RMA Credit Risk Certification US Body of Knowledge PDF

CREDIT RISK CERTIFICATION US BODY OF KNOWLEDGE THE RISK MANAGEMENT ASSOCIATION The Risk Management Association (RMA) is a not-for-profit, member-driven professional association serving the financial services industry. Its sole purpose is to advance the use of sound risk principles in the financial services industry. RMA promotes an enterprise approach to risk management that focuses on credit risk, market risk, operational risk, securities lending, and regulatory issues. Founded in 1914, RMA was originally called the Robert Morris Associates, named after American patriot Robert Morris, a signer of the Declaration of Independence. Morris, the principal financier of the Revolutionary War, helped establish our country’s banking system. Today, RMA has approximately 2,500 institutional members. These include banks of all sizes as well as nonbank financial institutions. RMA is proud of the leadership role its member institutions take in the financial services industry. Relationship managers, credit officers, risk managers, and other financial services professionals in these organizations with responsibilities related to the risk management function represent these institutions within RMA. Known as RMA Associates, these 16,000 individuals are located throughout North America and financial centers in Europe, Australia and Asia. Members actively participate in the RMA network of chapters. These chapters are run by RMA Associates on a volunteer basis and they provide our members with opportunities in their local communities for education, training, and networking throughout all stages of their financial services career. Chapters are located across the U.S. and Canada as well as in financial centers internationally. RMA members also avail themselves of benefits offered through headquarters in Philadelphia, Pennsylvania. To assist members in advancing sound risk principles, RMA keeps members informed and provides access to industry information at this site; publishes a journal (The RMA Journal) and a variety of newsletters, books, and statistics; conducts many workshops and seminars; holds several conferences, an annual convention (Annual Risk Management Conference); and has numerous committees working on a variety of projects. RMA welcomes all personnel involved in lending and risk management in member organizations to become RMA Associates. Note: As a not-for-profit, professional association, RMA does not lobby on behalf of the industry. Copyright © 2015 by RMA. All rights reserved. Printed in the USA No parts of this publication may be reproduced, by any technique or process whatsoever, without the express written permission of the publisher. While RMA believes the material contained in this publication is accurate, the conclusions and opinions expressed are those of the authors. Moreover, no opinion expressed on a legal matter should be relied on without the advice of counsel familiar with both the facts in a particular case and the applicable law. This material is part of RMA’s educational resources for commercial bankers at every stage of their careers. For more information, contact the Customer Care Department, RMA, 1801 Market Street, Suite 300, Philadelphia, PA 19103. Or contact us by: Phone 800-677-7621 / Fax 215-446-4101 / E-mail [email protected] or our website: www.rmahq.org. CREDIT RISK CERTIFICATION US BODY OF KNOWLEDGE BODY OF KNOWLEDGE TABLE OF CONTENTS Dimension 1 Evaluate Client Industry, Markets, and Competitor Dimension 2 Assessing Management’s Ability to Formulate and Execute Business and Financial Strategies Dimension 3 Complete Accurate, On-Going and Timely Financial Assessments of the Client and its Other Credit Sponsors Dimension 4 Assess Strength and Quality of Client/Sponsor Cash Flow Dimension 5 Evaluate Collateral Values and Conduct Periodic Inspections of Collateral Dimension 6 Identify Repayment Sources and Appropriately Structure and Document Credit Exposures for Their Intended Purpose (Loan Structure and Documentation) Dimension 7 Identify and Develop Strategies for Problem Loans 640849 02/2015 JOIN. ENGAGE. EVALUATE CLIENT INDUSTRY, MARKETS, AND COMPETITOR LEAD. Dimension 1:.............................................................2 Characteristics of Agribusinesses...............................56 Purpose of Dimension 1..............................................2 Characteristics of Educational Institutions...............59 Additional Skill-Building Resources............................2 Characteristics of the Leisure/Tourism Industry........62 Evaluating the Client’s Industry..................................3 Characteristics of Nonprofit Companies...................65 Industry/Product Life Cycles.......................................3 Characteristics of Government Entities....................68 Emerging Stage..........................................................6 Evaluating the Client’s Market..................................71 Growth Stage.............................................................8 Buyer/Supplier Profiles..............................................72 Mature Stage............................................................10 Buyer/Supplier Concentrations................................74 Declining Stage........................................................12 Buyer Concentration................................................74 Industry Risks...........................................................14 Supplier Concentration.............................................74 Macroeconomic Issues..............................................15 Entry/Exit Costs.......................................................75 Cyclicality................................................................18 Vulnerability to Substitutes......................................76 Seasonality...............................................................20 Evaluating Competition in the Client’s Market.........76 Technology Risks.....................................................23 Profiling Market Competitors...................................77 Life Cycle Stage........................................................23 Putting Competition in the Context of the Market...78 International Considerations....................................24 Business Process and Product Risks...........................25 Characteristics of Key Industry Sectors......................35 Characteristics of Manufacturing Companies............36 Characteristics of Wholesaling Companies................41 Characteristics of Retailing Companies....................45 Characteristics of Service Companies.......................49 Characteristics of Construction Companies...............52 CRC US Body of Knowledge // Dimension 1 // Evaluate Client Industry, Markets, and Competitor DIMENSION 1 DIMENSION 1 - 2 NOTES: PURPOSE OF DIMENSION 1 The purpose of Dimension 1 is to provide tools and insights to support evaluation of a client’s industry, markets, and competitors. Key topics in this Dimension are: Evaluating the client’s Industry. Industry/product life cycles. Industry risks Characteristics of key industry sectors. Evaluating the client’s market. Buyer/supplier profiles. Buyer/supplier concentrations. Entry/exit costs. Vulnerability to substitution. Evaluating competition in the client’s market. Profiling market competitors. Putting competition in the context of the market. CRC US Body of Knowledge ADDITIONAL SKILL-BUILDING RESOURCES 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 1 skill building: Analyzing Industry, Business, and Management Risks Uniform Credit Analysis DIMENSION 1 - 3 EVALUATING THE CLIENT’S INDUSTRY NOTES: Understanding the industry within which a company operates is key to understanding the total risk in lending to that company. The objective of this section of Dimension 1 is to provide insights to help you answer the question: “Does the company have a business strategy that makes sense within the context of general industry characteristics and economic trends?” The three topics included in this discussion are: Industry/product life cycles. Industry risks Characteristics of key industry sectors. In addition to general industry characteristics, businesses are affected by industry and product life cycles. Industries, companies, and products all have life cycles that are determined by their acceptance in the marketplace. Over time, sales for a successful product will grow, then level off, and eventually decline. You can recognize stages of product life cycles in the sales of such diverse products as light pickup trucks and minivans, personal computers, toys, and cassette tapes. Product life cycles are influenced by demand for a product (however derived) and by the elasticity or inelasticity of that demand. Demand is simply defined as the need or desire for the sellers’ goods and services. Inelastic demand occurs when price is of little concern to the customer; therefore, a change in price has little effect on the demand for the product. When demand is elastic, a change in price results in a proportionate change in the quantity of the product or service demanded. As products and services mature, they tend to become more pricesensitive (demand becomes more elastic). This flattening of the demand curve is part of the natural life cycle of a product and another way to understand the profit decline for mature-stage products, companies, or industries. The same product life cycle concept of emerging, growth, maturity, and decline can be applied to businesses and entire industries. Dimension 1 // Evaluate Client Industry, Markets, and Competitor INDUSTRY/PRODUCT LIFE CYCLES DIMENSION 1 - 4 NOTES: When evaluating companies, you should remember that: Optimistic sales and profit projections may not materialize from a company whose products or industry are in the growth stage because new competitors may be able to rapidly and inexpensively enter the market. When a company has diversified to the point at which it has multiple products and services, it is prudent to analyze each product line’s life cycle stage before underwriting and documenting a loan. When a company’s success depends on a single product or service, understanding its life cycle is critical to how you structure a repayment schedule before sales and cash flows are reduced or exhausted. Inelastic demand can be an advantage because the company is able to more easily raise prices to cover costs and create more profits. In many cases, inelastic demand does not last long because of an increase in competition or a sudden decrease in demand, or because a substitute for the product or service has been created. In this discussion, we will cover the following life cycle stages: EMERGING STAGE Total sales are very low, consumer acceptability is uncertain, and cash flow is probably not sufficient to cover start-up costs and the fixed costs of production or providing the service. GROWTH STAGE CRC US Body of Knowledge If the product has gained market acceptance, sales build rapidly and profits can be very attractive, until other competitors enter the market. DIMENSION 1 - 5 MATURE STAGE Profitability peaks, flattens out, and then begins to decline because other companies have successfully entered the market. One company’s early success in a market is often due to its dominant market share, which may be reinforced and sustained by a patent, copyright, or secret formula. Competitors are attracted by the sales and profit success of early entrants and the success of these new competitors is related to ease of entry into the market. Competition tends to drive prices down, especially if demand for the product at higher price levels has been satisfied. NOTES: DECLINING STAGE Dimension 1 // Evaluate Client Industry, Markets, and Competitor Consumer demand for the product declines and sales fall. Profits fall when sales can no longer cover the fixed costs or the company lowers prices in an attempt to maintain sales levels. However, there are substantial profit opportunities in this stage for a limited number of well-managed companies selling to a reduced, but stable, customer base. DIMENSION 1 - 6 NOTES: EMERGING STAGE Companies in the introductory or emerging stage often need large amounts of capital to sustain them through long periods of research, product