Let’s start with the need! Why do firms borrow money? If you think about it there are actually two separate questions. The first question is why does the firm need money – as in what will the money be used for? The second question is why is the firm borrowing money? A healthy business should have a number of financing options readily available – why is a bank loan the first choice? Is it the first choice?
How these questions are asked and answered is a key input in the final credit decision.
Why does the firm need money and what is it going to do with it? The most common reasons shared by loan applicant are:
- To fund working capital. Businesses need to invest in inventories & receivables before they can generate and collect revenues from customers. A working capital loan is used to fund inventories and current assets build up and is paid off when these assets are converted into sales or cash. Firms use the working capital loans to cover operating expenses during the production and sales cycles and then use proceeds from the collection cycle to pay down the loan.
- To get better terms on existing loans or lines of credit. Although businesses prefer to work with relationships, any exercise that can improve fixed cost structure of a firm can create value. The fact is interest payments are as fixed as it gets (despite their occasional floating nature) and it is difficult to ignore proposals that can reduce debt servicing load on operating income. Improving credit conditions and scores, lower market interest rates, competition, economic growth are all factors which should result in a higher credit ranking and lower interest rates for a customer.
- Growth. Return on equity and retention ratios determine the rate at which a business can grow without resorting to external funding. When businesses grow faster than their sustainable growth rate, they need external sources to fund the excess growth. The real issue with growth is that it needs to be managed. More businesses fail due to mismanaged and out of control growth than due to an absence of the same. In a credit setting it’s wise to remember that growth is the most common reason for business loans as well as business bankruptcies.
- Expansion of business. Beyond organic growth covered above, businesses also come across opportunities to expand in jumps. Investment in new plant and equipment, land, real estate, warehouses is one way to do it. Buying related businesses or franchises, new branches and locations are others. These are normally classified as special projects. A key consideration is the value created by the project by itself as well as part of the business.
Some businesses are reluctant to disclose the exact motivation behind borrowing. In such instances stage of development of a firm can justify, to some extent, the rationale behind the loan. However, for the credit analysis process to work and for the optimal design of the credit facility it is important that the exact need and use of proceeds is identified.
Sources of repayment.
Once the need and use are identified, the next big question is how the loan will be paid back?
Some potential repayment sources are:
- Healthy companies generate positive cash flows from operations, with which they can make interest payments and repay principal. If a loan will accrue value by increasing cash flows and improving profitability then the incremental change in cash flows and profitability will become the source for repayment. A new plant that adds capacity in a growing market where customers orders are backlogged is one example.
- Companies also sell or convert liquid assets to generate cash. The generated cash is dependent on how and when cash conversion or sale occurs. Current assets, like inventory and customer receivables, when converted to cash under the normal operating cycle, generate excess cash captured in the form of profits. However the same asset when liquidated under bankruptcy may not cover costs. The same holds true for receivables when factored or sold under times of stress. Some businesses also hold excess cash or cash reserve on their balance sheets.
- Fixed assets are a tricky item. If the two sources above cannot cover the loan you are in “big game territory” or asset based lending. The question that you may want to ask yourself is – With the possible exception of real estate, how do you plan to collect on the loan in event of default? You need to walk through the worst-case scenarios first to see if the end result would be acceptable to the bank. Remember the bank is primarily in the lending business. While foreclosures and forced sales are part of the workout business, they destroy value for both the bank and the client. Even if a lender has a direct claim on the title for the asset, bankruptcies and workouts get complex very quickly. Especially if a court decides that the asset in question is essential for allowing the business to survive as a going concern.
- It is also very common for a firm to take on fresh debt to refinance maturing loans. Such a situation is generally applicable to companies that maintain a specific level of debt or leverage. When the time to repay maturing loans comes, instead of using cash flows from operations, these companies take on new debt to pay off maturing obligations.
- As businesses become profitable, attract additional equity investment or start building up cash reserves it is quite common for them to pay off existing loans to improve profitability and cash positions.
Most lenders want to identify at least two reliable and independent sources of repayment. One primary, one secondary.
Lets take a look at Willy Whale Inc., a 10-year old firm in the stuffed toys & franchising business that has applied for a credit line of $18,000,000. Willy’s sales are very seasonal with 90% of revenues generated between October and March the rest of the year remains very flat. Willy Whale uses the quiet period to produce inventory and close orders with major retail chains.
The loan officer has gone through Willy Whale’s Cash Flow Statement. The statement shows that in 1997, 1998 and 1999, Willy had the following cash flows (all figures in ‘000’s):
|Willy Whale Inc.||1997||1998||1999|
|Annual Cash Flow||$(8,000)||$(8,000)||$(8,000)|
On the most recent balance sheet as of 31 Dec 1999, the biggest items were:
|Willy Whale Inc.||1999|
|Cash & Marketable securities||$5,000|
|Other Current Assets||$3,000|
|Plant & Machinery||$57,000|
|Warehouses & Real Estate||$57,000|
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.
As a member of the credit committee for your bank, this information has now landed on your desk. A few things jump out at you.
- Inventory and receivables are potentially 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 is of concern. Do we have enough history and data to be sure that the next year is going to be positive year?
- Between inventory and 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 and the most worrying feature are 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.
Think about Willy Whale. We will come back to it later.