1 The Bank’s Perspective. 2 Commercial banks: Purposes and profile (1) Transfer funds from...

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The Bank’s Perspective

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Commercial banks: Purposes and profile (1)

Transfer funds from ultimate lenders to ultimate borrowers Acquire funds by receiving money from savers: savings accounts, deposit accounts, etc. Provide funds to borrowers through term loans, lines of credit, bonds, etc.

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Commercial banks: Purposes and profile (2)

Commercial banks aim to:– Maximise their returns– Minimise the risks they accept

Expertise in evaluating borrower credit-worthiness Competition between commercial banks helps to keep down lending rates

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Project finance from banks: the main options

Term loans:– Related to specific projects– Specific amount and term– Rate will reflect risk– Rate may be fixed over time or variable

Lines of credit:– Limited amounts– Flexible in use– Higher interest rates– Interest charged only on finance actually

used

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Loan application and approval procedure (1)

1. Research and review potential sources2. Initial informal discussions with bank loan officer3. Fill out bank’s loan application form; obtain all necessary data4. Submit to bank the loan application and supporting documents

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Loan application and approval procedure (2)

5. Review of application by bank6. Negotiate specific terms of loan7. Bank sends commitment letter8. Bank sends a “term sheet” which defines the specific lending terms9. Sign the loan agreement10. Receive the funds11. Proceed to implement project

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Bank will usually require...

Procedural completed loan application forms additional documentation as required, e.g. the firm’s accounts

Financial acceptable repayment plan proven economic viability (of both project and firm) collateral (i.e. security such as mortgage)

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Banks’ information needs

To assess loan applications, banks need information on :

1- Economic viability of the specific

project

2- The firm’s overall financial and

economic situation

3- The general economic and political background of the country and sector

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1- Economic viability of the specific

project

2- The firm’s overall financial and economic situation



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Information on the project

Purpose of the loan Expected cash flows from project Expected profitability of project (NPV, IRR...) Assessment of risks of project How project relates to the firm’s business generally

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Purpose of the loan: to demonstrate:

cost reductions and increase in revenue?

sales and production levels increase?

reduced risks?

• Reduce energy use• Reduce material input costs• Reduce penalty fees

• Increase in sales and production and establish increase in demand• Improve product quality

• Environmental compliance and regulation costs

How will the CP Investment produce the perceived...

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Cash flow forecast/projection

• Look at the likely future cash position of the company.

• Examine the possible effects of changes in the cash flow components.

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Profitability analysis:Profitability indicators

A profitability indicator, or “financial indicator”, is: “a single number that is calculated for characterisation of project profitability in a concise, understandable form.”Common examples are:

• Simple payback period

• Return on investment (ROI)

• Net present value (NPV)

• Internal rate of return (IRR)

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Assessment of risks: Sensitivity analysis

– What could go wrong with the plans for the project?– What will be the effect on NPV if different assumptions are made re sales demand, costs, length of project life, etc.?

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1- Economic viability of the specific project


economic situation



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Concern about the financial facts of a business includes:

Organization's ability to meet current obligations

The nature of liabilities

The company’s ability to stand pressure

from both internal and external sources

The true worth of the various assets of the business (accurate picture)

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The bank’s information needs

To demonstrate a company’s credit-worthiness, bank will require: past financial statements (balance sheets, income statements, etc.) forecast future financial statements past credit history and references information on the firm’s management

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Business plan: Objectives

To show to outsiders to help to raise money

To use within the business– As a guide to future action– To control the firm by using the

business plan as a benchmark against which to compare performance

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Business plan: content past and forecast future financial statements brief overview of business markets, customers and competitors products and services distribution management sales forecasts how the firm is to be financed

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Information: what makes it useful

relevance reliability consistency completeness comparability timeliness understandability materiality feasibility and cost-effectiveness

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Interpretation of financial statements

RATIO ANALYSIS

•Is useful to virtually all readers of financial accounting statements.

•Ratios are like a thermometer which takes the actual temperature of a business in relation to some standard measure.

Ratio analysis can help to identify problem areas but in itself cannot offer solutions: these must be provided by the businessman.

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For financial analysis purposes, it is useful to classify ratios under five headings:

Profitability ratios which measure the overall effectiveness of managers as shown by the returns generated on sales and investments.

Liquidity ratios which judge whether a business is likely to run out of cash in the short term.

Ratio Analysis

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• Solvency ratios which measure the extent to which a business is financed by borrowed money and the risk involved.

•Activity ratios which measure how effectively the business is using its resources.

•Growth ratios which measures the business’s past rate of growth and assess the potential for future growth.

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Profitability Ratios key question: at what rate does the business generate profit from its activities?

Test 1: What is the proportion of direct trading profit contributed by every dollar worth of sales?

Test 2: What is the amount of profit generated out of every dollar invested in the company?

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Profitability RatiosExamples

Test 1: Gross Profit percentage on sales :

=

Test 2: Return on Capital employed :

= Profit before interest & TaxCapital employed

Gross ProfitGross Sales

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Liquidity Ratios definition: ability to meet short- term operating liabilities

key question: how much is the total of the firm’s short-term liabilities?

Test 1: are the liquid (short-term) assets sufficient to cover adequately these short-term liabilities?

Test 2: are the regular operating cash inflows adequate to cover short-term

liabilities, as they fall due for payment?

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Liquidity RatiosExamples

Test 1: Current Ratio :

=

Test 2: Acid test quick ratio :

=

Current Assets Current Liabilities

Current Assets - StockCurrent Liabilities

The acceptable ratios depend upon the type of industry in which a company operates.

