Credit and Risk Review

Transcription

1 Utah Bankers Association Credit and Risk Review Executive Development Program 2013 Jeffery W. Johnson Bankers Insight Group, LLC June 2013

2 TABLE OF CONTENTS 1. WELL DEFINED CREDIT CULTURE SUPPORTED BY A GOOD LOAN POLICY CULTURE 2. CREDIT RISK UNDERWRITING 3. HIGHLY EFFECTIVE CREDIT COMMITTEE 4. UTILIZE CREDIT RISK RATING TO IDENTIFY RISK IN THE LOAN PORTFOLIO 5. EFFECTIVE LOAN PORTFOLIO MANAGEMENT 6. PROBLEM LOAN MANAGEMENT AND ACCOUNTING 7. TROUBLE DEBT RESTRUCTURE Bankers Insight Group Page 2

3 WELL DEFINED CREDIT CULTURE SUPPORTED BY A GOOD LOAN POLICY CULTURE Most of the above factors are items that can be established and measured. But what about those intangibles? You know, those things that people do, think, say and behave without any formal instructions from some type of a policy. I am talking about Culture. Culture is the key attitudes and behaviors of members of a group. It is what people think and what people do. For an example, a sales culture exists in a bank when these attitudes and behaviors are pro-selling and selling is perceived as legitimate and important. It is part of the job. A bank s credit culture is the sum of its credit values, beliefs and behaviors. It is what is done and how it is accomplished. It exerts a strong influence on a bank s lending and credit risk management. Values and behaviors that are rewarded become the standards and will take precedence over written policies and procedures. What is the dominate Culture within your bank? RISK PROFILE A bank s risk profile is more measurable than its credit culture. A risk profile describes the various levels and types of risk in the portfolio. The profile evolves from the credit culture, strategic planning, and the day-to-day activities of making and collecting loans. Developing a risk profile is no simple matter as it varies from bank to bank. Some banks approach credit very conservatively, while growth oriented banks may approach lending more aggressively It is all about achieving a good CAMELS Rating! C A M E L S Bankers Insight Group Page 3

4 CREDIT POLICY The loan policy is the foundation for maintaining sound asset quality because it describes the organization s risk tolerance and provides the parameters for managing those risks. A policy cannot anticipate all situations; therefore, lenders must exercise their judgment within the framework of the policy Desirable and non-desirable loans. Underwriting standards and monitoring requirements The credit approval process including lending authority and responsibility of the board in reviewing, ratifying, and approving loans. Transactions requiring credit memorandums. Desirable and non-desirable loans. Underwriting standards and monitoring requirements The credit approval process including lending authority and responsibility of the board in reviewing, ratifying, and approving loans. Transactions requiring credit memorandums. Appraisal guidelines to ensure compliance with Regulation Y and the Uniform Standards of Professional Appraisal Practices (USPAP). Risk-rating definitions and guidelines on pricing for risk. Portfolio mix and risk diversification guidelines. Collection and problem loan resolution procedures. Charge-off and non-accrual policies. Method for determining the adequacy of the allowance for loan and lease losses (ALLL). Bankers Insight Group Page 4

5 LOAN POLICY OUTLINE COMPARED WITH A CLIENT s POLICY I. Loan Policy Addressed in Client Policy Table of Contents NO Introduction NO Lending Objectives YES External Policy Goals NO Internal Policy Goals NO Lending Philosophy YES* Compliance Assessment Area YES* Out of Territory Lending YES Legal Lending Limit YES II. Loan Administration The Executive Loan Committee YES The Officers Loan Committee YES Loan Administration YES* Lending Officers NO The Role of the Lending Officer YES* Authority to Make Loans YES* Approval of Loans YES* Current Loan Authorities NO Individual Lending Authority NO Expiration of Approvals NO Loan Operations Department NO III Lending Criteria Desirable Loans NO Undesirable and Problem Loans YES* Unacceptable Loans/Prohibited Loans YES VI Definition of Loan Types Consumer Loans YES Real Estate Loans YES* Interim Construction Loans NO Commercial Loans YES Unsecured Loans YES Secured Loans YES Bankers Insight Group Page 5

6 V Credit Guidelines Addressed in GCB s Policy Loan Applications NO Financial Statements NO Types of Financial Statements NO Analysis of Financial Statements NO Frequency of Financial Statements and Follow-up Procedures NO Waiving Financial Statements NO Confidentiality of Information NO Deposit Relationships NO Fee Reimbursement NO Government Regulations NO Guarantors YES Credit Investigation YES Credit Files YES Renewals YES Capitalization of Interest NO VI Loan Documentation Signatures on Loan Documents NO Computer-generated and Standard Credit Memo Form NO Responsibilities for Loan Documentation YES* Collateral Files YES* Insurance YES VII Loan Pricing YES* VIII Commercial Lending Commercial Loans-General YES Unsecured Loans YES Lines of Credit YES Secured Credit YES Loans Secured by Marketable Securities YES* Accounts Receivable and Inventory Collateral Monitoring YES* Loans Secured by Equipment YES* Term Loans YES* Letters of Credit NO Loans to US Agencies or Other Government Bodies YES Bankers Insight Group Page 6

