Credit Risks in Working Capital

Working capital is known as the blood of business. No business can survive without
adequate working capital.
DEFINITION OF WORKING CAPITAL
Usual balance sheet definition of working capital is given below:
Working Capital = Current Assets − Current Liabilities

Working Capital Cycle – Finance Manager’s Key Concern

All firms require a minimum amount of current assets to operate smoothly and to carry out
day-to-day operations. Working capital usually revolves around the business several times
during the year. This is called the working capital cycle, which we will discuss in detail later.
The working capital ‘cycles’ around the business. On each turn of the cycle the firm or
company is expected to make a profit – i.e. the goods or services should be sold for more
than the cost of their production – resulting in more cash.

Working Capital Cycle – Lending Bank’s Point of View

1. To avoid over-financing the customer. For example, if the stock is already bought on a
credit basis from the supplier, the banks should avoid funding the same stock.
2. To decide the usance period for letters of credit. For example, if the trade creditor
provides 90 days’ credit period (from the date of receipt of goods) and the time taken for
shipment is 30 days, the usance period of the letter of credit may not exceed 120 days
3. To decide the tenor of short-term revolving loans.
4. To structure the various working capital facilities, including overdraft, short-term revolving
loans, factoring, bill discounting, letters of credit and/or letters of guarantee.
5. To understand the liquidity management of the entity. The liquidity position is closely
linked to the working capital management and its components (i.e. stock, debtors and
creditors).

ASSESSING WORKING CAPITAL THROUGH THE BALANCE SHEET

The balance sheet shows the working capital as on a particular day and we have to assume
this as the average situation for the year/period, given the dynamic nature of working
capital. If the position as reflected in the balance sheet is not reflective of an ‘average’
situation, the analyst ought to derive a best case based on the understanding of the nature
(e.g. seasonality) of business, especially its cash flows, developed through
discussions/customer visits.

Let us use the following example to understand how the balance sheet can provide clarity
in the working capital requirements.
You have been informed that the bank has extended an overdraft facility of $50m only, of
which $24m is currently utilized. No other facility is enjoyed from any other bank.
Calculate the following and explain your views:
1. Working capital requirement from the finance manager’s point of view.
2. Working capital from a lending bank’s perspective.
3. Is there any defect in the way working capital facilities are structured?
4. What is your view on the liquidity of ABC Ltd?
‘Working capital cycle’ refers to the time taken for the business activity (or operation) to
complete its course. For example in the case of a manufacturing entity, the working capital
cycle denotes the time period between the point at which raw materials are bought and the
point at which finished goods (made from those raw materials) are converted into cash.
Generally, the shorter the working capital cycle, the more efficient the company’s use of
working capital. A company with an extremely short working cycle requires less cash, and
can survive even at relatively lower margins. Conversely, a business may have fat margins;
however if it has a lengthy working capital cycle, it may struggle to grow even at a modest
pace.
Let us see the various components and the functioning of the working capital cycle of a
trader:

M/s ABC Co, a trading firm enters into an agreement with the supplier and places an order
on a particular day and receives the goods after 30 days. The supplier, who usually extends
30 days’ credit period, is settled on time. The goods are kept in the warehouse for 45 days,
when they are sold on credit to XYZ Ltd, which usually enjoys 60 days’ credit from ABC Co.
XYZ Ltd pays on time, completing the trading activity or trade cycle of this particular
transaction. We can summarize these events as follows:
The sequence of events in the cash cycle is as follows:
∙ The firm gets the funds to be deployed in the working capital or cash cycle from equity
funds or bank borrowings.
∙ The firm uses cash to pay for a cash advance (usually a percentage of total purchase price)
to the suppliers and thereafter obtain the raw materials on credit. After some time, the
creditors are settled in cash.
Thereafter, cash is paid forwages (to skilled and unskilled labourers) as the cost of
converting the raw materials into finished goods (i.e. working capital needed to pay
conversion costs).
∙ The finished goods are held in the warehouse until they are sold at a reasonable profit.
∙ The sales are usually on credit terms to the firm’s customers.
∙ As the final step in the cycle, the debtors settle their dues, resulting in cash inflows.
∙ This cash is then either utilized to settle the bank borrowings or reinvested in raw materials
and the cycle is repeated. If a firm is profitable, the cash inflows increase over time.
WORKING CAPITAL RISKS
Whether trade credit or bank finance, the provider of working capital facilities is exposed to
credit risk, which necessitates credit risk analysis to understand the risk being undertaken.
However, working capital, because of its uniqueness, has certain exclusive risks, which are
discussed below and depicted in Figure.
Over-trading
As the name implies working capital difficulties emerge from the fact that the business
entity tends to do business beyond its capacity.
As the firm focuses on volume growth there are other perils such as drag on margin, low
quality debtors, etc., which will further worsen the liquidity situation. Besides tarnishing its
business image, the business entity will struggle to settle bills, pay wages and other
expenses or would be forced to raise money from costlier sources orwould have to offer
exorbitant discounts to debtors to speed up collection. Fall in inventory levels due to lack of
creditors’ support and increased purchase costs (loss of discounts) could be further fall-out
of over-trading.
The financial statements reveal whether a firm is over-trading or drifting towards this
malaise: (i) If balance sheet variables such as stocks, debtors, creditors or short-term
borrowings show sharp increase with dramatic increase in turnover usually without any
increase in profitability, that requires further investigation. (ii) Examination of certain
financial ratios such as Operating Profit Margin (OPM), Sales to Operating Capital Employed
(SOCE), current ratio, quick ratio, working capital/sales ratio, gearing, leverage and interest
rate cover can indicate the stage of over-trading. Over-trading symptoms, at the initial stages,
can be cured easily, while at the later stages, a thorough reorganization would be the only
option – such as sale of certain non-core/fixed assets and/or additional equity injection
and/or reduction of the scale of operations.
CREDIT PRICING FACTORS
While pricing credit risk, several factors need to be considered. The credit default risk is
most critical. However, there are also other factors to be considered, for example, cost of
funds. Figure 20.1 shows the major factors to be considered while pricing a credit asset. It
may be noted that the diagram is only indicative and additional factors – for example
liquidity or migration risk – may also need to be considered depending upon the
circumstances.
Let us examine each factor in detail:
Credit Risk Premium
As with the generally accepted classic case of risk vs. return, the higher the credit risk, the
higher should be the return and vice versa. When considering credit risk pricing, credit
executives should ensure that the credit risk is not only thoroughly analyzed and understood
but also priced adequately. The following simple rule is sometimes forgotten (by credit
professionals) in the real world as higher risks are underwritten for low prices.
Figure illustrates the direct relationship of credit risk pricing with probability of default.
PD plays an important role in arriving at the credit risk premium on various credit derivatives
such as CDS and CSO.
How is PD factored into pricing? The higher the PD, the higher the credit premium, as we
have seen in the case of CDS. This is the reason why corporate credit assets have a higher
yield than government or treasury securities. Corporate debt is costlier than treasury bills
because the latter are considered to be risk free.
It is evident that theoretically credit risk pricing and PD have a positive relationship;
however there is an exception – if the LGD is low, then the credit risk pricing may not strictly
have a direct relationship. As we discussed in Chapter 15, Expected Loss (EL) is a function of
PD and LGD. EL is the cost of doing business and, accordingly, it will be factored into the
pricing. The higher the EL, the higher the credit pricing; and the higher the PD, the higher
the EL unless LGD is zero or near zero (i.e. backed by strong collateral).
PD is also useful in the calculation of multi-year credit assets, i.e. credit assets that mature
in more than one year. In such cases it is necessary to know the credit asset’s or borrower’s
marginal probability of default over the entire period.
Portfolio Risk
The relationship between credit risk and return ought to be recognized not only at firm
level but at portfolio level as well. The credit portfolio should be managed in such a manner
that it meets the targeted portfolio return and accounts for portfolio risks.
Cost of Capital
When a credit asset is created, it involves investment of funds or capital, which in turn
results in cost of funds/capital. Hence, the return on credit should not only cover the cost of
capital and related administrative charges but leave sufficient margin to satisfy the
shareholders as well. Cost of capital is one of the important considerations to be taken into
account when pricing credit risk. There are other factors also to be considered, which will be
discussed later. But capital is more critical, especially in regulated bodies such as banks.

