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Asset Based Lending

Training Pack
Author

Sohailuddin ALAVI
International Training Adviser, AIBF (International Expert in Capacity Building and Institutional Development)

Authors Profile

ALAVI, Sohailuddin
He is a capacity building and institutional development expert. He brings learning through working internationally for more than 28 years. Through the years he has unleashed skills in document writing, proposal development, critical thinking and creativity. His career spans over 28 years of learning In his initial career he has worked in a Pakistani bank as trainer, coordinator and training manager for management development programs for almost 15 years. Later he established his own institutional management and training consultancy. As consultant he has had conducted numerous management training workshops both in Pakistan and Afghanistan. Besides, he has had worked on many institutional development projects in the corporate, development sector and the Govt. departments, as consultant. He has taught for more than ten years in the undergraduate and post graduate programs of Shaheed Zulfikar Ali Bhutto Institute of Science and Technology, Faculty of Management Sciences and Karachi University Business School, Pakistan. He has written extensively in management, leadership, organization-behavior; business ethics, and entrepreneurial development for professional magazines, authored books and training manuals.

Personal Contact Details: Email: sohailuddinalavi@yahoo.com Public Profile: http://pk.linkedin.com/pub/alavi-sohailuddin/44/ab4/997 Cell No. 00 92 (0) 333 213 87 42 Karachi, Pakistan

Table of Contents
1. Preface 2. Bank Credit Overview 3. Asset Based Financing 4. Financial Analysis for Lending Decisions 5. Business and Financial Projections 6. Credit Risk Analysis 01 02 09 18 23 26

Afghanistan Institute of Banking and Finance (Author Sohailuddin ALAVI) March 2012

Preface
Credit function plays a vital role in the profitable operations of a commercial bank. Interestingly, unlike other services, where the customer transactions come to an end when the service or product is delivered, however, the transactions between borrower and the banker enter into a more complex relationship when the loan is disbursed. The reason is obvious; bank must secure timely repayment of its monies (principal and return thereof). Understanding credit transactions is equally important for all bankers for their professional development and sound performance. This training pack is structured on reflective learning approach. It allows the readers to build their understanding in a simple way. It is by no means a bible of credit operations, however, it does clarify concepts, introduce processes and presents a practical approach to selling, assessing, and structuring commercial credits in a secure fashion. I would like to dedicate this booklet to my Parents, Family members, the Institute of Banking and Finance (AIBF) and the Universities and other institutions where I studied and taught.

Sohailuddin Alavi
March 12, 2012

Afghanistan Institute of Banking and Finance (Author Sohailuddin ALAVI) March 2012

Bank Credit Overview


1. Significance of Credits on Banks Balance Sheet
a. Balance Sheet Characteristics Bank equity is usually lower Bank deposits are payable on demand Bulk of bank loans portfolio consist of low risk low yielding loans High price loans are relatively fewer Fixed assets are relatively fewer, too b. Repercussions Low equity Higher financial leverage Reduced risk taking ability Relatively liquid and low income loans portfolio c. Implications Low return on financial assets Higher insolvency risk d. Mitigates Quality loan portfolio High due diligence Diversification to complement lower return on financial assets Economies of scale

Afghanistan Institute of Banking and Finance (Author Sohailuddin ALAVI) March 2012

2. Risks Facing Banks*


Technological risk

The risk that technological change will render existing operations and delivery systems obsolete, and thereby impair a banks earning potential and capital

Technological risk

The risk that new regulations such as additional capital requirement, stricter compliance regulations etc., adversely limits lending operations and deposit mobilization potentials.

Interest-rate risk

The risk that unforeseen changes in interest rates will adversely affect a banks net interest income, and thereby impair its earnings potential and capital.

Customer risk

The risk that competing players will capture banks existing customers and markets, and thereby impair its earnings potential (e.g., through squeezed interest-rate spreads) and capital. Customer risk can also be referred to business or competition risk.

Kapital adequacy risk Assuming a comprehensive risk-based capital measure this risk can be viewed as the probability that the bank will have its capital impaired (i.e. become insolvent). Specifically, if all the risks faced by the bank impair its earnings potential, then eventually, other things remain unchanged, the banks capital will be exhausted.

__________________________________________ Source: F. Sinkey Jr, Bank Financial Management

Afghanistan Institute of Banking and Finance (Author Sohailuddin ALAVI) March 2012

3. Borrowing Rationales and Characteristics


a. Rationales Entrepreneurs have skills but no money to start a business Entrepreneurs have skills and some money, but no physical assets to optimize operations Entrepreneurs have skills and some money, of which much is usually locked in physical assets. Entrepreneurs have potentials and opportunities for growth, besides likely tax advantage by way of increasing financial leverage

b. Characteristics Working Capital (Trade) Credits o o o o o Fund working assets, such as inventories, debtors, and operating expenses, etc. Short term single or evergreen credit facility repayment in one year Repayment usually through assets conversion Banks charge on working assets, besides additional collaterals Short term loans and limits, loan against imported goods, packing credit, LCs., etc.

