GE20803 DEPOSIT & FINANCING OPERATION OF ISLAMIC BANKING FINANCING EVALUATION TECHNIQUE Updated version 24th November 2015 BY DR. HANUDIN AMIN LABUAN FACULTY OF INTERNATIONAL FINANCE UNIVERSITI MALAYSIA SABAH
PREAMBLE Appropriate analytical tool is important in credit assessment to determine a correct credit decision Two important techniques are commonly used: The qualitative method The quantitative method
5C OF CREDIT Condition Character Collateral Capacity Capital
WHAT, WHY, HOW, EXAMPLE CHARACTER? Questions asked: Character means the moral or ethical quality of a person Moral factor/human factor Also means the probability that customers will honor their obligation Borrower s reputation Willingness to pay How long you have lived at current address? How long you have been in your current job? Have you used credit before? What Why Real Activities How CHARACTER Ethical Example Governance Banks consider for people with excellent character to extend loans to them Individuals with ideal character are the most likely to repay the loan Every credit transaction implies a promise to pay
As an experienced credit officer of ABC Bank, you are assigned to evaluate the character of each loan applicant. What is your evaluation on Simon and Richard? How do you make the evaluation Points to consider Historical credit records Character reference by a 3rd party etc
WHAT, WHY, HOW, EXAMPLE CAPACITY? The ability to pay Capacity means the ability of the borrowers to generate the necessary cash flows to repay the borrowings Person s ability to pay debt when it is due What Real Activities CAPACITY Why Ethical The credit officer should evaluate borrower capacity from the aspects of law and finance The credit officer should determine if borrower has the legal capacity to borrow The credit officer should determine if borrower has capacity to repay loan Questions asked: Do you have legal capacity? Do you have income tax statements? How Example Governance
WHAT, WHY, HOW, EXAMPLE CAPITAL? Capital refers to your net worth the value of your assets minus liabilities What Why We need to know the financial worth of a prospective borrower through his net work because net worth symbolizes the success and commitment of the person Questions asked: How much your own minus how much you owe? Real Activities How CAPITAL Ethical Example Governance
WHAT, WHY, HOW, EXAMPLE COLLATERAL? Questions asked: Collateral refers to security in the event the borrower does not pay Collateral refers to any asset of a borrower that a lender has a right to take ownership of an use to pay the debt if the borrower is unable to make the loan payments as agreed Do you have collaterals to support your loan? What Why Real Activities How COLLATERAL Ethical Example Governance Ensure sufficient security in case of default To protect the interest of banks A secondary source of repayment of the loan Something of value an asset or property - that you pledge when getting a loan For example, when you buy a home, the home you purchase is often the only collateral available
WHAT, WHY, HOW, EXAMPLE CONDITION? When we evaluate a prospective borrower s capacity to borrow, we actually need to evaluate the economic conditions that may affect the borrower s capacity to repay the loan What Why The analysis on economic conditions is to forecast the exposure of the borrower s business to economic changes and interest rate changes Questions asked: Are you able to pay loan during the recession/economic downturn? What is your capacity to repay when the economic is expanding? Real Activities How CONDITION Ethical Example Governance For example, the economic recession that hit the country in mid 1997 as a result of the financial crisis in the region
LECTURETTE #1 TRUE/ FALSE QUESTION: 1. Character refers to the probability that customers will attempt to fulfil their obligations 2. Ability of the borrower to generate the necessary cash flows to repay the borrowings is referred as Capacity 3. Conditions deal with any external influences that can affect the ability of the borrowers to honor their obligations to the lenders 4. Collateral is intended to provide lenders with more comfort when providing loan to borrower 5. Capital is the value of your assets minus your liabilities. How much you own (for example, car, real estate, cash and investment) minus how much you owe
SOURCES OF CREDIT INFORMATION Loan applicant interview To collect information on the character and intention of the applicant Opportunity to evaluate applicant in terms of commitment and motivation Bank records Loan repayment records Current account and savings account balances Factual, it is deemed highly reliable Applicant s business premises Visit to the business premises of the applicant gives the opportunity to verify the existence of the company, the structure, the skillfulness and the details of the company s operating assets and fixed assets To prevent acute fraud Inter-bank references Confirmation from other banks regarding a loan applicant s credit standing is a common banking practice Credit Bureau In Oct. 2001, a borrower database known as Central Credit Record Information System (CCRIS) was set up by the Credit Bureau of Bank Negara Malaysia Enables Fis to acquire information on their prospective borrowers for the purpose of loan application evaluation Financial statements Include income statements, balance sheets and cash flow statements To make quantitative judgement on the applicants capacity to repay their loans More reliable than that obtained from unaudited financial statements
