A forward looking approach should also be adopted
By S. FAHIM
Nov ,12 - 18, 2001
The Banking sector in Pakistan continues to suffer
from a loan problem portfolio, due to a variety of reasons. While there
is no guaranteed procedure for ensuring loans do not go bad (certain
circumstances can go against the best of borrowers), I have tried to
develop a procedure for analyzing credits, as outlined below. This is
based primarily on personal experience of over 20 years as a lending
offficer, sitting on the Board of Banks besides guidance from earlier
supervisors, and training programmes attended.
The important thing to remember is not to be
overwhelmed by marketing or profit center reasons to book a loan but to
take a balanced view when booking a loan, taking into account the risk
reward aspects. Generally we remain optimistic during the upswing of the
business cycle, but tend to forget to see how the borrower will during
the downturn, which is a shortsighted approach. Furthermore we tend to
place greater emphasis on financials, which are usually outdated; this
is further exacerbated by the fact that a descriptive approach is
usually taken, rather than an analytical approach, to the credit. Thus a
forward looking approach should also be adopted, since the loan will be
repaid primarily from future cash flows, not historic performance;
however both can be used as good repayment indicators.
Having postulated above guidelines, following is a
suggested general procedure for reviewing short term lending proposals
Company Profile / Ownership: This should cover
the legal structure of company, i.e. is it public / private / listed. If
listed then broker reports can be an additional source of information
besides share price. Sole proprietorships / partnerships tend to be
higher risk. Potential support can be provided by sister concerns,
multinationals etc. While this can be a support it can also work as a
disadvantage with possible diversion of funds to sister concerns,
transfer pricing etc. which should thus be addressed.
When dealing with individual Group companies it is
essential go review overall Group exposure to ensure that the Group Risk
is adequately analyzed and monitored, and Group limits also set.
Proposed Transaction: Following key items should
Purpose of facility: This must be specific and
general terms should be avoided, such as "working capital
facility." A specific need would be to "finance
inventory" or "receivables" (or both). These two assets
generally constitute the rationale for short-term borrowings.
Source of repayment: The cash cycle including
payment and selling terms must be reviewed, which impact cash flow.
Normally there should be reliance on identifiable cash flows for the
first way out to repay the loan rather than the security itself. The
lending officer should understand the cash production cycle and its
tenor, and should question how the Bank will be repaid if things do not
work out as expected for the customer e.g. slow sales, increases in
inventory costs, etc.
Credit Limits - Bank experience to date with borrower
and use of facility should be reviewed. Limits with other Banks should
also be provided, besides ability to obtain additional debt i.e. Bank
should avoid being in a situation of lender of last resort. Sole Banking
relationships are undesirable as it shows too much reliance on one
source. Proposed Limit will give the overall exposure to the company,
which should be reviewed to see if it is warranted, in relation to
facility purpose, size of sales, capital etc., besides the usual credit
Security: Full details should be provided,
besides description of security as the alternative loan repayment source
and its realizable value, where possible. It should be properly insured
by a Bank approved Insurance Company and covered against various risks.
Documentation must be precise, while security evaluation should cover
control, marketability and lending margin, to protect against price
fluctuations. Frequent independent verification of the security should
If the security taken is not saleable, then this
should be recognized and the risk addressed e.g. if there is only a sole
seller of the product, then there will be no other buyer for his assets,
in event of a forced sale. The Bank will thus be left with an
unrealizable asset. Where receivables are taken as security, then
quality / ageing should be reviewed, which would enable the Bank to
assess the reliability of this asset as a loan repayment source.
Banks should not lend in an inferior position; all
charges on security should be First Registered and pari passu with other
lenders, to ensure the Banks interests are properly covered. If the
Directors' guarantees are taken then separate individual Net worth
statements or tax returns should be provided to support these guarantees
and judge their capacity to repay guaranteed amounts.
Financial Analysis: Normally a spread sheet
should be used for analysis, which shows ratios, trends etc. At minimum
the last three years financials should be spread to analyze trends.
Figures should be updated and not more than six months old. Quality of
auditors should be ascertained to judge reliability of figures, and
check if the accounts are qualified. The figures should be analyzed, not
described, in order to judge the financial position of the company.
Where possible projected financials should also be
obtained as repayment will be from future cash flows. Key items such as
trends, market position, industry risk, industry status, capitalization,
liquidity, dependence on borrowings, leverage, profitability,
inventory/receivables position, besides capital/debt structure should be
reviewed. Asset Turnover ratio is useful, besides leverage which shows
net worth coverage of liabilities.
