Business Credit Analysis Chapter 3 PDF

# Business Credit Analysis ## Chapter 3 ### Module Authors - Jasman Tuyon, PhD - Rapheedah Musneh, PhD - Siti Julea Supar - Nurziya Muzzawer ### Faculty of Business and Management Universiti Teknologi MARA, Sabah Branch, Kota Kinabalu Campus ## Chapter's Outline ### 3.1 Small and Medium Enterp...

# Business Credit Analysis ## Chapter 3 ### Module Authors - Jasman Tuyon, PhD - Rapheedah Musneh, PhD - Siti Julea Supar - Nurziya Muzzawer ### Faculty of Business and Management Universiti Teknologi MARA, Sabah Branch, Kota Kinabalu Campus ## Chapter's Outline ### 3.1 Small and Medium Enterprises (SME) Lending - Introduction to SME Lending - Types of Business Credit Borrowers - Types of Business Credit Products and Pricing Strategy ### 3.2 Evaluation of SME Lending Applications - Business Analysis - Credit Request Analysis - Business Plan Analysis - Financial Analysis - General Accounting Principles and Policies - Understanding Financial Statements - Quantitative Analysis of Financial Statements - Qualitative Aspects of Financial Statement ## Learning Objectives Upon completion of this chapter, students should be able to: 1. Recognize the various legal entities characteristic, and borrowing capacity. 2. Identify various business financing needs of borrower. 3. Understand various types of credit facilities characteristics and pricing. 4. Perform credit request analysis 5. Perform business analysis in connection to the 5Cs and the credit report. 6. Perform financial analysis in connection to the 5Cs and the credit report. ## Small and Medium Enterprises (SME) Lending ### 3.1.1 Introduction to SME Lending #### 3.1.1.1 Types of Bank Business Lending The image shows a diagram depicting a branching structure of types of bank business lending: - **Type of Firms**: - Small business - SMEs - Listed Corporation - **Type of Banks**: - Retail Banking - Business Banking / SMEs Banking - Corporate Banking / Investment Banking #### 3.1.1.2 SME Definition A new SME definition was endorsed at the 14th NSDC Meeting in July 2013. The definition covers all sectors, namely services, manufacturing, agriculture, construction and mining & quarrying. Sales turnover and number of full-time employees are the two criteria used in determining the definition with the "OR" basis as follows: - **Manufacturing Sector**: SMEs are defined as firms with sales turnover not exceeding RM50 million OR number of full-time employees not exceeding 200. - **Services and Other Sectors**: SMEs are defined as firms with sales turnover not exceeding RM20 million OR number of full-time employees not exceeding 75. Under the new definition, all SMEs must be entities registered with SSM or other equivalent bodies. It however, excludes: - Entities that are public-listed on the main board; and Subsidiaries of: - Publicly-listed companies on the main board; - Multinational corporations (MNCs); - Government-linked companies (GLCs); - Syarikat Menteri Kewangan Diperbadankan (MKDs); and - State-owned enterprises. This is further broken down visually into a pyramid diagram displaying a hierarchy of size within Small and Medium enterprises: - **Manufacturing**: - **Medium**: Sales turnover: RM15 mil ≤ RM50 mil OR Employees: From 75 to ≤ 200 - **Small**: Sales turnover: RM300,000 < RM15 mil OR Employees: From 5 to < 75 - **Micro**: Sales turnover: < RM300,000 OR Employees: < 5 - **Services and Other Sectors**: - **Medium**: Sales turnover: RM3 mil ≤ RM20 mil OR Employees: From 30 to ≤ 75 - **Small**: Sales turnover: RM300,000 < RM3 mil OR Employees: From 5 to < 30 - **Micro**: Sales turnover: < RM300,000 OR Employees: < 5 #### 3.1.1.3 SMEs financing situation in Malaysia SMEs are critical to Malaysia's economic growth. They represent 97.3% of registered businesses and 65% of total employment. **Fast Facts:** | Statistic | Description | | :--------------- | :---------- | | 97.3% | SME share of total formal businesses | | 35.9% | SME contribution to GDP in 2014 | | 41.0% | Target SME contribution to GDP in 2020 (SME Masterplan) | | RM266 Billion | Outstanding financing to SMEs, including non-financial institutions | | 96.0% | Financial institutions' share of total financing extended to SMEs | | 82.0% | High financing approval rate by financial institutions | **Sources of Financing (Census of Establishment and Enterprise 2005):** | Category | Own | Others | Friends Family | Bls | DFIs | Total No. of Estab. | SME reliance on financing from financial institutions (banking and development financial institutions). | | :-------- | :-- | :----- | :------------ | :-- | :--- | :-------------------- | :------------------------------------------------------------------------ | | SMEs | 34% | 25.7% | 23.6% | 13.4% | 2.7% | 518, 996 | | | Large | 37.2% | 4.7% | 5.6% | 47.6% | 2.6% | 4,136 | | | **Total No. of Estab.:** | **177,863** | **133,456** | **122,644** | **71,287** | **14,166** | **523,132** | | **Loans to SMEs in all Sectors in 2005 (Bank Negara Malaysia:** - The pie chart displays the following allocation of loans: - Real Estate: 6% - Business Services: 5% - Agriculture, Forestry & Fishing: 4% - Wholesale & Retail Trade, Restaurants & Hotels: 26% - Manufacturing: 21% - Construction: 13% - Others: 14% - On a sectoral basis, lending to SMEs was diversified, with almost two-thirds being channeled to distributive trade, manufacturing and construction sectors. **Types of Facilities and Purpose (Census of Establishment and Enterprise 2005):** - **Types of Credit Facilities Utilised by SMEs (Pie Chart):** - Factoring: 1.1% - Others: 3.2% - Leasing: 10.8% - Long Term Loans: 30.2% - Short Term Loans: 54.7% - **Purpose of Financing by SMEs (Pie Chart)** - Improvement/upgrade of production process: 7% - Product Development: 4.1% - Others: 3.3% - Project Financing: 9.4% - Working Capital: 29.9% - Land/building (incl. extensions and renovations): 17.8% - Purchase/lease of equipment/machinery (incl. vehicles): 28.5% **Constraints Faced by SMEs (Census of Establishment and Enterprise 2005):** - The pie chart shows a visual breakdown of the constraints SMEs face in obtaining Financing: - Long loan processing time: 9.8% - No financial track record: 10.7% - Insufficent documents to support loan application: 13.1% - Others: 5.9% - Fls deem business plan as not viable: 5.3% - Lack of collateral: 55.2% **Chart: Share of financing approvals and application by years in operation (BNM Quarterly Bulletin)** - X-axis: Years in Operation: - 0-3 - 4-7 - 8-10 - >10 - Y-axis: Share of accounts (%) (0 - 100) - The chart shows two lines, one for Application and one for Approval with the following figures represented in the chart: - Application: - 0-3: 22 - 4-7: 13 - 8-10: 21 - >10: 20 - Approval: - 0-3: 22 - 4-7: 13 - 8-10: 21 - >10: 46 **Chart: Financing rejection rate by years in operation (BNM Quarterly Bulletin)** - X-axis: Years in Operation: - 0-3 - 4-7 - 8-10 - >10 - Y-axis: Rejection rate (%) (0 - 25) - The chart shows a line representing the rejection rate with the following figures represented in the chart: - 0-3: 21 - 4-7: 20 - 8-10: 18 - >10: 16 - According to the source, the rejection rate for young SMEs is only slightly higher than overall average (20%). ## 3.1.2 Types of Business Credit Borrowers In Business and Retail lending, the lender needs to deal with different types of borrowers which come in various legal entities as follows: ### Business Borrower <start_of_image> - Sole Proprietorship - Partnership - Limited Liability Partnership (LLP) - Limited Liability Companies ### Other Borrower - Cooperative Societies - Clubs and Societies - Government Organization Each legal entity has its individual characteristics and has a different legal capacity to operate and borrow. Therefore, lending to these borrowing entities needs to be analyzed in different ways. #### Credit Officers must have a sound understanding of: - Regulation surrounding the incorporation and borrowing capacity of these entities. - Strengths and weaknesses of the respective legal entities. - Key credit considerations when extending loans to these entities. Each business entity has a different risk. Therefore, it is important for the Credit Officer to identify the relevant business risk and mitigation, as well as assess their business and assets needs before proposing appropriate banking facilities to the respective borrowing entities. - This is to ensure that the Lender has control over the purpose and repayment of the banking facility granted and adequate protection with effective legal enforcement to recover the loan when the need arises. Credit officers must also focus on the borrower's business and roles within the industry, including the borrower's competitive position and operating model. Variation in the business role (e.g., manufacturer, wholesaler, retailer, service agent) will create different asset needs and, therefore, different financing requirements, as well as wide variations in business risk. ### Business Borrower: (a) SOLE PROPRIETORSHIP - When an individual decides to venture into business, a simple form of business to be set up is a sole proprietorship. The owner becomes the sole proprietor. - Under Malaysia law, the sole proprietor and the business (sole proprietorship) are considered the same legal entity as there is no legal distinction between the business and its