Tag Archives | banking

Analyzing Your Return on Investment (ROI)

return on investmentReturn on Investment is a useful tool to understand, analyze, and compare different investment opportunities. ROI measures the efficiency of a specific investment by revealing how net earnings recover the cost of the original investment. Have you ever wondered if the result of your investment was really worth the cost? Well, a return on investment model looks at the inputs and assumptions of the ROI equation to determine if the benefits of the investment are worth the costs. Following are the ROI model tools you need to analyze ROI and improve ROI so that you can determine the value of your investment:

The first step is to identify and analyze overall benefits from the investment. For different financial situations, the percentage of returns may vary according to what the decision-makers consider to be gains or losses from the investment. As long as you are consistent with how you classify benefits of the investment, you should be able to effectively use your calculations for analysis and comparisons. Focus on benefits which are measurable and attainable. Tangible benefits can be measured and evaluated to improve ROI percentages.

If the benefits appear significant, the next step is to identify and analyze associated costs of the investment. Costs are simpler to identify than benefits. Make a list of costs and then breakdown the costs into groups to better categorize the origination of costs. This will enable you to understand where the majority of costs are coming from. Are there any costs that appear inflated? Can you easily reduce some costs? Are there costs that could be eliminated completely? These questions will help you analyze expenses of the investment. Keep in mind that the cost of an investment includes not only the start-up cost, but also the maintenance and improvement of the investment over time.

To improve the return on your investment, business managers and directors should develop comprehensive and realistic projections for both revenues and expenses. Effective planning will account for unexpected expenses and underperforming sales revenue. By analyzing projections, you should be able to develop strategies to reduce costs and increase sales.

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What Does A Lender Want To Know?

See Also:
Relationship with Your Lender
Finding the Right Lender
The Dilemma of Financing a Start-up Company
Every Business has a Funding Source, Few have a Lender
Required Rate of Return
Venture Capital

What Does A Lender Want To Know?

I had a conversation with a prospect that needed working capital funding. He asked, “What information does a lender need?” I hear this from every prospect I meet with. So, I gave my normal answer, “We will need personal and business financial statements, a completed application, detailed information on accounts receivable and inventory, and that is just the beginning.” After leaving the prospect, I realized not only did I not answer his question, but also I have never totally answered that question. I now know, the prospect is really asking me what information the lender is looking for so he can get the money.

When I answered this question in the past, I just gave a list of requirements and never explained why they were important to the lending decision process. This information is telling the company’s story to the lender. To start with, think of the financial statement you provide the lender as a score card. In the lender’s mind the more income you make the higher your score. As an example, the more runs a baseball team scores the more powerful the team is.

So after you tell the lender the score of your company, you should tell the lender about your company with the following information:

• How much money do you want to borrow? The lender needs this information to determine the potential to loan you money.

• Why do you want the money and how will it be used? Think of this one as if your child or family member asked to borrow money from you. I believe you would want to know what they were going to do with the money.

• What primary source will generate the funds to repay the loan? Some ways the lender might expect you to repay the loan are; selling a building, producing a product and selling the inventory, or increasing the profits of your business to generate cash flow.

• What is the secondary source of repayment? Amazingly, lenders want to be repaid as you would if you were loaning money. So they consider such things for their repayment as liquidating equipment or injecting additional capital from personal funds.

• How will the loan be secured (collateral)? The lender wants a security interest in whatever you are going to do with the money.

• Who will guarantee the loan? From the lender’s point of view, you must be 100% sure of your ability to repay the loan. And, you must be willing to put your personal assets on the line. Otherwise, they would be risking their job by making a potentially bad loan.

The better you tell your story the better your chances are of getting the money.

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What Is Dilution

See Also:
Financial Ratios
Accounts Receivable Turnover
How to collect accounts receivable
What is Factoring Receivables?
Working Capital

What is Dilution?

Dilution is any portion, regardless of why, of your receivables that you did not collect. This is important as the amount available from your line of credit with the bank is based on your outstanding accounts receivable balance. The bank wants to know the extent to which your receivables are likely to be turned into cash receipts. The greater the amount of dilution, the greater the risk to the bank and the less will be your available borrowing base.

The following are common causes of dilution and suggestions for remedying them.

Discounts

Discounts offered to customers for faster repayment can increase your dilution rate. If these discounts account for a significant amount of dilution, you may consider other methods of encouraging faster repayment.

