Dimension 6 - 2 Credit Risk Certification PDF

DIMENSION 6 - 2 NOTES: PURPOSE OF DIMENSION 6 Dimension 6 focuses on appropriately structuring and documenting credit with respect to the identified repayment sources. In Dimension 6 we will cover the following topics: 1. Identifying primary and secondary sources of repayment and financing. 2. Deter...

DIMENSION 6 - 2 NOTES: PURPOSE OF DIMENSION 6 Dimension 6 focuses on appropriately structuring and documenting credit with respect to the identified repayment sources. In Dimension 6 we will cover the following topics: 1. Identifying primary and secondary sources of repayment and financing. 2. Determining the loan structure, including loan support and covenants. 3. Documenting the credit, including perfecting liens and documenting third party support. 4. Regulatory compliance 5. Loan closing procedures. CRC US Body of Knowledge 6. Identifying and mitigating environmental risk. DIMENSION 6 - 3 The material in the Body of Knowledge provides an overview of knowledge related to topics covered by the Credit Risk Certification exam. Mastery of topics reviewed here is essential preparation for the exam, but no amount of reading and study can substitute for lending skills that must be acquired through formal classroom and on-the-job training. In addition to reviewing the Body of Knowledge, consider taking the following RMA courses to support your Dimension 6 skill building: Uniform Credit Analysis I and II Structuring Commercial Loans I Structuring Commercial Loans II Product Profiles for Commercial Loans IDENTIFYING PRIMARY AND SECONDARY SOURCES OF REPAYMENT AND FINANCING Interviewing the Borrower about Expected Borrowing Needs and Resources The first step in identifying sources of repayment is to ask the borrower about expected needs and resources. Questions to ask during the loan interview include: Primary sources: –– How does the borrower expect to obtain funds for repayment? –– What are the present main sources of financing? Banks? Suppliers? Additional sources: –– What other sources of repayment are available? Other financing? NOTES: Dimension 6 // Identify Repayment Sources and Appropriately Structure and Document Credit Exposures for.. ADDITIONAL SKILL-BUILDING RESOURCES DIMENSION 6 - 4 NOTES: Sale of fixed assets? –– What are the secondary sources of financing? Sale of equity? Conversion to other types of debt? –– Are finance companies or factors used for funds? –– Do principals, relatives, friends, customers, or suppliers advance funds to the company? –– What is the nature and extent of these loans? Suppliers: –– Who are the major suppliers? –– What are the regular trade terms offered to the company? –– How good is their current relationship? –– Are discounts taken? Are payments prompt? –– Are any items currently in dispute or litigation? –– Are any special terms or relationships involved? –– Are any transactions with or through closely affiliated or mutually controlled enterprises? CRC US Body of Knowledge –– Are contracts or franchises involved? What are the details of these relationships? DIMENSION 6 - 5 Next, perform your own assessment of primary repayment sources. Recall from your reading in Dimension 4 that there are five principal borrowing causes. Each of these causes also suggests a repayment source if the underlying cause reverses: Borrowing cause: current asset growth resulting from sales growth, both seasonal and permanent. Repayment source: liquidation of current assets when a seasonal asset build-up reverses itself as the seasonal operating cycle is completed, or when longer-term growth stops or reverses. Current asset liquidation through a seasonal operating cycle is a very high quality source of repayment because it stems directly from company operations and demonstrates that the company’s seasonal asset buildup is temporary. Current asset liquidation from curtailing longer term growth, or when sales recede, is a non-renewable source of cash flow that may also signal difficulties within the company’s business model. Borrowing cause: current asset growth resulting from declining efficiency. Repayment source: current asset reduction resulting from improved efficiency. A reduction in the cash cycle reduces the cash investment in current assets. Cash released through efficiency improvement is a quality source of repayment, although it may not be a repeatable source of repayment. For example, a company that improved its cash cycle by eliminating ten days from its collection period is not likely to be able to achieve a comparable improvement in subsequent years. Borrowing cause: fixed asset expenditures. Repayment source: sale of assets. Keep in mind that sale of assets is usually not a high quality repayment source, as asset sales are generally infrequent and/or nonrepeatable. An asset sale may produce desirable cash inflows, but these should generally be considered as one-time sources that are not presumed to be available for future debt service. NOTES: Dimension 6 // Identify Repayment Sources and Appropriately Structure and Document Credit Exposures for.. PERFORMING YOUR OWN ASSESSMENT OF PRIMARY REPAYMENT SOURCES DIMENSION 6 - 6 NOTES: Borrowing cause: reduction in trade credit. Repayment source: increase in trade credit availability. When suppliers provide additional financing, the cash cycle decreases and fewer current assets need to be supported by external sources. Trade credit increases are quality sources of repayment, with the significant qualification that they are generally non-repeatable sources of new cash. Borrowing cause: decreases in net worth, including the result of unprofitable operations or the payment of dividends. Repayment source: net worth infusions from owners or new