owner. - The sole proprietor, therefore, is personally liable for all the liabilities / debts of the business. - Need to register with the Companies Commission of Malaysia (CCM) under the Business Registration Act 1956 with the issuance of a Certificate of Registration of Business. The certificate of registration is to be renewed annually. #### The characteristic of Sole Proprietorship are as follow: - Owned by a single owner/individual - Business and owner are the same legal entity, and the owner is liable for the business's debts - Small capital and limited capacity to expand - All business profits and losses belong to the owner - No regulatory requirement for audit and filing of account at CCM - In terms of loans, the borrower can choose to apply for credit facilities under the individual name or under the business name. - If the loan is extended under the business name, the individual owner or sole proprietor remains liable for the outstanding loan amount owed by the business. - When lending to a sole proprietorship, the lender does not need to request a personal guarantee from the sole proprietor/owner. - This is because the said guarantee will be invalid as the owner and business are of the same legal entity, and the owner is personally liable for the business debts. - Under the contract act, a guarantee must be obtained from a third party. - Another key credit consideration when lending to a sole proprietorship is the limitation in accounting record and financial statement, which is not required to be audited and filed at CCM under the law. To facilitate credit evaluation, the lender can obtain supplementary information to substantiate the financial position of the business, such as: - Bank statement - Sole proprietor's personal income tax - Net worth statement ### Business Borrower: (b) PARTNERSHIP - Partnership is governed in Malaysia under the Partnership Act 1961. - A partnership is an association of two or more persons to jointly conduct a business with a view to profits. - Like a sole proprietorship, a partnership firm must be registered with the Companies Commission of Malaysia (CCM) under the Business Registration Act 1956 with a Certificate of Registration of Business to be renewed annually. - Professional bodies like legal and accounting firms are usually registered as partnerships. - Its individual partners are of the same legal entity as the firm (partnership) with unlimited liabilities because all partners are jointly liable for any unpaid debts incurred by the firm. - Generally, the maximum number of partners in a partnership is limited to 20 partners unless the partnership is a professional firm where the number is limited to 50. - A business with more than 20 partners is required to be incorporated as a Limited Liability Company. - Under the Partnership Act 1961, each partner is an implied agent of the partnership therefore, the act of one partner will bind all partners. - Based on this, it is sufficient to deal with any partner who has the mandate to act on behalf of the partnership. #### The major characteristics of partnership are: - No legal distinct between a partnership firm and its partners. The partners are jointly liable for debts of the partnership - Profits and losses are shared equally amongst the partners - Partners carry the unlimited liability of the partnership unless agreed otherwise - No regulatory requirement for audit and filing of financial account - A Partnership Agreement /Deed can be drawn up between the partners with legally binding terms governing the capital contribution of each partner, profits sharing arrangement, and drawing of salaries/funds from the partnership. - In the absence of a Partnership Deed, the Partnership Act 1961 prevails. - When lending to a partnership, lenders need not request for personal guarantees of individual partners. - This is because the partners are jointly and legally liable for the unpaid debts of the partnership. Therefore, the personal guarantee of the partners is not valid. - A partnership must be dissolved and reconstituted each time a partner is admitted to or left the firm. This changes the legal liabilities of partners and pose new risks to lenders. - The incoming partner will only assume the new debt incurred after his admission, but not the existing debt of the partnership. - To mitigate risk, the lender is required to obtain a letter of undertaking from the new partner to assume the partnership's existing debts. - The outgoing partner will not be liable for new debts incurred after his cessation unless he provides a guarantee in his personal capacity after he is no longer a partner. ### Business Borrower: (c) LIMITED