Collection costs

The greater the fees directly paid to collect on your receivables, the less of your receivables balance you will realize. This is worth examining to see if it has a material impact on your dilution rate. You may consider less costly collection services.

Bad debt

Receivables not collected due to the default or other negligence of the customer. This can be reduced through the establishment of tighter credit policies, such as more thorough credit checks prior to extending trade credit to customers.

Offsets

Sometimes a customer may also be a vendor. In the course of paying an invoice it may seem attractive to you or them to net out the amount they owe you from the invoice’s total. You may want to end this practice depending on the amount of the dilution and its subsequent impact on your borrowing base availability.

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Mining the Balance Sheet for Working Capital

See Also:
Categories of Banks
Working Capital from Real Estate

Asset Based Lending Versus Commercial Bank Cash Flow Lending

Let’s face it; there has been significant liquidity in the marketplace over the past couple of years. Debt and equity capital has been relatively easy to find and commercial banks have been very willing participants as capital providers. However, many of the commercial banks have admitted that this robust marketplace is a prolonged cycle and not a permanent or semi-permanent marketplace shift. By definition as a cycle, what goes up must come down.

Already, many of the commercial banks are starting to whisper about declining portfolio quality and tighter credit standards. This has been attributed to issues regarding the sub prime mortgage market, rising energy costs, and other economic factors. These issues have resulted in some companies experiencing a weaker balance sheet and a decline in cash flow results.

As banks start to tighten their credit standards, many companies may find they have less access or no access to working capital from commercial banks. Banks may elect not to renew certain loans that come due. Also, companies that have tripped a covenant or are in a technical default may find that their commercial bank is not as patient and has asked that the loan be refinanced.

So how can a company still access adequate working capital in a changing bank marketplace? One way is to mine the balance sheet assets through an asset based, working capital line of credit.

Asset based lending is more common than ever and has become for many companies a more aggressive way to grow their business. Asset based lenders look beyond a company’s cash flow and balance sheet ratios to leverage the business assets for working capital purposes. Asset based lenders also provide an ease of doing business and typically have less restrictive operating covenants than commercial banks.

Commercial banks typically underwrite and grant credit by emphasizing in the following order:

1) Balance sheet strength/Cash flow

2) Management/Guarantors

3) Collateral/Assets

Asset based lenders assume there is some fundamental weakness to #1 above (at least by commercial bank standards) and flips the above equation upside down. The result is asset based lenders typically underwrite or grant credit by emphasizing in the following order:

1) Collateral/Assets

2) Management/Guarantors

3) Balance sheet strength/Cash flow

By emphasizing the value of a company’s assets as security and collateral for a working capital line of credit, an asset based lender has greater patience and tolerance for the bumps in the road and inconsistencies in the marketplace that many companies will face on a regular basis. Asset based lenders typically will provide a revolving line of credit against accounts receivables and inventory as collateral. Many asset based lenders will also provide term loans against equipment and possibly real estate.

Obviously, asset based lending is not the answer for every company’s need for working capital since not all companies generate these types of assets. Companies selling at retail or on cash terms don’t typically generate commercial accounts receivable which is the asset that most asset based lenders leverage as the base for a loan. However, if a company is involved in manufacturing, distribution and many of the service industries, chances are they would generate the types of assets favored by asset based lenders.

The benefit of this type of lending is that the loan availability can grow as a company’s assets grow and, therefore, is not as restrictive as traditional commercial bank cash flow lending; especially in rapid growth situations. Since asset based lenders rely primarily on the company’s collateral versus its cash flow results, they are able to embrace greater credit risk and accept inconsistent cash flow results versus commercial banks.

So as the marketplace changes and as commercial banks start to tighten up, remember that accessing adequate working capital may be as simple as mining the balance sheet through asset based lending.

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5 C’s of Credit (5 C’s of Banking)

See Also:
What are the 7 Cs of banking
How to Manage Your Banking Relationship
Line of Credit
Trade Credit
Collateralized Debt Obligations

Five C’s of Credit (5 C’s of Banking)

Cash Flow
Collateral
Capital
Character
Conditions

The “5 C’s of credit” or “5C’s of banking” are a common reference to the major elements of a banker’s analysis when considering a request for a loan. Namely, these are Cash Flow, Collateral, Capital, Character and Conditions. This article will provide an in-depth description of each of the 5 C’s of credit or banking to help you understand what your banker needs to understand about your business in order to approve your loan. By the end of this article, you will have insight as to where your banker is coming from, and therefore better prepare you to handle their questions and concerns.