development, and test marketing. After the product has been developed, test marketed, and is ready for rollout, additional funds are needed to support advertising and marketing expenses in order to educate the consumer and gain market acceptance. Because of the uncertainty of success, company owners and venture capitalists usually supply such capital. This is especially true in companies with one or just a few products, all of which are at the same stage of development. In addition, emerging companies generally possess entrepreneurial management and may lack experienced management in all of the core competencies needed to operate a company. Financial products and services required by companies in the emerging stage include: Equity type financing (venture capital, private placement, etc.) due to the high cash needs and limited demonstrated debt repayment ability. Subordinated debt, preferred or common stock, or other sources of long-term capital. For very small businesses, the owners’ personal borrowings (such as home equity loans) may provide adequate initial long-term capital. CRC US Body of Knowledge Typical liabilities found on the emerging company’s balance sheet include accrued expenses, accounts payable, lines of credit (generally if guaranteed by a sponsor) and perhaps real estate loans (with sponsor support). Dimension 1 - 7 The following chart summarizes the strengths of an industry or product in the emerging stage, along with some of the relevant risks. EMERGING STAGE CHARACTERISTICS Emerging: Products are developed and presented to potential consumers. It is uncertain at this point if there will be acceptance of the new product/industry. POSSIBLE STRENGTHS High sales due to product introduction and unique positioning. Little competition High prices and gross margins (as result of little competition). Registration of patents and intellectual property rights to create barriers of entry to competitors. Able to develop brand loyalty. RISKS Failure: The failure rate for new products is high—some gain acceptance only after modification from their original form. Production capacity: either under or over capacity as demand varies substantially from projections. Low net margins because of high R&D and marketing costs. Initial mismatch of cash flows. Initial product quality may be poor dictating the need for expensive changes to the product design or formulation. Winning marketing strategy prior to implementation not apparent. Dimension 1 // Evaluate Client Industry, Markets, and Competitor LIFE CYCLE STAGE Dimension 1 - 8 NOTES: GROWTH STAGE Companies with products in the growth stage may show rapid sales growth and strong profitability. Often companies project that this growth and profitability will continue and commit to major production expansions, only to find that they have shrinking sales or lower profits or both. At the outset of the growth stage, demand may allow for creation of additional capacity and competitors. But as the industry’s sales begin to grow at a slower rate and then peak along with increased competition, only the strongest companies survive. Lending to growthstage companies requires very careful judgment of the critical factors that will help the company succeed over its competition and how management will meet these competitive challenges. Financial products and services required by companies in the growth stage may include: Cash Management services. Revolving lines of credit to finance growing working capital assets. Long-term debt to finance fixed asset growth associated with increased production capacity. Export financing if international in nature. CRC CRC US Body of Knowledge Mortgage loans to finance real estate needs. Dimension 1 - 9 The following chart summarizes the strengths of an industry or product in the growth stage, along with some of the relevant risks. LIFE CYCLE STAGE Growth: The industry/product gains acceptance, demand grows, and competitors enter the market. POSSIBLE STRENGTHS RISKS Increasing demand and high selling prices as product acceptance leads to growth in demand. Increasing competition, depending upon the cost of entry. Product quality improved as a result of changes made in the emerging stage. Optimistic sales and profit projections may not materialize because new competitors enter the market. Higher net margins than competitors still in the emerging stage. Production overcapacity due to increased competition. Expansion and solidification of significant brand loyalty. High marketing costs relating to increasing market share and product differentiation strategies. Development of compatible products with high margins. Sales may outstrip company’s capital base, putting additional requirements on external funding sources. Dimension 1 // Evaluate Client Industry, Markets, and Competitor GROWTH STAGE CHARACTERISTICS Dimension 1 - 10 NOTES: MATURE STAGE Companies in mature industries or with mature products/services may ultimately have lower gross profit margins than they enjoyed in the growth stage but, because of stable demand, their cash flow for debt service may be stronger and their likelihood for continued success is more predictable. They have weathered the trials of tough competition and are marketing proven products or services. Mature-stage companies are usually less risky loan candidates, especially those requiring shorterterm credit facilities. Financial products and services required by companies in the mature stage may include: Cash management services. Revolving lines of credit to finance working capital assets. Long-term fixed asset financing for equipment and other capital expenditures. Export financing if international in nature. CRC CRC US Body of Knowledge Mortgage loans to finance real estate needs. Dimension 1 - 11 The following chart summarizes the strengths of an industry or product in the mature stage, along with some of the relevant risks. MATURE STAGE CHARACTERISTICS Mature: Competitors have entered the market and corporate efficiency has sorted out companies unable to survive. POSSIBLE STRENGTHS Price stability at some level. Superior quality Maximum brand/ product loyalty achieved. Product enhancements (real or perceived) developed to extend product life. RISKS Declining profits caused by: –– Demand levels off and begins slow decline, leading to market share contraction for existing companies. –– A few low cost producers enter the market. –– Competition is maximized; products begin to become more price sensitive and demand more elasticity, forcing companies to lower selling prices. Production overcapacity likely; OEM’s (original equipment manufacturers) likely to invade after-market in order to use idle plant capacity. Dimension 1 // Evaluate Client Industry, Markets, and Competitor LIFE CYCLE STAGE DIMENSION 1 - 12 NOTES: DECLINING STAGE Companies in declining industries or with declining products may still be suitable borrowers, particularly for seasonal or short-term loans not dependent on long-term economic success. Companies in the declining stage have either failed to develop new products or lines of business, or they are in industries in which the demand for the product or service is in absolute decline. Sometimes the demand for the product or service is fading very rapidly or so gradually that it is difficult to notice. Financial products and services required by companies in the declining stage may include: Cash management services. Revolving lines of credit to finance working capital assets. Long-term debt to finance fixed asset repair or replacement. Export financing, if international in nature. Mortgage loans to finance real estate needs. CRC US Body of Knowledge Trust services. Dimension 1 - 13 The following chart summarizes the strengths and risks of an industry or product in the declining stage DECLINING STAGE CHARACTERISTICS Decline: Sales drop as demand falls. Unless innovation occurs, the industry will shrink and perhaps ultimately fail. POSSIBLE STRENGTHS Low advertising costs as industry/product is fully accepted. Weak competitors eliminated; no longer able or willing to compete. If demand for product diminishes greatly, but does not disappear, remaining companies can compete effectively in a smaller overall market. RISKS Lower sales Cost control discipline required in order to maintain a gross margin contribution to overhead. Substantial over-capacity as demand declines. Lowering margins until production capacity is reduced to level of diminished demand. Product quality deteriorates due to cost cutting in the manufacturing process in order to maintain gross margin. Unable to find skilled labor force to continue manufacturing process. Dimension 1 // Evaluate Client Industry, Markets, and Competitor LIFE CYCLE STAGE DIMENSION 1 - 14 NOTES: INDUSTRY RISKS Different industries have very specific risks, but they are also subject to generic risks that affect all industries, albeit in different ways. In this section, we will analyze the risks that each company faces within the context of its industry and business strategy. We will examine the following issues: MACROECONOMIC ISSUES The extent to which an industry is affected by regulatory, economic, political, and public events, and labor and environmental issues. CYCLICALITY The extent to which an industry is affected by economic or business cycles. SEASONALITY The extent to which an industry is affected by normal changes in climate or calendar specific buying patterns. TECHNOLOGY RISKS The extent to which technology has improved people/production efficiencies, but also has created new types of risk. LIFE CYCLE STAGE CRC US Body of Knowledge The extent to which the industry is affected by its stage in the life cycle. INTERNATIONAL CONSIDERATIONS The extent to which this industry is affected by international events. BUSINESS PROCESS AND PRODUCT RISKS The extent to which industry characteristics influence a customer’s business processes, practices, and products. DIMENSION 1 - 15 MACROECONOMIC ISSUES NOTES: Most companies face many of these macroeconomic issues at one time or another during their life cycle. Your customer’s financial statement reflect the direct and indirect impact of these macroeconomic issues. You should discuss these macroeconomic issues with management and examine them for existing or potential problems that could impact their repayment ability. REGULATIONS All companies face regulatory guidelines. Find out which regulations affect your customer and how they impact the company’s financial performance. In assessing the financial effect of regulations, know the cost of compliance and risk of noncompliance. Fines associated with “out-ofcompliance-conditions” or outright noncompliance can be significant. ENVIRONMENTAL REGULATIONS All companies face the impact of this particular group of regulations. At some point in the supply chain for the production of a product, environmental costs will be felt. You need to assess which environmental regulations directly affect your customer. The liability for clean-up costs and fines for noncompliance could alter the financial health of your customer. Most financial institutions require a review of the environmental regulations that affect specific customers at origination and during the life of the transaction. Additionally, most loan documentation requires an environmental certificate signed by an officer of the company attesting to the firm’s compliance with applicable environmental regulations. In some cases, your institution, as a lender to the company, can become liable for environmental infractions. You should enlist legal and environmental expert assistance when documenting a loan to a company with known or perceived environmental problems. Dimension 1 // Evaluate Client Industry, Markets, and Competitor Regulations that require initial licensing and ongoing recertifications can raise the cost of doing business. DIMENSION 1 - 16 NOTES: CHANGING INTEREST RATES All companies are affected by changes in interest rates, if not directly then through their effect on customers and suppliers. Interest rates can raise or lower operating expenses, and, as a result, raise or lower profits. Doing a mental calculation using total interest expense and interest rates (or blended rates), you can determine approximate average principal amount of debt outstanding during the