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Solvency Ratios definition: ability to meet long-term liabilities such as debt

key question: how much is the total of the firm’s indebtedness?

Test 1: what are the relative proportions of (1) equity, and (2) debt?

[“gearing”, or “leverage”]

Test 2: are operating profits adequate

to cover the interest that has to be paid regularly on the debt?

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Solvency RatiosExamples

Test 1: Debt ratio :

=

Test 2: Times Interest earned :

=Interest charges

Earnings Before Interest & Taxes

Total DebtTotal assets

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Activity Ratios

Key question: How effectively does the firm use its resources?

Test 1: What is the turnover of stocks?

Test 2: What is the quality of debtors and credit policies of the business? How many day’s sales represented by debtors?

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Activity RatiosExamples

Test 1: Stock Turnover Ratio :

=

Test 2: Debtors Turnover Ratio :

=

Sales revenueStocks (at period end)

Debtors (Balance sheet)Average Daily Sales

Average Daily Sales =

Sales as per income statementDays (365)

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Limitation of Ratios

(A) differences found among the accounting methods used by various companies, which make comparisons difficult even when talking about the same industry

(B) financial statements are based upon past performance and past events, we must project our evaluation from this basis

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• Though with limitations, ratios still provide guides and clues in spotting trends towards better or poor performance and in finding significant deviations from average or an acceptable standard, if any is available.

• It is in the interpretation of such trends and deviations that the analyst will use his skills and experience to determine what is likely to happen in the organization.

Conclusion

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1- Economic viability of the specific project


economic situation



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General economic background

National and world economy: - forecasts of economic growth - forecasts of inflation - political or economic instability

Sector-specific background: - developing new technologies - changes in product markets - new legislation and regulation - level of competition in the sector

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Conclusions (1)

Banks have specific demands for information due to their loan application/approval procedures Most information should be provided by applicants Banks will maintain some data themselves (e.g. general economic data)

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Conclusions (2) banks obtain information on firms through:

– the application forms and supporting documents submitted by the firms– face-to-face contacts and visits to the firm– the history of the bank’s relationship with the customer

post-funding control enhances the relationship and facilitates future borrowing

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Conclusions (3)

Firms should set up and maintain adequate information systems:-

Before

They are needed !

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Group exercise - Acme: Part 1

Preparing a ‘bankable’ proposal Read the Acme case overnight, it is

detailed in your handout Tomorrow morning you will be

working in a small group with others The task will be to develop a proposal

to a bank for finance for acme’s project

Your group will present this to the banker

Plan ahead - what points to include?

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Developing a Bankable Proposal:Acme Electroplaters

Part 1

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The task1. Prepare presentation to a bank making the case for finance for Acme’s project

2. Complete the standard application bank loan application form, located in your handout

3. Anticipate possible questions from the banker

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firm’s current financial position

history of firm

the project’s expected returns and risks

availability of relevant information

firm’s ability to implement the project


Criteria for success

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Checklist:

“Funding Application Format Checklist”

Checklist:

“Funding Application Format Checklist”

Refers to the checklist document

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Developing a bankable proposal:

the banker’s response

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Post-funding management and control

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Aims ensure repayments are made in

full and on time avoid foreclosure / calling in

security comply with all loan contract

conditions build strong credit history and

relationship for the future

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Post-funding management and control: issues

1-implementation phase2-security for loans (collateral)3-other loan contract conditions4-regular financial information5-evidence of strong internal

management 6-keeping the lender informed

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1-Implementation

need to synchronize:– receiving the finance– acquiring the new asset(s)– starting the new business activities

project management techniques and skills, e.g. ‘critical path’ analysis

clear organizational responsibilities

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2-Security for loans usually requested by banks,

though less crucial than the firm’s ability to repay

can include owner’s personal assets as well as the firm’s assets

need to protect assets used as security

Third-party guarantee

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3-Loan contract conditions (‘covenants’)

Examples: - adequate liquidity - adequate solvency (gearing / leverage) - no significant changes in:

- nature of business - ownership

- no sales of major assets without the prior agreement of the lender

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4-Regular financial information Financial Reports

(FR’s): rules based on legal rules and

accounting standards (‘Generally Accepted Accounting

Practice’) required annually by law lenders may require more

frequently– and promptly– with supporting analyses

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Analyzing FR’s

FR’s can be analysed by readers to evaluate the firm’s likely return and risk position, as reflected in:

liquidity solvency profitability operating efficiency

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Analyzing FRs: comparators

over time– ‘vertical’, or ‘trend’, analysis

against other (comparable) firms– ‘horizontal analysis’, or

‘benchmarking‘

against other standards

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Preparing FR’s: guidelines for management

disclose accounting policies, especially if different from normal

be open where estimates and approximations have been necessary

indicate if any amounts in the FR’s are no longer realistic

ensure reliability of the accounting systems which collect the data

thoroughly review FR’s before sending outside the firm

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5-Evidence of good internal management

performance indicators

budgeting

costing and cost control

ex-post audit of projects

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6-Keeping the lender informed

Keep lenders informed about any significant changes in:

trading the firm’s risk factors key personnel nature of the business any other factors relevant to risk and

return

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Post-funding experiences

any experience during this phase?

what terms did lenders impose?

were any difficulties met, in complying with these terms?

how did the firm deal with them?

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Acme Electroplaters:Part 3

1 The Bank’s Perspective. 2 Commercial banks: Purposes and profile (1) Transfer funds from...

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