7 XI Real Estate Lending Addressed in GCB s Policy General Requirements YES Interest Reserves NO Loan to Value Limits for Real Estate Loans YES Specific Requirements for Single-Family Owner-Occupied Dwelling NO Construction Loans NO Land and Development Loans NO Commercial Mortgage Loans NO Loans to Churches and Other Non-Profit Organizations NO Home Improvement Loans NO Home Equity Loans NO Second Lien Real Estate Loans NO XI Real Estate Appraisal Procedures Selecting the Appraisal NO Ordering Appraisals NO Regulatory Requirements for Certified and Licensed Appraisers NO Minimum Appraisal Standards NO Appraisal Foundation Standards NO Written Appraisals Requirements NO Analysis of Deductions and Discounts NO Market Value Prospective Values NO When Federal Regulatory Standards are not Firm Requirements NO Unsafe and Unsound Appraisal Practices and Policies NO Real Estate Appraisal Reviews NO Problem Loans and OREO Appraisal Policies YES Environmental Requirements on Potential Borrowers YES Environmental Audits YES Phase 1 Environmental Audits NO Historical Use Record Review NO Regulatory Agency Review NO Site Inspection NO Phase 2 & 3 Audits NO When an Audit is Needed NO When to Use Bank Personnel to Perform Limited Audits NO Bankers Insight Group Page 7

8 XII Loans to Directors, Officers and Employees Addressed in GCB s Policy Directors and Executive Officers YES Other Officers YES* Reports of Officer Borrowings YES Loans to Employees YES XIII Overdrafts Customers YES Employees Who Are Not Directors or Executive Officers YES Reports to the Board of Directors Regarding Overdrafts YES XIV Loan Participations YES XV Collection Procedures YES XVI Charge Off Policy YES XVII Extensions / Modifications / Repossessions YES* XVIII ACH Origination NO XIX Predatory Lending NO XX Other Real Estate Owned YES XXI Credit Grades YES XXII Concentration of Credit YES* XXIII Allowance For Loan and Lease Losses YES Bankers Insight Group Page 8

9 Addressed in GCB s Policy XXIV Loan Review NO XXV Conflict of Interest XXVI Policy Exceptions and Review XXVII Distribution of the Loan Policy NO YES* NO *Requires expansion, clarification or improvement Bankers Insight Group Page 9

10 CREDIT, RATIO AND CASH FLOW ANALYSIS Credit (Risk) Analysis is one of the most important functions performed by banks. Since interest and fee income from loans represent the largest source of revenue for banks, it is vital that thorough credit analysis be performed before loans are approved and funded. Credit Analysis not only considers the financial condition of prospective borrowers, but also considers non-financial factors which may impact the ability to repay loans. Proper Credit Analysis starts with analyzing the financial statements followed by reporting the findings in a Credit Memorandum, then recommending a loan structure that provides the borrower what they need while providing the bank with the highest possible chance of being repaid. There is a very thin line between Financial Analysis and Credit Analysis because many of the techniques utilized to make an assessment overlap. However, the biggest difference is that Credit Analysis is appropriate when money is on the line. It focuses on analyzing financial and non-financial factors with the primary objective of determining the ability of a borrower. Bankers Insight Group Page 10

11 TYPES OF ANALYSIS Common Sizing: Balance Sheet items as a % of Total Assets Income Statement items as a % of Net Sales Percent Change: Amount change shown as a percentage Ratios: Mathematical relationship among logically related factors Cash Flow: Determination of cash generation or usage from items on the Income Statement and from the changes in the Balance Sheet items from one period to another period Comparative: Matching or contrasting to similar peer or industry data Trend: Analysis of changes over at least a 3 year period Indexing: Changes related to a designated base year Forecasting: Forecasting financial statements to observe the likely results based upon management s assumptions Breakeven: Determination of the level of Sales required to cover Fixed Costs Working Capital: Determine ability to meet current debt payments and to measure working assets efficiency Sustainable Growth: Rate at which a company can grow and maintain a certain level of leverage (Debt to Worth position) Bankers Insight Group Page 11

12 RATIO ANALYSIS I believe all borrowers being analyzed for financial soundness should be scrutinized to determine five vital signs that are critical for an entities financial success. The method I recommend to check these vital signs is referred to as: LLAMOPCAFLO (Pronounced: la-mop-ca-flo) LLAMOPCAFLO measures an entity s financial factors only. Non-Financial factors such as the character of management or the condition of the economy are not measured through LLAMOPCAFLO therefore; it is recommended that elements of the Five C s of Credit should be utilized in conjunction with LLAMOPCAFLO in order to develop a full assessment of an entity. LLAMOPCAFLO is an acronym for the following: LIQUIDITY LEVERAGE ASSET MANAGEMENT OPERATIONS CASH FLOW If you stop and think about it, an entity s financial woes occur in its inability to pay current debts as they come due (Liquidity); or debt on their balance sheet is more than the owners equity (Leverage); or management is not utilizing their assets (or may have the wrong assets) to generate sufficient sales or to create profits (Asset Management); or the company may lose money as a result of their operations (Operations); or the company may not be able to generate sufficient cash flow to sustain the company or to pay down long-term debt (Cash Flow). If LLAMOPCAFLO is utilized, these issues will easily be uncovered. Bankers Insight Group Page 12