RATIO ANALYSIS The purpose of ratio analysis is to examine the financial performance and position of a company Credit officers of banks use ratio analysis to determine if the financial performance and position of a prospective borrower show sufficient loan repayment capacity As such, credit officers use trend analysis to find out if the financial performance and position have improved or deteriorated or remained unchanged over a period of time Four groups of financial ratios used: Liquidity ratios Asset management ratios Financial leverage ratios Profitability ratios
RATIO ANALYSIS Ratio Formula Remark Current ratio Current asset/current liabilities Quick ratio (Current asset inventories)/ Current liabilities Average collection period (Account receivable/annual credit sales ) x 365 days A current ratio of 2 is sufficient which implies that every RM1 of current liabilities are protected by RM 2 of current assets. A quick ratio of 1 is sufficient because every RM1 of liabilities is protected by RM1 of quick assets A shorter average collection period is intended. A very short collection period is not necessarily favorable rather it suggests a very restrictive credit and collection policy Inventory turnover Sales/Average inventory High ratio means inventors are quickly swiftly turned into sales suggests better inventory management Debt ratio Total debts/total assets Banks prefer customers with low debt ratio since the lower the debt ratio the lower the debt repayment risk
RATIO ANALYSIS Ratio Formula Remark Times interest earned Earnings before interest and taxes/interest payable on loans The higher the ratio, the better it is. No benchmark but the ratio should be at least 2 to give the firm sufficient buffer to pay the interest Gross profit margin Gross margin/sales A gross profit margin of 40% suggests that every $1 of sale costs the business $0.6 in terms of production expenditure and generate $0.4 profit before accounting for any non production costs Operating profit margin EBIT/Sales A high operating profit margin means that the company has good cost control and or that sales are increasing faster than costs Asset turnover Revenue/Total assets Comparing the fixed asset turnover ratio and the total asset turnover ration to determine if there is weakness in the fixed asset and current asset managements Fixed asset turnover Sales/Fixed assets Low ratio indicates that the management failed to utilize fixed assets productively to generate sales ROA ROE After tax earnings/total assets After tax earnings/shareholder s equity The higher the ROA ratio, the higher the company s ability is to generate return by using its assets and vice versa How much profit a company generates with the money shareholders have invested
CREDIT SCORING CONSUMER LOAN APPLICATIONS Most lenders have used credit scoring to assess the loan applications they received from customers Advantages handle a large volume of credit applications quickly with minimal labor The basic theory of credit scoring is that lenders and statisticians can identify the financial, economic, and motivational factors that separate good loans from bad loans by observing large groups of people who borrowed in the past
PREDICTIVE FACTORS IN AN EXAMPLE OF A CREDIT SCORING MODEL AND THEIR POINT VALUES Factors for predicting credit quality 1. Customer s occupation or line of work Point value Professional or business executive 100 Skilled worker 80 Clerical worker 70 Student 50 Unskilled worker 40 Part-time employee 20 2. Housing status Owns home 60 Rents home or apartment 40 Lives with friend or relative 20 3. Credit rating Excellent 100 Average 50 No record 20 Poor 00
PREDICTIVE FACTORS IN AN EXAMPLE OF A CREDIT SCORING MODEL AND THEIR POINT VALUES Factors for predicting credit quality 4. Length of time in current job Point value More than 1 year 50 One year or less 20 5. Length of time at current address More than 1 year 20 One year or less 10 6. Telephone in home or apartment Yes 20 No 00 7. Number of dependents reported None 30 One 30 Two 40 Three 40 More than three 20
PREDICTIVE FACTORS IN AN EXAMPLE OF A CREDIT SCORING MODEL AND THEIR POINT VALUES Factors for predicting credit quality 8. Deposits accounts held Point value Both checking and savings 40 Savings account only 30 Checking account only 20 None 00
LECTURETTE #2 APPLYING 5C TO CURRENT PRACTICE Read the case below Pn Anis, the finance manager of Syarikat Mekar Bhd has submitted the company s loan application to you in your capacity as the loan manager of Bank Nikmat Bhd. She has enclosed the company s financial statements for year 2015 The main business activities of Syarikat Mekar is manufacturing furniture for domestic as well as overseas customers. On overage, the company exports 25% of its furniture products to European and ASEAN countries. Besides, the company sells home decoration supplies and various types of lawn mowers that represent 10% of the company s business activities