Medium and Long Term Credits o o o o o Fund fixed assets, such as building, plant and machinery, equipment, vehicles and other capital expenditures Medium to long term repayment schedule Repayment usually through successive cash flows from the operations Banks charge on assets, besides additional collaterals Project finances, Long term loans and Venture capital

Afghanistan Institute of Banking and Finance (Author Sohailuddin ALAVI) March 2012

4. Asset Based Financing


Asset Based Financing is relatively a newer term. It refers to financing of assets in the balance sheet on the basis of actual asset conversion value and potential cash flows in the business.
a. Loan Products i. Working Asset Financing ii. Asset Conversion Credit Asset Protection Credit

Fixed Assets (Equity) Financing Cash Flow Credit

c. Loan Structures i. Working Asset Financing ii. Revolving Financing Seasonal (Short term) Financing

Fixed Assets (Equity) Financing BMR Financing Bridge Financing LMM (Locally Manufactured Machinery) Suppliers Credit Consortium Financing

iii. Trade Financing Export Re-finance Pre-shipment Post-shipment Part I & Part II classification FAFB (Finance against Foreign Bills) FAPC (Finance against Packing Credit) Import Finances - PAD (Payment against Documents) - FATR (Finance against Trust Receipt) - FIM (Finance against Imported Merchandise) Non-Fund Based Finances - Documentary Letter of Credit - Guarantees, Performance Bonds, Etc.

Afghanistan Institute of Banking and Finance (Author Sohailuddin ALAVI) March 2012

5. Credit Portfolio Quality Indicators


Credit portfolio quality refers to the banks ability to collect back loan money without loss of principal and interest therein and within the given time frame. a. Credit Quality Factors

Portfolio diversity Sector wise Customer wise Ability to successfully assess risk at the onset Credit documentation and collateral Ability and success in recovering credits well in time Early identification of potential non performing credits Adequacy of provisions

Afghanistan Institute of Banking and Finance (Author Sohailuddin ALAVI) March 2012

6. Typical Credit Process

Stage Business Prospecting

Description This involves proactive identification of customers (also responding to walk in customers) and establishing their preliminary eligibility

Gathering and verifying critical information

Building financials from unstructured information Returns and risk analysis

Credit structuring and proposal development

Documentation and Disbursement of monies

Competencies Upright selling attitude Effective selling skills Know the Credit products and processes Know the customers: needs and expectations This entails Difficulty in relying Interviewing and collecting financial on informal sources investigative skills and other and obtaining Know the sources information from verifications of gathering formal as well as information informal sources Ability to select and infer required facts from the scattered information Constructing Constructing Know the basics of financial statements financial statements constructing from incomplete from incomplete financial statements data data Credit profitability Possibility of Know the drivers of and risk normative profitability and the identification and construction of risks in the analysis financials Credited investments Determining the Officer fails to Know the basis and Credit exposure, perceive the Credit techniques of price, and maturity proposition in projecting assets in line with the holistic perspective requirement, customer business Absence of Credit pricing, and financial conclusive criteria matching cash projections and flows and writing Credit mitigating risk proposals Follow a systematic approach in formulating Credit structure and proposal Credit Deficiency in legal Know the legal documentation and documents and aspects of Credit disbursement of negligence in documentation monies disbursement may Follow the prudent jeopardize the practices in

Risks Sales targets may over shadow the creditability of Credit investments Avert to selling mindsets may hinder prospects

Afghanistan Institute of Banking and Finance (Author Sohailuddin ALAVI) March 2012

Credit monitoring and recovery

Financial and business performance monitoring, followup for recoveries, search for early warning signals and classification.

security of Credited investment Complacency towards Creditors business performance, and changing business scenario may jeopardize the credits

disbursement of monies Know what, how and when to monitor Know what, how and when to act for preventing as well as working out problem Credits

Afghanistan Institute of Banking and Finance (Author Sohailuddin ALAVI) March 2012

Asset Based Financing


1. Scope of Asset Based Financing a. Basics:

Focus on assets within balance sheet Typically asset based facilities are clean (Non collateralized) Security of these facilities is determined by the o Potential value of assets conversion ratio o Potential assets net realizable (forced sales) value o Potential net operating cash flows

b. Collateralized vs. Asset Based Financing: Collateralized Financing: Banks secure their loans by acquiring mortgage or charge on borrowers assets, not necessarily presented on the business balance sheet. The assumption is default occurs when business fails to run profitably and so the bank relies on sale proceeds of the borrowers assets (collaterals). This approach has limitations: o Generally access to collateralized asset eclipses the need for projecting normal free cash flows and or assessing the risk in asset conversion cycle, which are supposedly the prime source of repayment o Forced sale of collateralized assets fails to fetch adequate price/cash flows o Forced sales of collateralized assets puts the business in to liquidation automatically o Forced sale of collateralized assets is a costly affair and has legal hitches