13 LIQUIDITY Liquidity is a measure of the quality and adequacy of current (short-term) assets to meet current (short-term) obligations as they come due. Current Ratio Calculation: Current Assets Current Liabilities This ratio gives a general indication of a firm s ability to pay its current obligations. Generally, the higher the Current Ratio, the greater the cushion between current obligations and a firm s ability to pay. A benchmark for this ratio has been 2 to 1. The higher the ratio reflects more current assets available to cover Current Liabilities. However, the composition and quality of Current Assets is a critical factor in the analysis of an individual firm s liquidity. Quick Ratio Calculation: Cash + Marketable Securities + Accounts Receivable Current Liabilities Also known as the Acid Test Ratio, it is a refinement of the Current Ratio and is a more conservative measure of liquidity. The numerator from the Current Ratio is adjusted by omitting inventory (because of obsolesce, slow moving items and encumbered items). The ratio expresses the degree to which a company s Current Liabilities are covered by the most liquid Current Assets. Generally, any value of less than 1 to 1 implies a dependency on inventory or other Current Assets to liquidate short-term debt Working Capital Calculation: Current Assets minus Current Liabilities Working Capital is the amount of Current Assets remaining after the Current Liabilities are paid. This excess cash can be used to repay long term debt, invest in long term assets or pay a dividend. The higher the working capital the stronger the entity Current Ratio Quick Ratio Working Capital 1,878,000 2,005,000 2,352,000 Bankers Insight Group Page 13

14 Getting Behind The Numbers Hint: The stronger the ratio trend the more you need to check the quality of the current assets serving as the numerator. Here are some check points: 1. Check to see if there are any restrictions to Marketable Securities or can they be liquidated with ease and within a short period of time 2. Check the quality of Accounts Receivable by examining an aging schedule, dilution rate, issuance of credit memos and credit terms 3. Check the quality of Inventory by reviewing the inventory lists and noting items that do not turnover regularly Defensive-Interval Ratio Neither the current ratio nor the acid-test ratio gives a complete explanation of the current debtpaying ability of the company. The matching of current assets with current liabilities assumes that the current assets will be employed to pay off the current liabilities. Some analysts argue that a better measure of liquidity is provided by the defensive-interval ratio, which measures the time span a firm can operate on present liquid assets without resorting to revenues from next year s sources. This ratio is computed by dividing defensive assets (cash, marketable securities and net receivables) by the average monthly expenditures from operations. Monthly expenditures are computed by dividing cost of goods sold plus operating expenses by 12 months. Calculation: Cash + Marketable Securities + Accounts Receivable Average Monthly Costs and Expenses Defensive- Interval Ratio Days The next set of ratios is known as Activity Ratios and is included in with the Liquidity because they determine when these assets are to be converted into cash. In order to know the rational why certain accounts on the balance sheet are matched with certain accounts on Income Statement, the following chart may prove helpful. I recall when studying accounting in college, one of my college professor stated that the Income Statement causes items on the Balance Sheet to appear. I did not quite grasp the concept back then but I certainly understand it now because, what ever happens during the operations of a company will end up on the balance sheet as an asset, liability or in the equity section. Bankers Insight Group Page 14

15 Income Statement Balance Sheet Sales Accounts Receivable Cost of Goods Sold Inventory Accounts Payable Operating Expenses Income Tax Expense Accrued Expenses Income Tax Payable Dividend Declared Dividend Payable Accounts Receivable Turnover Rate Calculation: Net Sales Accounts Receivable It measures the liquidity of Accounts Receivable by calculating the number of times trade Accounts Receivable turn over during the year. The higher the turnover of Accounts Receivable, the shorter the time between sale and cash collection. For example, if Accounts Receivable turnover rate is 12 times this year versus 8 times last year, it means the company received 4 more payments from its customers this year than last year. Because this ratio is calculated using one day s Accounts Receivable as of the statement date, seasonal fluctuations are not taken into account. Accounts Receivable Turnover in Days Calculation: 365 days (or the number of days in a period being measured) Accounts Receivable Turnover Rate This figure expresses the average number of days that Accounts Receivable are outstanding. Generally, the higher the ratio (i.e., the greater number of days outstanding), the greater the probability of delinquencies in Accounts Receivable. Inventory Turnover Rate Calculation: Cost of Goods Sold Inventory It measures the liquidity of Inventory by calculating the number of times Inventory turns over during the year. The higher the turnover of Inventory, the shorter the time between the purchase Bankers Insight Group Page 15

16 of raw material need to produce finished goods for sale (for a manufacturer); or the purchase of completed goods for re-sale (for a wholesaler and retailer). Because this ratio is calculated using one day s Inventory as of the statement date, seasonal fluctuations are not taken into account. Inventory Turnover in Days Calculation: 365 days (or the number of days in a period being measured) Inventory Turnover Rate This figure expresses the average number of days it takes for cash used to purchase raw material or finished goods inventory to be sold to the end user. Generally, the higher the number of Inventory days outstanding, the more the need for cash to carry this inventory. Inventory to Net Working Capital Calculation: Inventory Working Capital This ratio measures the relationship between the least liquid of the current assets and the amount of free, or uncommitted, current assets of an entity. If the ratio of inventory to working is less that 1 (say.75 or 75%) it means the remaining 25% of net working capital is made up of highly liquid assets that would be able to supply additional cash needs beyond the current liabilities. The generally accepted standard for this ratio is between 75 to 100 percent, since it is usually desirable for current assets minus inventory to at least equal current liabilities. The standard, however, depends upon specific situation. Accounts Payable Turnover Rate Calculation: Cost of Goods Sold Accounts Payable It measures how often Accounts Payable are paid by calculating the number of times trade Accounts Payable turn over during the year. The higher the turnover of Accounts Payable, the shorter the time of payment between the purchase of goods and the payment for those goods. For example, if Accounts Payable turnover rate is 12 times this year versus 8 times last year, it means the company issued 4 more payments to its suppliers this year than last year. Because this ratio is calculated using one day s Accounts Payable as of the statement date, seasonal fluctuations are not taken into account. Bankers Insight Group Page 16

