8 - 14, 2010

The business relationship between the corporate and banking sectors is subject to certain SBP-prescribed conditions spelled out under prudential regulations regime. These prudential regulations are the financial benchmarks the corporate sector is required to maintain to be able to borrow business funds.

Similarly, the banks are also monitored by the SBP for their financial health and viability. The world bank-designed financial management and information system CAMEL prescribes certain operating and reporting standards for banks. The acronym CAMEL stands for: Capital Adequacy, Asset and Liability Structure, Management of Risk, Earnings Performance, and Liquidity.

Under the "Management of Risk" parameter, bank's interaction with the corporate sector is brought into focus. The said parameter covers a number of risks that include credit risk, portfolio risk, interest rate risk, foreign exchange risk, and risks related to off-balance- sheet items. The sub-parameter "credit risk" relates to the basic risks inherent in lending. The banks are expected to manage their credit risk by focusing on the following key areas.

Customer risk: This includes the understanding of borrower company's market position and its reputation among its peers as well as other banks. It also implies a comprehensive study of the company's financial performance over a period of time. An analytical study of company's financial statements particularly the liquidity management side would be of great help to make decision on its working capital finance request.

Loan risk: This refers to the collateralization of finance that may be in the shape of certain securities and guarantees. This is the key area that influences the long term relationship between a bank and its corporate customer. A properly secured credit is what the two parties should aim at. An under secured credit will give the bank line executives and managers a cause to be uncomfortable. Conversely, an over-secured credit will earn a corporate customer's indignation. He might either move to some other bank or wish to do so at the first available opportunity.

Sector risk: It relates to the study and analysis of current trends in the sector for which working capital finance facility is intended to be utilized. The growth potential and profitability of the sector could be the points the lending bank would like to concentrate on. The seasonal fluctuation of working capital demand - such as in textile and sugar sectors - is an important factor that needs to be taken care of by the parties concerned.

Seasonal purchases of cotton and sugarcane would swell up corporate inventories on current assets side and short term bank borrowings on current liabilities side. This puts pressure on the borrowing company for additional collaterals for which advance planning is essential.

Concentration risk: This relates to the management of entire bank loan portfolio and demands that financial risks are properly diversified without any uncalled for concentration on a particular sector of economy. That particular sector might appear quite sound and highly profitable at a given point in time but prudence demands that banks desist from over-investing in a single sector as unusual business conditions might change as quickly as they develop.

The US sub-prime mortgage fiasco is an example. Our textile and sugar sectors heavily rely on short term bank borrowings to carry out their business operations. A sudden change in global and domestic conditions followed by frequent policy rate hikes, as has recently happened, might push the corporate borrowers to default situation. The least hurt banks, in such a scenario, would be those that manage the concentration risk prudently.

Working capital could be either permanent or temporary. Permanent working capital is the portion of working capital that ever remains invested in the business. This is based on certain calculations and is included in the original project cost. This will be dealt with separately under project financing.

A corporate entity's short term liquidity management is measured by certain ratios - the most important being the current ratio which compares total current assets with the total current liabilities. Corporate borrowers are required under statute to show the portion of long term loans that fall due within a year time under current liability section as short term maturities of long term loans. This amount is excluded from current liabilities while current ratio is calculated.

The acceptable current ratio is where total current liabilities equal total current assets. A current ratio of less than one is usually not acceptable to bank that has to expedite company's working capital finance request. A current ratio of more than one should always be comfortable for a lending bank but that is not a rule. The concept of current ratio is closely related to a company's cash cycle which means the outflow of cash from a business for manufacturing a product, and the corresponding inflow of cash through sale of that product. The outflow is utilized for the purchase of raw material and other supplies, payment of wages, salaries, utility charges etc.

The timing of outflow may vary according to the use of trade payables facility by the company. The inflow is in the shape of sales revenue. Again the timing of inflow may vary according to the use of trade receivables facility allowed to and used by the company customers. Purchasing inventories and selling goods on credit result in an altered cash cycle.

Another liquidity ratio, more relevant from a lending bank's viewpoint, is quick ratio or acid test ratio. Some manufacturing companies have to hold large quantities of raw material for conversion to finished product. These inventories of raw material and unfinished goods can not be sold until the production process is completed - textile spinning, sugar, cement etc are the examples. So, the inventories in such cases are not the near-cash item. The lending bank would like to measure the company's ability to repay working capital finance without taking into account the inventories. The acid test ratio is calculated by simply deducting inventories from the current asset total. Surprisingly, this all important liquidity ratio is of academic significance only as it is not dealt with under prudential regulations.

The said two liquidity ratios are indicative of a corporate borrower's liquidity position at a given point in time. The hypothetical assumption that a current ratio of 1.5 and an acid test ratio of 0.8 lie in the comfort zone for the lending bank should only be taken as a guide rather than the rule. For different businesses, these ratios may have different meanings. For a financial sector organization, these ratios could virtually become meaningless. Quick inventory turnover might also alter the significance of benchmarks. For cash and carry, the current and quick ratios could be as low as 0.5 and 0.2 and still acceptable to a corporate banker. A study of company's past financial records would show that the company has been operating with approximately the same liquidity ratios since decades and is still growing by the measure of its sales and profits. Mere reliance on liquidity ratios could therefore be a pitfall for a corporate banker dealing with the working capital finance side of a corporate customer.