investors; change of policy to retain earnings instead of paying dividends; profitability improvement. Outside capital supplied to the business is a valuable potential source of repayment, but absent a contractual agreement it is difficult to compel future capital contributions and thus new capital as a prospective repayment source is neither predictable nor dependable. Minimum net worth requirements enforced through loan agreements can encourage earnings creation and retention, but keep in mind that although retained profit makes a stronger borrower, profits themselves do not necessarily correlate to cash flow. It is important to view fundamental profitability as a long-term driver of ability to repay debt, but the more useful measure of quality sources of repayment lies in analyzing the cash flow statement. Earnings retained in a business can contribute to long-term cash flow available to service long-term debt, but short-term operating needs must be satisfied first. CRC US Body of Knowledge Other borrowing causes can include outlays for other asset acquisition (such as investments), and restructuring current or long-term liabilities. Of course, investment sales, or liability restructurings that introduce new capital can provide repayment sources. To refresh your understanding of how to identify primary repayment sources, please review Dimension 4, which discusses performing cash flow assessments. In Dimension 4, you learn to use cash cycle analysis, cash flow statement analysis and projections to identify both primary borrowing causes and repayment sources. Also see Dimension 3, which reviews financial analysis tools and includes discussion of assessing the quality of earnings and assets. DIMENSION 6 - 7 After you have identified potential primary repayment sources, and after you have compared your analysis with the borrower’s view of repayment source, evaluate potential secondary and tertiary sources. These will become key determinants of your loan structure (loan structure concepts are covered later in this Dimension). Secondary and tertiary repayment sources include: Liquidation of collateral Sale, conversion, or liquidation of assets is often a primary source of repayment, as in the liquidation of current assets to repay a seasonal line of credit. If asset conversion is a primary repayment source, consider securing the loan to ensure the bank will have access to these assets to enforce collection of the primary source. If asset conversion is not a primary repayment source (such as for a term loan made to finance a capital asset), consider securing the loan to ensure access to a secondary source of repayment. If primary or other secondary repayment sources are uncertain or subject to interruption, consider securing the loan to provide enforcement, access, and control of assets as a secondary or tertiary repayment source. To help you qualify assets as potential collateral for the loan, see Dimension 5, which provides detailed analysis of collateral value and limitations for these types of assets: –– Securities and investments. –– Accounts and notes receivable. –– Inventory –– Plant and equipment. –– Real estate –– Intangible assets, including intellectual property. Performance of guarantees and other third party support. If your borrower is a closely-held entity, and/or if the borrower’s legal form of organization features limited liability, there may be a compelling reason to require personal and/or corporate guarantees or other forms of third party support. Growing private companies may be thinly capitalized; owners of closely held companies may need or prefer to remove earnings from the company; and companies that are part of closely held groups may easily transfer assets and repayment sources between related entities. NOTES: Dimension 6 // Identify Repayment Sources and Appropriately Structure and Document Credit Exposures for.. IDENTIFYING SECONDARY AND TERTIARY REPAYMENT SOURCES DIMENSION 6 - 8 NOTES: Third party support for loans may include: Personal guarantees Corporate guarantees Subordination agreements Comfort letters Letters of credit. The effectiveness of each of these secondary/tertiary repayment sources may be limited by three factors: value, willingness, and enforceability. For example, the value of a personal or corporate guarantee is limited to the underlying resources provided by the guarantor. For the repayment source to be meaningful, you should assess the guarantor’s current and probable future financial resources. For a corporate guarantor, perform a credit analysis using tools provided in Dimensions 1 through 4. For an individual guarantor, assess personal financial statements and liquidity using techniques presented in Dimension 3. Evaluate the willingness factor for potential guarantors or issuers of comfort letters, including individuals, affiliated entities, or other credit sponsors. Look for clues to suggest whether prior commitments have been honored, or whether there has been litigation to try to avoid honoring a contingent commitment. Determine if the guarantor has a financial or emotional stake in the success of the company whose obligations are being guaranteed. To evaluate enforceability, make sure that you have documents that require a full, unconditional guarantee, and ensure that the structure of the transaction will stand up to legal challenges from company creditors or other parties. For detailed explanations of structuring third party support effectively, see Loan Support and Covenants and Documenting the Loan later in this Dimension. CRC US Body of Knowledge Non-operating resources If you have identified operating sources of cash as the primary repayment source for a loan, it may be appropriate to consider