Corporate and Business Lending: Setting the Standards

By Kenny Tay

If youre seeking a practical approach to building a safe and profitable business loan portfolio, you already know its easy to get overwhelmed.
The environment doesnt make the task easier: Economies continue to undergo structural adjustments, and markets are getting increasingly competitive and volatile.
Kenny Tay, a veteran merchant banker and licensed securities dealer, provides a framework that allows new entrants into the corporate lending world succeed. Drawing on his decades of experience, he delivers lessons so you or your lending team can:
understand the financing structure of a typical business corporation;
determine the rationale for borrowing and lending;
assess a companys credit risk profile;
and evaluate loans until they are fully repaid.
Many unforeseen events can happen along the way that can turn a good loan into a bad one, which is why you need to fully understand the process. Make a complete commitment to building a business loan portfolio that will stand the test of time with Corporate and Business Lending.

• Language: English
• Publisher: Partridge Publishing Singapore
• Release date: Feb 19, 2016
• ISBN: 9781482853384

Kenny Tay

Kenny Tay began his merchant banking career with an affiliate of JP Morgan, the US -based investment banking group, followed by various executive appointments at the Dow Banking Group, Royal Trust Company of Canada, and UOB Australia Limited, a subsidiary of the United Overseas Bank Singapore. He is a Fellow of the Association of Chartered Certified Accountants, United Kingdom and holds a certificate in Company Law from Macquarie University, Sydney, Australia. He was also at one time a securities dealer licensed by the Victoria Securities Commission, State of Victoria. Currently he is the Chief Executive of the Australia New Zealand Institute, a work – based skills development organization providing learning and training using global electronic networks to develop human capital.

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Copyright © 2016 by Kenny Tay.

All rights reserved. No part of this book may be used or reproduced by any means, graphic, electronic, or mechanical, including photocopying, recording, taping or by any information storage retrieval system without the written permission of the author except in the case of brief quotations embodied in critical articles and reviews.

Because of the dynamic nature of the Internet, any web addresses or links contained in this book may have changed since publication and may no longer be valid. The views expressed in this work are solely those of the author and do not necessarily reflect the views of the publisher, and the publisher hereby disclaims any responsibility for them.

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Contents

Appreciation

Foreword

Introduction

Chapter 1   Business Financing And Financing Structure

Chapter 2   Loan Repayment And The Lending Rationale

Chapter 3   Credit Risk Assessment

Chapter 4   Financing The Requirements Of The Business

Chapter 5   Financial Assessment For Credit Decisions – Historical Analysis

Chapter 6   Financial Assessment For Credit Decisions – Review Of The Financial Forecasts

Chapter 7   Lending Products And Loan Structuring

Chapter 8   Loan Structuring – Business Lending

Chapter 9   Legal Documentation – The Loan Agreement

Chapter 10   Legal Documentation – Securities And Documentation

Chapter 11   Loan Monitoring – Review Of Loan Account

Chapter 12   Loan Monitoring – Recognising Warning Signals

Chapter 13   Causes Of Bad Loans And Preventative Measures

Chapter 14   Rehabilitation Of Bad Loans And Business Recovery

Chapter 15   Basel Iii And Credit Risk Implication

Final Conclusion

APPRECIATION

This book has come about only after much encouragement of my friends and my participants in various training sessions I have facilitated, as well as colleagues in the banking and financial services sector. All of them have been my source of inspiration. Without them this book would not have been here. I am sincerely indebted to them and I thank them all.

Next, I pay tribute to my wife Esther and our children, May and Calvin, who have had to put up with me and my habits during the time I was immersed in writing this book. Without their tolerance and patience with me, this book would remain incomplete. I appreciate and thank them sincerely.

To those who feel that I could have written and discussed the issues better, I welcome your comments and will incorporate them in the next revision of the book, which will undoubtedly take place. To them, I extend my thanks in advance.

FOREWORD

Kenny Tay combines his extensive teaching and practical experience, with his credit made simple approach in this easy to read book. The book covers the end to end process of what you must know in corporate lending both from lenders and borrowers perspectives. The book details the steps supported by sound analysis of the theories and hypothesis. The book explains very well each of the elements of corporate lending. It is a must read for everyone who has something to do with corporate lending."