accounting period and compare that number to the ending period debt balance. This comparison will allow you to estimate a company’s interim period borrowing requirements. LABOR Companies face challenges in attracting qualified people while at the same time maintaining product or service quality. There has been a big change in how people work (flex-hours, job sharing, etc.) and what they expect from their employers. The issues that employers face from labor laws, changes in work ethics, labor union contracts, and essential skill shortages can be expensive and fraught with potential liability. POLITICAL AND PUBLIC OPINION Some companies may escape this issue, only because they, for one reason or another, do not appear on the radar screen of some political body or public advocacy group. The problem with this area is that very often your customer does not control the impact or timing of its exposure to these issues. CRC US Body of Knowledge While issues in this category can be expensive in terms of settlements, sometimes the larger problem becomes the disruption in the execution of the day-to-day business plan and the allocation of people and financial resources. These issues often arise when your customer wants to expand their business and they must get variances from code in the case of real estate or approval from existing labor pools before moving ahead. All of these groups have “agendas” that can be far different from the operating strategy of your customer. DIMENSION 1 - 17 WEATHER As an economic force, weather becomes apparent many times only in the form of a catastrophe such as a drought, hurricane, blizzard, hard freezes, fire, disease, etc. Unfortunately, with the movement to “mega” businesses as companies consolidate, if a natural disaster strikes at just the right place, it can be devastating to your customer. The disaster doesn’t even have to have a direct effect on your client, but only has to affect one company in the supply chain for problems to occur. NOTES: Some of these weather issues, such as business disruption, and fixed asset replacement, can be insured against. However many of the consequences from such a disaster can permanently affect the future viability of your customer, especially if a significant time disruption occurs in the production cycle. With the worldwide economy firmly in place, there is the potential for substantial changes in currency valuations. The risk is more than the extreme event of a country’s unexpected currency devaluation. The risk is that day-to-day volatility in the world currency markets can affect the profitability and potential repayment ability of your customer, if not properly hedged. Not only is there the currency risk, but if inexperienced financial managers address the risk, the risk can be compounded considerably. If your customer is dealing directly with international clients, it is prudent for you to assess their ability to manage their foreign currency risk; an opportunity may exist for your institution’s international department! Dimension 1 // Evaluate Client Industry, Markets, and Competitor CURRENCY FLUCTUATIONS DIMENSION 1 - 18 NOTES: CYCLICALITY Cyclicality refers to the extent to which an industry is affected by the expansion and contraction in economic cycles, often referred to as business cycles. There is much debate as to whether business cycles are repeatable with similar economic dynamics. Economists agree that there are often similarities between business cycles and what instigates change, but they also agree that each business cycle has its own set of economic traits. Defining the business cycle is not easy in today’s economy. As a lender, you should understand the principles of expansion and contraction in the market place and how these movements affect your customer. You should investigate your customer’s strategic approach to counter-cyclicality, i.e., having products and services that are marketed to the other side of the business cycle. This is an especially important concept to grasp when considering long-term loans to fund expansion or fixed asset replacements. While economists disagree on the definition and early warning signals for the onset of a change in the business cycle, it is best for you to talk with your customer and other companies in a particular industry. Management of these firms, and their industry associations, often have an ear to the ground and know what is happening in the marketplace and where the industry stands in the business cycle. Using an intellectual barometer for business cycle movement is sometimes not as meaningful as talking with people who have an intimate and historic knowledge of the industry and vision as to how the past can be used to forecast the future for the industry. EVALUATING CYCLICALITY RISK CRC US Body of Knowledge Evaluating the risk that cyclicality poses to a particular business involves assessing: How vulnerable the company and its industry are to a business cycle, i.e., changes in the economy into which the company markets its products or services. Not all industries react the same way or at the same time to changes in the continuum of economic cycles. How have the company and industry withstood the impact of previous business cycles? Whether the financial condition of a company is strong enough to withstand the possible negative effects of a downturn in the business cycle or has enough capital to take advantage of opportunities as economic growth occurs. The quality of the business’s plan for dealing with economic cyclicality and its ability to insulate itself from extreme economic swings through thoughtful management. Dimension 1 - 19 STAGES OF THE BUSINESS CYCLE Understanding how each stage in the business cycle impacts your customer’s borrowing requirements is important to your assessment of risk. The following chart helps frame risks by showing the characteristics and resulting effects on a business in each stage of a general business cycle: STAGES OF THE BUSINESS CYCLE Early Expansion Stage CHARACTERISTICS Interest rates relatively low. Sales and profits usually increase. Consumer and business credit are plentiful. Companies often expand production facilities, increase inventories, add employees, start new business lines, and/or introduce new products. Consumers have good levels of disposable income because of secure jobs, increasing wages, and available credit. Late Expansion Stage Consumer and business spending and demand for credit increase, pushing up interest rates and prices. Capacity utilization climbs and prices stabilize for goods and services. Early Contraction Stage EFFECTS ON BUSINESS Optimism about the future decreases as interest rates and prices remain high. Sales stabilize or begin to decline as the higher cost of credit and of goods and services begins to dampen consumer spending and business expansion. Fewer new products are developed or additions to capacity are begun and less production capacity is brought on line. Less credit is demanded as companies seek to reduce reliance on debt and increase liquidity. Late Contraction Stage Economy slows down. Unemployment increases. Interest rates gradually fall. As demands for goods and services shrink, businesses begin to see new opportunities for growth. Falling prices and increased availability of credit set the stage for a new expansion. Dimension 1 // Evaluate Client Industry, Markets, and Competitor STAGES DIMENSION 1 - 20 NOTES: SEASONALITY Without the influences of natural disasters, major alterations in weather patterns or sudden changes in consumer purchasing habits, the effects of seasonality on a business may be reasonably predictable, and provide your customers with profit making opportunities. WHAT MAKES A BUSINESS SEASONAL? Weather—Traditional seasons of spring, summer, fall, and winter. Calendar-dictated seasons. Religious, cultural, and national holidays. Other industries’ annual business cycles, including things such as back to school and income tax deadlines. These seasonal influences cause cash receipts to temporarily decline and cash disbursements to temporarily increase and vice versa. In a normal season, these variations in the cash flow cycle can be anticipated and even taken advantage of by your customer. EFFECTS OF SEASONALITY ON CASH REQUIREMENTS Seasonality can alter cash requirements in two ways: By temporarily lengthening the cash cycle CRC US Body of Knowledge By increasing daily average sales or cost of sales Dimension 1 - 21 TYPES OF SEASONALITY SEASONALITY TYPES & CHARACTERISTICS TYPES Seasonal sales Increase in average daily sales and cost of sales. This is the most common type of seasonality. CHARACTERISTICS Usually preceded by increase in inventory and followed by a period of high receivables. The company’s need for additional cash begins with inventory buildup and continues until receivables have been collected and have dropped back to lower permanent levels. If receivables or inventory grow faster than sales (such as during inventory buildup), the cash cycle can lengthen and the demand for cash could be more severe than expected. Seasonal cash Disbursements that lengthen the cash cycle. Seasonal sales are usually preceded by an increase in inventory and followed by a period of high receivables. The company’s need for additional cash begins with inventory buildup and continues until receivables have dropped back to permanent lower levels. Accounts payable may have extended payment terms including datings, which result in a significant source of funding. If receivables or inventory grow faster than sales (such as during inventory buildup), the cash cycle can lengthen and the demand for cash could be more severe than expected. Higher daily sales cause a spike in cash needs for funding higher levels of working capital assets, even if the length of the cash cycle does not change. Seasonal cash Receipts that lengthen the cash cycle. This is the least common type of seasonality. Accounts receivable don’t get paid until your customer’s customer gets paid, for example: Suppliers to government agencies may not be paid until the agency receives funding allocations. Suppliers to educational institutions are often not paid until after the students pay tuition. Suppliers to farmers may not be paid until crops are harvested and sold. Dimension 1 // Evaluate Client Industry, Markets, and Competitor Higher daily sales cause a spike in cash needs for funding higher levels of working capital assets, even if the length of the cash cycle does not change. DIMENSION 1 - 22 NOTES: TOOLS FOR IDENTIFYING SEASONAL PATTERNS AND DETERMINING THEIR CASH FLOW EFFECTS Interim (quarterly or monthly) Financial Statements. Annual financial statements may not reveal the existence or effects of seasonality. Interim financial statements offer the advantage of showing how sales fluctuate during the year and how working capital assets have been affected. Using historical performance as one guide, you can estimate future seasonal borrowing requirements. Interim financial statements are especially helpful when: You want to determine if a company is truly seasonal from a cash cycle perspective. You want to estimate the future seasonal funding needs of a company. You have made a seasonal or long-term loan to a company, and you wish to follow the company’s progress (and your loan’s quality) more often than annually. Such monitoring is especially important when the company is new, growing rapidly, or undergoing significant change in its marketing strategy. Because interim statements are usually company prepared and not audited, they are subject to reporting errors that might be detected in a full audit, such as the verification of physical inventory. Comparing interim financial statements for the same period in prior years will help you get comfortable with the quality of the information. CRC US Body of Knowledge Cash budgets that project actual receipts and disbursements on a monthly basis can be helpful in structuring loans that meet the company’s borrowing needs. Cash budgets trace the movement of cash into a business, as customers pay for goods and services, and movement out of a business, as the company pays its suppliers, employees, shareholders, and lenders. Cash budgets differ from, but can be reconciled to, interim financial statements in two ways: Cash budgets describe the