LIABILITY PARTNERSHIP (LLP) - LLP is a hybrid of both a normal partnership and a registered limited liability company. - It must be registered with the Registrar of Limited Liability Partnership under the name of Perkongsian Liabiliti Terhad or PLT. - LLP company is a legal entity by itself; its partners have limited liability protection similar to a limited liability company registered under the Company Act 1965. #### The advantages of LLP as compared to normal partnership are as follows: - Limited liability protection for its partners - Unlimited capacity to hold property under the company's name, unlike partnerships that are not allowed to be registered owners under the National Land Code. - Any incoming and outgoing of partners will not lead to dissolve and reconstitution of a LLP company - LLP company enjoys the same advantage as a normal partnership where there is no regulatory requirement for audit and filing of its financial account CCM. ### Business Borrower: (d) LIMITED LIABILITY COMPANY (LLC) - Under the Company Act 1965, there must be a minimum of 2 persons known as promoters or shareholders to incorporate a company. - They must each subscribe to one share of RMI each issued by the company. - A company incorporates with 2 shares of RM1 each as issued and paid-up capital is also known as a 'two ringgit' company. #### Under incorporation, a registered LLC will have: - A certificate of incorporation as evidence of registration - A set of Memorandum and Articles of Association setting out the object of the company and rules of management - Form 24 detailing the amount issued and paid-up capital, and shareholders - Form 49 detailing all directors of the company - LLC can be incorporated as 'Sendirian Berhad' (Sdn Bhd) or 'Berhad' (Bhd), which is indicated at the end of the company name. - A private limited company (Sdn Bhd) is restricted under the Company Act 1965 to transfer its shares to a third party except with the approval of its Board of Directors. The shares transfer restriction ensures that the company remains private to a certain group of shareholders. - A public limited company (Bhd) can transfer its shares freely to shareholders and third party and can raise funds from the public through the public listing of its shares on the Bursa Stock Exchange. - A limited liability company is a separate legal entity from its owners (shareholders). - They can sue or be sued. - They can enter into a contract or terminate a contract on behalf of its shareholders. - A company's shareholders' liabilities are limited to the extent of issued share capital regardless it is paid up or not. - The shareholders can subscribe to more shares as the Company increases its issued share capital. - This will be reflected in Form 24, which is a return filed at the Companies Commission of Malaysia (CCM). - The maximum share capital that the company can raise is bound by the amount of its authorized share capital as provided in the company's Memorandum and Articles of Association. - Shareholders can raise their share capital by way of: - Cash call - Share swap - Bonus issue by way of capitalization of retained earnings and reserves - Convert from convertible bond and preference shares - Directors are people engaged by the shareholders to manage the company. - Directors are responsible for the implementation of business development and corporate strategies and the appointment of senior management to run the company in a prudent and sustainable manner. - Executive directors involved in the day-to-day operation of co. Non-executive directors are restricted to directorial duties. - It is important to note that a directorship does not come with the need to extend a guarantee for the liabilities of the company. - A director extends a guarantee in his personal capacity but not in his capacity as director. Therefore, the guarantee remains valid and enforceable even when the director resign/leave the company. - Upon the winding up of a company, directors would have unlimited liability to make contributions towards settling the corporation's debts. - A company also has the right to own shareholding in other companies. These are known as 'corporate shareholding'. There are relationships between various companies within a corporate group structure. - It is imperative for the Credit Officer to understand the relationship within the corporate group structure, the underlying credit risk arising from inter-company transactions, and accounting treatment for companies with parent company-subsidiary relationship as a single consolidated Group. #### Companies within a corporate group structure are: - **Holding Company**: A company that holds