Mr. Tay Kay Luan

Chief Executive

Asian Institute of Chartered Bankers

INTRODUCTION

This book is intended to be complementary to many others already written on this subject. Credit is a business discipline that requires numerate skills, creative thinking and critical analysis. A successful business lending manager is a person who possesses these attributes, some of them acquired over the years and with experiences in the field. Knowledge alone may not be enough without these skills. Lending is an art and has its creative element in every aspect of the business lending process, from risk analysis, to financial assessment, to loan structuring, to detecting and anticipation of warning signals.

The various chapters herein form a framework for the introduction of basic ideas on the lending process and sets the backdrop for future discussions on best banking practices. Hopefully, the content here can stimulate thinking and develop critical analyses using the ideas and issues discussed herein. Some ideas and issues are already well-known and well-discussed elsewhere, while others remain subjective and contentious.

At the very end, it is intended that this book would contribute to the understanding of business lending and to the lively debate of what would be better lending practices to minimise non-performing loans and the improvement of loan quality at the bank.

BUSINESS FINANCING AND FINANCING STRUCTURE

CHAPTER 1

1.   How a business finances its operations

1.1.   The business as a separate financial entity

A business is a commercial undertaking operating under a legal structure such as a limited liability company, or as an unincorporated partnership with a partnership agreement. The choice of operating the business through a limited liability company or otherwise is a decision to be made by the owners of the business. A limited liability company has been a popular choice because of the attraction of legal protection for the owners against unsettled liabilities. However, limited liability partnerships – LLP, are an alternative for that reason though with much less formality or regulatory requirements, and lower compliance expenses.

1.2.   Financing the company and its activities

The financing requirements of the newly set-up company should address the needs of the business it is engaging in. The following diagram shows the requirements and the funding plan:

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1.3.   Capital and business risk

1.3.1. Undertaking a business requires the assumption of commercial risk and for this purpose a company should be appropriately capitalised. Inadequate capital may be regarded as a weakness, while insufficient funds might handicap the company in its activities.

1.1.1. A larger or more risky business should have a larger capital base. If the capital base is disproportionately small, it raises the concern of the creditors and lending banks over the risk level they are asked to undertake against their expected returns from engaging with the company.

1.1.2. A company can choose to have more debt or more equity capital. The choice is the result of the capacity of the owners and investors, and access to the banks and credit availability. The choice is also influenced by the risk-return preference of the owners of the company. Debt financing is always cheaper and more convenient than introducing new capital into the company.

1.1.3. Eventually the company will have to decide whether it will have a low debt or high debt structure as illustrated here under Option B and Option A respectively.

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1.1.4. An on-going company may also evaluate its debt-equity structure from time to time to decide on optimising the returns from that structure, especially if interest rates on debt change.

1.1.   Role of financing

1.1.1. The main purpose of debt is to enable the company to undertake its business with sufficient funds. Debt may be required when equity capital contribution from the owners (or sponsors) of the company is not sufficient. Therefore, debt financing supplements the equity capital.

1.1.2. Debt may be raised as temporary financial support in anticipation of earnings from the business activities. If requirements are of a much longer term, or when debt costs are too high, debt may be less suitable. In such a situation any proposed business expansion may have to be deferred to a later time, or more equity capital should be brought into the business.

1.1.3. Business management sometimes prefers more debt-to-equity because of the tax-deductibility of interest expense, especially if returns are low. In addition, debt is always cheaper than equity because it is for a limited time, and once repaid, there will not be any further interest expense.

1.2.   Debt-equity decision and its drivers

1.2.1. The debt-equity decision is one of proportion. The choice of more equity or more debt depends on the circumstances at the time of requirement such as easy financing availability. This is also moderated by the philosophy of the top management.

1.2.2. Some management ideals prefer a lower debt and would rather delay any new business or expansion than to increase the level of borrowings. Others may prefer to achieve a higher return on investment for its shareholders within a shorter period of time. If the cost of debt is cheaper than the prospective returns from the business, it would be a reasonable argument for a higher level of debt.

1.2.3. The nature of the business and its risk condition also affect the debt-equity decision. A volatile business with uncertainties in revenue, thin cash-flow and high fixed costs would have to avoid a high level of debt in favour of more equity. For example, a construction business with uncertain projects in the future and unpredictable costs should avoid large debt financing.