cash effect of events during a period and the balance sheet describes the cash condition at the end of a period. The cash budget and the balance sheet both show the cash balance at the beginning and end of any period (interim or fiscal). Both cash budgets and income statements describe events during a period, but the cash budget does so on a cash basis, and the income statement does so on an accrual basis. DIMENSION 1 - 23 TECHNOLOGY RISKS Technology has allowed companies to increase staff efficiency and reduce personnel costs per unit sold or service provided as companies have grown. NOTES: You should asses the following risks associated with technological advancement: Are there substantial costs to be incurred in the initial purchase of hardware and software? Will there be disruption to the company’s workflow during system upgrades or conversions? Is the system “user friendly?” How will the end-user be affected by system modification? How compatible is a system modification with any existing programs or systems that your customer may be using in its operation? What kinds of system support risks are in existence after the system has been installed, and how financially stable is the support entity? LIFE CYCLE STAGE Understanding the position of the industry in the life cycle is important to identifying the types of risk the company will encounter. Earlier in this section we presented a detailed analysis of life cycle stages. Dimension 1 // Evaluate Client Industry, Markets, and Competitor Does your customer have a labor force that possesses the necessary skills to run the system or will time and financial resources have to be spent to bring the workforce “up to speed?” DIMENSION 1 - 24 NOTES: INTERNATIONAL CONSIDERATIONS If your customer is a supplier to, or purchaser from, the international community, economic risk issues become compounded by political and cultural factors. Consider the following international economic issues as they relate to your client: Currency valuations and exchange rates, Raw material availability. Labor force stability and costs. Distribution channels in and out of the country. Foreign competition Export/import tariffs. Import/export balance of trade for that particular country. Overall economic growth of the country. Given a stable political environment, probably the most common risk is that of currency fluctuations. This risk, if thoroughly understood by you and your customer, can be mitigated quite successfully by using hedging techniques such as purchasing futures/options contracts in the local currency. The political and cultural risks relate to the stability of the government and the relative impact of various cultural attitudes within the country. Some of the international political and cultural issues to consider are: Work rules, skill availability, and ethics. Foreign corporate ownership structure. CRC US Body of Knowledge Country-specific regulations including environmental regulations. Openness to foreign investment and threat of nationalization of foreign businesses. Language difficulties Religious influence Political relations with the country where your customer/supplier is domiciled. DIMENSION 1 - 25 Letters of credit and foreign exchange are two products that you can use to help your customers manage some of those international risks. NOTES: BUSINESS PROCESS AND PRODUCT RISKS Many characteristics common to an entire industry can have particular influence on a customer’s business processes, practices, and products. Significant industry factors that introduce business-level risks include: LABOR RELATIONS AND SUPPLY RISKS How vulnerable is your customer to interruptions in labor supply, for both production and administrative support staff? DISTRIBUTION RISKS PRODUCT AND SERVICE RISKS How does the development and marketing of the company’s products and services affect its life cycle stage? PRODUCTION RISKS What impact do the complexities of the production cycle have on the overall business operation? In response, how has the customer configured its operations and facilities? TECHNOLOGY RISKS What technology strategies does the company use and how are they funded, implemented, and embraced by the employees? INTELLECTUAL PROPERTY RISKS What is the risk of loss of value or of control over the company’s intellectual property, and how effectively does the company protect itself against misuse, or allegations of misuse, of other parties’ intellectual property? Dimension 1 // Evaluate Client Industry, Markets, and Competitor What are your customer’s distribution channels and what are some of the distribution system risks? DIMENSION 1 - 26 NOTES: OUTSOURCING RISKS How does your customer’s outsourcing strategy affect its risk profile, particularly if it is a large user of outsourcing or outsources a critical function? OTHER RISKS What other issues might affect your customer and how can you capture these issues? LABOR RELATIONS AND SUPPLY RISKS Access to a skilled, affordable, and uninterrupted labor supply is a key business requirement for many companies. We commonly think of manufacturing labor when considering labor relations and supply constraints, but the risks can be equally significant for management and non-manufacturing employees. In some industries, labor supply can be a life threatening risk to companies. For example, in the truckload sector of for-hire trucking companies, driver shortages are chronic and driver turnover commonly ranges between 90% and 120% per year. Companies in this segment of trucking are obligated to spend significant dollars for driver recruitment, and the most successful companies are often those that develop innovative driver retention programs, not necessarily geared just to monetary compensation. To find out if your customer is at particular risk for labor interruptions, ask the following questions: In which part(s) of company operations is there a significant risk of qualified labor shortage? CRC US Body of Knowledge What are the particular challenges that make it difficult to find qualified employees, such as highly specialized skills, chronic shortages that have created bidding wars for employees, etc.? Does organized labor influence your hiring and compensation practices either directly (union contract) or indirectly (union has influenced wage base and employment practices in the industry)? What has been the company’s employee turnover experience in the past three years? What special recruitment, training and retention programs has the company used to attract desirable employees? How do those programs differ from the competition? How does the company describe the quality of its labor relations? How does it measure the quality of its labor relations? DIMENSION 1 - 27 What strategies is the company pursuing to lower its dependence on scarce labor, such as an outsourcing strategy or an automation strategy? NOTES: DISTRIBUTION RISKS The issue here is very simple: who has direct contact with the customer? If your company is interfacing directly with the end-user, then it controls the fate of the customer relationship. If your customer is either a manufacturer or a wholesaler, then it may not be interfacing directly with the consumer or end-user and has to rely on a distribution system: wholesaler, broker, manufacturer’s representative, and retailer. The following issues should be reviewed: The exact relationship between your customer and the ultimate consumer of the company’s product or service. Where can the breakdown in the distribution system occur and who controls its resolution? All parts of the distribution system need to have a set implementation strategy as well as a backup plan, especially for those parts not controlled within your customer’s operating infrastructure. An independent trucker strike, for example, can be a substantial detriment to a company’s ability to complete sales, especially if the strike is in the company’s seasonal selling period. The new age e-commerce companies are particularly susceptible because they rely exclusively on a third-party distribution system. Companies selling perishable items are susceptible to weather, construction, and normal traffic pattern delays. Dimension 1 // Evaluate Client Industry, Markets, and Competitor You can establish the points of risk in the distribution system and quantify them in terms of net sales, gross profits, and operating profits. DIMENSION 1 - 28 NOTES: PRODUCT AND SERVICE RISKS The ability to differentiate one company’s product line from another is based on the profile of the particular product or service. For example, is the product or service a luxury or staple item? A luxury item to one market segment may be a staple item to consumers in a higher economic bracket. Questions to ask include: Is the product line diversified? Is the product line diversified horizontally (i.e., many products being sold into the same market segment) or is the company selling the same types of products vertically into several different economic brackets? Product diversification is usually an advantage, a success factor, to the extent that it helps a company adapt to changing aggregate demand and meet more of each customer’s needs. However, a diversified product line is more expensive to support than producing and carrying inventory for a narrow product line. Is the product or service being purchased with discretionary income or with nondiscretionary income? In an economic downturn, purchases with discretionary dollars have a tendency to be curtailed, whereas nondiscretionary expenditures for staple goods and services tend to be the last ones eliminated from the consumer’s budget. CRC US Body of Knowledge Is the product or service vulnerable to style or technological obsolescence? This is an especially important question to ask of high tech marketers, such as those in the telecommunications and computer industries. Companies involved with the toy industry are also susceptible to obsolescence risks. If the product life cycle is relatively short, committing high fixed costs or financing the production or marketing infrastructure long-term may lead to cash flow problems for your customer. What is the demand for each product line? Demand influences sales volume, growth, and profit margins. Strong or growing demand is a success factor. However, if the product or service is faddish, the success could be short-lived. DIMENSION 1 - 29 Is the product difficult or expensive to produce? Difficulty and expense involved in making the product can be positive or negative. It may mean the company can enjoy higher profit margins and less threat from new competitors. It also can mean that more capital is needed to operate the business and that customers demand higher quality standards. NOTES: Uniqueness of the product usually is an advantage. However, a niche product line might limit demand for the product to a very small market segment. A niche product line is by definition a concentration, which is a risk factor. Alternately, if a product is a commodity, there is little opportunity to distinguish from competitors’ products and price becomes the sole basis of competition. Keep in mind that it is not just traditional commodities, such as sugar or pork bellies that sell solely on the merits of price. Products become commoditized, or genericized, when the market’s offerings evolve into look-alike products. To some extent this process is a natural element of the product lifecycle. Successful companies find ways to add or enhance product features to extend the innovative life of their product or service, providing a continuing basis for valueadded pricing. What value does the company add to the product? Value added, like diversification can result in a competitive advantage, but it can be expensive to create and maintain.. For example, bee keepers’ primary products are honey, wax, pollen, royal jelly, venom, bees, and their larvae—all products produced naturally by the bees, with no value added by the bee keeper. The bee keeper that also produces a line of soaps or lotions that contain honey or royal jelly is selling value-added products, the pricing of which is independent of the more commodity-like honey and bee products. Of course, creating the manufacturing capability for soaps and lotions requires a significant investment of both capital and expertise, along with access