Asset Based Financing: Banks secure their loans by focusing potential business risk resulting from the projected ability of the enterprise to manage its asset conversion cycle Repayment of short term loans are assessed on the basis of working capital adequacy Repayment of medium to long term loans are assessed on the basis of projected free cash flows over multiple periods Collaterals are considered as additional security to compensate uncovered risks in the asset conversion cycle or due to short projections of free cash flows

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Afghanistan Institute of Banking and Finance (Author Sohailuddin ALAVI) March 2012

2. Asset Based Financing Rationales Opportunity for selling the short term loans for working assets has many faces o o o To fund permanent but revolving investment in work assets To fund seasonal (one asset conversion cycle) working assets. It arises out of gap between the assets conversion cycle and maturity of the current liabilities. Example: If ACC takes 45 days to complete, while the current liabilities become due in 30 days the need for the facility will be of 15 days on an average To cover the gap in a seasonal ACC a short term facility would suffice To cover the gaps in successive ACCs a revolving facility has the solution

Opportunity for selling medium to long term loans for fixed assets has following bases o o To overcome inadequacy of entrepreneur's own resources To support expansion of the enterprise through balancing, modernization and replacement of fixed assets To substitute equity with long term debts (lease), being relatively efficient source of borrowing thus affecting ROE positively

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Afghanistan Institute of Banking and Finance (Author Sohailuddin ALAVI) March 2012

3. Asset Based Facility Dynamics Concept of Working Asset Conversion Financing

Assets conversion cycle (value chain) is a process of investing in current assets and subsequently realizing profits upon their liquidation (sale) Typically it has 5 stages, namely; Acquisition, Holding, Conversion, Selling, and Collection Positive ratio of an asset conversion cycle reflects business stability and viability Financials interest in the companys ability to successfully convert its assets has two manifestations, namely; - The Business is a going concern - It provides primary source of repayments

Characteristics of Working Assets Conversion Financing

One time short term facility Suitable to provide liquidity solution for seasonal needs Repayment is linked with successful completion of a single/seasonal assets conversion cycle A single specified assets conversion cycle is forms the basic source of repayment

Concept of Working Assets Protection Based Financing Sanctioned credit line to fund several asset conversion cycles with short term repayments Suitable to provide liquidity solutions for revolving needs Repayments are linked with successful completion of multiple assets conversion cycles over a specific period of time Successive assets conversion cycles are the basic source of repayment

Cash Flow Based Financing Medium to long term financing Suitable to provide funding solution for fixed asset building; acquisition; and, modernization Repayments (rentals) are synchronized with periodic free cash flows (net profit after taxes) Projected cash flows all along the currency of the financing provide the primary basis of repayments Should be rescheduled / restructured if merit Preferably issued on floating rate basis

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Afghanistan Institute of Banking and Finance (Author Sohailuddin ALAVI) March 2012

4. Risks in Asset Based Facility a. Asset Conversion Cycle Risks


Working Asset Conversion Cycle Exemplified

Materials Acquisition

Holding Cost

Cash

Conversion Cost

Collection

Sale

Acquisition of materials Who are the major suppliers? What factors affect the price (how stable it is)? Are there acceptable substitutes of materials and suppliers in the market? Should the suppliers always obtain and supply the material Are there any specific factors that could affect the willingness and ability of the suppliers to continue the relationship and/or business Are there any systemic and/or non-systemic risks of spoilage of materials in transit Holding Risk Size of investment in inventory Storage requirements and cost Inventory controls Lead time Conversion of Materials Risk Labor power Technological dependence Managerial ability Productivity Selling Risk What is the companys competitive position? What are the major products and their brand position? Who are the major customers of the product? Who are the major competitors, locally and abroad? How does the company sell its products?

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Afghanistan Institute of Banking and Finance (Author Sohailuddin ALAVI) March 2012

What is the required average value of inventory? What is the cost and risk of inventory spoilage? Possible effect of regulations on companys sale? Possible change in the macro economic scenario on companys sale?

Collection Risk Customers: Who are they and how many? What are the usual credit terms? What is the collection process? What is the charge off policy What is the quality track record of recoveries?

b. Fixed Asset Conversion Cycle Risks


Fixed Asset Conversion Cycle Exemplified
Fixed Asset Acquisition Usage in Business Increase in Income

Free Cash Flows


Add back Depreciation Savings in Income Tax

Systemic Factors Stability of sales and profit margins Overall productivity of the enterprise Effectiveness of internal control system Dividend policy Non Systemic Factors Macro-economic scenario Industry / market conditions Stability in taxes and tariffs structure

Implications for Banks Uncertain / weakening systemic indicators increase chances of business failures Complex / highly uncertain ACC leads to high potential risk of loss in business operations which would in turn reduce cash flows Inadequate or uncertain projected cash flows lead to high potential risk of default Low or uncertain projected NRV of the asset(s) relative to the value and period of outstanding loan balance i.e. principal plus interest (mark-up) lead to high delinquency chances