17 Accounts Payable Turnover in Days Calculation: 365 days (or the number of days in a period being measured) Accounts Payable Turnover Rate This figure expresses the average number of days that Accounts Payable are outstanding. Generally, the higher the ratio (i.e., the greater number of days outstanding), the greater the probability of the company being delinquent with its suppliers and other creditors A/R Turnover Rate A/R Turnover Days Inventory Turnover Rate Inventory Turnover Days Accounts Payable Turnover Rate Accounts Payable Turnover Days Inventory to Working Capital Net Working Investment Analysis When the Accounts Receivable, Inventory and Accounts Payable turnover ratios are calculated, the results can be used to calculate the Net Working Investment ( NWI ) for the entity. Before the NWI can be defined, a definition of the Operating Cycle must be established. The Operating Cycle is defined as the time it takes for an entity to utilize its available cash to purchase raw material; convert it to finish goods inventory and eventually sell it (for a manufacturer): or purchase finished goods inventory and sell it to the end user (for a wholesaler and retailer): or fund upfront expenses in order to provide a service (for service companies). Therefore, the Operating Cycle can be calculated as follows: Inventory Days (116 Days) 2,205,935 A/R Days ( 49 Days) 1,280,430 Operating Cycle (165 Days) 3,486,365 Bankers Insight Group Page 17

18 Part of the Operating Cycle is carried by an entities Suppliers. Since Suppliers provide their customers time to pay their invoices (usually 30 days); they are providing a source of funding a portion of the Operating Cycle because they are not demanding payment when the goods and services are provided. When we consider the Accounts Payable turnover by subtracting it from the Operating Cycle, the end result is Net Working Investment. This is displayed as follows: Inventory Days (116 Days) 2,205,935 A/R Days ( 49 Days) 1,280,430 Operating Cycle (165 Days) 3,486,365 Less: A/P Days ( 27 Days) ( 506,961) Net Working Invest. (138 Days) 2,979,404 Is this the amount the bank should make available under a Line of Credit? The answer is yes and no Yes, If there are no other sources of cash No, if the company has a positive Working Capital position and able to generate cash from their normal operations Just because the Gap is 138 days long does not mean the bank must provide all the funds to build the bridge across the gap. That bridge should be built utilizing available company resources in addition to the bank s funds. Net Working Investment ( GAP ) $ 2,979,404 Less: Excess Cash Flow (Profit Margin)* ($ 315,824),Financing Needs After Excess Cash Flow: $2,663,580 *(138/365 X $835,332) Prorated Cash From Operating Activities While Excess Cash Flow repay long-term debt, it is also available to cover cash needs resulting from a financing shortfall in a company s operating cycle. There is some daily excess cash flow spun off via profit margins and the completion of an operating cycle each day. Bankers Insight Group Page 18

19 Financing Needs After Excess Cash Flow: $ 2,663,580 Less: Existing Equity in Trading Assets*: ($2,554,929) Amount Required from Bank s Line of Credit $ 108,651 *While in theory, the cash from existing equity in trading assets is not available until the end of the operating cycle (when A/R is collected), the reality is that new and old operating cycles are started and completed nearly every day. Thus, there is some ongoing daily return of equity embedded in the trading assets. If the operating cycle turns every 138 days, then the equity in the operating cycle is released in the form of cash every 138 days on average. Putting It All Together: Inventory Days (116 Days) 2,205,935 A/R Days ( 49 Days) 1,280,430 Operating Cycle (168 Days) 3,486,365 Less: A/P Days ( 27 Days) (506,961) N W Investment (138 Days) 2,979,404 Less: Excess Cash Flow (315,824) Less: Equity in Trading Assets (2,554,929) Amount Required from Bank 108,651 We now see that the required amount of the Line of Credit is in the neighborhood of $110,000. With this information, we are able to finally compare what our customers requests in a Line of Credit with what we determine to be the true need. Having this knowledge should accomplish the following goals: Prevents loan officer from going to loan committed repeatedly to obtain the right amount needed. The risks of the Line becoming an Evergreen Line is substantially reduce if the customer managers the credit facility properly. Bankers Insight Group Page 19

20 FINANCIAL IMPACT ANALYSIS What is the financial impact on the cash flow of a company if Accounts Receivable, Inventory and Accounts Payable turnover measured in days speed up or slow down. There is a definite positive or negative impact that can be measured and will serve as justification for a need for additional cash or an explanation for an excess of cash being generated. The methods to determine the financial impact on these asset and liability accounts can be calculated as follows: Accounts Receivable Turnover Financial Impact Sales 9,545,000 = 1,178,395 Target Turnover Rate 8.1 Minus: Actual Accounts Receivable Balance - 1,280,430 = Positive or Negative Financial Impact (102,035) Inventory Turnover Financial Impact Cost of Sales 6,806,593 = 2,520,960 Target Turnover Rate 2.7 Minus: Actual Inventory Balance - 2,205,936 = Positive or Negative Financial Impact 315,024 Accounts Payable Turnover Financial Impact Cost of Sales 6,806,593 = 986,463 Target Turnover Rate 6.9 Minus: Actual Accounts Payable Balance - 506,961 = Positive or Negative Financial Impact =479,502 Bankers Insight Group Page 20

