Credit Risk Assessment 17 November 2010

Credit Risk Assessment 17 November 2010 PowerPoint PPT Presentation

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Required knowledge and information. . . Bank policiesCredit ProcessUnderstand bank's productsUnderstand risks associate to the lendingReturn to the bank. The traditional 5 Cs. Character (integrity), Capacity (sufficient cash flow to service the obligation)Capital (net worth)Collateral (assets

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Credit Risk Assessment 17 November 2010

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3. The traditional 5 Cs Character (integrity), Capacity (sufficient cash flow to service the obligation) Capital (net worth) Collateral (assets to secure the debt) Conditions (of the borrower and the overall economy)

4. The new 5Ws Who is the borrower: get to know the business, the competitive factors. What is being proposed: working capital, investment loan, appropriate to the needs of the borrower. Why: needs of funds, use of funds, producing cash flow. When and How; maturity, repayment schedule, source of funds, cash flow based. What if: in case the sources of repayment are not as expected what to fall back upon

5. What is the purpose of Borrowing?

6. Bank’s products O/D SPN (Short-term Promissory notes) RPN (Revolving Promissory notes) LC/TR (Letter of Credit and Trust Receipt) Export Bills discount Bills for collection Packing credit Long-tern loan Pre-settlement Products e.g. FX trading, Option, Derivatives, bond trading, commodity derivatives Settlement Products Letter of Guarantee (bid bond, Performance bond, Retention bond, Advance payment) Etc.

7. What need to know? Appropriate products? Appropriate limit/ credit line? Appropriate tenor? Hedging Approach Fixed Asset v.s. LT Loan & Equity Working Capital Assets v.s. ST Loan

8. Two types of analytical tests are applied when assessing credit risk.   Liquidity test which determines if a business is generating sufficient cash from normal day-to-day operations to cover all operating expenses, including the payment of interest and scheduled payments of debt amortisation.   The solvency test is the second of these two key assessments.   This test is designed to establish if there is adequate cash from other sources (primarily liquidation of assets in distressed circumstances) to pay interest and pay off all of a firm’s debt.

9. Type I and Type II Errors Type I: Lending to the wrong person Type II: Reject the wrong person

10. Overview of Credit Assessment

12. Credit Policy Assessment Credit Policy: A set of loan or credit policies that are most likely formal and thoroughly documented.  These policies generally determine the types of credit transactions that are acceptable or prohibit to the institution.  Lending guideline : Guideline on how to deal with the request from the customer in specific industry.

13. Business risk assessment Business risk assessment broadly encompasses the analysis of Market Risk Production risk/ Technical risk Environmental risk Legal/ regulatory/ risk Natural disaster/ War/ Political unrest risk Culture risk Bank’s reputational risk

14. Market Analysis Industry Analysis 5 Forces Factors Analysis SWOT analysis Business Model Assessment Customer & Supplier Concentration Risk

15. Economic factors Economic factors influence a firm’s financial performance, including its cash flow and the ability to repay debt as scheduled. An economy's status and direction may affect individual businesses and their cash flow in different ways. Recessions, periods of contraction and inflation tend to adversely affect the business environment. A stable, or static, environment tends to have a somewhat neutral impact on credit risk. Economic growth and periods of recovery tend to be beneficial for businesses. Global, national, and local economies are not necessarily in the same condition at the same time, nor do they necessarily move in similar directions at the same time.  

16. Industry analysis: Understand customer’s product and market Rolex v.s. Swatch L&H Bank v.s. Thanachart Bank v.s. BBL Toyota v.s. Rolls-Royce The industry relies on other industry or not? Furniture industry relies on real estate industry Plastic Industry relies on Petrochemical industry Industry trend Industry cycle Competition

17. Five Forces Analysis (On White board Case study 10 mins)(On White board Case study 10 mins)

18. (On White board Case study 10 mins)(On White board Case study 10 mins)

19. Customer / Supplier concentrations Client concentrations influence financial performance, the timing of cash flows and the ability to repay debt as scheduled. If a firm has many clients, the loss of one, or even several, typically has little impact on its overall success and stability. If a business relies heavily on a very few customers, problems suffered by even one of them could result in financial difficulties. If a firm’s accounts are concentrated in one industry, future cash flow is exposed to any changes in that industry’s economic well-being. If a business relies heavily on a very few suppliers, problems suffered by even one of them could result in shortage of supply, which could lead to production problem, losing customer, and financial difficulties.