to distribution outlets. Does the company incur product liability? Food, pharmaceutical, and cosmetic products bring obvious product liability risks, as do vehicles, many toys, and infant products. Product liability is an inevitable business risk for many companies, and the management interview should include a discussion of the company’s product liability risk management programs. Dimension 1 // Evaluate Client Industry, Markets, and Competitor How do competitors differentiate their products or services? DIMENSION 1 - 30 NOTES: PRODUCTION RISKS What is the exact nature of the production cycle and facilities? Issues to be evaluated here are as follows: Do you consider your firm a processor, fabricator, or assembler? You want to understand the length and complexity of the production cycle. How long or complex is the production cycle? Is the company susceptible to shutdowns in the production cycle caused by: –– Labor unrest? –– Raw material supply interruptions? –– Equipment malfunctions or plant disasters such as a fire or flood? Does management have a plan in place in the event of a major disaster or other lengthy disruption in production or administrative function? Backup plans should be in place for critical functions. Has your customer continued to invest in fixed assets and their maintenance? Is there proper insurance on the production equipment, and does the company maintain business interruption insurance to ensure cash flow to pay overhead and debt service expenses in the event of lengthy production disruptions? Has your customer outsourced some or all of the production process? CRC US Body of Knowledge What is the present production capacity, what is the percentage of capacity utilization, and what are the economically efficient capacity increase increments? Where are the facilities located? If a company’s properties are well maintained, well located, and have value to other businesses (multipurpose), these are advantages. Are facilities adequate, inadequate, or excessive? If the company has too many dollars invested in fixed assets and has a great deal of excess capacity or has spent more frivolously on nonproductive assets, these are risk factors. However, a company that has inadequate facilities, either in terms of location, size, or efficiency, will also suffer. DIMENSION 1 - 31 Does the company own or lease its premises? Owning or leasing is not a significant success or risk factor by itself. How does the company acquire the use of production and administrative fixed assets? How does the method of acquiring the asset (buy versus lease) affect the company’s financial activities? NOTES: Does the production process introduce any environmental risk? Environmental contamination can arise from: –– Pesticides –– Poisons –– Solvents –– Petroleum products –– Industrial chemicals –– Animal by-products and waste –– Building materials Companies are held legally responsible for appropriate handling of hazardous substances and other wastes. Severe financial and criminal penalties can be imposed on individuals or businesses found guilty of contaminating the air, land, or water. The costs associated with the cleanup and remediation of a contaminated site can cripple a business financially. There are several levels of environmental audit that can be performed, and these are detailed in Dimension 7. The most comprehensive environmental audits must be performed by qualified professionals. However, you should do an initial screening by asking the company to disclose: Any production inputs or processes that create environmental risk. Knowledge of any prior use of their property that might have created an environmental hazard. Please see the Dimension 7 exhibit titled Signals of Environmental Problems: Things to Identify and Consider (SEPTIC) for additional help in understanding environmental risk. Dimension 1 // Evaluate Client Industry, Markets, and Competitor –– Metal fragments DIMENSION 1 - 32 NOTES: INTELLECTUAL PROPERTY RISKS Intellectual property (IP) risks can be direct and indirect. Direct IP risk is the risk of loss of control or value of the company’s exclusive knowledge assets that are embedded in its product or service. Indirect IP risk refers to the risk of loss of access to critical intellectual property, such as software, or the risk of litigation alleging improper use of others’ intellectual property. To help disclose IP risk, you should ask the following: DIRECT INTELLECTUAL PROPERTY RISK What intellectual property does the company own, and how does it currently protect this IP? For example, what brands, logos, software programs, inventions or publications has the company developed, and how has it protected these with service marks, trademarks, patents, or copyrights? Does the company directly own the IP protections? For example, copyrights generally belong to authors unless specifically assigned to their employers or to clients when works are written by employees or contract workers. You should verify that the company owns or has received assignment to all legal rights to its intellectual property. Does the company require confidentiality agreements to be signed by all key employees, clients, and contractors to minimize the risk of proprietary secrets being compromised? CRC US Body of Knowledge What human resource retention programs are in place to minimize the loss of intellectual capital to competitors? Does the company protect the value of its intellectual property through continued research and investment in new product development or by purchase from outside developers? How adequate are financial and nonfinancial resources to ensure a seamless replacement or update of aging intellectual property? Nonfinancial resources include access to technology and to skilled employees or contractors. How effectively is the company monitoring the state of the art of its IP in the market? The company cannot protect the value of its IP through enhancements, or defend against any perceived infringement, if it is not aware of competitors’ evolving product or service offerings. DIMENSION 1 - 33 INDIRECT INTELLECTUAL PROPERTY RISK Is the company a legitimate owner or licensee of others’ intellectual property used for any business purpose? For example, bootleg software, installed with or without the knowledge of company management, exposes the company to costly litigation risk. NOTES: Does the company purchase critical software from vendors that provide an IP indemnification with the product license? A company may legally license software that subsequently becomes the target of litigation alleging it contains a competitor’s proprietary code. Although not responsible for the purloined code, the user may find itself embroiled in an IP dispute that can include a legal block against using the software in dispute. Dimension 1 // Evaluate Client Industry, Markets, and Competitor Does the company educate its employees about intellectual property responsibilities, and does it maintain and enforce policies to prevent unauthorized use of outside IP, such as copied software or copyright infringement? DIMENSION 1 - 34 OUTSOURCING RISKS A company may alter and increase its risk profile by outsourcing various functions; i.e. hire other companies perform functions that were previously done in-house. The following risks should be considered whether your customer is a large user of outsourcing as a strategic initiative or outsources only a few, but very critical, functions: CRC US Body of Knowledge OUTSOURCING RISKS Credentials Do the principals, either singularly or together, have the credibility (formal training and experience) to deliver the service within mutually established parameters for quality and timeliness? Knowledge Does the company have sufficient depth and breadth of knowledge to continue delivering the service should one of the principals (or the only principal) be separated from the firm for any reason? Intellectual What is the ability of the firm and its employees to keep pace with changes within the industry on a timely basis? Reputation Does the firm have a well-documented reputation within the industry that it is serving? Your customer’s reputation, in turn, will be greatly affected by the reputation of the outsource provider. Financial stability Does the outsource provider have the financial strength to handle “this project” and all of the other projects that it is presently (or contemplating) handling? Obtain financial statements if necessary. Licensing Does the firm possess all of the necessary licenses needed to deliver the services, and does the firm have the ability to have those licenses renewed during the term of the outsourced contract? Capacity Does the firm have the people/administrative capacity to deliver the services to be rendered or do they have to acquire additional capacity to handle this contract? Technological Does the firm have the technological capabilities and capacities to deliver the service and are their systems compatible with the client’s systems? Who provides their backup? Contract term Review terms and conditions including reporting requirements. Ask your customer for a copy of the RFP (Request for Proposal) that the outsource firm completed when bidding on the contract. DIMENSION 1 - 35 OTHER RISKS You should look for risks that are not conveniently categorized in any of the sections previously described. Some risks to look for and questions to ask your customer are: NOTES: What are the company’s critical success factors? What are the corporate attributes that make the business operate well? What are the greatest risks and opportunities in the industry and related industries? Are there any personnel issues or personal issues that could have major financial implications for the business going forward? For example: –– The five D’s of credit: death, divorce, drugs, disagreements, or disabilities. Small businesses with limited management teams are particularly vulnerable to these risks. –– Employee morale or pending legal actions. CHARACTERISTICS OF KEY INDUSTRY SECTORS This section profiles the characteristics, special problems, and credit needs of the following industry sectors: Manufacturing companies Wholesaling companies Retailing companies Service companies Construction companies Agribusinesses Educational institutions Leisure/tourism industry Nonprofit companies Government/municipal entities. Dimension 1 // Evaluate Client Industry, Markets, and Competitor –– Changes to compensation and benefit packages. DIMENSION 1 - 36 NOTES: CHARACTERISTICS OF MANUFACTURING COMPANIES In manufacturing businesses, the timing of the production cycle (making and selling the product) is difficult to predict. As the production cycle increases, regardless of the industry, the receipt of cash takes longer, which results in the company having to maintain more cash on its balance sheet to meet liabilities as they come due. Depending on how vertically integrated they are, manufacturers usually have a considerable investment in both inventory and physical plant, so their percent of assets in cash relative to total assets may not be as high as it is for retailers. There are three general types of manufacturers: Processors Fabricators Assemblers The key to differentiating among these three types of manufacturers is to compare the level of vertical integration. Vertical integration relates to the portion of the manufacturing, marketing, and service functions that the company provides internally rather than having another company provide any portion of those functions. Typically, the more your customer is vertically integrated, the longer its production and resulting cash cycle will be. CRC US Body of Knowledge With the recent use and acceptance of outsourcing, the once fully integrated company no longer needs to be fully integrated—nor is it, necessarily, economically appropriate for it to be fully integrated. Years ago, a company, literally, had to make its own parts before it could begin to fabricate or assemble the final product. In today’s world economy, with just-in-time delivery, there are fewer fully integrated processors and more assemblers. DIMENSION 1 - 37 ASSETS A key to understanding the risks associated with a manufacturer is to analyze inventory management strategies. Levels of inventory will vary due to: NOTES: Length of the manufacturing cycle, which