more than 50% of the paid-up capital of another limited liability company. Holding company may consolidate all assets, liabilities, income and revenue of the company which it controls. - **Ultimate Holding Company**: A company that holds more than 50% of the paid-up capital of a Holding Company - **Subsidiary Company**: A company with more than 50% of its paid-up capital owned by another company, which is a Holding Company. - **Associated Company**: A company where 20% to 50% of its paid-up capital is owned by another company (known as a corporate shareholder). The corporate shareholder cannot consolidate the revenue, income, assets, and liabilities of the associate company, but only equity account for the share of profits or losses of the associate company. - There are several key credit considerations that lender needs to take note of when granting banking facilities to a limited liabilities company: - **Power of a company to enter into transactions and the authorization required**: To ensure that the company has the empowerment and authorization to enter into a transaction, bank borrowings, and provision of security, the lender must ensure the borrower provides a certified Memorandum and Article of Association and Board Resolution duly passed by the Board of Directors. - **Power of a company to give a valid charge as security over the company's property that ranks in priority of claim over other creditors**: For a legal charge over property to be valid against any creditor, the legal charge must be registered with the Company Commission of Malaysia within 30 days after it is granted. Any floating charge granted by the company within six months of the commencement of the winding-up of a company is invalid except in respect of monies paid to the company at the time or subsequent to the creation of the charge. - **Enforcement of debts against a company upon liquidation/winding up**: For Secured creditors under floating charge, their debts shall be subordinated to the priority debts such as liquidation expenses, workers' salaries/compensation, and income tax liabilities if the liquidation proceeds are insufficient to meet all liabilities. ### Other Borrower: (a) COOPERATIVE SOCIETIES - Cooperative Societies, which are registered under the Cooperative Societies Act 1948. - It is a society with the objective to promote the economic interest of its members in accordance with cooperative principles. - They are organized societies of consumers or producers who voluntarily pool their resources together to meet common objectives. - Cooperatives provide opportunities for their members to save, invest, and participate in economic interests since members possess better bargaining power as a collective group than they would as individuals. - A registered cooperative society has the legal capacity to borrow and lend: - Borrow from lender by charging their assets, such as housing schemes. For example, housing cooper provides members with housing finance at a reasonable cost and softer terms of repayment than those offered by major financial institutions. - Make loans to its members, employees, and subsidiaries or to another registered society. - In Malaysia, the cooperative societies operate under the supervision of 3 authorities: - The Farmer Organization Authority (FOA) - Department of Cooperative Development - Fisheries Development Authority (MAJUIKAN) ### Other Borrower: (b) CLUBS AND SOCIETIES - Clubs and Societies are unincorporated bodies with no legal status of their own. - Therefore, these entities do not have the legal capacity to borrow and register property in their name. - Societies must be registered with the Registrar of Societies. A registered Society may be sue or be sued in the name of any office bearer of the society. - Clubs do not need to be registered. The liabilities of the club members are restricted to the amount of their subscriptions. - Clubs and Societies are managed by committees elected by the members. The committee cannot act outside the scope given to them by the general body of the members. - All borrowings incurred by Clubs and Societies to finance land and buildings must be in the individual name of the committee members, such as the president or treasurer. - To ensure that the committee borrows within the power and authority entrusted by the club and society members, all borrowings must be supported by a resolution passed by its committee members with the power of borrowings clearly stipulated in the constitutions. - The purpose of borrowing must be within the scope of authority of the trustee, committee, or board. - The land and buildings acquired by clubs and societies can be registered in the name of the trustee or committee members subject to power for the creation of charge and signatories to the charge documents duly authorized under the board resolution. - For any recovery of debt from Societies or Clubs, legal proceedings must be commenced against the committee or principal office bearer. However, judgment can only be enforced against the property of the society as office bearers are not personally liable for the debts, unlike he stands as guarantor for the loan. ### Other Borrower: (c) GOVERNMENT ORGANIZATION - Government Organizations are government departments and agencies established and supervised by the Federal Government through various ministries. - Some of the government agencies are MIDA, Malaysia Palm Oil Board, and Malaysia Rubber Board, while government departments are the Department of Agriculture, Fisheries, FAMA, JPJ, Customs, etc. - They also include State Government backed bodies such as State Economic Development Corporation, statutory bodies such as RISDA, MARDI, FELCRA, Malaysian Multimedia Commission, and municipal councils/local authorities such as DBKL, Majlis Daerah, Majlis Bandar. - All government departments and agencies are restricted in their borrowing activities as the Ministry of Finance controls their finances. - Any borrowings that require a government guarantee or support need to be approved by the Ministry of Finance. - This is known as sovereign borrowings, which are pegged to the country risk rating assigned by local and international rating institutions. - The government has, over the years, privatized some of the government organizations such as TNB, FELDA, BERNAS, and others. - These companies are operating now as Public Limited Liabilities companies and are required to comply with the Company Act 1965. - Government guarantees are no longer expected for these companies as they are run privately as commercial enterprises. ## 3.1.3 TYPES OF BUSINESS CREDIT PRODUCTS AND PRICING STRATEGY - **TYPE OF BANKING CREDIT FINANCING**: - **Current Assets**: - Business Operating Cycle - 1. Working Capital Financing: Overdraft, Trade Facilities, Non-cash Facilities - **Fixed Assets**: - Capital Investment Cycle - 2. Capital Expenditure Financing: Term Loan, Hire Purchase, Leasing - 3. Construction and Property Based Financing - 4. Transaction Financing - 5. Seasonal Financing - Each commercial entity will have different operational needs and capital investment requirements depending on its nature of business, capital, and funding structure, as well as the industry conditions in which it operates. - A trading and distribution business will carry more current assets in its balance sheet than fixed assets. - These current assets, such as raw materials, finished inventories, trade receivable, etc., are short-term in nature and frequently used in the business operating cycle to generate cash flow for the business. - A company involved in manufacturing and capital-intensive industries such as electronic and electrical business, airline, telecommunication, steel, and cement require higher capital investment in long-term fixed assets such as building, plant and machinery, equipment and fixture, computer-controlled system, and others. - The short-term and long-term assets needs of the company can be funded by shareholders' capital, external trade creditors/suppliers, and / or external bank borrowings. - Amongst the three sources of funding, shareholders' equity financing is the most expensive from the Return to Equity perspective, as owners of the company will demand reasonable returns relative to the risk of capital that they underwrite in the company. - Trade creditors operate as short-term financiers by extending credit terms for payment of goods and services supplied. - The supplier credit terms carry an implicit cost of credit and are often expensive. - Bank financing is relatively cheaper, but as a debt lender, the bank has lower risk tolerance compared to shareholders as the bank earns a fixed return only as compared to shareholders who can participate in the potential unlimited growth of the business. - The financing needs of a business are driven by its asset requirements. - The tenure of assets needs must be matched with the tenure of financing to avoid instability caused by funding mismatch. This is known as tenor matching. - Based on that, long-term assets/capital investment is best funded by long-term funds such as equity financing and long-term bank loans. - In a situation where business risk is perceived to be high, the lender may require shareholders to commit a minimum amount of capital to the business prior to loan financing. - For short-term