Dimension 7 - 2 Past Paper PDF

DIMENSION 7 - 2 NOTES: PURPOSE OF DIMENSION 7 The purpose of Dimension 7 is to describe early signals of problem loans and to review appropriate responses to those signals. In Dimension 7 we will cover the following topics: Financial and nonfinancial warning signs. Account management alternatives fo...

DIMENSION 7 - 2 NOTES: PURPOSE OF DIMENSION 7 The purpose of Dimension 7 is to describe early signals of problem loans and to review appropriate responses to those signals. In Dimension 7 we will cover the following topics: Financial and nonfinancial warning signs. Account management alternatives for problem loans. Gathering information about the problem loan. Developing problem loan strategies. Bankruptcy considerations. Lender liability issues. 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 7 skill building: Credit Cycle Management Applied Credit Risk Series Detecting Problem Loans CRC US Body of Knowledge Problem Loan Workouts DIMENSION 7 - 3 INTRODUCTORY NOTE NOTES: Dealing effectively with problem loans requires early detection. Any number of events can alert you and your borrower to a problem. The warning of a problem loan may come as a surprise, or as a result of a slowly deteriorating credit. Either way, when it occurs, you should immediately shift into your institution’s problem loan procedures. Each institution has its own process, and it is not the intent of this section to suggest that one procedure is better than another. In Dimension 7 we present certain steps that are common to most problem loan approaches. WARNING SIGNS Early identification of a problem loan may be documented through your risk-rating system or through the process of putting the company’s name on a watch list. Watch-listed credits are generally not those in imminent danger of bankruptcy. They may be identified as watchlisted because the company has changed management or is in a certain industry experiencing economic difficulty. The earlier you can detect a potential loan problem, the more likely it is that you will successfully deal with the problem. Appearance of a warning sign does not always mean that the loan has or will become a problem. It does indicate, however, that you should ask questions. The causes of the problem could be financial or nonfinancial or some combination of both. Module 7 // Identify and Develop Strategies for Problem Loans Nothing can be more chilling than to have a borrower walk into your office, hand over the keys to the plant, and say that they are unable to continue the operation. If the problem is a surprise, due diligence before funding and the subsequent monitoring of the loan were ineffective. (Due diligence, a term borrowed from the investment community, applies to the efforts of the analyst to identify the key issues of the credit.) The most important tool in detecting a problem loan is ongoing monitoring of the credit. DIMENSION 7 - 4 NOTES: FINANCIAL CAUSES Your first warning of company problems is likely to come from financial factors. Early warning signs of company problems based on financial causes could include any or all of the following: Late statements Frequent overdrafts Covenant violations Late payments Overadvances Deteriorating trends LATE STATEMENTS Is this a new event? – If so, you should find out why the statements are late and look for other warning signs. This may indicate that the company is delaying production of financial information because it has bad news to report. Is the company slow in providing other requested information? – This may signal deterioration in the borrower-lender relationship. CRC US Body of Knowledge Have you responded properly to late statements? When statements or other information are late, you can call the loan, extend the time for compliance or suggest changes in reporting requirements. Never ignore the breach. If you decide to call the loan, consult with your legal counsel first. How you initially respond could set a course of dealing with the company that could limit your options when subsequent violations occur. DIMENSION 7 - 5 FREQUENT OVERDRAFTS Overdrafts are signs of deterioration in the company’s cash position. Overdrafts are unauthorized, undocumented, and often unsecured loans. This is frequently the earliest indicator of a troubled company. Unfortunately, by the time the lender is directly affected, the company may already be in trouble. This may be a warning that the company has poor cash management, a lack of working capital, or a growing heldcheck problem. You should track monthly average collected balances to see if there are cyclical trends or a pattern of overdrafts. It is important to ask questions early to prevent problems and avoid losses. Questions you might ask include the following: NOTES: Is this a new event? Are the overdraft items written to suppliers? If so, this could signal a deterioration of supplier relationships. Are the overdraft items written to the Internal Revenue Service (IRS)? If so, this could signal serious tax problems and lead to potential lender liability for unpaid taxes. COVENANT VIOLATIONS In your view, how serious are the violations? Legal counsel, with your input, drafts loan agreements that are tailored to each transaction and borrower. Loan agreements typically contain affirmative and negative covenants or standards that the borrower must satisfy to continue to borrow. An effective loan agreement requires that timely and frequent financial statements be delivered. It generally includes covenants that permit you to monitor liquidity, leverage, and debt service coverage. They provide trigger points to protect the interests of the lender. Typically, covenants have three functions: 1. To allow you to gain control if the company’s financial condition deteriorates. 