Cash Flow Importance

Cash Flow After Tax is the first “C” of the 5 C’s of Credit (5 C’s of Banking). Your banker needs to be certain that your business generates enough cash flow to repay the loan that you are requesting. In order to determine this the banker will be looking at your company’s historical and projected cash flow and compare that to the company’s projected debt service requirements. There are a variety of credit analysis metrics used by bankers to evaluate this, but a commonly used methodology is the “Debt Service Coverage Ratio” generally defined as follows:

Debt Service Coverage Ratio = EBITDA – income taxes – unfinanced capital expenditures divided by Projected principal and interest payments over the next 12 months

Typically the bank will look at the company’s historical ability to service the debt. This means the banker will compare the company’s past 3 years free cash flow to projected debt service, as well as the past twelve months to the extent your company is well into its fiscal year. While projected cash flow is important as well, the banker will generally want to see that the company’s historical cash flow is sufficient to support the requested debt. Usually projected cash flow figures are higher than historical figures due to expected growth at the company, however your banker will view the projected cash flows with skepticism as they will generally entail some level of execution risk. To the extent that the historical cash flow is insufficient and the banker must rely on your projections, you must be prepared to defend your future cash flow projections with information that would give your banker visibility to future performance, such as backlog information.

The banker will also want to see a comfortable margin of error in the company’s cash flow. A typical minimum level of Debt Service Coverage is 1.2 times. This means that the company is expected to generate at least $1.20 of free cash flow for each dollar of debt service. This margin of error is important since the banker wants to be comfortable that if there is a blip in the company’s performance that the company will still be able to meet its obligations.

Importance of Collateral

In most cases, the bank wants the loan amount to be exceeded by the amount of the company’s collateral. The reason the bank is interested in collateral is as a secondary source of repayment of the loan. If the company is unable to generate sufficient cash flow to repay the loan at some point in the future, the bank wants to be comfortable that it will be able to recover its loan by liquidating the collateral and using the proceeds to pay off the loan.

How does the banker assess your company’s available collateral? It is common place for borrowers to think that the bank will lend a dollar for every asset that their company owns. This is not the case.

First, the banker is interested in only certain asset classes as collateral – specifically accounts receivable, inventory, equipment and real estate – since in a liquidation scenario, these asset classes can be collected or sold to generate funds to repay the loan. Other asset classes such as goodwill, prepaid amounts, investments, etc. will not be considered by the banker as collateral since in a liquidation scenario, they would not fetch any meaningful amounts. In the case of accounts receivable, the debtor (your company’s customer to whom a good was sold or service rendered) is legally required to pay their bill with the company, and in a liquidation scenario the bank will collect the accounts receivable and use those amounts to pay down the loan. In the case of inventory, equipment and real estate, the bank can sell these assets to someone else and use the proceeds to pay down the loan.

Secondly, the bank will discount or “margin” the value of the collateral based on historical liquidation values. For example, bank’s will generally apply margin rates of 80% against accounts receivable, 50% against inventory, 80% against equipment and 75% against real estate. These advance rates are not arbitrary. These are the amounts that in the bank’s historical experience they have realized in a liquidation scenario against the respective asset class. While you might think that your accounts receivable would collect 100% on the dollar, in actuality the amounts have been historically closer to 80% because in liquidation scenarios, account debtors will come up with reasons why they don’t owe the entire amount, or, worse, they won’t pay at all and force the bank to sue them for collection. In some cases, the amount of the receivable would be exceeded by the legal costs of collection, and thus the bank simply won’t pursue collection. In the case of inventory, 50 cents on the dollar is usual since the buyers of this inventory know that it is a distressed sale and are in a position of leverage to buy the goods for less than what it cost you to buy them.

In the case of equipment and real estate collateral the bank will need to have a third party appraisal completed on these assets. The bank will margin the appraised value of these asset classes to determine the amount of the loan, as opposed to using the company’s carrying value of these assets on its balance sheet. Keep in mind that you will be responsible for the cost of third party appraisals, and be sure to factor in the time needed to complete the appraisals.