1.2.4. In the same vein, the outlook of the economic environment in which the business is operating may also have an impact. An expected economic downturn may deter the idea of having more debt while a higher borrowing level may be deemed acceptable if the economy is heading towards an upward trend.

1.3.   Cost of capital and its impact

1.3.1. The cost of funds of a business is made up of cost of debt and cost of shareholders’ funds. The decision to borrow more or less is also driven by the cost of debt at the time of the debt-equity decision.

1.3.2. The cost of capital will be the general screening criterion for new investment projects and returns from existing business. Where the returns of a company are below the cost of capital, those businesses would be reviewed and potentially eliminated in favour of better yielding assets or projects.

1.3.3. Company managers use the cost of capital as the discount rate for discounting future cash-flows of business projects. A higher cost of capital would reduce the attractiveness of business proposals. Therefore, they are likely to seek to reduce the cost of capital, or look for projects and investments with higher rates of return.

1.4.   Summary and conclusion

A company and its business activities can be financed by either capital or borrowings and suppliers’ credit. While the choice rests with the management of the borrowing company, the willingness of the financial markets and trade creditors will also weigh in significantly in the final decision.

The risk reward condition will always be assessed by the shareholders, bankers and creditors from their respective standpoints. Each stakeholder has different expectations of the borrower.

LEARNING REVIEW 1

LOAN REPAYMENT AND THE LENDING RATIONALE

CHAPTER 2

2.   The purpose of lending – the lending bank’s perspective

2.1 Banks and financial institutions function as public trustees, holding funds of the public at large. As a result, they need to be diligent and prudent in their employment of depositors’ funds and other institutional monies. In the exercise of lending prudence, the lending bank would ascertain the use of the loan funds by the borrower and avoid possible misuse or for non-productive purposes.

2.1.1. As a cardinal rule, a loan is granted to the borrower to meet the stated purpose. It becomes a matter of bad faith if the loan is used for another purpose different from its declared intention. This might be deemed as a misuse of the loan. For this reason, lending banks stipulate requirements and procedures to ensure the money is used as declared by the borrower in the loan application.

2.1.2. Another related matter on the proper use of loan funds is the appropriate matching of the loan funds to ensure meeting the objective of the loan. The loan to a business may be requested for financing purchase of raw materials, stocks and payment of expenses before sales take place. This is a short-term requirement and it should be appropriately financed by short-term funds to avoid expensive and long-term interest costs.

2.1.3. A loan can also be for the acquisition of plant and machinery and other fixed assets. In this case, the loan should be a long-term loan to provide stability and provide enough time for the business to generate cash-flow for payment of the loan. This is referred to as the principle of tenor matching – providing the right funding to meet the requirements.

2.2. The next major consideration is the productive nature of the loan and its contribution to generating increased cash-flow. Sometimes, a loan may be requested for activities that do not benefit the business, but instead increases its burden through additional interest costs and loan repayments. Where the loan is intended for some activities that are not productive, the lending bank would reconsider that proposition.

2.2.1. Non-productive loans include loans for settlement of income tax due, purchase of land for future development and purchase of non-strategic investments unrelated to the company’s activities. New or additional cash-flows can seldom be identified and are, at best, uncertain. Therefore, these loans are considered as speculative lending.

2.2.2. A productive loan, as the term suggests, creates value in the form of revenue and cash-flow, and by extension, the means for loan repayment. The risk of lending a productive loan is therefore likely to be lower than to a speculative one. If the lending bank makes or accepts an unproductive loan, it must have very good reasons for doing so.

2.3.   The common purposes of commercial lending to a business include the following –

2.3.1.   Working capital financing

• Working capital funds are required for a business to conduct its daily operational activities. These activities comprise buying and paying for raw materials and component parts, or finished goods.

• The funds are also required for payment of monthly staff payroll, payment of utility bills and other services that the business needs.

• A minimum amount of working capital financing of a typical business is needed for regular business activities. This is referred to as the permanent working capital.

• When there is some additional business or unexpected delay in sales collections, extra working capital may then be required. This is then referred to as temporary working capital.