21 LEVERAGE Leverage refers to the proportion of funds invested in an entity by the creditors in the form of loans and the owners in the form of equity. Highly leverage firms (those with heavy debt in relation to net worth) are more vulnerable to business downturn than those with lower debt to worth positions. While leverage ratios help measure this vulnerability, it does greatly depend on the requirements of particular industry groups. Debt to Net Worth Calculation: Total Debt Tangible Net Worth This ratio indicates the extent to which the company s funds are contributed by creditors compared to the owners. It expresses the degree of protection provided by the owners for the creditors. A low ratio generally indicates greater long-term debt paying ability. A firm with a low debt/worth ratio usually has greater flexibility to borrow in the future. A highly leveraged company has a limited ability to absorb more debt. Debt to Total Assets Calculation: Total Debt Total Assets This ratio indicates the extent to which the assets of a company are supported by debt. It should always be below a 1 to 1 mark. The lower the ratio the less creditors have at risk in relations to the investment by owners. It is another way to view leverage by determining if creditors or owners are providing the majority support of the assets. Net Fixed Assets to Equity Calculation: Net Fixed Assets Tangible Net Worth This ratio is most useful for companies in which Fixed Assets represent a major portion of Total Assets. It measures the extent to which owners equity (capital) has been invested in plant and equipment (Fixed Assets). A lower ratio indicates a proportionately smaller investment in Fixed Assets in relation to Net Worth, and a better cushion for creditors in case of liquidation. Similarly, a higher ratio would indicate the opposite. The presence of substantial leased Fixed Assets, which are not shown on the balance sheet) may deceptively lower this ratio. Bankers Insight Group Page 21

22 Debt to Tangible Net Worth Debt to Total Assets Net Fixed Assets to TAN ASSET MANAGEMENT (EFFICIENCY) RATIOS Asset Management or Efficiency Ratios measures management s ability to utilize assets to generate revenue or create value (i.e. generate a profit). Asset Efficiency or Asset Turnover Ratio Calculation: Total Sales Total Assets This ratio measures management s ability to use its Total Assets to its best advantage. Since sales are the numerator, it measures the ability of Total Assets to generate sales. A lower ratio from earlier periods indicates that the existing assets owed at the time the ratio was calculated were not as efficient in generating sales as in the past. This ratio is useful when considering a loan request to increase operating and non operating assets. Net Fixed Assets Efficiency or Turnover Ratio Calculation: Total Sales Net Fixed Assets This ratio is most useful for companies in which Fixed Assets represent a major portion of Total Assets. It measures the extent to which Fixed Assets can generate revenue or sales. A falling ratio indicates the existing Net Fixed Assets are not as efficient in generating sales as they were in previous periods. It is most useful when considering a term loan request to acquire equipment or other Fixed Assets. I. Fixed Asset Usage Ratio Calculation: Accumulated Depreciation Gross Fixed Assets This ratio is useful in determining how much usage the Fixed Assets has experienced. It is most useful to lenders considering a request to finance new equipment. If the usage is less than 50%, further justification should be required for new or replacement Fixed Assets. Bankers Insight Group Page 22

23 Fixed Asset Life Ratio Calculation: Net Fixed Assets Depreciation Expense Similar to the ratio above, this ratio indicates how much life is left in the Fixed Assets by taking the Net Fixed Assets and dividing it by the current year s depreciation expense. This ratio should complement the above ratio. For example, if the Fixed Assets Usage Ratio indicates usage of 90%, you would not expect the Fixed Assets Life Ratio to show 8 years of life left Asset Turnover Ratio Net Fixed Asset Efficiency Ratio Fixed Asset Usage Ratio Net Fixed Asset Life Ratio 5.2 years 6.4 years 4.8 years Bankers Insight Group Page 23

24 OPERATING PERFORMANCE These ratios indicate management s ability to manage a company towards profitability. Gross Profit Margin Calculation: Gross Profit Net Sales This ratio expresses Gross Profit as a percentage of Net Sales. It measures how many dollars out of each dollar of sales remains to cover all operating expenses (those that are not directly related to the costs required to produce the good or service). The higher the margin, the more funds available to cover operating expenses. Operating Profit Margin Calculation: Operating Profit Net Sales This ratio expresses Operating Profit as a percentage of Net Sales. It measures how many dollars or cents out of each dollar of sales remains to cover other non-operating expenses including: Interest, Extra-Ordinary Expenses, Taxes, etc. The higher the margin, the more funds available to cover these items. Net Profit Margin Calculation: Net Profit Net Sales This ratio expresses Net Profit as a percentage of Net Sales. It measures how many dollars or cents out of each dollar of sales remains as profit. The higher the margin, the more profitable the company Gross Profit Margin 22.8% 25.8% 28.7% Operating Profit Margin 6.1% 6.0% 9.4% Net Profit Margin 1.9% 2.6% 5.2% Bankers Insight Group Page 24

25 Return on Stockholders Equity Calculation: Net Income Stockholder s Equity This ratio expresses the profitability of the company s operations to owner after income taxes. It can be compared to alternative investments available to the owners. Return on Investment (Assets) Calculation: Net Income Total Assets This ratio measures the effective utilization of the assets of the company in generating profits or creating value Return on Equity 8.3% 9.8% 20.5% Return on Assets 3.4% 4.7% 10.6% Bankers Insight Group Page 25