Also, the bank will in many cases want to complete due diligence on your accounts receivable and inventory to confirm asset values as well as the reliability of the reports you provide to the bank. This due diligence is called a “collateral exam” or “field audit”, and involves the bank sending an auditor to the company’s offices to review books and records to (1) ensure that the company-generated reports for accounts receivable (your accounts receivable aging) and inventory are accurate and reliable, and (2) to determine and confirm the amounts of any “ineligibles” within these asset classes. In general, ineligibles are amounts that the bank will not lend against. For example accounts receivable over 90 days past due, accounts that are due from foreign counter-parties, and accounts that are due from counter-parties that are related by common ownership to your company. In the case of inventory, ineligibles will generally include any work-in-process inventory, any consignment inventory, and inventory that is in-transit or otherwise not on your company’s premises.

Importance of Capital to Banks

When it comes to capital, the bank is essentially looking for the owner of the company to have sufficient equity in the company. Capital is important to the bank for two reasons. First, having sufficient equity in the company provides a cushion to withstand a blip in the company’s ability to generate cash flow. For example, if the company were to become unprofitable for any reason, it would begin to burn through cash to fund operations. The bank is never interested in lending money to fund a company’s losses, so they want to be sure that there is enough equity in the company to weather a storm and to rehabilitate itself. Without sufficient capital, the company could run out of cash and be forced to file for bankruptcy protection.

Secondly, when it comes to capital, the bank is looking for the owner to have sufficient “skin in the game”. The bank wants the owner to be sufficiently invested in the company such that if things were to go wrong, the owner would be motivated to stick by the company and work with the bank during a turnaround. If the owner were to simply hand over the keys to the business, it would clearly leave the bank fewer (and less viable) options on how to obtain repayment of the loan.

There is no precise measure or amount of “enough capital”, but rather it is specific to the situation and the owner’s financial profile. Commonly, the bank will look at the owner’s investment in the company relative to their total net worth, and they will compare the amount of the loan to the amount of equity in the company – the company’s Debt to Equity Ratio. This is a measure of the company’s total liabilities to shareholder’s equity. Banks typically like to see Debt to Equity Ratios no higher than 2 to 3 times.

Conditions

Another key factor in the five C’s of credit is the overall environment that the company is operating in. The banker is going to assess the conditions surrounding your company and its industry to determine the key risks facing your company, and also, whether or not these risks are sufficiently mitigated. Even if the company’s historical financial performance is strong, the bank wants to be sure of the future viability of the company. The bank won’t make a loan to you today if it looks like the viability of your company is threatened by some unmitigated risk that is not sufficiently addressed. In this assessment, the banker is going to look to things such as the following:

The competitive landscape of your company – who is your competition? How do you differentiate yourself from the competition? How does the access to capital of your company compare to the competition and how are any risks posed by this mitigated? Are there technological risks posed by your competition? Are you in a commodity business? If so, what mitigates the risk of your customers going to your competition?

The nature of your customer relationships – are there any significant customer concentrations (do any of your customers represent more than 10% of the company’s revenues?) If so, how does the company protect these customer relationships? What is the company doing to diversify its revenue base? What is the longevity of customer relationships? Are any major customers subject to financial duress? Is the company sufficiently capitalized to withstand a sizable write-down if they can’t collect their receivable to a bankrupt customer?

Supply risks – is the company subject to supply disruptions from a key supplier? How is this risk mitigated? What is the nature of relationships with key suppliers?

Industry issues – are there any macro-economic or political factors affecting, or potentially affecting the company? Could the passage of pending legislation impair the industry or company’s economics? Are there any trends emerging among customers or suppliers that in the future will negatively impact operations?

The banker will need your help to identify and understand these key risks and mitigants, so be prepared to articulate what you see as the primary threats to your business, and how and why you are comfortable with the presence of these risks, and what you are doing to protect the company. The banker will need to understand the drivers of your business, which is equally as important to the banker as understanding the company’s financial profile.

Character

While we have left “Character” for last, it is by no means the least important of the 5 C’s of Credit or Banking. Arguably it is the most important. Character gets to the issue of people – are the owner and management of the company honorable people when it comes to meeting their obligations? Without scoring high marks for character, the banker will not approve your loan.