operational assets needs, it is usually funded by suppliers' credit. - In addition, the lender would structure short-term transactional-based working capital financing to meet the business's operational needs. - For companies involved in construction and property development, there is usually a timing mismatch between the progress payment receipts and payment of development or construction costs. - Therefore, a lender is required to structure a type of financing known as bridging finance to bridge the financing gap arising from a mismatch between progress receipt and payment. - Apart from structuring appropriate types of financing to meet borrowers' business needs, the Credit Officer must be mindful of the loan pricing. - The pricing of the loans and credit facilities has to be able to cover the fixed regulatory, statutory cost, funding cost, and operational costs of the bank in order for the Bank to operate profitably. - In like of keen competition in the banking environment, lender faces the challenge of interest margin compression, and therefore, it is imperative that the Credit Officer makes an effort to enhance the risk-free ancillary income to compensate for the shortfall in the interest income, such as: - Outward bill for collection - Remittance services - Spot foreign exchange transaction - Cross-selling of wealth management products and services - The loan pricing is also affected by the credit risk profile of respective borrowing customers as determined by the Bank's internal credit risk rating system. - Borrower with lower credit rating has a higher possibility of default, and therefore, the pricing of facilities needs to be higher to cover possible losses on loan default. ## 1. WORKING CAPITAL FINANCING ### a) Identification of Net Working Capital Needs - **The Business Operating Cycle of a Trading Concern**: The diagram shows a circular flow of cash in the business with the arrow pointing in a clockwise direction. - Purchase of goods for Resale and Account Payable created is the starting point. - The next step is to convert the Account Payable into Cash. - Next is to sell finished goods and create Account Receivable. - The final step is to collect the Account Receivable. - Working Capital is represented by the amount of cash tied up in a business, mainly in the form of trade receivables and inventories - It is the amount of cash needed by a business to support its daily operating cycle, also known as the Working Capital Cycle or Cash Flow Cycle or Assets Conversion Cycle (ACC). - The understanding of ACC, which commenced with the purchase of raw materials / goods for resale and ended with the sales collection of goods sold, provides the Credit Officer with an insight into the business operation and financing requirements as well as identification of business risk and mitigation. - The working capital (WC) of a business can be partially financed or fully financed by trade creditors. - Spontaneous Financing is the situation where working capital is fully financed by trade creditors i.e., suppliers are paid only upon collection of sales receivable. - Most businesses have a financing or timing gap in their operating cycle due to a mismatch between sales collection and payment of trade payable. - The financing gap is known as net working capital. Lenders are essentially the gap financiers. - **Alternate Depiction of the Operating Cycle**: This second diagram emphasizes the financing gap/net working capital. The visual representation highlights the flow of resources from raw materials purchased to finished goods being sold, along with the concept of owing money (Owe) and paying money (Pay) for trade items. ### Computation of Net Working Capital | Item | Description | | :---------- | :---------- | | Projected Stock | Average stock holding period (in months) x stock cost as a% of sales x average monthly sales | | Projected Debtors | Average debtor turnover (in months) x (100% - cash profits margin) x average monthly sales | | Projected Creditors | Average creditor turnover (in months) x purchase cost as a % of sales x average monthly sales | - The net working capital of a business can be funded by excess long-term funds (shareholders' funds + long-term liabilities - long-term Assets) and short-term borrowings. - If a business has Excess Long-Term Funds (ELTF), then the amount of short-term borrowings will be less than its net working capital as part of its financing needs is funded by ELTF. - If a business does not have ELTF, then the amount of short-term borrowings will equal to the company's net working capital. ### b) Types of Facilities of Working Capital Financing - Lenders can structure revolving cash