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Afghanistan Institute of Banking and Finance (Author Sohailuddin ALAVI) March 2012

5. Measuring the Risk in Asset Based Financing a. Liquidation Analysis Experience has shown that availability of adequate capital is an effective buffer against high default risk. Capital adequacy in an enterprise is determined by the amount of risk (gray) area in its assets at a particular point in time vis--vis amount of equity capital available The concept of capital adequacy or net realizable value analysis is demonstrated in the following example:

Assets

Expected Net Realizable Value

Grey

L+C
Example 1

Liabilities

Equity

Assume that expected decline in the realizable value of business assets is cumulatively 10%. This includes expected losses in trade stock; trade debtors; and, decline in the market value of fixed assets. Assumed total asset base (current and fixed) as at of today 100,000/Risk in the assets @ 10% of 100,000/- is 10,000/Equity in this situation should be equal to or more than 10,000/- to effectively mitigate the risks

Example 2 Assumptions Enterprise fails to continue in the future Assets are liquidated at a loss Available cash (most of it) is used up in the process of liquidation Available credit limits are usually exhausted Liquidation cycle takes 60 days or more Calculate net realizable value of the available assets Cash X shrinkage = Net Realizable Value Debtors X shrinkage = Net Realizable Value Stocks X shrinkage = Net Realizable Value Fixed Assets X shrinkage = Net Realizable Value Total = Cumulative Net Realizable Value

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Afghanistan Institute of Banking and Finance (Author Sohailuddin ALAVI) March 2012

Liabilities at high point Suppliers Credit (Maximum limit) S.T. Bank Credits (Maximum limit) L.T. Debts (Actual balances) Interest accruals up to the end of liquidation cycle Debt Servicing Capacity (WC Adequacy) Calculation Cumulative Net Realizable Value 1.0 Million Liabilities at high point 0.6 Million Cushion 0.4 Million Conclusion A positive balance indicates availability of adequate cushion in form of equity to absorb potential risk of shrinkage in the value of assets, thus the position of the creditors is considered secured Negative balance prompts necessity of increasing equity; reducing existing debts; or acquiring collateral security b. Free Cash Flow Analysis Evaluates the enterprises ability to service its existing debts from its operational revenues: To see that the Cash Flow is adequate to meet Financial Payments To determine the maximum debt (servicing) capacity To construct a realistic credit runoff (repayment) schedule and set reasonable covenants Example Assumptions No inflation No asset growth Asset maintenance equals to depreciation expense Debt servicing requirements as per LTD runoff No unusual items The Framework NOPAT : NPAT : ROA : CPLTD : IE : CF : FP : FCF : Normalized Operating Profit after Tax Normalized Profit after Tax & IE Return on Assets Current Portion of Long Term Debts Periodic (Yearly) Interest Expense Cash Flow Financial Payments (CPLTD + IE) Free Cash Flow after FP & Div.

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Afghanistan Institute of Banking and Finance (Author Sohailuddin ALAVI) March 2012

Mechanics Historic NOPAT Historic ROA No Growth NOPAT No Growth FCF

= = = =

(NPAT + IE & Dividend Payments) (NOPAT / Avg. Total Assets) (Historic ROA X TA) (No Growth NOPAT) (IE + Dividend)

Exemplified No Growth NOPAT Calculations

Year 1 NPAT Interest Expense (1) NOPAT Total Assets (2) Average Assets (1 / 2) ROA 4,240 3,899 8139 180,000 175,000 4.65%

Year 2 8,009 3,442 11451 190,000 185,000 6.19%

Year 3 17,972 3,787 21759 250,000 220,000 9.89%

Year 4 23,024 5,967 28991 330,000 290,000 10.0%

Year 5 26,274 6,105 31379 340,000 335,000 9.37%

Reference ROA (Average of the years, that represent similar conditions) Last 3 years avg. No Growth NOPAT ROA(9.89 + 10 + 9.37) / 3 = 9.75% 9.75% multiplied by Total assets Year 5 0.0975 X 340,000 33,150
Exemplified No Growth Free Cash Flows Year 6 NGNOPAT Less Financial Payments (Source: \Loan amortization) Free Cash Flow Cumulative FCF (Dividends) 33,150 (10,584) Year 7 33,150 (9,912) Year 8 33,150 (9,385) Year 9 33,150 (8,115) Year 10 33,150 (7,933)

22,566 119,821 (5882)

23,238

23,765

25,035

25,217

(5882)

(5882)

(5882)

(5882)

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Afghanistan Institute of Banking and Finance (Author Sohailuddin ALAVI) March 2012

Free Cash Flow after paying Dividend Cumulative FCF

16,684

17,356

17,883

19,153

19335

90,411

Conclusion:

No growth free cash flows before and after financial and dividend payments are fairly reasonable. We have basis to say that repayment capacity for additional CF loans is good, hence new loans can be extended subject to repayments being matched with the available Free Cash Flows If Available FCF < FP then suggested Interventions Include: Rationalize dividend policy i.e. cut dividends Refinance / Reschedule debts Draw Down Cash Sell Fixed Assets Take on Short Term Debts

Lessons Learnt Lending decisions must consider followings: Can the enterprise repay its existing loan principal and interest out of its current profits? Can the enterprise repay its additional loan principal and interest out of its current profits? Can the enterprise repay its existing and additional loan principal and interest by way of forced selling of its current and fixed assets?