2. To ensure that a certain level of cash and other operating assets remains in the business. 3. To maintain management stability in the business. Module 7 // Identify and Develop Strategies for Problem Loans Have you properly responded to overdrafts? Never ignore overdrafts. How you respond could set a course of dealing with the company that could limit your options when subsequent overdrafts occur. DIMENSION 7 - 6 NOTES: Questions to ask include: Have you set up an effective system for monitoring the company’s compliance with covenants? An early warning system is needed. Have you properly responded to covenant violations? When the borrower violates a covenant, you can call the loan, extend the time for compliance or suggest an amendment to the covenant. Never ignore the breach. How you respond could set a course of dealing with the company that could limit your options when subsequent violations occur. LATE PAYMENTS Late payments on debt are among the more obvious warning signs. This is typically the last sign before major problems surface. If late payments occur, you can call the loan, extend the time for payment or suggest an amendment to the payment terms. Never ignore the breach. How you respond could set a course of dealing with the company that could limit your options when future payments are late. Questions you might ask include the following: Did the company warn you in advance that the payments would be late? Did the company give a plausible explanation for the late payments? Was the cause a temporary problem that has no permanent implication? OVERADVANCES CRC US Body of Knowledge Overadvances on a borrowing base are a primary cause of loan loss. Deviations from anticipated line utilization suggest potential problems. When an overadvance occurs, it overrides the lending decision you made in granting the loan. Questions you might ask to determine the reason for the overadvance include: Was it required to finance unanticipated growth of the business? If so, are you willing to finance that growth? Was the overadvance caused by a slowdown in accounts receivable collection or other liquidity shortfalls? If accounts receivable collections are slowing, why? If so, are you willing to continue your financing arrangement? DIMENSION 7 - 7 DETERIORATING TRENDS This warning sign comes in many forms. Trends to consider include: NOTES: SLOWDOWN IN ACCOUNTS RECEIVABLE COLLECTION Is it a function of credit policies and collection practices? What is the size of an average transaction? Can the company make money on a minimum credit transaction? How long does the company wait before beginning collection procedures? Did the company acquire the additional assets to prepare for anticipated future demand or to inflate the balance sheet? An increase in fixed assets accompanied by a corresponding increase in sales would generally be a positive sign for the company. If the company purchases more fixed assets and does not have sales growth, it may not be able to service its debts. What is the basis of the company’s predictions and are they reasonable? How were the fixed asset acquisitions financed? Are there purchase money security interests that would be senior to your collateral position? FIXED ASSETS FINANCED WITH SHORT-TERM DEBT Is the company financing assets with consideration to sources of repayment? Is short-term debt financing the purchase of long-term fixed assets rather than short-term needs? Module 7 // Identify and Develop Strategies for Problem Loans INCREASE IN FIXED ASSETS WITH NO CORRESPONDING INCREASE IN SALES DIMENSION 7 - 8 NOTES: DECLINING SALES Did the loss of a major account cause the decline? If so, does the company have any prospects for replacing that account? Did a change in competition or new regulations cause the decline? Does the company have a workable plan to meet this new challenge? RAPID INCREASE IN SALES Is the company discounting prices to increase sales? Does the company have the capability to finance increased accounts receivable? Has the company lowered its credit standards to spur sales? Is the company’s bad debt expense increasing? INCREASE IN SALES WITH NO INCREASE IN EQUITY Are profit margins being eroded? Rapid sales growth with consistent margins would be expected to result with commensurate increases in equity. When this does not occur, it may indicate that growth has been excessive. SLOWDOWN IN INVENTORY TURNOVER Has the company failed to write off non-salable or obsolete inventory and book the loss? CRC US Body of Knowledge Has the loss occurred, but not yet been realized? OPERATING EXPENSES AS A PERCENTAGE OF SALES ARE INCREASING Have sales fallen? What effort has the company made to reduce operating expenses? Operating expenses tend to be fixed in nature. Therefore, when sales fall, the company must make an effort to reduce operating expenses to keep the percentage constant. DIMENSION 7 - 9 DRAMATIC CHANGES IN THE RELATIVE MIX OF ACCOUNTS RECEIVABLE AND INVENTORY NOTES: Are the changes unusual for this company, that is, not due to seasonality? The balance or relationship between accounts receivables and inventory (and cash, of course) is not static and often changes over time—especially in seasonal companies. Do you have a good understanding of the operating cycles of the company? You will need this understanding to be able to recognize when the balance or relationship changes in ways