(a) maximize the returns on possible credit assets with the existing capital or
(b) (b) raise more capital to do more business (underwrite more credit assets) invariably
depends upon pricing. If more capital is required for a particular credit asset, naturally
the associated cost of capital (in absolute terms) will also be more (higher), which in
turn would require a better return, hence the need for higher credit pricing.
Economic capital based pricing is expected to ensure that the ‘higher risks’ are rewarded
with higher returns. As we have discussed earlier, economic capital is a function of variables
such as PD, LGD and the confidence level required by the bank. Accordingly, PD and LGD
influence credit pricing in two ways. First directly, as PD and LGD determine the expected
loss which is directly priced in. Secondly, PD and LGD play an important role in determining
economic capital, which in turn will influence credit pricing by way of cost of capital.
Cost of Leverage
Banks and FIs operate with high leverage. Since they depend on external funds – mainly
deposits from the public and/or inter-bank (wholesale) market – to create credit assets, they
always carry a refinancing risk. There is a risk either that the refinance may not be available
or, if available, that it will be at a higher cost. Refinancing is mainly a function of market
liquidity and creditworthiness of the borrowing bank and FI.

Sector Risks
Pricing should reflect the underlying risk associated with the sector. Certain sectors are more
risky than others and, as a consequence, the constituents of such sectors may become
defaulters while the constituents of a stable sector will continue to perform well.
Similarly, concentration risk, if any, which has crept into any part of the credit portfolio
must also be priced in.
For example, Bank XYZ has the sector cap as shown in Table
Inflation: As we have discussed in earlier chapters, inflation eats into the value of a credit
asset and hence it should be compensated through pricing.
7. Exit strategy: Often, higher pricing of facilities is used as a strategy to cease dealings with
a particular customer. Realizing that the price is higher than what is offered by competitors in
the market, the customer ought to prefer other suppliers of capital. However, one important
aspect to be remembered is that this strategy should be applied well in advance, before a
sharp deterioration in the creditworthiness of the customer.

PRICING STRUCTURE
Interest on advances being the main source of a financial institution’s revenue, credit
executives must ensure that the rate of interest on credit provides a satisfactory return.
However, usually there are accepted ways of deriving income (usually one-off) other than
interest income, which are intended to remunerate the financial institution for services,
whether connected with the credit or not. The following are the major sources of income
which determine pricing:
1. Interest rates
2. Non-interest income (commission and fees).
Fixed or Variable Interest Rate
A fixed rate of interest is one that will be applied right through the life of the advance.
Changes in the base rate will not affect fixed rates. For example, if the loan is extended at
10% fixed rate for five years, this rate remains whatever happens to the base rate. The
interest is deducted from the proceeds when the advance is granted (e.g. in the case of a
discounted bill)
A variable interest rate is fluctuating and moves with the base rate or reference rates such
as LIBOR. Since there is uncertainty as to the interest rate, the charging of interest on the
outstanding amount of the advance takes place periodically, e.g. monthly or quarterly. For
example, if a loan is granted at 2% above LIBOR and the current LIBOR is 5%, then the
interest rate would be 7%. If the LIBOR changes to 7%, the interest rate will automatically
increase to 9% (i.e. 7% + 2%).