The main shareholder of the company is En. Mekar who is also the managing director of the company. He holds 55% of the company shares. Others are his wife 10% and child 5% The company has been incorporated 30 years by En. Mekar s father. The company was handled by En. Mekar after his father passed away 10 years ago. En. Mekar is a certified accountant and according to this staff are a hardworking person The company has not borrowed from your bank before but holds current account and fixed deposit account at your bank. You have been informed by Pn Anis that the company wishes to borrow from your bank because it is dissatisfied with the treatment and facility provided by its other bank which is indeed the closest rival of your bank. Pn. Anis has also advised that the purpose of the loan applied for is to increase the working capital of the company
Syarikat Mekar Bhd Balance Sheet as at 31 December 2015
Syarikat Mekar Bhd Income Statement as at 31 December 2015 You are required to make the credit decision on the loan application of Syarikat Mekar based on 5C credit analysis model
Proposed Analysis Character Evaluate the character of the company by making reference to the character of the owner The majority and managing director of the company 55% majority shareholding suggests that En. Mekar is committed and feels responsible for his business Capacity The company s capacity to repay loan, ratio analysis, cash flow statement and pro forma statement Ratio analysis for trend analysis is needed to understand the company capacity to repay debt
2015 2014 Average
Ratio Analysis Average collection period is 36.5 days, the management of account receivable has been consistent. The analysis is meaningful if the information on the CREDIT PERIOD is available Inventory Turnover Ratio appears to have deteriorated from the previous year Besides, the company s performance is worst than the industry average The company s fixed asset management is better than the industry average but has deteriorated from the previous year Based on Total Asset Turnover, it appears that the company s performance in total asset management is worst than the previous year s and the industry average. The deterioration in inventory management leads to the performance The company s ROA has declined, below industry average The company s ROE has improved and closed to the industry average, since ROE > ROA, the company managed to increase shareholders wealth through financial leverage Financial position the company s liquidity is worse than the position in the previous year. It is also below the industry average. This is evident from the current and quick ratio The Quick Ratio has deteriorated significantly due to the weakness in inventory management which has resulted in a large quantity of inventories being held by the company In terms of debt capacity, the company s capacity to pay loan interest has reduced as measured by the times interest earned (TIE) ratio The deterioration is attributed to the increased utilization of loans, as shown by the current ratio and the decline in income generating capacity. The financial risk of the company has increased as evidenced from the increase in debt ratio from 50% to 61%
Proposed Analysis Collateral Assets that can be used as collateral consist of current assets such as accounts receivable and inventories and fixed assets En. Mekar and other shareholders can also provide personal guarantee as collateral With all collateral available, compared with the amount of loan applied Conditions Capital It is needed to determine if the furniture business is seasonal business because the volatility in cash flow may affect the company s capacity to repay debts As furniture represents the main products of the company, it is important to focus on the factors that can affect the demand for these products analyze the effect of regional as well as global economic since some of the company s products are exported to European and Asean countries It is difficult to perform since we do not have any comparative figures, nevertheless we should investigate if the capital of the company has increased because that will provide an indication on the financial performance of the company We should review company s working capital position from year to year By making reference to the deterioration in the current ratio and quick ratio, the capital position is expected to have deteriorated too
Proposed Analysis From the above analysis, it appears that we are unable to approve the loan application based on5c credit analysis model Why The company s capacity to repay the loan looks very doubtful, deteriorated liquidity, deteriorated profitability and growing financial risk ARE the negative indicators of the company s capacity to repay its debts
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