facilities such as Overdraft, Revolving Credit, and trade facilities (such as trust receipt and banker's acceptance) to finance the short-term net working capital needs of a business. - **i. Overdraft (OD)** - It is the most flexible form of financing for borrowers. - It is a higher risk for the lender as there is no assurance that money drawn down will be directed for the intended purpose. - OD is usually structured to finance value-added selling and general and administrative expenses that cannot be financed by the trade facilities. - **ii. Trade facilities** - It is a preferred type of financing as it allows lenders to have control over the use of facilities for intended purposes and is short-term, transactional in nature, which is settled with cash flow generated from the operating cycle of business. - **iii. Non-cash facilities** - In addition, lenders can also structure non-cash facilities such as Letters of Credit, Bank Guarantees, shipping guarantees, and foreign exchange facilities to facilitate borrower's day-to-day business needs. ### c) Key Credit Considerations for Working Capital Financing - Borrower must generate operating profits to ensure there is sufficient business revenue in meeting all operating expenses incurred in the operating cycle and net cash flow at the end of the operating cycle to liquidate short-term borrowings. - The operating cycle must be of good quality and efficiency to ensure cash flow can continuously be generated at the end of each cycle. - Borrowers must have sound business strategies and action plans to mitigate business operational risks identified from the operating cycle, such as supply risk, production risk, product risk, selling and distribution risk to sales collection risk. - The lender is required to consistently keep track of changes to the borrower's sales and terms of trade because it would affect the amount of Working Capital financing needed to meet its business. ## 2. CAPITAL EXPENDITURE FINANCING ### a) Identification of Capital Expenditure Financing Needs - **The Capital Investment Cycle for a Business**: This diagram shows a series of operating cycles, all feeding into the same central cycle. - Capital Expenditure (CAPEX) financing deals with acquisition of fixed assets such as factory and plant and machinery. - It is probably the second most common financing request from borrowers after working capital financing. - It relates to the business's Capital Investment Cycle, where business owners will use funds from shareholders' capital and long-term borrowings to finance assets that are productively used in the operating cycle to generate cash flow for payment of loans, cover business operating expenses, and meet the return to investment. - In some businesses, such as manufacturing, the purchase of fixed assets is a prerequisite to cash flow generation. - The fixed assets acquisition can be funded by: - Capital injection by shareholders - Revenue reserves (or retained earnings) that are retained in the company - Long-term bank borrowings - Lender needs to understand borrower's Capital Investment Cycle in the following three (3) aspects: - The specific fixed assets needed by the borrower for the nature of the business - Estimated cost of the fixed assets /machinery and its resale value - Estimated economy lifespan of the fixed assets to ensure financing tenure is appropriately structured - The amount of CAPEX financing is normally set as a percentage of the purchase price for the assets to be acquired and is determined by the following factors: - **Shareholders' financial commitment in the business**: - This is reflected by the gearing (debts/ equity) of the company. - Shareholders in a highly-geared company are perceived to be less financially committed to the business, which poses a higher risk to the lender. - **The depreciation nature of fixed assets to be financed**: - Machinery and equipment have higher depreciation brought by wear and tear as compared to properties, thus attracting a lower margin of financing. - **The estimated economic lifespan of the fixed assets**: - Property has a longer useful life as compared to machinery and equipment therefore commanding a higher margin of financing. - Credit officers must take note of the key factors in structuring the quantum and tenure of CAPEX financing to ensure adequate shareholders' financial commitment in long-term assets purchase and loan repayment schedule can be met by operational cash flow generated from the capital investment cycle. ### b) Types of Facilities for Capital Expenditure Financing Needs - Borrower can finance their long-term fixed assets or capital expenditure in the form of Term