directly relates to the amount of cash that is tied up in work-in-process. Difficulty of obtaining quality raw materials and parts, which directly dictates how much raw material must be kept on hand at all times. What is the permanent level of, and funding requirement for, raw materials in the company’s working capital assets structure? Reliability of the raw material delivery channel and duration of the shipment schedule. Whether the company is producing goods for its finished goods inventory or whether it is producing goods to fill customer orders. This production strategy will dictate a company’s investment in the finished goods component of inventory. Planned production shutdowns for occurrences like holidays, model switchovers, or for seasonal reasons. Processors and fabricators usually have a slower inventory turnover (i.e., more days’ sales in inventory) than manufacturers who only assemble what they sell. Generally, any type of manufacturer must invest heavily in production plant and equipment, so a manufacturer’s total working capital asset turnover is lower than in other industry sectors. Businesses that normally have low asset turnover are called capital intensive; they need many dollars invested in assets to generate sales. Dimension 1 // Evaluate Client Industry, Markets, and Competitor Stability of the labor force relative to issues such as the availability of required skilled labor and any labor agreements. DIMENSION 1 - 38 NOTES: PROFITABILITY Profit is heavily influenced by: Proportion of variable costs to fixed costs. Competition Amount of perceived value added. As with any industry, the more competition there is, the lower the profit margin will be. In addition, the more value (perceived or real) a company adds to its product or service, the higher the profit margins are likely to be. Therefore, because manufacturers are perceived to add more value, their profit margins are usually larger than those exhibited by wholesalers or retailers. OTHER CONSIDERATIONS CRC US Body of Knowledge Manufacturers bear the brunt of product liability and performance representations of the products that they produce. Typically they provide product guarantees that the consumer relies on in the purchase decision. These guarantees contribute significantly to the value-added equation. DIMENSION 1 - 39 ASSET DISTRIBUTION CHARACTERISTICS As an example, a manufacturer of Candy and Other Confectionery Products (SIC # 2064/NAICS # 31133) would have the following asset distribution characteristics: NOTES: CANDY AND OTHER CONFECTIONARY PRODUCTS FIXED ASSETS OTHER INVENTORY FIXED ASSETS CASH AND EQUIVALENTS INVENTORY OTHER TRADE RECEIVABLES Dimension 1 // Evaluate Client Industry, Markets, and Competitor CASH AND EQUIVALENTS TRADE RECEIVABLES Dimension 1 - 40 For the asset distribution characteristics of other manufacturers, you should refer to the most recent edition of RMA’s Annual Statement Studies—Financial Ratios Benchmark. The following is a summary of the general characteristics, special problems, and credit needs of manufacturers. MANUFACTURING BUSINESSES: FEATURES INDUSTRY Manufacturing CHARACTERISTICS Dominated by larger, more mature firms. Processor SPECIAL PROBLEMS Cost accounting High credit needs; borrowing tends to be short and long term. Fixed cost management. Fabricator High fixed assets requirements. Inventory control Assembler High fixed costs. Long-term forecasting. High cyclicality Equipment/process obsolescence. Moderate seasonality Environmental considerations CRC CRC US Body of Knowledge CREDIT NEEDS Particular needs include: –– Financing of fixed assets. –– Financing of working capital assets. DIMENSION 1 - 41 CHARACTERISTICS OF WHOLESALING COMPANIES NOTES: Wholesalers are distributors or middlemen who buy a finished product or component parts directly from the manufacturer and sell these goods to users other than the ultimate consumer. Their value added” results from the availability, storage, and movement of the product. In contrast to brokers, wholesalers take title of the goods and control their physical movement. Due to the intense competition among wholesalers and the relative ease with which new companies can enter the industry, the cash cycle tends to become stretched out. Wholesalers, especially those selling commodity products, differentiate themselves by offering liberal credit terms in order to boost sales and attract or retain customers. ASSETS Cash reserves must be slightly higher than in less competitive sectors. Inventory will also represent a considerable percentage of total assets as they try to carry enough inventory to meet anticipated demand. Well-managed wholesalers tend to turn their inventory faster than retailers because retailers are forced to stock for seasonal demand and deal with unpredictable consumer buying patterns. PROFITABILITY Profitability is dependent on how an individual wholesaler differentiates itself from the competition and its level of value added. Because wholesalers generally add less value in the sales cycle, they have a tendency to show lower profit margins than manufacturers or retailers. Dimension 1 // Evaluate Client Industry, Markets, and Competitor Accounts receivable may represent a considerable percentage of total assets and their collection may be slow. DIMENSION 1 - 42 NOTES: OTHER CONSIDERATIONS Brokers act as an outsourced sales force for the manufacturers that they represent. Broker’s value added is in the intellectual value added by the sales force that may have particular expertise in an industry or group of related industries. The purchaser looks to the broker’s sales force as a source of information and not just a source of product. Brokers typically have a large percentage of their assets in accounts receivable and collection may be slow. The need for cash is dependent on the disparity between accounts receivable turnover and accounts payable turnover. There should be no investment in inventory as the goods are shipped directly from the manufacturer. There is little investment in fixed assets because a broker neither manufactures nor stores any product. Typically wholesalers do not have a significant risk in product liability or performance guarantees. Large retailers (mega retailers) in certain industries have cut out the wholesaler from the sales cycle by incorporating the wholesaler’s function into their own operation. CRC US Body of Knowledge Mega retailers buy directly from the manufacturer (sometimes under the retailer’s label) and sell directly to the consumer. Mega retailers may use a captive centralized warehouse and distribution system in order to economically enhance product distribution logistics. The sheer buying power of these large retailers allows for this business strategy to work. The profit center eliminated and economies gained by reducing distribution costs, as a result of cutting out the traditional wholesaler, presumably increases the mega retailer’s gross margin while also discounting the price of the product to the ultimate consumer. In many industries, wholesaling is a vibrant sector, which uses inventory control technology and creative transportation to ensure its place in the sales cycle. DIMENSION 1 - 43 As an example, a wholesaler of Computers, Peripheral Equipment & Software (SIC # 5045/NAICS # 42343) would have the following asset distribution characteristics: For the asset distribution characteristics of other wholesalers, you should refer to the most recent edition of RMA’s Annual Statement Studies—Financial Ratios Benchmark. NOTES: Dimension 1 // Evaluate Client Industry, Markets, and Competitor ASSET DISTRIBUTION CHARACTERISTICS DIMENSION 1 - 44 The following are general characteristics, special problems, and credit needs of wholesalers. WHOLESALE BUSINESSES: FEATURES INDUSTRY Wholesaling CHARACTERISTICS Dominated by small firms. SPECIAL PROBLEMS Gross margin management. Size and location of Inventory control techwarehouse facilities and nology. equipment varies. Low fixed costs. Accounts receivable collection. Accounts receivable and Structuring debt reinventory are usually quirements properly. the biggest assets. Moderate cyclicality Needs a quick cash-tocash cycle. Low seasonality (depending on subsector). Available transportation networks. CRC US Body of Knowledge Lowest level of profitability due to least value added. CREDIT NEEDS High credit needs including: –– Equipment financing –– Short term loans to finance the cash conversion cycle. DIMENSION 1 - 45 CHARACTERISTICS OF RETAILING COMPANIES NOTES: Retailers buy goods from wholesalers or, in the case of large retailers, directly from the manufacturers. Retailers’ value added results from providing convenience, product selection, and consultation to the ultimate consumer. There is intense competition in retailing and there exists relative ease of entry for new companies (especially smaller ones) into the market. ASSETS Small or local retailers will carry their own accounts receivable. Larger retailers do not carry their own accounts receivable because that function and risk have been outsourced to the national credit card companies. For regional and national retailers, there is considerable investment in retail outlets and personnel costs. PROFITABILITY The retailer’s value added can be considerable and results in higher gross margins than those exhibited by the wholesaler and, in some cases, even the manufacturer. Value added comes in the form of: Convenience for the consumer. Product selection – style and features. Sales terms – discounts, returns and allowances, payment terms. Technical advice. Backup to manufacturers’ representations and warrantees. Price. Dimension 1 // Evaluate Client Industry, Markets, and Competitor The risks of lending to retailers lies in their physical location, quality and marketability of their inventories, and quality of their service. DIMENSION 1 - 46 NOTES: OTHER CONSIDERATIONS Some retailers sell products under exclusive distributorship arrangements with specific manufacturers that contain valuable protected territory provisions. This contractual relationship results in the manufacturers being able to have significant influence over the marketing and pricing strategies of their products. The benefit is that the retailer has a branded product to sell with recognized product performance and reliability. The inventory risk is mitigated because of its known marketability and because the manufacturer may provide your financial institution with a buyback agreement for all unsold inventory. The buyback agreement could substantially reduce your risk in lending to a retailer, but benefits of such an agreement need to be well documented in your loan agreements. Franchise agreements under which some retailers operate also reduce the operating and marketing risks, because of the marketing credibility provided by an established franchisor. Generally, the risk to you as a lender is not in the marketability or quality of the product, but in the location of the retailer relative to the existing or potential marketplace. It is important to understand the underlying terms and conditions of the franchise agreement, as well as the overall strength and reputation of the franchisor. Depending upon the products sold, a retailer may have to deal with unpredictable consumer demand. Retailers have the challenge of stocking the right amount of inventory for which there is steady demand, but in unpredictable amounts. In other cases, to meet unknown or volatile consumer demand, the retailer may have to stock inventory in, or have quick access to, a wider and deeper array of products than other competitors in the marketing channel, including the new E-commerce retailer. CRC US Body of Knowledge There are many nuances to retailing today, and to establish a valued lending relationship with the customer, you need to understand exactly how your customer purchases and sells its products. DIMENSION 1 - 47 ASSET DISTRIBUTION CHARACTERISTICS As an example, a small retailer of Cameras & Photographic Supplies (SIC # 5946/NAICS # 44313) would have the following asset distribution characteristics: NOTES: CAMERA AND PHOTOGRAPHIC SUPPLIES FIXED ASSETS OTHER INVENTORY TRADE RECEIVABLES FIXED ASSETS CASH AND EQUIVALENTS INVENTORY OTHER TRADE RECEIVABLES For the asset distribution characteristics of other