additional resources analyzed earlier as a secondary repayment source. For example, there may be potential for additional capital from shareholders, or for a refinancing of an asset with a private lender. Bear in mind that absent enforceable contracts or agreements to compel this eventual source of repayment, the value of these resources is limited. DIMENSION 6 - 9 Once you have identified the underlying borrowing cause(s) and understand both primary and secondary repayment sources available, the next step is to structure the loan. Loan structure depends on the nature of your customer’s business and how your institution intends to provide financial services to the company. To properly structure a customer relationship, you must be able to: Project how the company will perform in the future, including likely primary and secondary repayment sources. Anticipate challenges and problems that may arise. Match an appropriate type of loan to both the loan purpose and the likely repayment sources. Develop a set of covenants that protects your institution for the duration of the relationship. Loan structure is important to the customer because they need to clearly understand the boundaries within which they can operate and continue to depend upon your institution for their financial services needs. The structure of the deal appropriately establishes your customer’s expectations for how your institution will perform during the term of the relationship. They need this assurance in order to run their business efficiently; i.e., if they operate in accordance with the terms and conditions of the loan agreement, your customer can expect funding from your institution. By having an appropriate structure to the relationship, agreeable to both parties, you have established a mechanism for monitoring individual transactions within a relationship. This monitoring process can be accomplished in two ways: Have a loan covenant checklist that routinely tracks your customer’s adherence to covenants. Require that an officer of the company regularly (quarterly, for example) certify as to the company’s compliance with all of its outstanding agreements. NOTES: Dimension 6 // Identify Repayment Sources and Appropriately Structure and Document Credit Exposures for.. DETERMINING THE LOAN STRUCTURE DIMENSION 6 - 10 NOTES: Failing to give notice to your customer of a covenant default may make your institution’s future enforcement of the covenant difficult. This section of Dimension 6, provides an overview of various products, services, and tools to structure a transaction. We will profile common credit facilities and specialized products that are available to meet your customer’s borrowing needs, given the identified repayment sources. For each credit facility and specialized product profiled, you will learn to: Match structure with loan purpose. Identify sources of repayment that are appropriate for the facility or specialized product. Determine collateral appropriate for the facility or specialized product. Identify and understand how to mitigate risks associated with the facility or specialized product. CREDIT FACILITIES The purpose of this section is to provide an overview and understanding of the application of each of the following financing mechanisms: Seasonal line of credit Revolving line of credit Term loans Leases Bridge loans CRC US Body of Knowledge Mortgage financing Special programs DIMENSION 6 - 11 In addition, we explore the following funding facilities: Subordinated debt Private placements Loan syndications High yield debt Commercial paper These products are an introduction to less traditional financing options. In the past, these products were only available to the largest, most creditworthy companies. As Main Street continues its convergence with Wall Street, smaller companies will have greater access to these products. Although your institution may not offer these products today, it is important for you to have knowledge of their application. In your role in the customer relationship, you may find ways to provide these products to your customers through strategic alliances with other financial institutions, while at the same time maintaining control of the overall customer relationship. NOTES: Dimension 6 // Identify Repayment Sources and Appropriately Structure and Document Credit Exposures for.. Although these products are commonly used today, it is helpful to ensure that you have mastered the applicability of each of these structuring considerations. DIMENSION 6 - 12 NOTES: SEASONAL LINE OF CREDIT GENERAL FEATURES A seasonal line of credit is a short-term loan, usually less than one year, used to finance inventory and/or accounts receivable for a company with a seasonal financing need. The loan is handled under an advised or confirmed (officially notified but not contractually committed) line of credit set at a limit that allows for peak borrowing and structures repayment with the low point in the seasonal cycle. Depending on the length of the cycle, there may be a clean-up or clean-down period, when the company is required to be free of debt for at least 30 days each year to prove their borrowings are seasonal and not required as permanent working capital. PURPOSE The principal purpose of the proceeds is to finance the cash cycle, i.e., payment of operating costs, the purchase of inventory, financing of accounts receivable, and the ultimate payment of the suppliers. Determining the high and low point borrowing periods is key to structuring the loan. COLLATERAL CONSIDERATIONS The credit may be secured by a perfected security interest in accounts receivable and inventory, at a minimum, and plant and equipment, at a maximum. This requirement may not be necessary with