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Afghanistan Institute of Banking and Finance (Author Sohailuddin ALAVI) March 2012

Financial Analysis for Lending Decisions


1. Introduction to Financial Statements a. Balance Sheet Basics A snap shot of the enterprises assets, liabilities and equity Reveals liquidity, extent of capitalization, leverage and owners stake in the enterprise Can determine opportunity for additional bank financing and the potential risks thereto Balance Sheet Logic: Assets = Liabilities + Equity The above equation follows that: Total asset will always be equal to liabilities plus equity Total assets are funded through a combination of liabilities and equity Every increase in the liabilities at constant asset value, will decrease the equity and vice versa Decrease in equity at constant return on assets increases effective rate of return on equity and at the same time increases the likeliness of enterprise bankruptcy Equity at any point in time should be more than or equal to the potential business risk (likely loss of asset value). Thus equity is a buffer against potential losses and if adequate it would allow the business to continue into the future without fail and make good of the losses incurred in the past Hence we may conclude that risk and return potentials of an enterprise are directly linked with its balance sheet structure

b. Income Statement Basics A financial narrative of business operations of a particular period, usually one year Reveals if the enterprise has been able to utilize its assets efficiently (profitably) or not? Provides basis to determine if the enterprise is (would be) capable of paying its financial obligations in time Income Statement Logic: i) Gross Revenue - (Cost + Operating Exp.) = NOP ii) Net-O-Profit = (CPLD + IE + Dividend) The above equation follows that: Increase in NOP is directly dependent on increase in gross revenue and/or decrease in cost, or operating expenses Higher net operating profit means higher debt servicing capacity and vice versa

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Afghanistan Institute of Banking and Finance (Author Sohailuddin ALAVI) March 2012

c. Cash Flow Statement Basics It traces the inflow and outflow of cash An increase in net cash inflow is usually the result of

Sale of fixed assets, etc. A positive net cash inflow is comfortable for the banker, for it means a positive DSC

Increase in net operating profit Change in companys credit policy

d. Equity Reconciliation Statement Basics It reports the net change in owners equity over time It is a good indicator of the business performance in terms of change in owners equity An increased equity means high risk bearing capacity

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Afghanistan Institute of Banking and Finance (Author Sohailuddin ALAVI) March 2012

2. Analysis of Financial Statements a. Financial statements generally reveal the followings Enterprise past performance Clues on likely enterprise future performance, especially in terms of its ability to earn profits, liquidity, solvency and more importantly its ability to repay its liabilities b. Why to analyze? To understand the inter-relationship of profitability; asset utilization; and leverage as the determinants of an enterprises overall performance To calculate and interpret various financial trends (ratios) To determine the mix of funds in an enterprises capital structure that the bank considers most appropriate financing for its particular asset investment and cost function i. Horizontal Analysis (HA) It analyzes the firms performance over a period of time, usually five years, in order to determine key trends that may provide clues about the enterprises ability to repay a liability (loan) ii. Vertical Analysis (VA) In vertical analysis the firms performance is analyzed in comparison with other similar entities or with the industry norms If the enterprise performance deviates significantly, the reason should be zeroed in and credit impact be assessed iii. Financial Statements Spreading It is a systematic transposing of data from the enterprise financial statements on one page (spread sheet) It allows to quickly review the financial performance over recent years as well as analyze its present financial condition It also allows comparison of the enterprise from year to year (HA) and with other similar enterprises (VA) iv. Common Size Analysis Income statement and balance sheet data are reduced to percentages Usually gross sales figure is taken as base, equal to [100%] All other figures in the balance sheet and income statement are then reduced to relative percentages It allows tracking changes over time It also allows to project income statement and balance sheet on the basis of projected sales It provides basis to identify opportunities for new financing in the light of projected sales

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Afghanistan Institute of Banking and Finance (Author Sohailuddin ALAVI) March 2012

3. Financial Statement Ratios a. Ratios and their significance Liquidity Ratios: Indicate current debt paying capacity as a objective basis to predict future Efficiency (Profitability) Ratios: Indicate the efficiency of utilizing assets thus provide an objective basis to ascertain predictable profitability margins Leverage Ratios: Indicate the extent of debts relative to equity in the balance sheet. It is an objective indicator to assess the financial strength and risk bearing capacity of the enterprise