retailers, you should refer to the most recent edition of RMA’s Annual Statement Studies— Financial Ratios Benchmark. Dimension 1 // Evaluate Client Industry, Markets, and Competitor CASH AND EQUIVALENTS DIMENSION 1 - 48 The following are general characteristics, special problems, and credit needs of retailers. RETAIL BUSINESSES: FEATURES INDUSTRY Retailing CHARACTERISTICS Dominated by small firms – some mega retailers coming into market. SPECIAL PROBLEMS Gross margin management. Inventory management Low fixed asset requirements – unless mega retailer. High inventory requirements. Moderate to high cyclicality. Variable seasonality CRC US Body of Knowledge Tends to have high margins due to value added. Fixed cost management. Sales force hiring, training and retention. CREDIT NEEDS Credit needs may include: –– Short-term loans to finance the cash conversion. –– Occasional seasonal line of credit. –– Term loans or leases for fixed asset acquisitions. DIMENSION 1 - 49 CHARACTERISTICS OF SERVICE COMPANIES Service businesses generate their revenues more from the marketing of expertise and knowledge possessed by their employees than from the sale of goods. NOTES: ASSETS The issue of accounts receivable financing on a whole account basis is especially critical in lending to service companies. The whole account basis is discussed further in Dimension 3 but basically refers to the process of eliminating the entire amount of an account receivable for financing purposes if any amount is due beyond a defined acceptable age. Service companies have very little inventory. Generally, they are not capital intensive, although large professional service companies (lawyers, CPAs, engineers, money managers) can have a considerable investment in buildings and office equipment. PROFITABILITY Profit margins are generally high, especially when the service provided is either rare or complex, and requires specialized talents or skills. Value of the service is in the mind of the customer. Margins are somewhat lower, when the service is a commodity service, i.e., it is simple, doesn’t take long to provide, and doesn’t require highly technical skills. Dimension 1 // Evaluate Client Industry, Markets, and Competitor Accounts receivable tend to be a service company’s major asset and their turnover tends to be slower than in some other industry sectors. As a lender to a service company, your risk is the ultimate collectability of the accounts receivable. The longer the accounts receivable payment cycle, the more susceptible the company is to nonpayment. In addition, the quality of the service provided can often result in disputed receivables making it important to understand the past track record of the service provider. DIMENSION 1 - 50 NOTES: OTHER CONSIDERATIONS Historically, there have been relatively low barriers to entry in the service sector. This is especially true of commodity-type services. However, in service businesses dependent upon rare or reputable skills, such as money management firms and internet-based service companies, significant funding for relatively high fixed personnel costs will be required. Any service business that is dependent upon licenses in order to operate may also have significant costs of entry. The cost of entry to a particular service subsector will have significant influence on the risk that you take in lending to a service firm. ASSET DISTRIBUTION CHARACTERISTICS CRC US Body of Knowledge As an example, a firm providing Accounting, Auditing & Bookkeeping Services (SIC # 8721/NAICS # 54121) would have the following asset distribution characteristics: For the asset distribution characteristics of other service firms, you should refer to the most recent edition of RMA’s Annual Statement Studies—Financial Ratios Benchmark. DIMENSION 1 - 51 The following are general characteristics, special problems, and credit needs of service companies. SERVICE BUSINESSES: FEATURES CHARACTERISTICS Services Dominated by small firms. High investment in accounts receivable. SPECIAL PROBLEMS Labor expense management. Low cyclicality Moderate seasonality Margins tend to be higher in specialized knowledge businesses. Low barriers to entry in commodity services. Credit needs may include: –– Equipment financing Job costing Fixed asset requirements Pricing depend on size of company. Low fixed costs, except personnel costs. CREDIT NEEDS –– Short-term loans to finance the cash conversion cycle. Perception of value of service provided. Dimension 1 // Evaluate Client Industry, Markets, and Competitor INDUSTRY DIMENSION 1 - 52 NOTES: CHARACTERISTICS OF CONSTRUCTION COMPANIES The construction industry experiences unpredictable timing of cash receipts, keen competition, and costs that are difficult to predict and control. There are some general guidelines that are applicable to most companies in the construction industry. ASSETS There is a general need for relatively high levels of cash. The cash cycle can be unpredictable, depending on how payments are made under specific contracts. Large outflows of cash for labor and equipment utilization are routine. Bonding companies that provide completion and performance bonds to the ultimate purchaser often require a minimum level of cash to be available at all times, which can reduce the amount of cash available for ongoing requirements. Because of staged or progress payments, large sums of money are often tied up in receivables that will not be collected until approval or acceptance by the purchaser, or until a project is completed. If progress payments are made to help reduce a construction company’s investment in accounts receivable, there are retainages or retentions (often called holdbacks) that must be financed until the completion of the job. For large contracts, retainages of typically 10% can represent significant dollars. Costs in excess of billings (asset) and billings in excess of costs (liability) are balance sheet categories that can mitigate risk or create risk. If these accounts are significant in their absolute amount, or if t a large difference exists in the relative balances between the two accounts, this can represent a significant source of funds (liability) or use of funds (asset). In a contractor’s financial statements: CRC US Body of Knowledge –– Costs in excess of billings (an asset) represent the difference between the total of costs and recognized estimated earnings to date and the total billings to date. –– Billings in excess of costs (a liability) represent the difference between the total billings to date and the total of costs and recognized estimated earnings to date. DIMENSION 1 - 53 Inventory requirements are typically low, because material is purchased and priced for specific contracts. NOTES: Historically, fixed assets (mostly equipment) have made up a large part of the construction company’s balance sheet. This may still be true for companies with equipment that can be used repeatedly for many different contracts and which does not exhibit great technological obsolescence. There is a trend away from outright ownership of equipment to a strategy of gaining the utility of the required piece of equipment for only the time period for which it is needed. This equipment utilization is gained through a leasing or rental agreement. This leasing/renting strategy increases variable expenses that are expensed through contracts, but should reduce a construction company’s fixed expenses. PROFITABILITY Profitability is typically predicated upon: Accuracy in job costing. The control of fixed expenses allocated to individual jobs. Dimension 1 // Evaluate Client Industry, Markets, and Competitor Total volume of work. DIMENSION 1 - 54 NOTES: ASSET DISTRIBUTION CHARACTERISTICS As an example, a construction company focusing on Bridge, Tunnel & Elevated Highway Construction (SIC # 1622/NAICS # 23731) would have the following asset distribution characteristics: For the asset distribution characteristics of other types of construction enterprises, you should refer to the most recent edition of RMA’s Annual Statement Studies—Financial Ratios Benchmark. CRC US Body of Knowledge For articles about construction lending, see the Construction, and Construction Contractors Industry Studies Packs by RMA. DIMENSION 1 - 55 The following are general characteristics, special problems, and credit needs of construction businesses. CONSTRUCTION BUSINESSES: FEATURES INDUSTRY CHARACTERISTICS Construction Dominated by small firms. SPECIAL PROBLEMS Job costing Low to moderate fixed asset Fixed cost management. requirements. High accounts receivable and retainages. Management of direct versus indirect costs. CREDIT NEEDS Credit needs may include: –– Revolving lines of credit for accounts receivable financing. –– Equipment financing Cash flow projections. Moderate to high seasonality. Balancing accounts for costs in excess of billings and billings in excess of costs. Dimension 1 // Evaluate Client Industry, Markets, and Competitor –– Project financing High cyclicality DIMENSION 1 - 56 NOTES: CHARACTERISTICS OF AGRIBUSINESSES Agriculturally oriented businesses, i.e., agribusinesses, have two significant categories on their balance sheet: inventory and fixed assets. These businesses face a number of risks in getting their product to market: Changes in consumer eating habits, Changes in the environment, Disruptions in the growth of the product due to sudden changes in weather or prolonged weather patterns, Disease Changes in government regulations, Changes in the market price for the end product, ASSETS Inventory represents direct costs associated with the growth of a plant or animal until sold in the market. CRC US Body of Knowledge Agribusinesses typically have a very large investment in land. While the preponderance of family farms is decreasing, there are still significant land holdings dedicated to farming. The cost basis of the land as recorded on the company’s financial statements is an important number. If the land has been handed down from generation to generation, there is a low cost basis. If land must be purchased at today’s market price, this can represent a large portion of the company’s assets and be a significant call on cash. This asset requires relatively little maintenance other than fertilizers and insecticides to keep it fertile for the proper crop or grazing rotation. The equipment necessary to “work” the agribusiness represents another significant portion of the company’s assets. It is generally expensive to purchase and maintain, and often cannot be leased or shared in a cooperative because of concurrent harvesting or slaughtering schedules. DIMENSION 1 - 57 PROFITABILITY Profitability relates to the price of the product received at the time of sale less the costs incurred over the period of time to bring the product to market. There can be considerable volatility in both costs and market prices from one growing season to the next. There are several different aspects in accounting for agriculture and these need to be understood to gain an appreciation of the actual profitability. For example, much of the accounting for agriculture is cash accounting versus accrual, which can provide significantly different results. NOTES: OTHER CONSIDERATIONS Agribusinesses are asset-intensive and susceptible to large swings in buying patterns and market prices. This industry’s ability to control disease and avoid the impact of sudden changes in weather patterns is key to its profitability and survival. As an example, an agribusiness growing vegetables (Agricultures – Farm- Vegetable, SIC # 0161/NAICS # 11121) would have the following asset distribution characteristics: Dimension 1 // Evaluate Client Industry, Markets, and Competitor ASSET DISTRIBUTION CHARACTERISTICS DIMENSION 1 - 58 For the asset distribution characteristics of other agribusinesses, you should refer to the most recent edition of RMA’s Annual Statement Studies—Financial Ratios Benchmark. The following are general characteristics, special problems, and credit needs of agribusinesses. AGRIBUSINESSES: FEATURES INDUSTRY CRC US Body of Knowledge Agribusiness CHARACTERISTICS SPECIAL PROBLEMS Historically dominated by small farms – large or mega farms coming into existence. Access to land High fixed asset requirements – depends on how the use of land is acquired. Changes in weather patterns. High