20. Business Model Assessment Cost leader Differentiation Niche market Production Cost v.s. Margin v.s. Flexibility Consideration: What are key Success factors to the business? What are competitive advantages of the customer compare to its competitors? Peer Group Comparison.

21. Technical Analysis (1) Raw material and supplies that need in production process Price trend Substitute products Bargaining power Quality control to those RM and Supplies Availability of RM and Supplies Logistic

22. Technical Analysis (2) Cost controlling Availability of work forces Investment plan Production process

23. Technical Analysis (3) Sufficient investment plan Appropriateness of process Low-ended product v.s. expensive machinery Hi-end, high quality products v.s. second hand machinery Experience of management Turn-key project Required industry standard e.g. ISO, DIN, TUF, HACCP, GMP, FDA etc.

24. Management Risk Who is running the company? Integrity of managements/ shareholders? Corporate Governance? What the appetite for risk? Management skills/ experience? Track Record? Can they achieve what they planned? Successor Family Tree / Corporate Structure

25. External Regulations Government Policies, Programs and Regulations : Government has always played a major role in the area of commerce through regulation, economic stimulation, special interest legislation, taxation, and the like. New legislation can substantially alter business activities and a firm’s ability to compete in either positive or negative ways. Hazardous Waste and Environmental Compliance International Trade Issues

26. Financial Analysis Past Performance Projection Sensitivity Analysis / Scenario 5 sources of cash to pay interest and principle:  cash from the operations of the business cash from additional equity contributed to the business cash from the sale of non-operating assets cash from additional borrowing cash from the liquidation of the business itself. projections and the credit decision.

27. Past Performance analysis (1) Types of financial statements Internal Tax report Audited Who is auditor? Any change in auditor from previous years? Auditor’s opinion Qualified Unqualified Notes to financial statements Vertical v.s. Horizontal Analysis (example) The analysis should not just analyse how much increased or decreased but the caused of change

28. Past Performance analysis (2) Peer Group Comparison Ratios Analysis How to interpret the ratios? Limitation of the ratios. Adjusted Financial Data Cash Flow Analysis Sufficiency and stability of cash flow Free cash flow v.s. EBITDA Liquidity is not just current ratio and quick ratio Note : Caution on sales growth if market share reduce)

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33. Projection How to forecast the projection? To forecast the financial performance and cash flow by consider the following factors: 1. Economic, industry, business trend 2. Company’s strategy 3. Risks factors 4. Factors that affect revenue, cost, cash flow 5. Capital Expenditure and debt obligations

36. Collateral Collateral does not mitigate probability of default but reduce the loss of default. Consideration: Type of collateral such as vacant land, Land with construction, commercial building etc. Usage and condition Value and Liquidity

37. Repayment Risk Factors that impact the repayment of short-term liabilities Production Problems Sales Problems Collection Problems Insufficient Basic Profitability Mismatching fund Factors that impact possibility of default on long-term liabilities. Deterioration in Sales and Market Share Deterioration in Basic Profitability Deteriorating Control of the Swing Factors (Trade Cycle) Inappropriate Capital Spending

38. Risk & Risk Mitigants The risks can be mitigated or not. If not, why we could accept such risks? Example of risks: Inexperience management High customer/ supplier concentration risk Close to retire management New competitor enter the market Unclear or insufficient business strategy, budget, planning Downward trend of revenue Obsolete machinery/ production line Change in regulations, law, tax

39. Early Warning Signal Management avoid answering negative questions by arguing that other banks has not asked for such questions. Corporate governance is in doubt Cease in operation to some production lines. Overstocked the finished goods or raw material Normally the company partially utilized working capital line but suddenly the line was fully be utilized. Volatile revenue (probably just its business nature) Increase in receivable days and/or inventory days Change in auditor

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