that were not expected. REVALUATION OF ASSETS Are you over lending based on an unrealistic appraisal? Companies revalue assets to create equity and increase borrowing capacity. MULTIPLE LIENS ON THE SAME BUNDLE OF ASSETS Do the liens indicate that suppliers are worried about getting paid? Are the liens old enough to avoid a bankruptcy preference claim? In a bankruptcy, unsecured suppliers who attempt to improve their positions have a 90-day preference window. The presence of supplier purchase money security interest (PMSI) inventory liens often suggests serious problems exist. A WIDENING GAP BETWEEN GROSS AND NET SALES Are returns, allowances, and discounts causing a deterioration in the company’s gross profit margin? Does the level of returns indicate poor quality or dated goods? Module 7 // Identify and Develop Strategies for Problem Loans Is your collateral actually worth the value claimed? Revaluation may not be allowed under generally accepted accounting principles (GAAP), but sometimes occurs in compiled statements in which the accountant reports management’s assessments without passing judgment. DIMENSION 7 - 10 NOTES: POSITIVE CASH FLOW DERIVED FROM NON-OPERATING SOURCES When positive cash flow is being derived from nonoperating sources, such as sale of fixed assets, it provides evidence that the company’s business plan is not working. The company’s strategy may not be sustainable. HIGH DIVIDEND PAYOUTS To whom are the dividends being paid? Except in the case of Subchapter S corporations, dividends do not make economic sense for owners who also receive a salary from the company. Dividends are paid from after-tax profits, on which the company has paid taxes and the recipient will also pay taxes. Are the dividend payouts hindering the ability of the company to internally finance? LOANS/ADVANCES TO INSIDERS Are the loans or advances vulnerable to Internal Revenue Service (IRS) attack? The IRS can recharacterize loans or advances to insiders as dividends or salaries. You need to look carefully at these transactions, noting the rates, terms, and repayment provisions. Are these loans having a negative impact on liquidity and working capital? CRC US Body of Knowledge CONVERSION OF SHORT-TERM BANK OR TRADE DEBT TO LONG-TERM NOTES Does the converted debt have a viable source of repayment? Conversion of short-term debt to long-term debt changes the source of repayment from conversion of assets to long- term profitability. Ensuring a viable source of repayment is critical in converting short-term debt to longterm. DIMENSION 7 - 11 TAX PROBLEMS Has the company paid its property taxes? Nonpayment of property taxes places a lien on property that is superior to your lien. NOTES: Has the company submitted withholding taxes to the Internal Revenue Service (IRS)? The IRS provides that a lender that advances funds to a borrower for wages knowing that that the borrower does not intend to or will not be able to make timely payment or deposit of taxes can be held liable for payment of those taxes. Your liability is limited to 25% of the amount advanced for wages. When this warning sign appears you may decide to require the borrower to make tax payments to you and supply a stamped receipt and photocopy of the tax payment card. You could also require a copy of the general ledger each month and have statements and canceled checks routed through your office. DEBT SERVICE DEFICIENCY Does the company have assets it could sell? NON-FINANCIAL CAUSES Nonfinancial causes of company problems are not as easy to detect as financial ones but can be equally damaging. Nonfinancial causes may include the following: Deteriorating supplier relationships Management issues Ownership issues Industry problems Economic cycles DETERIORATING SUPPLIER RELATIONSHIPS The following may provide warning signs of deteriorating relationships between the company and its suppliers: Module 7 // Identify and Develop Strategies for Problem Loans Does the company have sufficient cash flow to fund its operations and pay your loan? Are the owners/investors able and willing to provide additional capital equity? DIMENSION 7 - 12 NOTES: DISPROPORTIONATE INCREASES IN TRADE DEBT AND ACCRUALS Is the company making late payments or partial payments to suppliers? Have you received a rising level of inquiries from suppliers? Is there a buildup of accounts payable to suppliers? When this happens, suppliers may impose stricter terms, including the extreme “pay on delivery.” They may also require the company to convert trade debt to notes payable and may file purchase money security interest liens. Your lien position could be affected. CONVERSION OF TRADE DEBT TO NOTES PAYABLE Is there an increase in notes payable and a reduction in accounts payable? Are the changes caused by a conversion of trade debt to notes payable? If so, the supplier or suppliers will likely file purchase money security interest liens. Your lien position could be affected. VIOLATION OF FRANCHISE OR DISTRIBUTORSHIP AGREEMENTS Does the company have a franchise or distributorship arrangement with its supplier(s)? Has the company violated its agreement(s)? Can the violations be cured? CRC US Body of Knowledge What penalties are likely? DIMENSION 7 - 13 MANAGEMENT ISSUES Management skills can be a primary cause of business failure. Inadequate management can cause or prevent resolution of problems (see the Management Risk Analysis discussion elsewhere in Dimension 7). NOTES: LACK OF A SUPPORTABLE BUSINESS PLAN AND FORECAST Does the company have a business plan and forecast? Are the company’s business plan and