inventory costs. Fixed cost management. Moderate cyclicality Inventory management High seasonality Sales volatility and use of futures contracts to stabilize selling price. Disease control Cost to grow product. CREDIT NEEDS Credit needs may include: –– Short-term loans to finance the cash conversion cycle with a seasonal line of credit. –– Term loans, leases for fixed asset acquisitions. DIMENSION 1 - 59 CHARACTERISTICS OF EDUCATIONAL INSTITUTIONS NOTES: Like other nonprofit enterprises, the cash flow cycle is characterized by the significant inflow of cash, such as grants and fund raising from sources other than from the customers (students) of the institution. For some educational enterprises, this cash flow, regardless of its source, can be relatively predictable; for others it is not. ASSETS Cash balances are susceptible to significant swings based upon timing in the business cycle (i.e., semesters), and the health of the institution’s endowment and investment funds. The level of cash is dictated by the timing and amount of tuition inflows and the movement of funds from endowment funds into the operating accounts. The industry is characterized by large investments in fixed assets. Fixed assets, comprised of land, buildings, and equipment, are very expensive to purchase and maintain. The purchase funding typically comes from the fundraising activities of entities and individuals friendly to the institution. The funds for maintenance come from the operating fund of the institution. The amount of land and buildings as recorded on the institution’s balance sheet depends on when the investment was made, and may not reveal very much to a lender about its current value or alternative use. Equipment is usually highly specialized, especially in research facilities, expensive to buy, and is subject to quick obsolescence. Again, depending on its purchase date and useful life, the large amount of equipment usually found at an educational institution may not be reflected on the balance sheet. Only when a piece of equipment or building needs to be added or replaced does the significance of the demands on cash become known. Endowment funds in well-established institutions comprise a large portion of their total assets. The magnitude of these funds can vary substantially according to the fortunes of the investment strategy and general market conditions. Many of these funds are dedicated to support specific activities or programs at the institution and are generally not available to pay operating expenses of the institution including debt service. Dimension 1 // Evaluate Client Industry, Markets, and Competitor Accounts receivable are seasonal. The amount can be relatively insignificant when tuitions have been billed but not collected. DIMENSION 1 - 60 NOTES: PROFITABILITY The excess of revenues over costs is highly influenced by the percentage of fixed costs to variable costs. Therefore, fixed cost management or financial leverage is a critical management strategy for maximizing the excess of revenues over costs. The major outflow of funds is for fixed instructional salaries and maintenance costs for the vast campuses owned by an institution. OTHER CONSIDERATIONS How an educational institution is chartered as public or private dictates how it is funded. The institution’s ability to attract a qualified student body without giving significant scholarships affects its cash flow from tuition. The age of the institution’s campus will influence maintenance costs. ASSET DISTRIBUTION CHARACTERISTICS CRC US Body of Knowledge As an example, a college (Services – Colleges, Universities & Professional Schools, SIC # 8221/NAICS # 61131) would have the following asset distribution characteristics: For the asset distribution characteristics of other educational enterprises, you should refer to the most recent edition of RMA’s Annual Statement Studies—Financial Ratios Benchmark. DIMENSION 1 - 61 For related articles, see the Colleges and Universities and Private Schools Industry Studies Packs by RMA. The following are general characteristics, special problems, and credit needs of educational businesses. EDUCATIONAL BUSINESS: FEATURES Educational CHARACTERISTICS High fixed asset requirements. High accounts receivable – tuition receipts. SPECIAL PROBLEMS CREDIT NEEDS Ability to attract a qualified student body and instructors. Revolving lines of credit to fund operating expenses pending tuition receipts. Management of tuition and Equipment and building endowment funds. financing. Moderate cyclicality Cash flow projections. Low seasonality Fixed cost–instructional salaries and campus maintenance management. Dimension 1 // Evaluate Client Industry, Markets, and Competitor INDUSTRY DIMENSION 1 - 62 NOTES: CHARACTERISTICS OF THE LEISURE/ TOURISM INDUSTRY Inherent in the leisure industry are an unpredictable cash flow and intense competition from similar companies as well as from companies offering other forms of leisure activity. For the most part, this industry depends on its customers’ discretionary spending and therefore is tied to the health of the economy and to people’s attitudes toward spending on recreation. ASSETS The leisure industry tends to have large cash balances in order to fund expenses during seasonal periods of erratic cash inflows. Accounts receivable are typically not a large portion of a company’s asset structure, because that function is provided by the national credit card companies. Fixed assets are usually a significant portion of the company’s asset structure, and these may be comprised of land, buildings, and equipment. There is a trend toward mega companies in this industry because of the large amount of funding required from both the debt and equity markets. PROFITABILITY CRC US Body of Knowledge Profit margins are heavily influenced by consumer spending of discretionary dollars and by capacity utilization. Since the industry is fixed-expense driven, after breakeven cash inflows are achieved, incremental cash inflows contribute significantly to net income. Depreciation expense (noncash) is a significant portion of total expenses because of the inordinately large investment in fixed assets. Costs of adhering to environmental concerns can be substantial and unpredictable. OTHER CONSIDERATIONS The borrowing needs result from the need to pay day-to-day operating expenses and large amounts of long-term debt, or bridge financing, required to fund fixed asset construction or acquisition. The lead-time in acquiring assets is generally greater than one year and can extend over an entire business cycle, during which consumer-spending habits can change dramatically. DIMENSION 1 - 63 As an example, a company operating hotels (Services – Motels, Hotels & Tourist Courts, SIC # 7011/NAICS # 72111) would have the following asset distribution characteristics: For the asset distribution characteristics of other leisure-oriented companies, you should refer to the most recent edition RMA’s Annual Statement Studies—Financial Ratios Benchmark. For related articles, see Hotels, an RMA Industries Studies Pack. NOTES: Dimension 1 // Evaluate Client Industry, Markets, and Competitor ASSET DISTRIBUTION CHARACTERISTICS DIMENSION 1 - 64 The following are general characteristics, special problems, and credit needs of the leisure industry. LEISURE BUSINESSES: FEATURES INDUSTRY Leisure CHARACTERISTICS Size, type, and location of leisure activity. High fixed asset requirements. High fixed costs. Moderate cyclicality SPECIAL PROBLEMS Fixed cost management. High credit needs including: Breakeven volume management. –– Equipment and building financing. Structuring long-term debt requirements. –– Short term loans to finance the cash conversion cycle. Availability of discretionary funds from consumer. High seasonality Changes in weather patterns. CRC US Body of Knowledge CREDIT NEEDS DIMENSION 1 - 65 CHARACTERISTICS OF NONPROFIT COMPANIES NOTES: The nonprofit industry has grown into a significant sector in terms of asset size and employment base. The industry is characterized by volatile cash flows dependent on patron giving patterns and the receipt of grants. ASSETS A nonprofit organization generally maintains a large amount of cash relative to its total asset size and annual operating budget. The asset structure for large nonprofits may include significant investments in land, buildings and equipment; however, most nonprofits serving a small local constituency have very few fixed assets. PROFITABILITY Cash flow sources are annual renewals of grants, government funding, and private donations. The sustainability of annual operating cash flows depends on the health of the economy and the credibility of the organization in the market that it serves. The reliability of government funding under annual contracts is often questionable, unless the nonprofit provides a mandated service for which funding is annually appropriated by a specific government agency. Larger nonprofits with a long history may have substantial endowments. While the earnings from these funds may be available to meet operating needs of the nonprofit, the principal amount of most endowment funds is restricted for a specific purpose or program. Smaller nonprofits typically do not have the benefit of substantial endowment assets. Dimension 1 // Evaluate Client Industry, Markets, and Competitor The accounts receivable base and subscriptions receivable can be large in relation to total assets and have a tendency to turn slowly. The funding for payment of accounts receivable may be a government appropriation, which typically pays slowly. The subscriptions receivable is scheduled giving by donors, but can be susceptible to sudden downturns in the economy. The borrowing needs of nonprofit organizations result from the need to pay day-today operating expenses pending collection of accounts receivable. DIMENSION 1 - 66 NOTES: OTHER CONSIDERATIONS The health of the economy in general and the appeal of the “cause” will greatly influence the level of annual charitable giving to nonprofits. Minimizing fixed costs and being able to attract personnel on a variable cost basis (or volunteer) is instrumental to their financial health. ASSET DISTRIBUTION CHARACTERISTICS CRC US Body of Knowledge As an example, a small local nonprofit, if it owns its own facility, might have the following asset distribution characteristics: For related articles, see Nonprofit Organizations an RMA Industries Studies Pack. DIMENSION 1 - 67 The following are general characteristics, special problems, and credit needs of nonprofits. NONPROFIT BUSINESSES: FEATURES Nonprofit CHARACTERISTICS SPECIAL PROBLEMS Dominated by small firms. Fixed cost management. Low fixed costs. Accounts receivable and subscriptions receivable collection. Cash and accounts receivable are usually the biggest assets – unless they own their own building. Moderate cyclicality Structuring debt requirements properly. Level of philanthropic giving. Low seasonality Level of volunteerism. CREDIT NEEDS Credit needs including: –– Short-term loans to finance the cash conversion cycle. –– Equipment financing term Dimension 1 // Evaluate Client Industry, Markets, and Competitor INDUSTRY DIMENSION 1 - 68 NOTES: CHARACTERISTICS OF GOVERNMENT ENTITIES The level and predictability of cash flow is key when lending to this large economic sector. Most cash inflows are a direct result of taxation. The inflow of tax dollars is related to the health of the economy (for both earned and unearned income) and the size of the population served. For the taxing entity, the timing of cash inflows is predictable because tax due dates are historically established and seldom change. ASSETS The value and marketability of assets are not issues in underwriting loans or bond issues to government or quasi-government enterprises. Repayment of credit to this sector depends solely on the ability of the entity to tax directly or to receive tax dollars by appropriation. Generally, liquidation of assets is not a viable second source of repayment. PROFITABILITY Annual tax receipts must cover annual operating and debt service expenses with any excess transferred into an investment account. For a government-run utility, such as a waste management facility, cash outflows are mostly for fixed expenses. With oth

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