The ratios provide objective basis to owners, bankers and other stakeholder to assess the business performance and financial strength of an enterprise thus can make informed investment and/or lending decisions. b. Ration Mechanics i. Liquidity Ratios Current Ratio (Current assets / Current liabilities) Indicates enterprises short term liquidity position and/or working capital adequacy in the normal course of business (CA less Inventories & prepaid expenses)/(Current liabilities) Indicates enterprises short term liquidity position and/or working capital adequacy under the sub normal condition, such as when the company is in the process of liquidation

Quick Ratio

ii. Efficiency (Profitability) Ratios Debtors Turn Over (Net credit sales / Average debtors) Indicates quality of debtors on account of credit sales. This provides basis to ascertain possible losses in collecting debts. Inventory Turnover (Cost of goods sold / Average inventory) Indicates average time it takes for finished goods to be sold out. This provides basis to determine if the business is managing its finished goods inventories efficiently. Efficient inventory management indicates less optimized funding requirements thus lower cost of funds.

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Afghanistan Institute of Banking and Finance (Author Sohailuddin ALAVI) March 2012

Assets Turnover

(Net sales / Average total assets) Indicates average sales generated as a percentage of total investment in assets. This provides a basis to determine if the business is managing its investment in overall assets efficiently. An efficient asset management means higher return on investment (Net profit after tax / Total assets) Indicates net earnings as a percentage of total investment in assets. This provides a basis to determine if the business is generate adequate return on its total investment (Net profit after tax / Total equity) Indicates net earnings as a percentage of total equity. This provides a basis to determine if the business is generate adequate return on its given equity.

Return on Assets

Return on Equity

iii.

Leverage Ratios Debt Ratio Debt to Equity Ratio (Total Debts / Total Assets) Indicates the percentage of total assets funded by debts. (Total Debts / Total Equity) Indicates the ratio of debts to equity. Also referred to as financial leverage. Higher financial leverage means higher debts.

c. Challenges in Ratio Analysis and Interpretation Need for comparable data Influence of external factors Impact of inflation Need for valid benchmarks Based on past performance Future can never be predicted but estimates can be made

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Afghanistan Institute of Banking and Finance (Author Sohailuddin ALAVI) March 2012

Business and Financial Projections


a. Financial Projections Basics What to project?
Future sales Future operating volumes Future funding needs

Why to project?
To assess profit potentials To determine additional financing requirements To evaluate debt servicing capacity (DSC)

What are the limitations?


Time consuming Future Implies uncertainty However, it forces you to think analytically and to quantify the unknown

Considerations
Historical influences Economic outlook Competition Technology Company strategies (Product line, backward and forward integration, acquisition)

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Afghanistan Institute of Banking and Finance (Author Sohailuddin ALAVI) March 2012

b. Projecting Sales i. Methods Subjective Estimates (Best Guess)


Apply a growth percentage to sales revenues Based on Company track record Economic / industry indicators Gut feelings

Time Series Analysis


Apply a growth percentage based on historic sales growth (Keep in mind inflation) Methods Simple averages Best representative base period(s) Simple regression

Price / Volume Method


Project volume, considering Operating Rates Market Share Industry Growth Rate Project price based on Historic patterns Outlook for industry growth Inflation Regulations Gut feeling

Demand Analysis
Demand elasticity Cross demand factors Nature of the product itself - Staple or complimentary - Seasonal or regular

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Afghanistan Institute of Banking and Finance (Author Sohailuddin ALAVI) March 2012

c. Projecting Additional Financing Needed Sales Based Projection Model It is simple and consistent Additional financing requirements are based on projected assets (balance sheet) All projections are based on projected (additional) sales value It considers linear relationship of various accounts with that of sales It fails to recognize under-utilized capacity of fixed assets excessive investments in current assets and hence adjust projections Assumptions All expenses (including costs) are directly proportionate to sales All assets (current and fixed) are directly proportionate to sales All liabilities (current and long term) are proportionate to sales All expenses (including costs) are directly proportionate to sales All assets (current and fixed) are directly proportionate to sales All liabilities (current and long term) are proportionate to sales Projecting Additional Short Term Financing Requirements (Basic Equations) Projected Additional Gross Working Assets = (Avg. CA / Avg. Sales) X Projected Sales Projected Additional Current Liabilities = (Avg. CL / Avg. Sales) X Projected Sales Projected Additional Net Working Assets = (Projected Additional GWA Projected Additional CL) Projected Additional Short Term Financing Required = (Projected additional net working assets) less (Projected additional debtors multiplied by gross profit margin)

Projecting Additional Term Financing Requirements (Basic Equations) Projected Additional Fixed Assets = (Avg. FA / Avg. Sales) X Projected Sales Projected Increase in Equity = (Avg. Profit Margin X Projected Sales) X (1 Tax rate) Multiplied by (1 Avg. dividend rate) Projected Additional Term Financing Required = (Projected Additional FA Projected Increase in Equity)

d. Points to Ponder Projections are only calculated estimates Real scenario will and can be different Decisions must reflect the reality about projections Sometimes gut feelings are more meaningful that calculated estimates