larger, wellestablished companies with strong capital bases and credit ratings, and no other liens attached to its assets. Creating advance rates for accounts receivable (usually 75–80%) and inventory (40–50%) against which to lend may be possible to ensure good working capital management. SOURCES OF REPAYMENT CRC US Body of Knowledge The sources of repayment for seasonal lines of credit are: Contraction of current assets, specifically accounts receivable and inventory. Conversion to long-term debt. Liquidation of assets. Additional equity. DIMENSION 6 - 13 The key risks for seasonal loans are as follows: Will the season happen? Are the proceeds being used for the purpose for which they are intended? Has the bank provided sufficient funds in the event sales outpace projections, requiring an additional back up of inventory and accounts receivables? Are there significant risks associated with the assets being financed? Are the assets easily converted to cash? These risks are mitigated by: Careful monitoring of loan proceeds to ensure funds are being used as agreed. Evaluating and monitoring assets to maintain liquidation value. Ensuring maintenance of trade credit between the company and suppliers. NOTES: Dimension 6 // Identify Repayment Sources and Appropriately Structure and Document Credit Exposures for.. KEY RISKS DIMENSION 6 - 14 NOTES: REVOLVING LINES OF CREDIT GENERAL FEATURES A revolving line of credit (revolver) is a contractual agreement whereby the bank agrees to make loans up to a specified maximum for a specified period, usually a year or more. As the company repays a portion of the loan, an amount equal to the repayment can be borrowed again under the terms of the agreement. In addition to interest borne by notes, the bank charges a commitment fee to hold the funds available on the unused portion. Often, advance rates for accounts receivable and/or inventory are structured with the facility. Revolving lines of credit with advance rates and liens on current assets are also referred to as assetbased financing in some banks. There are three types of lines of credit: Unadvised credit line or guidance line is created when you obtain approval for a loan amount greater than the amount requested because you anticipate that the client will have a financial need in the near future. No commitment or terms and conditions letter is sent to the customer. Discretionary lines of credit is established for a specified period of time and expresses your intention to extend credit as required by the borrower at your sole discretion. It is intended to provide you with the widest latitude in adjusting or terminating the line. The written agreement must make it clear that you have no legal obligation to honor a request made by the borrower. Committed line of credit is an arrangement evidenced by a written agreement signed by you and the borrower in which you commit to advance funds on specific terms at their request. CRC US Body of Knowledge PURPOSE The purpose of the revolver is to finance permanent working capital needs that arise through the continual replacement of accounts receivable and inventory with new accounts receivable and inventory, thus providing a permanent layer of working capital. These financing needs occur in new or expanding companies when growth outstrips the financing generated internally from operating activities or external from debt or equity injections. DIMENSION 6 - 15 The bank may be secured by a perfected security interest in accounts receivable and inventory, at a minimum, and plant and equipment, at a maximum. This requirement may not be necessary with larger, wellestablished companies with strong capital bases and credit rating, and no other liens attached to its assets. Creating advance rates for accounts receivable (usually 75–80%) and inventory (40–50%) against which to lend may be possible to ensure good working capital management. SOURCES OF REPAYMENT The loan is repaid from: Earnings and effective conversion and/or contraction of working capital. Conversion to term debt. Liquidation of assets. Additional equity. KEY RISKS The key risks associated with revolving lines of credit are: The company’s ability to maintain sales, profitable margins, and effective management of working capital. The underlying integrity (marketability and liquidity) of accounts receivable and inventory to provide the bank with a secondary source of repayment. Unexpected or uncontrolled growth that can result in increased or unexpected incremental financing needs. Proceeds may be used for something other than the original loan purpose. These risks can best be mitigated by: Careful monitoring to ensure consistency in use of proceeds with the original loan purpose. Effective valuation and monitoring procedures for current assets. For detailed articles about revolving credits that finance accounts receivable, see the Credit and Lending Studies Pack, Accounts Receivable Financing, by RMA. NOTES: Dimension 6 // Identify Repayment Sources and Appropriately Structure and Document Credit Exposures for.. COLLATERAL CONSIDERATIONS DIMENSION 6 - 16 NOTES: TERM LOANS GENERAL FEATURES Term loans are structured as intermediate to long-term facilities, usually two to ten years. They are generally secured. The loan amount is amortized over a fixed period, sometimes ending with a balloon payment (final payment is substantially larger than preceding payments). LOAN PURPOSE The funds are used to finance the long-term needs of the company, including acquisitions, purchase of equipment or fixed assets, support increased levels of permanent working capital assets, and to refinance debt or equity. COLLATERAL CONSIDERATIONS A first lien on fixed assets or a first or second lien on current