BFW3841

CREDIT ANALYSIS AND LENDING MANAGEMENT

Week 3, Semester 1, 2018

CREDIT BORROWERS
CREDIT PRODUCTS AND SERVICES

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Lecture 3 Objectives
1. Understanding the type of Borrowers
- the corporate sector
- small and micro business enterprises
- the consumer sector
2. Understanding
- commercial & industrial credit (business loan)
- small business credit
- micro finance
- agriculture credit
- consumer credit

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The Corporate Sector
1. Definition of a Corporation
‘Relating to a large corporation or group’
The Oxford Dictionaries
‘A legal entity that is separate and distinct from its owners.
Corporations enjoy most of the rights and responsibilities that an
individual possesses; the corporation has the right to enter into a
contract, loan and borrow money, sue and be sued, hire employees,
own assets and pay taxes’
Investopedia
2. A Corporation is a registered entity with shareholders with
limited liabilities.
- private limited companies
- public listed companies
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The Corporate Sector
3. Corporations are governed by;
- the company act
- memorandum and articles of association (MAA)
4. The MAA stipulates the objectives, powers, duties and
responsibilities of the board of directors. The MAA also
stipulates the authorised capital of the corporations.

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 Small Business Lending
 Small business lending is a specialized area of lending
 Small business lending is gaining increased theoretical
support
 Two main approaches:
 Relationship Management Approach;
 Credit Scoring Approach

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Overview of Small Business Lending
 What is a small business?
 Numerous definitions exist including:
o Less than 20 employees
o Independently owned and operated
o Closely controlled by owners/managers who also contribute most,
if not all, of the operating capital
o Has loans less than $500,000
o Generally has turnover less than $5,000,000

• Some characteristics of Small Business Lending

o SB Lending 1/3 size of Large Business
o SBs pay 1.6% higher rates on average to reflect higher default risk
and economies of scale

BFW3841 S1 2018
 The Small, Medium and Micro Enterprises
TWO DEFINITION OF MICRO, SMALL AND MEDIUM ENTERPRISE (Malaysia)
VOLUME OF SALES and NUMBER OF EMPLOYEES DEFINITION
SCALE OF
MANUFACTURING (RM) SERVICES and Others (RM)
ENTERPRISE

Micro Sales turnover of less than RM300,000 OR less Sales turnover of less than RM300,000
than 5 full-time employees OR less than 5 full-time employees

Small Sales turnover from RM300,000 to less than Sales turnover from RM300,000 to less
RM15 million OR full-time employees from 5 to than RM3 million OR full-time
less than 75 employees from 5 to less than 30
Medium Sales turnover from RM15 million to not Sales turnover from RM3 million to not
exceeding RM50 million OR full-time employees exceeding RM20 million OR full-time
from 75 to not exceeding 200 employees from 30 to not exceeding 75

 A business will be deemed as an SME if it meets either one of the two specified qualifying criteria,
namely sales turnover or full-time employees, whichever is low
Look for the lower
 Effective date of implementation 1 January 2014

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 Agricultural Credit
Any loan or other extension of credit that a bank provides
for agricultural or other related and rural use.

Most agricultural credit finances farmers, ranchers,

fishermen, aquaculturalists as they plant crops, raise
animals, breed fish, buy equipment, harvest, or do other
things necessary for operations but from which profits will
not be realized for quite sometime.

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 Consumer Loans
 What are consumer loans?
 Consumer loans are lending to individuals and families, sometimes
called household debts which would include personal loans
 This loan portfolio is the fastest growing segment around the globe.
In Australia alone total loans reached AUD2,684.5 billion and the
personal loan sector reached AUD1,643.7 billion in December,
2014 forming about 61.2% of the total lending.
Lending By Sectors In Australia
31/12/2014 (AUD billion)
223.0
8.3%
817.8
30.5%

61.2%

1,643.7

Source:RBA

Lending to Government Persoanl Loans Commercial Loans 9

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 National Australian Bank (NAB)
 NAB lends to 6 sectors and housing loans constitute about 71% of
the total lending of the bank followed by other term loans totaling
about 20% in 2014.
Lending By Sectors Nationa Australian Bank, 2014
( AUD Million)

11,729, 2.7%

88,233, 20.1%
10,521, 7,998, 1.8%
2.4%
16,434,
3.7%
312,039, 71.1%
8,436, 1.9%

Housing Other Term Lending Asset and Lease Financing Overdrafts Credit Card Other Lending

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 Understanding
Commercial & Industrial Loan
and
Business Lending

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 A Quote On A Banker
“A banker is a fellow
who lends his
umbrella when the
sun is shining and
wants it back the
minute it begins to
rain.”

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Commercial & Industrial Loan (Business Loan)
 What is Lending to Commercial and Industrial
Sector (CI)?
 Lending to CI can be defined as loans extended to any
registered business, entity or corporation other than
individuals

 The purpose of the loan is to provide funds to the

organization involved in the manufacture and trade of
goods, services both to consumers and businesses or
carry on the business of the entity or corporation in
accordance with the constitution (MAA).

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Forms of Corporates (Businesses)
 Forms of Businesses
 Sole proprietorship
o Business owned by one person
 Partnership ask for partnership agreement
o Business owned by two or more persons
 Corporation
o Private limited and Public companies
 Cooperatives

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Short-term versus Long-term Business Loans
Type of Loan Features
≤ 1 year

Short Term Asset Based (current assets)

Largest Class of Loans
> 1 year
Look to flow of future earnings to
repay
Long Term
Repayment structured to expected
free cash flow
Secured by fixed assets

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Short-term versus Long-term Business Loans
Short Term Loans
Self liquidating inventory loans
Working Capital Loans
Interim Construction Financing
Security Dealer Financing
Retailer and Equipment Financing
Long Term Loans
Term loans to support the purchase of
equipment, rolling stock and structures
Revolving Credit Financing
Project Loans
Loans to support acquisitions of other
business firms (Leveraged Buyout)

Asset-based loans (accounts

receivables, factoring, and inventory
financing)
Syndicated loans

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Types of Short-term Business Loans: Asset-based Loans
1. Self Liquidating Inventory Loans
 Normal business cycle
 To finance purchase of inventory and the loan is settled once the goods are
sold and payment received
 Asset-based loans include accounts receivable financing, factoring, self-
liquidating inventory loans.
Cash Inventories Finished Goods A/c Receivable Cash
(use inventory you currently have, give it to the bank, obtain funding to create new inventory, once the inventory are
sold, repay bank)

Just In Time (JIT) inventory management has reduced this need

2. Working Capital Loans
 Credit lasting for a few days to about a year
 For the purpose of purchasing raw materials
 Designed to cover seasonal peaks
(seasonal: e.g. gift factories start production to meet demand for specific season)
 Secured by accounts receivable or inventories
 A commitment fee is charged on unused amount 17
 Compensating deposit may be required (cannot be withdrawn until loan is
BFW3841 S1 2018

repaid)
Other Types of Short-Term Business Loans
3. Interim Construction Financing
 a form of ‘bridge’ financing to cover the costs of construction. Once construction
is completed the loan is paid-off with a longer-term mortgage, usually from
another non-bank lender who commits to the mortgage prior to the interim loan.
To bridge the gap between production and sales
Paid straight from purchaser’s bank to developers’ bank

4. Security Dealer Financing

 Dealers in securities need short term financing to purchase new securities and
carry their existing portfolios
 Related type of financing is also extended to investment bankers for new issues
 Need margin requirements
 Financing amount in the US is no more than half of the securities acquired
 Securities are pledged as collateral

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Other Types of Short-Term Business Loans
5. Retailer and Equipment Financing
• Financing purchases of automobiles, home appliances, furniture, business
equipment and other durables
• Dealers are financed on the receivables and the installment contracts signed by
the purchasers
• The financial institution buys these receivables from dealers at a certain rate
depending on the risk profile (selling invoice to the bank)
• Lenders could also finance the dealer’s whole inventory through floor planning –
whereby dealers can place orders with the manufacturer to ship goods for sale
• This kind of loans are for only about 90 days
• Periodic inspections are made to determine what goods are sold
• Proceeds of the sales will be send to the financier

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Other Types of Short-Term Business Loans
6. Asset-Based Financing
• Short term credit secured by shorter term assets of a firm
• The shorter term assets are expected to be rolled over as cash in the future
• Lenders commit funds against a specified percentage of accounts receivables
and inventories ( e.g. 70% of the assets)
• Payment is when the inventories are sold or the accounts receivables are
collected
• For most collateralized loans, the borrowing firm retains title to the assets
pledged.
• Sometimes the title is passed to the lender, which then assumes the risk that
some of those assets may not be converted into cash.
• Factoring occurs when the lender takes the responsibility of collecting the
accounts receivable of one of its business customers

• Difference from 1 and 2?

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Other Types of Short-Term Business Loans
7. Syndicated Loans
 “Package” of loans extended to a corporation by a group of banks.
 Allows banks to spread risks.
 Many traded in the secondary market.

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Types of Long-term Business Loans
1. Term Loans
 Longer term loans to finance purchase of land, building, equipment and structures
etc.
 Period of loan longer than 1 year
 Repayment of loan are from future earnings or cash -flow
 There could be an interest moratorium on the term loans. Payment to coincide
with cash-flow.
 Secured by fixed assets and fixed and floating assets of the company

2. Revolving credit financing

 has pre-specified limit, may repay all or portion and re-borrow as necessary up to
limit. Term up to 5 years.
 Flexible of all loans.
 Popular form of financing when the customer is uncertain of the cash-flows or the
need for borrowing
 Normally a commitment charge is levied on the borrower
 One form of financing is the business credit card
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Types of Long-term Business Loans
3. Project Financing
 to finance the construction of fixed assets designed to produce future FCF’s.
Examples include power plants, toll highways, pipelines, etc.
 May include sponsor guarantee.
 More riskier due to long term nature where economic, laws and regulations and
environmental condition can change

4. Leveraged Buyout Financing

 Loans to finance mergers and acquisitions of other business firms
 Small group of investors often led by managers inside the firm
 Target firms are deemed to be undervalued in the marketplace
 Through buyout could enhance the revenue and the price of the stock in the
marketplace
 Frequently the optimistic assumptions have been wrong to the detriment
of delinquent loans

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 Understanding
Small Business Lending

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Overview of Small Business Lending
 Floating Rate Loans
 Overdrafts
o Very popular representing about 50% of SB borrowings
o Highly flexible funding source but around 1.5% more expensive than bill
finance
 Fully Drawn Advance (Installment Loans)
o Loan fully drawn down at start with repayments generally made in regular
installments
o Floating rate finance generally provided at a risk premium over a
benchmark rate
 Fixed Rate Loans
o 42% of SB loans are fixed rate for 3–5 years
o Generally used to purchase non-current assets such as property and plant
& equipment
o Risk margin generally added to 3–5 year Treasury Bond rates

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 Overview of Small Business Lending
 Competition in SB lending market
 Fierce competition, particularly where loans backed by
borrower’s property resulting in fixed risk-margin pricing
 Changes include
o Intensive efforts to reduce cost to income ratio

o Where property used as security, loans can be assessed via

simple credit scoring and capital funded at 50% risk-weighting
concession v. 100% (up to 150%) for other business loans

o Promotion of centralized credit analysis

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A Theoretical Basis for Understanding Lending
to Small Businesses
 While considerable emphasis on ratios, cash flow analysis,
etc., have been discussed, there are many other issues to
consider too:
 Asymmetric Information: Borrower is much better informed
about the firm than lender (also ‘Informationally Opaque’)

 Credit Rationing: Loan price set too high

o Adverse Selection: Better borrowers depart while poor
borrowers remain
o Moral Hazard: Seeking of riskier projects

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A Theoretical Basis for Understanding Lending
to SB
 Relationship lending helps reduce asymmetries via two information
types:
o Hard: Verifiable financial information
o Soft: Borrower’s character/reliability

 Stronger lending relationships lead to

o Lower interest rates
o Reduced collateral requirements
o Lower dependence on trade debt
o Greater protection against interest rate cycle
o Increased credit availability

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 The Decision to Lend to Small Businesses
 Specialized SB risks:
 Key-Person Risk: Is one person in the firm the key to
business success/viability?
 Lack of Capital: Due to limited funds, tax strategies, capital
flexibility, etc.
 Lack of Track Record: Often new business or first-time
business owner
 Poor Accounting Records:
 No audit or lodgement requirements, delays,
 emphasis on tax-driven strategies, reporting
 freedoms and/or attempted deception

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The Decision to Lend to Small Businesses
 Risk and SB Failure
o Over 30,000 fail each year
o 1/3 fail in first year
o Another 1/3 fail in second and third years combined
o 3/4 fail after five years
 Reasons for failure include
o Inexperienced/incompetent management
o Poor accounting and record-keeping
o Problems with financial management and liquidity
o Lack of expert advice
o Too much reliance on debt funding

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 Understanding
Micro Finance
And
Agricultural Credit

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 Micro Finance
What is micro finance?
- Is the provision of small scale financial services to people
who lack access to traditional banking services.
- Small loans to low income borrowers for self employment
with simultaneous collection of small amounts of savings.
- Entails micro savings, micropayments, microinsurance
and advisory services.

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 Micro Finance
Characteristics of micro finance
Nine characteristics
- Small transactions and minimum balance
- Loans for entrepreneurial activities
- Collateral free
- Group lending
- Lending to the poor
- Targets female clients
- Simple application process
- Services provided in underserved communities
- Market level interest rates
The World bank 2007

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 Agricultural Credit
Agricultural Credit in Australia
 Agriculture in Australia is a diverse industry.
 The main focus of agriculture in Australia is broadacre
agriculture.
 What is broadacre agriculture?
Broadacre agriculture is given by the Australian Bureau of
Statistics under the Australian and New Zealand Standard
Industrial Classification (ANZSIC06).

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 Agricultural Credit
Agricultural Credit in Australia
Broadacre agriculture is defined by six ANZSIC06 classes as shown in the
table below.
Agricultural Industry ANZSIC06 Class Description
Wheat and other crops Rice Growing Farms engaged mainly in growing rice, other
industry Other Grain Growing cereal grains, coarse grains, oilseeds and or
pulses
Mixed livestock-crops Grain-Sheep or Grain Beef Farms engaged in running sheep or beef
industry Cattle Farming cattle or both, and growing cereal grains,
coarse grains, oilseeds and or pulses.
Sheep industry Sheep Farming Farms engaged mainly in running sheep
Beef industry Beef Cattle Farming Farms engaged mainly in running beef cattle
Sheep-Beef industry Sheep-Beef cattle Farming Farms engaged in running both sheep and
beef cattle.

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 Agricultural Credit
Some Unique Features in Agriculture Financing
- Agriculture production is susceptible to weather conditions
- climate,
- temperature
- rainfall
- soil
- input materials
- Long gestation period
- agriculture production takes a long time to produce output.
- Price variability and volatility
- prices of inputs, plant and animal material quality are susceptible to
price variability
- output price volatility
- Inelastic supply and demand
- supply / demand variability
- Perishability
- Bulky commodity
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  Agricultural Credit
Assessing Farm Financials by Lenders
- First Way Out – Analysis of historical financials – ratios
- unlike other businesses, using ratios from historical financials in
assessing farm lending is inappropriate for the following reasons;
- the balance sheet and the profit and loss statement are not useful for
understanding farm loan repayment as they contain transactions that are
meant to reduce tax liability.
- The historical financial dates does not correspond to production cycles of
farm produce.
- The repayment ability can be appropriately analysed using cash flow
budgets of borrowers.
- Year in and year out cash flow budgets will indicate long term
viability indicating the ability to generate cash surplus by taking into
consideration;
- average and sustainable figures for the farm operation
- capital purchases are included
- debt is amortized over a longer period
- machinery replacement is allowed
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 Consumer Loans
 Consumer loans may be classified by:
Classification Types of loans
Residential Mortgage loans (Housing), Real
A Purpose Estate Loans, educational loans, motor vehicle
loans, holiday packages, credit card, etc.
Short-term (< 1 year), Medium-term (1–3 years)
B Term
and Long-term (> 3 years)
Instalment loans with regular P&I repayments,
Terms of
C and non-installment loans for emergency
Payments
purposes repaid in one lump sum
Secured or unsecured loans
D Security

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 Types of Consumer loans
 Real estate loans
 Defined as loans that are made for:
o The purchase of a home, apartment or land

o To fund improvements to a private residential block

o Also known as residential mortgages

o Generally for longer terms, i.e. 10– 30 years

o Payment by monthly instalments

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 Types of Consumer Loan
 Personal Loans:
 Generally 2 - 5 years with monthly installments (although
can be non-installment loan)

 Usually negotiated directly with the bank and requires a

loan application form to be filled
 Also includes
o Overdrafts/revolving line of credit
o Margin lending for share investments with loan- to-value
ratio (LTV) or (100% - margin requirement) between 40%
and 70%

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 Types of Consumer Loan
 Credit Cards:
 Offered by banks and other companies under franchising
agreement ( Visa & MasterCard)
 Card holder given a revolving line of credit usually based on
income
 Purchases are charged to the account
 Payments can be installment or non-installment based
o the customer can pay off the charges in one billing period, escaping
any finance charges or
o Choose to pay off the charge gradually incurring interest
o Sometimes no interest is charged for purchases of certain big ticket
items where monthly installments are made for a period of 1 year.

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 Types of Consumer Loan
 Credit Cards:
 Many consumer benefits including:
i. Convenience
ii. Monthly summary
iii. Financial freedom
iv. No procedural hassles
v. Low or no interest on transfer of account balances from
competitors
vi. Low or no annual credit card fees for certain cards

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 Types of Consumer Loans: Credit Cards
 Many card-provider, i.e. lender, benefits
include:
i. Relatively higher risk-adjusted returns
ii. Huge market
iii. Higher interest rates
iv. Expanding services
v. Price-insensitive customers

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 Types of Consumer Loans: Credit Cards
 Merchant benefits include:
i. Increased number of customers
ii. Prompt payment for credit sales
iii. Increase in number of prospects
iv. Customer profiling
v. Advantage over other merchants

 Important caveat — Card providers do face increased risk

from credit card fraud and ensuing exposures

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 Real Estate Loans
 Loans given for the purchase of real estate which includes
land, building and improvements to property
 Can be for the purchase of residential or commercial property
 Loans for commercial property are sometimes classified
as business loans
 Loans for residential property are generally classified as
home loans or residential loans
 Residential properties are either owner occupied or for
investment

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  Structuring of Loans
(e.g. Real Estate)
 Terms and conditions
o Purpose
o Tenure
o Repayments: Amount and frequency
o Interest Rates: Fixed, variable
o Security/Insurance: Details of assets to be mortgaged and any
insurance details
o Default Clause: Actions available in the event of default
o Pre-Payment Clause: Pre-payment procedures and costs
o Fees: Schedule of fees and payment timing
o Stamp Duty and Government Charges
o Points

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 Key Underwriting Criteria for Residential
Mortgage Loans
 Loan-to-Value Ratio or Amount of the Mortgage Loan / Appraisal or
Purchase Price.
 A typical underwriting requirement is a ratio that is less than or equal to
80%.
 Debt service ability or ratio of monthly mortgage payment / monthly
household income. A typical underwriting requirement is a ratio that is
less than or equal to 25%.
 Mortgage loan structuring.
 Pricing : Fixed rated or Floating rate. Could be based on a cost plus profit
or some prime rate plus margin (BLR +/- Margin).
 Collateral : The property bought pledged to the bank
 Covenants : Terms and conditions (repayments, frequency of payments,
default clause, pre-payments, penalties, fees etc.)

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Question
slide 20
Follow slide 6 or 7 in determining small business?

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