2.3.2.   Purchase of capital assets

• A manufacturing business may require expensive production equipment and extensive infrastructure such as factories, internal transport systems, machinery and warehousing complexes.

• These assets may require more funding than that made available by the shareholders as capital. The lending bank may then provide loans for this purpose of building infrastructure and the purchase of equipment.

• In specialised industries such as plantations, capital asset financing includes loans for purchase of land and planting of crops like oil palm and rubber, or the purchase of aircraft for the airline industry.

2.3.3.   Special transactions

• Specialised requirements may also occur from time to time in a business. The establishment of a new operating division or a new company to undertake a new business activity may be considered as a special event or transaction.

• Similarly, an acquisition of a significant stake in another company as a strategic investment is also viewed as a special transaction.

• Other situations of special transactions may involve the settlement of intercompany loan accounts, payment of back taxes and advance custom levies and pay-out under a guarantee that materialises as a liability.

• Some of these may no doubt be complex, and some lending banks may not want to finance transactions of this nature.

2.3.4.   Specific projects

• Specific projects are business activities that are independent in their character in terms of industry, customer base, or legal status. A petrochemical complex is such an example. An aquaculture project like an inland fish farm is another one.

• Sometimes the borrower or a sponsor of a project may want to keep a new business separate from existing business activities or it may have new partners. A specific project entity is then created to keep the relationship separate from the sponsor and be independently accountable.

2.3.5.   Unspecific lending

At times the lending bank may receive requests for financing in general terms such as ‘working capital’ with no further elaboration or details. The term ‘working capital’ has been overused or oversimplified. Unless more information and some clear details of purpose are given, lending for unspecified purpose is seldom of interest to a lending bank.

2.4.   Loan repayment and rationale of lending

2.4.1.   Sources of cash for loan repayment

• A prudent loan is made on the clear understanding of the repayment ability and the potential source of cash-flow for the repayment. The role of the bank is to provide a loan to bridge a temporary need of the borrower, subject to its discretion. If there is no clear source of cash-flow of an adequate amount, the loan risks a delay in repayment, or may even be subject to some potential loss if the borrower defaults.

• A business loan is expected to be repaid from its normal operations. A loan made to a business to improve or expand its sales and income generating ability is a productive loan. Such a productive loan would help a business increase its revenue and cash-flow, and therefore enhances its overall cash-flow to include funds for the repayment of the loan.

• Aside from the normal business activities as the main source of cash-flow for the company, there is the possibility of obtaining capital from its company shareholders, additional loans from the banks, or sale of some assets of the company. However, each of these sources is secondary and uncertain. Shareholders may have limited funds, banks may have credit risk thresholds and the market of assets may offer poor prices at the time of sale. Those sources of repayment are deemed more speculative in nature than the activities associated with normal business operations.

2.4.2. In principle, a proposed loan will not be approved if there is no clear source of cash- flow for loan repayment, regardless of the availability of security.

2.5.   Lending rationale

A loan is approved based on commercially sound reasoning, or rationale. The underlying focus in any event is the availability of cash for repayment of a loan granted. There are three sets of basic reasoning for granting a loan.

2.5.1.   Asset conversion lending

• The asset conversion lending is short-term lending to support temporary increases in the working capital needs of a business. An active business engages in purchase of materials, product manufacturing, sales and distribution and collection of sales proceeds. All these activities together form the asset conversion cycle of the business.

• There are times when the business has insufficient cash-flow due to unexpected delays in sales collection or due to a temporary rise in volume of materials and unsold inventories. At the same time, regular expenses and monthly commitments have to be paid on time.

• The asset conversion lending is meant to bridge the occasional intervals of cash shortage that may vary for up to a few months and for amounts relating to the volume of business. It is not meant for financing the acquisition of machinery and fixed assets for the business.

• The repayment of an asset conversion loan comes from the cash received upon collection of customers’ payments for sales made. This requires the completion of the asset conversion cycle on a timely basis by the borrower’s management. If the lending bank is not confident of the consistent completion of the asset conversion cycle, an asset conversion loan is not appropriate.

• The asset conversion cycle diagram below illustrates the flow of cash and phases of activities in a typical business environment. There are four phases in the asset conversion cycle through which initial cash is used and retained in the cycle until collection from customers takes place.

ILLUSTRATION A

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• It is crucial