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Afghanistan Institute of Banking and Finance (Author Sohailuddin ALAVI) March 2012

Credit Risk Analysis


a. Risk Concepts Risk management is not doing business without risk. It is also not to deny risks in business. In fact it is about knowing, accepting, and harnessing the risk to your advantage. Having said this, risk is but the reflection of what and how we do our business transactions. Hence risk management is harnessing our actions and decisions to keep the risk in business within bearable limits to ensure business continuity. It is imperative to assess and mitigate the inherent risks and avoid the induced risks b. Risks in Perspective Inherent Risk These risks are inherently associated with business assets and are likely to bring loss to the business if not managed, such as Risk of spoilage Risk of change in demand hence price Risk of theft Risk of delayed turnover Etc. Induced Risk: These risks are proactively created in order to increase the returns in business, such as Holding an asset in anticipation of rise in the demand and/or prices at a future date Forward buying or selling in anticipation of favorable price change in the future Extending loan to less credible borrower or against less secured collateral in anticipation of higher interest earnings Financial Risks: These risks are the obvious outcome of inherent or induced risk in assets, such as Liquidity risk: Inability to meet short term cash payments obligations Solvency risk: Inability to meet long term cash payments obligations Implications for the Enterprise Unmanaged inherent risks reduce enterprise viability both in the short and long runs Induced risks exposes enterprise to uncontrollable external factors Implications for the Creditors Unmanaged inherent risks restrict borrowers ability to pay back the loan money including interest in the normal course Induced risks pose additional vulnerability to the borrowers debt servicing ability both in the short and long runs

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Afghanistan Institute of Banking and Finance (Author Sohailuddin ALAVI) March 2012

c. Risks Concepts and Types i. Concepts Exposure: Total value of an asset subject to risk (loan) Risk: Estimated percentage of the total exposure that is expected to be lost in due to happening of certain foreseen contingencies Risk coverage: It is generally limited to the principal exposure only. Earlier the recovery of principal exposure, lower will be the risk Hedging: Taking actions to cover the risk

ii. Business Risk Risks associated with asset conversion cycle Risk of loss of assets market value (net realizable or forced sales value)

ii. Financial Risk Enterprises inability to pay its current liabilities on time, over time. Also referred to as Liquidity Risk Enterprises inability to pay its long term debts as these becomes due. Also referred to as Solvency Risk Interest rate risk affects the debt servicing value which in turn affect the duration of recovery of the principal. Moreover, it also affects profit margins

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Afghanistan Institute of Banking and Finance (Author Sohailuddin ALAVI) March 2012

d. Business Risk Analysis Model* Rivalry Analysis How many competitors are operating in the market? How do you view the rivalry amongst competitors? Are there any major competitors that influence the direction of market? Do you have competency and power to fight or adjust against such competitors? How cost effective is your business compared to competitors? Is price a major determinant of competition? Can your business fetch a good price that can keep the sales stable without facing loss?

Buyers Power Analysis What are the average volumes What is the level of buyers concentration Is buyer price sensitive? Do your sales contribute a significant portion in buyers total buying? Are buyer quality conscious / brand loyal? Are product differences amongst competitors significant and meaningful to buyers? What is the level of buyers switching cost to competitors products? Does the industry offer incentives to buyers? Are substitutes available to your products? Are they more effective on relative price than your products? Are they more effective on relative performance than your products? Are substitutes meaningful to buyers?

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Afghanistan Institute of Banking and Finance (Author Sohailuddin ALAVI) March 2012

Suppliers Power Analysis Who and how many are the suppliers? How differentiated are the suppliers inputs? What is the cost of switching suppliers? Are substitute inputs available in the market? Is volume important to supplier? What impact do the inputs have on the quality or cost advantages of your products?

Threat of New Entrants Analysis How vulnerable is the threat of new entrants? Is government policy encouraging to entering the business? Are distribution-channels open accessible? Are necessary inputs openly available at competitive prices? Does the new entry give rise to strong retaliation from the competitor?

Ease of Exit Analysis What is the average rate of closures in the industry? What is the average cost of closing the business in the industry? How much time is required on average to liquidate the business in the industry? What is the socioeconomic cost of closing the business in the industry, such as Induced unemployment Loss of export revenue Inflation Loss of tax money

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Afghanistan Institute of Banking and Finance (Author Sohailuddin ALAVI) March 2012

e. Credit Default Risk Manifestations Inability to recover all or fewer installments Inability to recover all or fewer installments on time Inability to fetch adequate amount from forced sales of the asset(s)

Some Root Causes Failure to manage asset conversion cycle Failure to match asset and liability maturities Improper / no utilization of the credit amount Unfavorable industry / market conditions Fraudulent attitude of the entrepreneur / borrower

Factors Affecting Credit Risk

Systemic Factors o Weakening industry o Weakening market demand o Intense competition Un-systemic Factors o Entrepreneurs inability to manage business efficiently o Unforeseen exit of the entrepreneur o Fraudulent orientations o Death of the entrepreneur Other Variables o Is the industry in growth phase? o Is the regulatory regime enabling for competitive business activity? o Is the technology accessible at affordable prices? o Is there sufficient supply of skilled professionals at sustainable level? o Is the competition from outside world is fair and effectively controlled? o Is access to foreign markets available on open merit? o What is the geo-political significance vis-a-vis the enterprise location and nature of operations? o What is the general investment climate? o How capital intensive is the business to start up the operations? o How much is the expected time to recover the cost of business? o Is there any minimum or maximum investment barriers? o How are the infrastructure facilities in the vicinity? o What is the level of market integration?