26 Dupont Analysis An ROE Perspective on Ratio Analysis The ROE (return on equity) ratio can be used as an effective map for ratio analysis, although it is more usually thought of as a measure of overall performance The basic ROE equation is: ROE = Net Profit Net Worth This ROE equation is actually the product of three component ratios that summarize the logic in a company financial statement: Total Assets X Net Profit X Sales = Net Profit Net Worth Sales Total Assets Net Worth Or in words: Asset Leverage Return on Sales Asset Turnover = Return on Equity (ALEV) X (ROS) X (ATO) (ROE) We can use the equation to direct the analysis of the company s overall performance (ROE) through the components of profitability (ROS), efficiency in asset turnover (ATO) and capital structure (ALEV). Using ROE can be a powerful tool to identify which area of the company s performance requires further analysis. It can also link back to a basic structure of credit analysis: Business Risk Performance Financial Risk Asset Management Profitability Liability Management ATO ROS ALEV ROE Bankers Insight Group Page 26

27 COVERAGE RATIOS Financial Ratios measure the ability of a borrower to meet its financing obligations including Interest Expense, Principal Payments on Long-Term Debt and other fixed charges such as Lease Payments. Interest Coverage Ratio Calculation: Earning (profit) before Interest, Taxes, Depreciation & Amortization Annual Interest Expense This ratio is a measure of a firm s ability to meet interest payments. It measures the number of times all interest paid by the company is covered by earnings before interest charges and taxes. A high ratio may indicate that a borrower would have little difficulty in meeting the interest obligations of a loan. This ratio also serves as an indicator of a firm s capacity to take on additional debt = 8.3 Times Cash Flow / Debt Coverage Ratio UCA Tradition Calculation: Net Profit Plus: Non-Cash Charges Change in Accounts Receivable Change in Inventory Change in Accounts Payable (532) + Change in Accrued Expenses ( 49) = Cash After Operating Cycle Minus: Dividends Declared (243) + Change in Net Worth 0 = Cash After Financing Cost 341 Less: Current Portion of Long-Term Debt (134) (134) = Cash Available for Other Debt Change in Gross Fixed Assets (219) (219) = Financing Surplus (Requirement) ( 12) 343 The Cash Flow calculation shown above is more comprehensive than the traditional formula of Net Profit plus Depreciation because it considers changes in working capital requirements of companies which either generate or use cash. By using the above calculation, the analyst can see the impact upon cash at various target points as shown by the bold lines in the formula. The definitions of cash at each target point are as follows: Bankers Insight Group Page 27

28 Cash After Operating Cycle: This is the Cash remaining after considering the operating performance of the entity plus or minus the impact of the change in Net Working Investment (Accounts Receivable plus Inventory minus Accounts Payable plus Accrued Expenses. Cash After Financing Cost: This is the Cash remaining after considering the impact of any dividends paid and/or owners withdrawals from the company. Cash Available For Other Debt: This is the Cash available to meet future debt payments. It measures the company s ability to take on additional debt. It is measured before Fixed Assets increases or decreases because changes in Fixed Assets are generally at the discretion of management. Financing Surplus (Requirement): This is the Cash Surplus or Requirement the company experienced after considering the major items that impact cash. If a Financing Surplus resulted, the cash was used to pay down existing debt, pay dividends or reinvested in the form of Fixed Assets or Equity. If a Financing Requirement resulted, the company was required to utilized its own cash, borrow, or raise equity to meet all their obligations incurred during the previous year. Bankers Insight Group Page 28

29 OTHER FINANCIAL RATIOS EARNINGS PER SHARE Net Income Minus Preferred Dividends Weighted Shares Outstanding PRICE EARNINGS RATIO Market Price of Stock Earnings Per Share PAYOUT RATIO Cash Dividends Net Income Less Preferred Dividends BOOK VALUE PER SHARE Common Stockholders Equity Outstanding Shares CASH FLOW PER SHARE Net Income + Noncash Adjustments Outstanding Shares Bankers Insight Group Page 29

30 DETERMINING CREDITWORTHINESS FOR REAL ESTATE LOANS Real Estate Loans are those in which the primary sources of repayment are from the sale, leasing or renting of the property to cover expenses and to service debt. If this fact does not exist, then loans that are secured by real estate as back-up collateral are loans where the primary sources of repayment are conversion of assets, cash flow or cash infusions from the personal assets of the principles and not the underlying real estate. The latter scenario are considered normal commercial loans and not real estate loans Underwriting real estate loans requires a different approach. The basic requirements are to determine the following: Capacity of Borrower Net Operating Income Debt Coverage Ratio (NOI / ADS) > 1.15 Value of Mortgage Property Overall Financial Strength of Borrower Hard Equity Invested into Property (Including unencumbered equity in properties) Secondary Sources of Repayment Additional Collateral or Credit Enhancements Bankers Insight Group Page 30

31 CALCULATING NET OPERATING INCOME AND DSCR Potential Gross Income (PGI) Less: Physical Vacancy Economic (Credit) Loss Effective Gross Income (EGI) Less: Operating Expenses Real Estate Taxes Hazard Insurance Repair/Maintenance (Buildings) Maintenance (Grounds) Depreciation Water/Sewer/Trash Electric (Common) Interest Expense Management Fees Leasing Commissions Reserves for Replacement Total Operating Expenses Net Operating Income (NOI) NOI ADS = > 1.25 times Bankers Insight Group Page 31