How does a banker assess character? After all, it is an intangible. It is partly fact-based and partly “gut feeling”. The fact-based assessment involves a review of credit reports on the company, and in the case of smaller companies, the personal credit report of the owner as well. The bank will also communicate with your current and former bankers to determine how you have handled your banking arrangements in the past. The bank may also communicate with your customers and vendors to assess how you have dealt with these business partners in the past. The soft side of character assessment will be determined by how you deal with the banker during the application process and their resultant “gut feeling”.

In the end, bankers want to deal only with people that they can trust to act in good faith at all times – in good times and in bad. Banks want to know that if things go wrong, that you will be there and do your best to ensure that the company honors its commitments to the bank. Even if the company’s financial profile is strong and the company has scored well in all of the other “Five C’s of Credit”, the banker will turn down the loan if the character test is failed. To be clear – it is not necessarily an issue if your company has gone through troubled times in the past. What is more important is how you dealt with the situation. Were you forthright and proactive with the bank in communicating problems? Or did you wait until a default situation was already in effect before reaching out to the bank? Were you cooperative with the bank while getting through the distressed period? The importance of character cannot be stressed enough.

Five C’s of Credit Management

To summarize, the 5 C’s of credit forms the basis of your banker’s analysis as they are considering your request for a loan. The banker needs to be sure that (1) your company generates enough CASH FLOW to service the requested debt, (2) there is sufficient COLLATERAL to cover the amount of the loan as a secondary source of repayment should the company fail, (3) there is enough CAPITAL in the company to weather a storm and to ensure the owner’s commitment to the company, (4) the CONDITIONS surrounding your business do not pose any significant unmitigated risks, and (5) the owners and management of the company are of sound CHARACTER, people that can be trusted to honor their commitments in good times and bad.

Hopefully this article has succeeded in helping you understand where your banker is coming from. With a better understanding of how your banker is going to view and assess your company’s creditworthiness, you will be better prepared to deliver information and position your company to obtain the loan that it needs to grow and thrive. You should use these 5 C’s as a credit managment tool to run your company.

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Company Debt: Pay Down or Borrow?

Many companies have been making a profit over the past few years. As a result, they have generated quite a bit of liquidity. With the banks calling on them offering tons of cash and low interest rates they are faced with the decision of either to pay down their company debt or borrow more?

Given the financial crisis of the past four years is now the time to increase leverage or reduce it? Warren Buffet has been quoted as having said that most companies borrow money in the good times and try to pay it back in the bad times when cash is tight. He says you should do the opposite. Borrow in the bad times when opportunities abound and pay back their company debt in the good times when cash flow is strong.

So given where the economy is do you borrow or pay back the your company debt has? Is the economy strong or weak? Are we nearing the top of the recovery or do we have many more years of improving financial performance?

I would say we are halfway to two thirds into the recovery depending on where you are in the country. If you are in Houston things are starting to get hot! So should you start paying down debt?

We are recomending to our clients to start paying down their short term lines of credit. Now is the time to start preparing for the next downturn. It may be years away but it is not to soon to make your company a fortress! We anticipate the economy lurching from growth to contraction for the foreseeable future.

So what about the banks? It is hard to walk away from cheap money. Our strategy is to borrow long term money against long term assets. Lock in to those interest rates for as long as possible. If you can get 5 to 10 year money against real estate do it!

Given the nature of the world economy, volatility and risk is the new paradigm. Reduce your company’s exposure to those risk and grow prudently!

 

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The 5 C’s of Banking

“The “5 C’s of credit” or “5C’s of banking” are a common reference to the major elements of a banker’s analysis when considering a request for a loan. Namely, these are Cash Flow, Collateral, Capital, Character and Conditions. This article will provide an in-depth description of each of the 5 C’s of credit or banking to help you understand what your banker needs to understand about your business in order to approve your loan. By the end of this article, you will have insight as to where your banker is coming from, and therefore better prepare you to handle their questions and concerns.

 

Cash Flow Importance

Cash Flow is the first “C” of the 5 C’s of Credit (5 C’s of Banking). Your banker needs to be certain that your business generates enough cash flow to repay the loan that you are requesting. In order to determine this the banker will be looking at your company’s historical and projected cash flow and compare that to the company’s projected debt service requirements. There are a variety of credit analysis metrics used by bankers to evaluate this, but a commonly used methodology is the “Debt Service Coverage Ratio” generally defined as follows…”

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