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Afghanistan Institute of Banking and Finance (Author Sohailuddin ALAVI) March 2012

f. Measuring Credit Risk Advantages of Quantifying the Risks: Fair criteria for approving or refusing a loan proposition Objective assessment of value of a particular loan on overall portfolio performance quality: Meaningful approach in managing risks Equitable basis for loan pricing Process Factors Correlates Potential default of the principal value and/or interest therein Potential delay in repayment of rentals Insolvency or fraudulent behavior of the entrepreneur Enterprise becoming a gone concern (loss bearing) Mismanagement by the entrepreneur Inadequate working capital (liquidity) in the enterprise Excessive periodic repayments of liabilities relative to debt serving ability - Potential delay in recovery of the principal Potential loss due to reduced NRV of the Loan asset - Potential inability to recover claims through guarantor(s) Loan price Loan amortization (run down) schedule does not match with DSA Reduced useful life of assets High technological obsolescence Incapacity / non availability of the guarantor(s) Identify risk factors Determine correlates Assign values to the corresponding correlates Synthesize corresponding risk factor

Assigning Risk Values Risk is a rational assumption of future events Risk can be identified on a scale of low, medium, high, etc. depending on the probability of occurrence of the event and its potential impact on the performance of a Loan Although highly sophisticated statistical derivations can be applied to translate the risks into financial percentages, however, simpler approaches merit in scenario A simpler approach could be to assign standard % values to Low, Medium, and High risk scenarios. For instance, Low 5%; Medium 10%; High 20% etc. This will allow standard application across the board hence would be more equitable, acceptable; cost efficient; and easy to apply in a typical scenario The risk factors (%) are initially determined at the onset of a loan transaction. It is imperative that on the basis of monitoring, feedback especially the

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Afghanistan Institute of Banking and Finance (Author Sohailuddin ALAVI) March 2012

repayment behavior, the risk factors are reviewed and revised in either directions depending on the performance

High

6:1

6:6

Probability of Occurrence

3:3
Impact

Low

1:1
Impact

1:6
High

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Afghanistan Institute of Banking and Finance (Author Sohailuddin ALAVI) March 2012

g. Mitigating Credit Risk i. Collateralization

Collateral refers to the assets of the borrower, which the bank access in security of its credits: Asset Category Cash and Near Cash Assets Trade Merchandise Immovable Assets Banks Security Lien Pledge / Hypothecation Mortgage

Margin on net-realizable-value and the credit amount is essential to establish effective security Personal guarantees are also taken to secure the credits - these can be termed as intangible collateral

ii. Alternates to Collateralization

Acquire equity (capital) participation commensurate with the gray area in the loan Adjust loan price correspondingly Keep Loan duration as minimum as possible Match loan installments with projected cash flows (DSA) Limit exposure proportionate to the risk Acquire seniority over other creditors through subordination agreements (optional) Regret / workout facilities (last resort)

iii. Risk Based Pricing Frameworl

Pricing Conventions Cost plus mark up Cost plus target return on equity Cost plus target return on equity plus risk premium Competitive pricing Premium (monopolistic) pricing

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Afghanistan Institute of Banking and Finance (Author Sohailuddin ALAVI) March 2012

Risk Based Pricing Framework


Internal Cost of Funds

Target Return on Equity

Internal Rate of Return

Risk* Premium

Target Loan Price

Disclaimer: Islamic shariah contemplates bearing Risk-of-Loss by the entrepreneur as prerequisite for a valid business transaction. Moreover, it also does not permit charging additional price for the risk, as it is a non-existent contingency hence it amounts to Mysar i.e. gambling. Reference: Business Ethics in Islam, page 79Quranic verse 4:29&30 and page 106 Process of riba.

>P

Target Price
P3

Equilibrium Price Line

Price
Risk Premium
P1

P2

<P

IRR Risk

Definitions Internal Cost of Funds is the weighted average cost of borrowed funds, including deposits from the public. Target Return on Equity is the average return on equity that the company wants to earn on a particular loan in order to set off its overhead expenses and earn a competitive margin on its equity. Internal Rate of Return is the cumulative rate of internal cost of funds and target return on equity. Risk Premium is the arbitrary financial value assigned to expected risk in a transaction, meant to compensate for the risk.

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Afghanistan Institute of Banking and Finance (Author Sohailuddin ALAVI) March 2012