Days Inventory and Days Receivable are crucial
indicators of a Company's liquidity and show the need for an amount of
borrowed funds, which are repaid through the liquidation of these
assets. Earnings are key to a company's success. Therefore one should
review long term earning power, consistency and trend of core earnings,
earnings mix, and dividend policy.
Balance sheet figures are at a point of time -
therefore it is essential to analyze realistically e.g.
borrowings/inventory can be reduced for balance sheet date purposes.
Thus average figures are more reliable where available. Figures can also
be inflated for seasonal factors e.g. inventory build-up during the
cotton-buying season, which should be recognized accordingly.
For Project Finance one should analyze both historic
and projected figures, with full sensitivity analysis, to ascertain
repayment ability. The Bank should rank pari passu on cash flows with
the lenders i.e. for long-term loans the tenor should not exceed that of
other lenders. Periodic project monitoring is essential to check
progress of the project both during implementation and after it is
Management Evaluation: This aspect is often not
given the importance it warrants. It should not be overlooked since the
management impacts overall performance of the company and hence its
ability to repay loans.
Following items should be noted when assessing
• Quality and depth of management, particularly the
• Experience, qualifications, and capability.
• Succession and back up plans.
• Management style i.e. conservative, centralized/ decentralized
Organization Culture, Corporate strategy.
• Career progression, training and development
• Staffturnover/personnel policies.
• Training, motivation, morale, besides staff quality.
The CEO sets the pace for the Company and can
determine its success with the necessary teamwork e.g. Jack Welch of
General Electric, who has been enormously successful as CEO.
People are the most important resource a Company has
and are crucial for its successful running. Those Companies are
successful which treat and recognize its talent properly and have a
clear, careful and thought out business strategy, formalized in a
Business Plan which is then followed accordingly. Besides this they have
a organized change culture, solid customer relationships and a strategic
brand management / differentiation.
Above items are not found in the Balance Sheet, and
should be analyzed by the lending officer, after careful scrutiny and
discussion with management.
Risk Areas: The lending order should review all
risks officer relating to the lending point wise along with the
mitigants and justified why lending is warranted, i.e. can the risks be
covered or are these acceptable risks. Each borrower will have different
risk profiles and therefore it is important to ensure there are
adequately understood and addressed.
Checkings: Written checkings from other lenders
should be obtained. Trade/market checkings can be obtained from various
sources e.g. suppliers, etc. Talking to suppliers and other market
information can give updated input on the company's financial position,
e.g. if company is delaying payment to suppliers this could indicate
liquidity problems. Also checks should be made from the market how the
company's product is selling in the market or if it suffers from quality
problems - these items are important since they impact sales and
ultimately cash flow.
Loan Profitability: Again this is an important
area which helps evaluate the risk / reward aspects of a transaction. It
is important to earn an acceptable spread on a loan, and therefore to
arrange necessary funding, to compensate for the credit risk. Apart from
this the Bank should make an adequate return on the loan to help build
the up net worth which is a cushion to absorb loan losses. The Bank
should maximize return on assets not only through spread income but
other non funds income such as commissions, exchange etc. which are
generated from contingent risk and do not involve the use of Bank funds.
There is no insurance against loan losses or
problems, nor is lending a rocket science. The lending officer must
therefore exercise common sense and follow basic lending rules when
analyzing a credit. There is no short cut to this - after disbursement
it is also essential to maintain contact with the company and remain
abreast of its financial position. A lending officer must not only have
requisite credit skills, but develop problem recognition abilities to
enable him to take necessary and timely action, as and when required.
The above is a basic guideline to reviewing
short-term credits and is not all exhaustive. It should thus be reviewed
on a case by case basis. Each borrower has different circumstances and
should be reviewed as such. I have attempted to cover short-term
borrowings only - project finance and other form of lending have
different risk criteria, which have not been addressed here. However 3
'C' s of a credit are crucial and relevant to all borrowers / lending
which must be kept in mind at all times
If any one of these are missing in the equation then
the lending officer must question the viability of the credit.
There is no guarantee to ensure a loan does not run
into problems; however if proper credit evaluation techniques and
monitoring are implemented then naturally the loan loss probability /
problems will be minimized, which should be the objective of every
About the Author
The author has a honors degree in Economics /
Accounting and a MBA, both from British Universities. Subsequently he
has gained over 20 years lending experience with Citibank and American
Express Bank, in Pakistan and the Middle East. He has served on the
Board of Directors of NDFC and Orix Investment Bank besides other
Companies and is presently working as a Credit Advisor with Pakistan
Kuwait Investment Company (Pvt.) Ltd.
The above article has been derived from presentations
the author has made to Bankers on Credit Analysis. It has been written
in view of the positive responses obtained, recognizing the need to
reach a wider audience on this relevant subject.