvent and becomes insolvent, it is left with limited options. Bankruptcy is one mechanism that allows a troubled business to seek legal protection from creditors. This give the firm an opportunity to focus on it’s core business and survive as a going concern.
For a firm to survive bankruptcy creditors & shareholders need to agree on a restructuring plan. A restructuring plan takes the pre-bankruptcy liabilities and reduces them to a level that could be supported by the post-bankruptcy firm. To compensate lenders for their losses, it also reallocates ownership of the firm to the creditors in a similar fashion. At the end of this exercise, if there is anything left, it is assigned to existing shareholders. If no amicable agreement is reached mechanisms exist to shut down the firm and liquidate assets to payoff creditors.
Stakeholders are all those individuals and institutions that have an interest and/or association with the company.
- Customers – this group is interested in whether a business can consistently provide quality goods and services at a reasonable price
- Employees – they want to be compensated adequately for the work they perform and would like to keep their jobs in the long run
- Owners – this group has invested a great deal of time and money in the enterprise and is interested in receiving adequate returns on investment
- Suppliers – they want to sell their products to the business and earn a profit on sales
- Creditors – this group lends money to the business, also want to earn a profit and be repaid
- The Government – wants to collect taxes and maintain a clean and healthy environment where the rights of various parties are protected
On and off stakeholders also become an important source of financing for a business. For example, by providing goods and services on credit, a supplier finances a part of the business for a short time period. Similarly, customers make advance payments, employees agree to work first and get paid later, while the government allows a reasonable flexibility in how and when taxes are paid. However, the big difference between creditors and other stakeholders is that other constituents may become creditors in support of their primary goals, while for a lender, being a creditor is the primary goal.
Credit Limit is the maximum amount a lender agrees to lend to a borrower. When a borrower approaches a lending institution for a loan, the final amount of the loan, may be less than or equal to the original request. Beyond creditworthiness and credit rating, the limit is closely related to the credit exposure a lender is willing to take with respect to a certain borrower.
With loans of very high amounts, (high being a relative term), a group of banks will form a syndicate (read: association) to make the loan and/or commitment. This helps avoid large credit exposure to any one client. It also makes negotiation and documentation simpler for the syndicate and the borrower. A syndicated loan is governed by one set of documents and covenants (read: terms and conditions) that all of the participating banks agree to. One bank takes the lead role of the arranger or agent.
The lead bank negotiates the terms of the loan with the borrower on behalf of all of the banks.
A basis point (bps) is a part of a percentage point. 100 basis points make up a full percentage point. Hence, 5 basis points equal 5 / 100 of a percentage point.
An example will make this clearer. Banks normally charge commitment fees on revolvers. You have an outstanding revolver of $10,000,000 and a commitment fee of 10 basis points (bps) on any unused balance of the revolver. If you don’t plan to use the revolver at all, the commitment fees due at the end of the year will be
Commitment fees = (10 / 100) * ( 1/ 100) * $10,000,000
= ( 10 bps ) * ( 1% ) * $10,000,000
= 0.001 multiplied by $10,000,000
One of the big concerns lenders have is creation of incentives that would force a borrower to make a lending relationship work (honor the loan obligations when due).
An unsecured loan is a loan that is a general obligation with no recourse to specific assets. These loans are made because of good faith, great track record of business, existing relationships, credit history or a strong parent company. But if the borrower defaults, the lender will have to stand in line with other creditors of the business and settle for the proportionate share of assets allocated to him by the bankruptcy court.
A secured loan on the other hand is a loan, which uses a specific asset to guarantee the performance of the loan by the borrower. For instance a mortgage loan secured by the underlying real estate, a car loan secured by the vehicle purchased by the loan, an equipment loan secured by assets purchased by the loan, etc. In event of a default on the loan the ownership and possession of the secured asset transfers to the lender, who can then do whatever he wants with the asset to recover principal and interest payments.
The asset used to secure a loan is called collateral. Secured loans or loans with collateral have a much lower probability of default than unsecured loan. Collateral also serves as a very powerful signaling instrument for lenders. Within a certain grade or class of borrowers, the credit risk associated with firms willing to offer collateral, is always lower than firms that are not. Collateral can be any asset including real estate, machinery, accounts receivable, inventory, etc. The two most common types are:
- Internal or inside collateral refers to assets owned by the firm itself. Examples are equipment, land, inventory etc. Even if the bank extends an unsecured loan, it would have a right over these assets (even if it may not be the first right). However, if an asset is promised as an inside collateral, the bank or other lending institution would have first claim over the asset.
- External or outside collateral refers to assets that are not directly associated with the business. The lending institution would not have claim to any of these assets unless they were pledged as collateral. Examples are the personal assets of the owner.
Lenders or creditors ask for collateral to ensure that in event of default or bankruptcy or liquidation, they are repaid at least in part if not in full. However, securing a loan with a collateral does not ensure recovery. The collateral can lose value. This may happen over the years, when the borrower acts in a manner that undermines the value of the collateral. Translation – value of the collateral diminishes before the lender exercises his or her claim on it. As a result the lender is unable to recover the loan, even after disposing the collateral. Besides the risk of deterioration, there are liquidation costs and legal costs associated with the transfer, collection and eventual sale of the collateral that further reduce recovered amount.