32 CREDIT COMMITTEE S ROLE IN CREDIT REVIEW Understand the Objectives of the Loan Committee o To grow the loan portfolio in a safe and sound manner o Place safety and soundness objectives over growth and profitability objectives o Understand they are not the ruler of the bank but play a vital role in its success o Nurture and develop loan officers into competent and responsible lenders o Establish portfolio limits Chairperson With the Right Temperament o Usually the Chief Credit Officer o Must have a keen awareness of the credit policy to enforce it without stifling growth of the loan portfolio o Understand the strengths and weaknesses of loan officers and avoid situations that may embarrass a sponsoring loan officer during a loan presentation o Fair in all dealings o Keenly aware of Hidden Agenda that may exist among the loan committee members, loan officers and others connected to the credit approval process Bankers Insight Group Page 32

33 25 Loan Discussion Bankers Insight Group, LLC 1/6/2011 Loan Committee Mix o Avoid Stacking the Deck with single minded individuals o Avoid creating a Group Think environment o Seek diversification by having members from or a background in: Lending (Commercial, Consumer & Real Estate) Credit Administration Loan Review (Non-Voting) Financial Management Auditing (Non-Voting) Marketing (Non-Voting) Enterprise Risk Manager Bankers Insight Group Page 33

34 Increasing emphasis on relationships 27 Loan Committee Member Matrix The Supporter The Pragmatist MIX The Clock Watcher The Stickler Bankers Insight Group, LLC 5/27/2012 Set Expectations of Loan Officers o Committee should provide clear expectations for Loan Officers to follow such as: Underwriting standards (Knowing the committee s and individual s Hot Buttons Loan Presentation Packages (What it should contain) Loan Presentation Style Common questions and factors that should always be addressed Presentation of exception loan approval to require written justification with demonstrated ability to track progress Timely Access to Relevant Information o Loan Process System should allow loan officers sufficient time to adequately prepare loan packages for presentation o In cases where an immediate decision must be made, a system should be in place to accommodate such requests Bankers Insight Group Page 34

35 o Loan Committee Packages should be submitted to all loan committee members in enough time for them to read and reasonably understand the loan requests o Each package should contain a Strength and Weakness matrix to show what s good and bad about each credit and a well written analysis of the credit o For each weakness, a mitigating factor should be provided, if any Communications, Questions & Expression o Members should be encouraged to raise questions, issues and openly discuss their feelings without fear of reprisal. In lending, Silence is not Golden o Members should avoid having hidden agenda or favorite lending personnel o Loan Committee is not Congress. Trading votes should never be a common practice in the loan committee o Patience should be a common virtue, which allows loan committee members sufficient time to gain a full understanding of the request o As a Loan Committee Member, you should have a firm understanding of three areas after each loan presentation: Who are we doing business with? Character, Capacity, Capital, Collateral, Conditions & Can We? How will the loan proceeds be used? Insure proper structure for best chance of being repaid How will they repay us? Always have a Primary and Secondary Source of Repayment o Walk Away Knowing LLAMOPCAFLO Minutes That Matter o Detailed notes should be taken by the Loan Secretary to indicate the depth of discussion held over the loan approval and reflect questions and concerns of the loan committee members Bankers Insight Group Page 35

36 o Secretary to the Loan Committee should not be a Loan Officer or anyone that is influenced by the Chairperson o Votes should be recorded with any dissenting votes duly noted and explained UTILIZE CREDIT RISK RATING TO IDENTIFY RISK IN THE LOAN PORTFOLIO Regulators expect community banks to have credit risk management systems that produce accurate and timely risk ratings. They consider accurate classification of credit among its top supervisory priorities Credit ratings are an approximation of the quality of the loan and the potential for complete repayment. They are based on the financial institution s underwriting standards. If a financial institution's underwriting standards are weak, then the Credit Ratings will not properly the risk in the loan portfolio. The standards act as signals that indicate the general quality of the individual loans and the loan portfolio. Before individual credit reviews can be performed, criteria for determining the quality of a loan must be established. The standards require that financial institutions: (1) Establish prudent underwriting standards that are clear and measurable (2) Establish loan documentation procedures (3) Establish review procedures for monitoring compliance with internal policies and regulations. There are five key control attributes that should be present for the grading system to be effective. They are as follows: 1. Definitions or attributes of each loan grade are stated clearly. 2. Loan officers and credit reviewers understand the definitions of the grades. 3. Loan grades are updated periodically. 4. Senior management reviews and approves loan grades and specific problem credits. 5. Loss credits deteriorate steadily through the grades and do not deteriorate suddenly from grade 2 to grade 9. Bankers Insight Group Page 36

37 Credit ratings are essential to other functions including: 1. Credit approval (who can approve) 2. Loan pricing 3. Credit administration 4. Allowance for loan & lease losses calculations EXPECTATIONS OF CREDIT RISK RATINGS System should be integrated into the bank s overall portfolio risk management Board should approve the credit risk rating system and assign accountability for the risk rating process All credit exposures should be rated Risk rating system should assign an adequate number of ratings Risk ratings must be accurate and timely Criteria for assigning each rating should be clear Rating should reflect the risks posed by borrower s expected performance and the transaction s structure The risk rating system should be dynamic and change when the risk changes The risk rating process should by independently validated in addition to regulatory examinations Banks should determine through back-testing whether the assumptions implicit in the rating definitions are valid, i.e. whether they accurately anticipate outcomes. If assumptions are not valid, rating definitions should be modified. The rating assigned should be well supported and documented in the credit file Examiners rate credit risk based on the borrower s expected performance, i.e., the likelihood that the borrower will be able to service its obligations in accordance with the terms. Remember, Payment performance is a future event Credit risk ratings are meant to measure risk rather than record history DEVELOPMENTS IN RISK RATING SYSTEMS Bankers Insight Group Page 37

38 Banks are developing more robust internal risk rating processes in order to increase the precision and effectiveness of credit risk measurement and management More and more banks are: 1. Expanding the number of rating they use, particularly for pass credits 2. Using two rating systems, one for risk of default and the other for expected loss 3. Linking risk rating systems to measurable outcomes for default and loss probabilities 4. Using credit rating models and other expert systems to assign rating and support internal analysis Most significant change has been the increase in the number of rating categories (grades) especially in the pass category The number of pass ratings a bank will find useful depends on the complexity of the portfolio and the objectives of the risk rating system Less complex community banks may find that a few pass ratings are sufficient to differentiate the risk among their pass rated credits: Rating for loans secured by liquid collateral A Watch category One or two other pass categories In addition to increasing the number of rating definitions, some banks have initiated Dual Rating Systems (DRS) DRS have emerged because a single rating may not support all of the functions that require credit risk ratings DRS typically assign a rating to the general creditworthiness of the obligor and a rating to each facility outstanding Facility rating considers the loss protection afforded by assigned collateral and other elements of the loan structure in addition to the obligor s creditworthiness Obligor ratings support deal structuring and administration, while facility ratings support ALLL and capital estimates Below is an example of a Dual Rating System proposed in the past (by the accounting industry). This system was not widely accepted by bankers but the concept has some validity Bankers Insight Group Page 38

39 Risk of Default Marginal Weak Default Probability of Loss No Risk of Loss Low Risk of Loss Moderate Risk of Loss High Risk of Loss The OCC and other regulatory authorities do not advocate any particular rating system rather; it expects all rating systems to address both the ability and willingness of the obligor to repay and support provided by structure and collateral. Such systems can assign a single or dual rating. RISK RATING AND THE MANAGAMENT INFORMATION SYSTEM A good MIS should enable the calculation of Volume of credits whose ratings changed more than one grade (double downgrades) Seasoning of ratings (time a credit holds grade) Velocity of rating changes Default and loss history by rating category Ratio of rating upgrades to rating downgrades Rating changes by line of business, officers & location Bankers Insight Group Page 39

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41 Special Mention (OAEM) Included in this category are loans that do not presently expose the bank to a sufficient degree of risk to warrant adverse classification but do possess credit deficiencies deserving the bank s close attention. Failure to correct deficiencies could result in greater credit risk in the future. Ordinarily, such borderline credits have characteristics which corrective action by the bank would remedy. Often in credit lines warranting Special Mention, it is the bank s weak origination and/or servicing policies that constitute the cause for criticism. The nature of this category of loan criticism precludes inclusion of smaller lines of credit unless those loans were part of a large grouping listed for related reasons. Substandard Assets A substandard asset is inadequately protected by the current sound worth and paying capacity of the debtor or of the collateral pledged, if any. Assets classified Substandard must have a welldefined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected. Doubtful Assets An asset classified Doubtful has all the weaknesses inherent in one classified Substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. Loss Assets Assets classified Loss are considered un-collectible and of such little value that their continuance as bankable assets is not warranted. This classification does not mean that the asset has absolutely no recovery or salvage value, but rather that it is not practical or desirable to defer writing off this basically worthless asset, even though partial recovery may be affected in the future. Bankers Insight Group Page 41

42 Troubled Commercial Real Estate Loan Classification Guidelines Additional classification guidelines have been developed to aid the examiner in classifying troubled commercial real estate loans. These guidelines are intended to supplement the uniform guidelines discussed above. After performing an analysis of the project and its appraisal, the examiner must determine the classification of any exposure. The following guidelines are to be applied in instances where the obligor is devoid of other reliable means of repayment, with support of the debt provided solely by the project. If other types of collateral or other sources of repayment exist, the project should be evaluated in light of these mitigating factors. Substandard - Any such troubled real estate loan or portion thereof should be classified Substandard when well defined weaknesses are present which jeopardize the orderly liquidation of the debt. Well defined weaknesses include a project's lack of marketability, inadequate cash flow or collateral support, failure to complete construction on time or the project's failure to fulfill economic expectations. They are characterized by the distinct possibility that the bank will sustain some loss if the deficiencies are not corrected. Doubtful - Doubtful classifications have all the weaknesses inherent in those classified Substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently known facts, conditions and values, highly questionable and improbable. A Doubtful classification may be appropriate in cases where significant risk exposures are perceived, but Loss cannot be determined because of specific reasonable pending factors which may strengthen the credit in the near term. Examiners should attempt to identify Loss in the credit where possible thereby limiting the excessive use of the Doubtful classification. Loss - Advances in excess of calculated current fair value which are considered uncollectible and do not warrant continuance as bankable assets. There is little or no prospect for near term improvement and no realistic strengthening action of significance pending. Technical Exceptions Technical deficiencies in documentation of loans will be brought to the attention of the bank for remedial action. Failure of the bank to effect corrections may lead to the development of greater credit risk in the future. Moreover, the presence of an excessive number of technical exceptions is a reflection on the bank s quality and ability. During the course of the examination, the bank will be given a listing of loans that possess technical deficiencies. Such a procedure is intended to expedite early correction, of the deficiencies and, in normal circumstances, inclusion of such exceptions in the report will be unnecessary. However, when spot checks reveal an excessive volume of deficiencies in loans under the cut-off point, regulatory agencies will insert the applicable technical exceptions page in the report of examination. Such a procedure adds emphasis to the importance of the documentation and provides support for the regulatory Bankers Insight Group Page 42