forecast realistic? Do facts support them? The most common cause of problem loans is a lack of adequate management. Management should be able to articulate a defensible short and long-term strategy. INABILITY TO MEET SCHEDULED COMMITMENTS What is the nature of the commitments it has failed to meet? What has caused the failure? Has management failed to consider the company’s capital requirements? What has been the effect on customer relations? When management cannot meet production, delivery, or other commitments on schedule, orders get canceled, goods get returned, penalties are assessed, and payments are held back. The cause can be due to either overselling or poor planning. RETURN OF SOLVED PROBLEMS In solving problems, does the company attack the causes or only the symptoms? How soon after being solved do the same problems reappear? When previously solved problems reappear within a relatively brief period of time, it is likely that management cannot find an effective solution. What kind of help is available? Is there untapped management talent within the company? Could a financial consultant help? Module 7 // Identify and Develop Strategies for Problem Loans In what phase of development is the company? Is it an emerging, stable, mature or declining company? The greatest risk to the company and your financial institution comes in the emerging and declining phases (see Industry/Product Life Cycles in Dimension 1). DIMENSION 7 - 14 NOTES: CAPITAL WITHDRAWALS/DIVIDEND PAYOUTS Have the owners withdrawn capital or paid themselves dividends? Are the capital withdrawals and dividends depriving the company of needed capital? Growing businesses need capital in the form of owner’s equity and debt. Owners may expect you to finance their strategies while withdrawing excessive amounts of capital from the company. You can add covenants to loan agreements to require capital to be maintained at minimum levels and to require injection of new owner capital to meet shortfalls. POOR FINANCIAL CONTROLS Is the company’s financial information late or inaccurate? Does this indicate that the company has failed to establish effective internal controls and systems? This usually occurs when the owners or managers of the business have not contracted for quality auditing reports or good bookkeeping systems. The best way to avoid this problem is to examine the company’s procedures before making the loan. If you find them unacceptable, you can require changes as a condition to making the loan. POORLY COORDINATED INTEROFFICE/INTRACOMPANY TRANSACTIONS Is the company divided into a number of small departments? Does it have affiliates? CRC US Body of Knowledge Are the transactions between departments and affiliates? Is it possible to clearly track those transactions? If the company has a number of small departments or business entities, it is important to be able to track ownership interests in the business entities and transactions among them. DIMENSION 7 - 15 CHANGES IN PERSONAL HABITS OF OWNERS/ MANAGEMENT NOTES: Has an owner or manager changed his or her lifestyle? Has an owner or manager changed his or her personal investing style? Have you noticed unusual personal behavior by an owner or manager? Has an owner or manager become less willing to share information? You must be able to identify lifestyle changes that could distract owners/managers from running the business or cause them to divert business funds for personal use. SUPPORTING MULTIPLE FAMILY MEMBERS AT THE EXPENSE OF MANAGEMENT EXPERTISE OR PROFITABILITY Are there family members on the company payroll? Do they add value equal to their compensation from the company? You should identify salary and other forms of compensation channeled to individuals who do not work for or provide services to the company. Should the money being spent on family members be redirected to the hiring of management expertise or funding of operations? VENTURING INTO NEW BUSINESS OR INVESTMENT AREAS OUTSIDE OF PROVEN AREAS OF EXPERTISE Has the company diversified into new business areas? How closely do the new business activities relate to the company’s proven expertise? Does the owner or manager have any experience in the new line of business? When a company gets involved in new activities that depart from their existing business, attention gets diverted from the ongoing operation of the entity for which you have provided financing. Has the company diverted funds into unrelated investments? Has this left the company with insufficient operating funds? Module 7 // Identify and Develop Strategies for Problem Loans Do they actually work for or provide services to the company? DIMENSION 7 - 16 NOTES: MANAGING PROFITABILITY Is the company managing profitability for tax reduction or has it mismanaged expenses? Tax minimization is acceptable as long as it is not considered fraud. However, extensive tax minimization strategies that reduce profitability can effectively reduce the company’s debt capacity. Are you able to get a clear view of the company’s financial performance and condition? ASSET MANAGEMENT Is the company maintaining the condition of its operating assets? Is the company properly servicing its equipment, updating its computer hardware, upgrading its software and protecting its business data? Well-maintained assets create the products or services that provide the cash flow to pay your loan as well as providing a secondary source of repayment. OWNERSHIP ISSUES UNPLANNED AND UNANTICIPATED CHANGES Has the company made changes in management or key personnel? (see Management Risk Analysis in Dimension 2) Has part