assets generally secures term loans. SOURCES OF REPAYMENT The possible sources of repayment are: Operating cash flows of the company. Although frequently these are equal amortizing payments, this may not be workable in a company that has limited cash flow in the early years of the transaction or that receives cash income in unequal amounts. The term and repayment schedule of the loan must match the business cycle of the company and its ability to generate the cash needed to make the debt payments. CRC US Body of Knowledge The liquidation of assets. Additional equity. KEY RISKS The key risks in term debt are: The company’s ability to maintain sales, profitable margins, and effective management of working capital to ensure forecasted cash flow. DIMENSION 6 - 17 The key risk mitigants allow the bank to: Offer only facilities that are warranted by the cash flows of the company. Access additional equity, if needed. Impose a cash flow recapture formula that allows the bank to benefit from prepayment of the loan from excess cash flow generated by the company. LEASES A lease is a contract granting the use of real estate, equipment, or other fixed assets for a specified time in exchange for payment. The various forms of leases are as follows: Financial or capital lease: The service provided by the lessor to the lessee is limited to the financing of the equipment. All other responsibilities related to the possession of equipment such as maintenance, insurance, and taxes are borne by the lessee. The lessee acquires essentially all of the economic benefits and risks of the leased property. The lease must be reflected on the company’s balance sheet as an asset with corresponding liability. The lease is usually non-cancelable and is fully paid out over its term. Operating lease: Generally involving equipment, this contract is written for considerably less than the life of the equipment and the lessor handles all maintenance and servicing. Most operating leases are cancelable, meaning the lessee can return the equipment if it becomes obsolete or is no longer needed. This form of financing does not appear on the balance sheet of the lessee, but is a contingent liability and should be included in the notes to financial statements. Sale and leaseback: In this form of lease arrangement, a company sells an asset to another party in exchange for cash, then contracts to lease the asset for a specified term. A company generally chooses sale and leaseback versus straight mortgage financing when the rate it would have to pay a mortgage lender is higher than the cost of rental or when the company needs to show less debt or fewer assets on its balance sheet. NOTES: Dimension 6 // Identify Repayment Sources and Appropriately Structure and Document Credit Exposures for.. The underlying integrity (marketability and liquidity) of assets to provide the bank with a secondary source of repayment. DIMENSION 6 - 18 NOTES: LEASE PURPOSE The proceeds of a lease are generally used to finance equipment, land, and buildings. Today, it is possible to lease virtually any kind of fixed asset. The type of lease chosen will depend on the balance sheet objectives of the firm. COLLATERAL CONSIDERATIONS As the owner of the asset, the lessor is entitled to take possession of the leased asset in the event of default. If the value of the asset is less than the required payments under the lease, the lessor can enter a claim for payment. SOURCE OF REPAYMENT The repayment structure of a lease is generally linked to the useful life of the asset and the company’s ability to generate those cash flows. From the lessor’s perspective, the liquidation of the leased asset is the second way out of the lease. KEY RISKS Like term debt, the key risks in a lease are: The company’s ability to maintain sales, profitable margins and effective management of working capital to ensure forecasted cash flow. The underlying integrity of assets to provide the lessor with a secondary source of repayment CRC US Body of Knowledge These risks can be mitigated by: Matching the term of lease to the useful life of the asset. Continued monitoring of the lessee’s financial position. DIMENSION 6 - 19 GENERAL FEATURES A bridge loan is a short-term loan, also called a swing loan, made in anticipation of intermediate-term or long-term financing, the infusion of equity, or the sale of an asset. Interim interest is charged and the principal is paid at maturity. LOAN PURPOSE An acquisition scenario, where part of a business will be sold shortly after being acquired. Real estate, construction projects or acquisitions by management and other investors where the company can refinance in the long-term debt market. A successful project or acquisition where a public offering will be well received by the market. COLLATERAL CONSIDERATIONS The need for collateral may not always be fulfilled, particularly with a financially strong and diversified company. However, in real estate, construction, and leveraged buyout financing, where there remains significant risk, the taking of collateral is essential. In the event that the sale of an asset or the proceeds of refinancing through debt or equity will repay the bridge loan, the lender should ensure control over the proceeds to arrange for immediate receipt. SOURCES OF REPAYMENT The primary source of payment is an asset sale or refinancing through debt or equity. In addition, a careful analysis of the projected operating cash flows of the company is a secondary source of repayment in the event that the sale or refinancing does not occur and the bridge loan must be converted to term debt. NOTES: Dimension 6 // Identify Repayment Sources and Appropriately Structure and Document Credit Exposures for.. BRIDGE LOANS