or all of the company been sold to new owners? CRC US Body of Knowledge Do the new owners, managers, or key personnel have the ability to implement the company’s strategy? Changes in management, ownership, or key personnel can be a warning sign that a loan may become a problem. Your original analysis was based on the ability of current management to implement the company’s strategy. You will need to do new analysis to determine the effect of any changes. DIMENSION 7 - 17 SUCCESSION PLANNING Is the company dependent upon the expertise of the owner for success? NOTES: Is someone ready to step in if the owner is absent, becomes sick, or dies? Has the owner been unwilling to share authority or management responsibility? Is the owner stretched too thin to be effective? Is there anyone in the company who can challenge unwise decisions the owner may make? Succession planning requires a focus on both personal and business financial planning needs. INDUSTRY PROBLEMS Industry segments may experience declines, despite the overall health of the economy. Problems common to an industry may include (see Industry Risk Analysis in Dimension 1): Excessive regulation: – What does it cost the company to comply? – Can the company recover the cost by increasing product prices? – Will increased prices cause declining sales? Product/service life cycle – Does the company sell a product or provide a service that will always be in demand? – Will technological or other changes make the product or service obsolete? Module 7 // Identify and Develop Strategies for Problem Loans – Can the company comply? DIMENSION 7 - 18 NOTES: ECONOMIC CYCLES Is the nation’s economy headed for a recessionary period? The economy is cyclical. When serious economic downturns occur, almost all loans become potential problems. You must take steps to determine what effect the downturn will have on your borrower’s business. Is the company’s business well positioned for an economic downturn? In a recessionary economy, consumers generally reduce spending for unnecessary items. Companies selling necessary items would likely survive. For instance, a company that makes spare parts for automobiles would be more likely to survive than a new car dealership. Consumers would put off buying new cars but need parts to keep their old cars running. ACCOUNT MANAGEMENT There are four basic methods for dealing with a problem loan once it has been identified. They are as follows: CRC US Body of Knowledge Workout specialist or special assets group. In this case, the account manager is not included in the process. The advantage of this approach is that the specialist or group has the expertise and time to effectively manage the problem loan. Their view of the credit is not influenced by prior relationships. The disadvantage is that the specialist does not have the account manager’s extensive experience with the account. Shared responsibility. In this case, the account manager works with the workout specialist to manage the relationship. The special assets group serves as consultant, providing assistance. The credit may move to special assets, but the account manager stays involved to provide the benefit of his or her experience and knowledge of the credit and the company. Account manager. In this case, the account manager stays with the account “no matter what” with no special assistance. This is the least desirable approach. It is unlikely that the account manager has either the time or expertise to effectively deal with a problem loan in a workout or exit strategy. DIMENSION 7 - 19 Task force approach. In this case, on any credit over a certain dollar level, a senior level task force is assigned to be the decision-making body. It provides a quick and efficient way to handle situations as they arise. This may be used in combination with any of the other methods. NOTES: Effective use of legal counsel is necessary in any event. The cost of legal counsel can be high. The key is to use counsel judiciously and selectivity. Use counsel for legal advice, and not for structuring the transaction. GATHERING INFORMATION A description of the relationship between the account manager and the borrower. This can provide insight into the ability of the account manager to handle the workout and the likelihood that the borrower will cooperate. Whether the account manager recognized the developing problem and took effective early measures to deal with it. Financial statements or correspondence that may provide clues to the cause and nature of the problem. Correspondence may reveal a basic people or communication problem. Whether there is legal vulnerability or advantage. A review of documents may reveal deficiencies that can be corrected. Whether there are potential debtor defenses. The files can be subpoenaed. Do they include subjective comments that may indicate account manager bias or unfairness? Is there indication that the financial institution was controlling the borrower? Talk to others in the industry; speak with companies of similar size in the same economic environment and with the company’s customers and vendors. Talk to other financial professionals about firms that are in the same industry, that are the same size, or that operate in similar markets. Module 7 // Identify and Develop Strategies for Problem Loans When a problem occurs, it is critical to understand the range and scope of the issue. Gather data about the company, the economy, the company’s position in the marketplace, and management. First, check your own credit files. Much of the information you need should be there, including: