Module II:

CORE CREDIT
E. Lending Rationales

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Table of Contents
Module II: Core Credit

E. Lending Rationales
Introduction........................................................................................................................1
Chapter 1: Overview on Lending Rationales...........................................................................2
Asset Conversion Lending.............................................................................................2
Cash Flow Lending..........................................................................................................4
Asset Protection Lending...............................................................................................7
The Logic Of Asset Protection................................................................................10
Unsecured Asset Protection Loans.......................................................................12
Secured Asset Protection Loans.............................................................................18
Subordinations..............................................................................................................21
Complete Subordination...............................................................................................22
Inchoate Subordination.................................................................................................24
Summary...........................................................................................................................28
Chapter 2: Credit Facilities..................................................................................................29
Short – Term Credits......................................................................................................29
Term Credits....................................................................................................................29
Offering Basis...................................................................................................................29
Line of Credit...................................................................................................................30
Pricing................................................................................................................................31
Documentation................................................................................................................31
Use of the Line of Credit...............................................................................................32
Term Loans.......................................................................................................................32
Advantages and Disadvantages.................................................................................33
Maturities and Repayment Schedules......................................................................34
Revolving Credit.............................................................................................................36
Chapter 3: Eighteen Credit Principals...................................................................................38

Participant Guide
 Participant Guide

OVERVIEW OF LENDING RATIONALES

& CREDIT FACILITIES
Introduction

The major purpose of credit analysis is to identify risks in lending situations,

draw conclusions as to the likelihood of repayment, and make
recommendations as to the proper type and structure of the loan facility in
light of the perceived financing needs and risks.

There are three distinct steps in the analysis of any loan proposition:
The first step is to evaluate the historical performance of the managers of the
business, determine the major risk factors, and evaluate how well these risks
have been mitigated in the past. The objective of historical analysis is to
identify factors in a firm's present condition and past performance that may
foreshadow difficulties, or indicate the likelihood of success, in the borrower’s
ability to repay a bank loan at some future time. Historical analysis is of
paramount importance as it is the foundation on which the second, most
critical, step is built.

The second step in analysis of any loan proposition is to make a reasonable

forecast of the probable future financial condition of the company and to
conclude on the company's ability to service proposed levels of debt.

The third step follows logically: having made judgments as to the present
degree of risk and the probable future degree of risk, the analysis process
concludes with an assessment of the firm's creditworthiness and a proposal
for structuring a loan facility that can be amortized given the firm's projected
cash flows and one that offers sufficient protection against loss and control of
the lending relationship.

Three generic lending situations or rationales have been identified, based on

the purpose of the loan, the source of repayment, the risk inherent in the
situation, and the structure of the loan. These lending rationales are:

ㄱ Asset Conversion

ㄴ Cash Flow

ㄷ Asset Protection

Chapter One

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OVERVIEW ON
LENDING RATIONALES

Each of the lending rationales imply a different source of cash to repay a bank
loan. The specific source of repayment is dependent on the purpose of the
loan, or the use to which the proceeds of the loan are applied. The specific
financing need implies the nature of the risk to the lenders, who must be
certain to evaluate carefully the factors that will mitigate that risk and protect
them against loss. The repayment source, loan purpose, and risks dictate the
form of protection and control employed by the bank to ensure repayment of
the loan.

Our primary purpose in distinguishing these three lending rationales is to

provide the analyst with guidelines for determining those areas or issues
that might be of primary concern when evaluating a particular credit and
to provide an approach to analysis. It is essential to recognize that lending
rationales are used to characterize a type of loan proposition or credit
facility and not a type of borrower. Thus, a company is not a "cash flow
company" or an "asset protection company." The same company may have
several different loans with the bank, each made on the basis of a different
lending rationale.

ASSET CONVERSION LENDING

As commercial enterprises conduct their business, rarely does the flow of

funds from the completion of sales transactions or rendering of services
parallel the outflows associated with purchasing of raw materials, wage
and salary payments, and other expenses involved in conducting the
business. In many cases, this unevenness of the flow of funds is not of
sufficient magnitude to create a need for outside financing, as the firm's
normal cash position is large enough to absorb these short-term
fluctuations. In other cases, however, particularly in seasonal companies
or in other situations in which a company temporarily builds up its
inventory first and then its accounts receivable above normal levels, there
is a significant difference between the inflows and outflows of funds for
short periods of time, necessitating the use of short-term, temporary funds
from outside sources. Such short-term, temporary financing, provided by
the bank under the asset conversion rationale, derives payback from the
cash collected when the receivables arising from the sale of inventory are
liquidated at the completion of the asset conversion cycle. Asset
conversion lending is the traditional form of bank lending to business.
Asset conversion loans are short-term, self-liquidating loans and are made
to finance a temporary build-up of current assets - inventory and accounts
receivable - above the permanent level the firm usually keeps on hand.

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The following diagram shows the working investment build up in a

classic seasonal business, a Christmas toy retailer.

WI
High Point

Low Point

(Months) J F M A M J J A S O N D

In this situation, the bank might provide a line of credit that the customer
could draw against to build up its toy inventory in preparation for the
Christmas season. The bank would expect to be repaid in full at the
completion of the selling season from the cash collected from the sale of
the toys and the collection of accounts receivable.

It can be seen that payback of an asset conversion loan is dependent on the

firm's ability to successfully complete the asset conversion cycle and
recover the costs invested in it. If, in the toy retailer example, the store
missed the Christmas selling season because of a strike by its employees,
the primary source of repayment and the conversion to cash of working
investment that was financed by the loan, would not be available when
the loan matured. The bank would then be required to look to secondary
source of repayment, or perhaps extend loan maturities ("roll over" short-
term notes) to recapture the loan principal from future sales.

Analysis of asset conversion lending situations, then, concentrates on

identifying risks in various stages of the asset conversion cycle. Asset
conversion loans are generally unsecured, and the primary protection
against loss is:

1) The bank's confidence in the management's ability to complete the asset

conversion cycle
2) The liquidity of the assets being financed. The defining characteristics of
asset conversion lending are summarized below:

Credit Analysis Features

Loan Purpose

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To finance seasonal working investment build-up, i.e. the difference between

working investment at low point (the permanent level) and working
investment at high point (the seasonal peak.)

Primary Source of Repayment

The cash received from the successful completion of the asset conversion
cycle, i.e., the recovery of costs at the end of a major selling season.

Risks

Inability to complete the asset conversion cycle successfully due to risks in the
supply, production, sales, or collection segment of the asset conversion cycle.

Protection

Sale ability (liquidity) of the working assets in the asset conversion cycle and
the ability of management to mitigate the risks inherent in cycle.

Loan Structure and Control

Use of a line of credit with borrowings on demand or short-term notes, which

allows the lender to review the financial condition of the company frequently
during the cycle before renewing the notes or adding new borrowings. (Lines
of credit will be discussed in the following section). The series of notes should
correspond to the length of the asset conversion cycle, ie. the expected time
needed to convert the assets to cash and repay the loan.

CASH FLOW LENDING

Cash flow lending is the lending to finance a firm's permanent, i.e., long-
term needs. Apart from seasonal needs, permanent needs are associated
with:
 permanent level of working investment
 capital expenditures
 investment activities

Cash flow lending by a bank is usually medium-term, with loan terms of

up to seven or eight years in most cases. (It is customary to refer to any
loan with a maturity of more than one year as long-term debt). The
"support" assets such as plant and equipment that are being financed are

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expected to produce other, working" assets which, when converted to cash

through the successful completion of successive asset conversion cycles,
will generate sufficient cash to repay the loan. In the case of permanent
levels of working investment, an increase in sales volume will usually
require an increase in the permanent level of working investment. It is
expected that the increased level of sales will result in additional retained
earnings that will repay the term loan.

For example, a loan to finance the purchase of equipment necessary to

manufacture a new product line is usually made on a long-term, cash
flow basis. The fixed asset being financed is not itself expected to be
converted to cash to repay the loan. Rather, profits generated from the
sale of the products produced by the new equipment provide the source
of cash used to repay the loan. The generation of sufficient profits to repay
the amount of the loan is expected to take place over a long-term and not
on a short-term basis.

Cash flow lending, then, is essentially lending to repeated asset

conversion cycles, and payback is dependent on the firm's ability to
generate (and retain in the business) sufficient cash over a number of years
of profitable operations to make required interest and principal payments
on the loan.

Assessing a firm's creditworthiness for a term loan to be repaid out of

cash flow requires making reasonable projections of the firm's future
sales prospects and cash flow and determining the amount of cash that
will probably be available to service the debt in the future. Long-term
loans present greater risk to the lender than short-term loans since the
longer into the future the payback is scheduled, the greater the chance of
unforeseen events intervening and jeopardizing the safety of the loan.
Term loans are, therefore, made only when the firm's future cash flow is
likely to be sufficient to make required interest and principal payments.
But the primary justification for a cash flow loan is a reasoned
expectation of the firm's future ability to generate sufficient cash flow,
not its historical ability to do so. Covenants in the term loan agreement
are often included to signal a deteriorating situation to the lender so that
corrective action may be taken to ensure the safety of the loan.

Credit Analysis Features

Loan Purpose

To provide external financing for permanent needs, which will support or

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enhance the generation of internal net cash inflows from profitable operations.

Primary Source of Repayment

Cash flow (primarily from additional profits) over time.

Risks

Inability to generate and / or retain sufficient cash from operations to

amortize debt because of, for example, selling problems arising from
competition, product failure or obsolescence, etc., or inability of the
management to efficiently and prudently manage the sources and uses of
cash.

Protection:

Primary protection against loss is the stability of the profit generation and
preservation of the strength of the firm's financial position. Covenants' in the
loan agreement establish conditions necessary to preserve cash flow and
financial strength and serve to signal deterioration in these areas that may
threaten payback.

Loan Structure

Cash flow lending by a commercial bank is medium-term, up to 7 or 10 years;

long-term loans of up to 40 years are made by insurance companies, pension
funds, governments, and the public (through bond offerings). Lenders are
often willing to refinance the individual debt issues depending on the
perceived ability of the firm to service the debt and thus, a serviceable level of
medium and long-term debt can be a “permanent” source of capital. Usually
term loans will call for amortization of a portion of the loan annually or
quarterly, while each long-term debt issue will have a series of notes
corresponding to the timing in the amortization schedule.

Form of Control

Covenants in the term loan agreement, with set parameters within which the
borrower must work to assure strength in the overall financial condition.
ASSET PROTECTION LENDING

Asset protection lending is a method of financing a relatively permanent

need with a short-term vehicle. The permanent need normally consists of a
stable but revolving level of current assets. The asset protection loan thus
combines features of the asset conversion loan (a short-term vehicle) and the

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cash flow, or term loan (a permanent financing need), but is quite distinct
from these forms of lending.

Asset protection lending differs from asset conversion lending, in that the
financing need is temporary and payback is expected in full at the
completion of the asset conversion cycle. The need financed by the asset
protection loan is, by contrast, a permanent level of current assets, and the
bank essentially finances an ongoing stream of asset conversion cycles. The
implication of this situation is that the asset protection loan is an “evergreen”
loan, meaning it is continuously rolled over. The loan cannot be paid back in
full without reducing the normal level of the firm's current assets and thus
seriously disrupting the firms operations. The fundamental paradox of asset
protection lending is that the repayment of principal is not expected as long
as the business is a going concern, although individual transactions or
promissory notes within that level are expected to be self-liquidating.

Asset protection lending also differs from cash flow lending. Although both
finance a permanent need, in an asset protection situation, the company does
not generate sufficient cash flow to amortize a substantial term loan. The
bank, however, has confidence in the ability of the firm to repay the loan, if
necessary, from the liquidation of the assets being financed and therefore,
makes funds available through a short-term vehicle in order to exert greater
control, similar to that inherent in asset conversion loans.

Of critical importance in assessing the creditworthiness of a firm for an asset

protection loan are the competence and integrity of the firm's management.
The bank will lend only when it is assured of the firm's ability to successfully
complete rapidly successive asset conversion cycles and will continue to do
so in the future. Asset protection lending also requires that the bank be
assured that the net realizable value (in a forced sale or liquidation) of the
assets being financed is sufficient to fully satisfy the amount of the loan,
given the sufficient senior creditor status. This requirement of asset
protection loans is designed to protect the bank against loss in the event of
bankruptcy or liquidation.
Depending on the strength of the borrower, the quality of the assets being
financed and the nature of the transaction cycle, asset protection loans may
be secured or unsecured. When unsecured lending is not felt to be justified,
specific security is taken in the assets being financed. However, collateral is
never regarded as the sole justification for making the loan, but rather as a
means to strengthen the weak elements of an otherwise strong or viable
proposition.

There are several situations in which asset protection lending is

appropriate:

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1- The most common use of the asset protection loan is to finance the
permanent level of current assets when dealing with wholesalers, importers
and exporters, banks and finance companies, commodity dealers, and security
brokers, i.e., where the business acts as an intermediary between buyer and
seller, supplier and manufacturer, saver and investor, etc. In these businesses
there is little value added during the asset conversion process and therefore
there is low profit per transaction and low retained earnings and equity, with
profits generated primarily by high volume. The high financial leverage that is
characteristic of these businesses implies high risk to the lender. The bank will
however, lend under the asset protection rationale and if it is assured of the
viability of the business as a going concern and also if the quality of the assets
is such that, if liquidated, the net realizable value would be sufficient to repay
senior claims.

2- There are also situations in which the asset protection rationale provides
secondary justification for a loan to be paid back primarily out of cash flow.
Because, in some cases, there may exist a significant degree of uncertainty
regarding a firm's ability to generate sufficient cash flow to amortize a term
loan or where the level of borrowing is so high that there is an unstable
financial condition in the near term. In such instances, the bank will take
security in assets with a liquidation value adequate to repay loan, if necessary.
The most obvious example of this type of lending is a personal mortgage,
which is amortized primarily by the borrower’s earnings but is also supported
by the liquidation value of the home and property being financed. The bank
would not extend the loan without reasonable assurance of the borrower's
earnings stream, but due to the risk inherent in the extremely long tenor of the
loan (often 30 years), there must also be adequate value in the underlying
asset, to which the bank retains title until the loan is fully paid. Other forms of
asset-based financing, such as leasing, will also fit this broad category.

This type of financing, as mentioned above, is also appropriate when the

bank has reason to doubt the firm's cash flow potential. An example would be
a start-up manufacturer, for which the bank might finance plant, equipment
or permanent working investment with a secured term loan, expecting
sufficient profits over time to pay back the debt. But due to the uncertainty of
the new enterprise, takes security in the company's assets to assure payback
should the firm prove unprofitable. Another example might be a firm that had
recently experienced cash flow problems causing new uncertainty into its
prospects for future profitability to an extent that disqualified it for
consideration for an unsecured term loan.

The characteristics of asset protection lending as the primary lending rationale

are summarized below:

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Credit Analysis Features

Loan Purpose

To finance permanent level of current or readily marketable working assets.

Source of Repayment

On a going-concern basis, it is the successful completion of individual

transactions in an amount equal to the stated value of the working assets (in a
going concern the loan is an evergreen one in which payback in full of the
principal is never really expected). In a distress situation, it will be the
liquidation of the assets being financed.

Risks

Risks which, due to price fluctuations or other factors the value of the assets
shrink below the net realizable value necessary to pay out the bank as a senior
creditor.

Protection

Value and liquidity of the assets financed. (This must be assumed in both
secured and unsecured lending situations).

Loan Structure and Control

Short-term secured or unsecured notes with tenors dictated by the expected

length of the financing need in the asset conversion cycle itself or in a
specifically financed transaction. Control becomes extremely important in
secured asset protection lending, the mechanics of which will be presented
later in this unit.

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THE LOGIC OF ASSET PROTECTION

The objectives of this section are

To define the asset protection rationale and to distinguish it from seasonal and
cash flow rationale.

Definition of the Asset Protection

The asset protection rationale is a method of financing, which employs a short

term lending vehicle to finance a permanent credit need. The short-term
vehicle often consists of secured or unsecured demand notes or acceptance
financing. The permanent credit need normally consists of a stable but
revolving level of current assets. The paradoxical combination of a short term
lending vehicle and a permanent credit need has two implications for
payback.

First, the loan is continuously rolled over. There can be no genuine clean up of
the asset protection loan. By a genuine clean up we mean one resulting from a
liquidation of assets rather than the mere substitution of other bank debts.
Secondly, bankers must look to liquidation of the company or collateral as the
ultimate source of payback. In short, when a banker extends an asset
protection loan he does not expect nor want clean ups since this implies a
reduction below a normal level of the company’s current assets. At the same
time he can justify the loan on the grounds that if worse comes to worse
collateral liquidation or bankruptcy will generate full payback.

The asset protection loan characteristics can be contrasted with those

associated with seasonal lines of credit and term loans.

Seasonal lines finance a temporary build-up of current assets created by

deviations in the timing of product demand or supply during the operating
cycle. As long as the operating cycle progress smoothly, the build-up in
current assets (beginning with the seasonal building up in inventory and its
conversion to receivables after the selling season) will be followed by the
conversion of receivables to cash at a sufficient volume to clean-up seasonal
line borrowings. The seasonal line is a short -term vehicle, which correctly
finances short term temporary financing needs and derives payback from the
successful completion of the asset conversion cycle.

Term loans finance permanent levels of current assets as well as plant. In time
these permanent asset levels should generate sufficient incremental cash flow
in the form of profits and depreciation to amortize the term loan.

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The term loan then, is a long-term vehicle financing a permanent need with
payback derived from the generation of additional cash flow overtime.

The asset protection loan is a hybrid of the seasonal line (short-term vehicle)
and the term loan.
(Permanent financing needs). The asset protection loan uses a short - term
vehicle for two reasons:

Many companies do not have the cash flow from operations to amortize a
substantial term loan, hence this vehicle is inappropriate.

The nature of many company’s operations and the revolving current assets,
which the asset protection loan finances, favor the control afforded by the
short-term vehicle.

The need, which the asset protection loan finances, is a permanent level of
revolving current assets rather than a temporary seasonal need.
Therefore, it would be impossible for a company with an asset protection loan
to clean up the line without periodically halting its asset conversion cycle to
permit the temporary liquidation of current assets.

To summarize, the key characteristic of the asset protection loan is that it uses
a short-term vehicle for permanent financing needs. The vehicle is short term
because many companies do not generate sufficient cash flow to amortize a
term loan and because it affords greater control by the bank. The need is
permanent and insistence on periodic clean – ups would disrupt the
company’s operating cycle.

There are two broad criteria, which the asset protection loan has to satisfy for
it to be creditworthy. The first criterion is that the corporate borrower’s track
record and outlook indicates that it will continue as a viable concern. Given
the initial costs of starting a credit relationship as well as the financial and
expenses involved in closing one, management integrity and competence are
fundamental considerations in the decision to extend any credit.

The second criterion focuses on the fact that the unfortunate but ultimate
source of payback for the asset protection loan is bankruptcy of the company
or liquidation criteria, which justify an asset protection loan. These are:

Either the corporate borrower’s true working capital affords sufficient asset
protection to justify unsecured asset protection lending.

Or

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The goals of secured lending have been realized to justify secured asset
protection loans.

The remainder of this section will define and interpret these criteria and the
method adopted for testing whether secured or unsecured asset protection
loans are justified from a credit point of view.

A. Unsecured Asset Protection Loans

To be creditworthy, unsecured asset protection loans must satisfy two

conditions. First, the banker must expect the company to continue as a going
concern. This requires that the asset conversion cycle should proceed
successfully such that trade and taxes payable are satisfied promptly. Second,
the banker must feel assured that the company’s true working capital (current
assets minus senior debt) is adequate.

True working capital is considered adequate to justify unsecured asset

protection loans when it affords sufficient protection or cushion to absorb all
distress shrinkage in current assets.

Sufficient liquidation proceeds should remain to satisfy all financial claims of

senior debt outstanding.

The method employed to quantify the adequacy of true working capital and
thus to screen the credit worthiness of actual and potential loans is called pro
forma-liquidation analysis.

This analysis involves four steps:

Step Action
No.
1. Determining the risks in current assets and attaching
shrinkage margins accordingly.
2 Determining the current asset level and mix associated with
senior debt at high point usage.
3 Quantifying the net realizable value (liquidation proceeds) of
current assets.
4 Comparing the pound value of net realizable value (NRV)
with the pound amount of senior debt at high point usage.
The basic objective of this risk analysis is to quantify the expected pound
shrinkage in current assets under distress conditions. The relevance of this
exercise is that bankruptcy provides the ultimate or last resort source of pay
out for the unsecured asset protection loan.

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The banker’s expectations regarding potential sources of bankruptcy will be

an important determinant of expected risks and associated shrinkage in the
value of current assets. Apart from extreme circumstances, such as fraud or
totally incompetent management (when current assets may disappear
altogether), bankruptcy may result from a disruption of the company’s cash
generating cycle which will result in the company’s inability to meet senior
creditor obligations in a timely manner.

Such a disruption maybe due to collections problems (receivable

concentration), production problems (strikes or supply difficulties), or to
inventory problems (price, fashion, or obsolescence risk). The existence and
extent of such risks in current assets will determine both the probability of
bankruptcy as well as the ultimate value of the assets in liquidation.

Note that a pound’s worth of true working capital in a finance company or a

commodity company affords considerably greater asset protection than is true
for a manufacturing company. This is because the finance company’s current
assets consist almost totally of receivables and because the commodity
company’s inventory consists of highly marketable staples without any work
in process, fashion or obsolescence risks.

Unlike a finance company, a manufacturing company’s current assets face the

whole spectrum of risks mentioned earlier.
As a result, classical asset protection lending to a manufacturing company on
an unsecured basis is more difficult to justify on credit grounds.

Once the risks have been identified for each category of current assets, the
risks are quantified as a set of margins. The margins represent the expected
shrinkage from face value in liquidation. If LE100 A/R’s have a margin of
10%. LE10 will be the shrinkage in liquidation. It follows that the net
realizable value (NRV) of each asset in liquidation will equal the face value
less the expected shrinkage. Each current asset category then has an
associated margin. Cash presents problem. One school of thought argues that
the cash will disappear altogether in liquidation so that the margins will be
100%.The other school argues that this is too conservative and that any
operating cash will be available and used to payoff the claims of creditors
thereby decreasing a senior liability. Therefore, it is argued the margin should
be 0.0%. For our analysis we assume a 100% margin to cover liquidation
expenses. Finally, non-current assets are generally expected to afford no
liquidation proceeds and receive a margin of 100%. In the typical unsecured
asset protection situation, non current assets are a relatively low percentage of
total assets, therefore any proceeds can be expected to be small and can be
ignored. (Generally those non-current assets should be financed by net worth
or subordinated debt.) Where non-current assets are significant and are

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financed by senior term debt that requires a cash flow payback, it is most
unlikely that true working capital will be adequate to justify unsecured asset
protection loans. Under such circumstances non-current assets should be
valued, especially if substantial hidden value exists (e.g., premium real estate)
or where such assets serve as collateral for specific senior debt. This completes
the first step since risks have been identified and a set of shrinkage margins
has been quantified for each asset category.

The second step involves the determination of the current asset level and its
mix at senior debt high point. This high point consideration allows for the
possibility that the bank loan usage maybe greater during the year because of
growth or seasonality in demand or supply. This may not be apparent if the
fiscal statements are drawn off at low point. At high point most or all the
company’s bank loans are in use supporting additional current assets. The
analyst focuses on high point since bank risk exposure is maximized. The
dollar amount of true working capital will remain constant at highpoint, since
the increased debt usage will be used to support additional current assets.

However, true working capital will also be supporting a higher level of debt.
In the example below the CA/Senior debt falls from 1.22 at fiscal date to 1.13
at high point.

Once the level of current assets and senior debts have been adjusted to high
point conditions the next task is to determine the current asset mix at high
point under distress conditions. Since the risks and margins for each asset
category are likely to be different, as described in step one, the choice of
current asset mix will have a significant impact on their estimated net
realizable value. With a seasonal company, current asset high point can be
discovered from interim statements, which show peak inventory build-up.

If the company has a very stable cycle the fiscal and interim statements may
show that bank lines and usage are identical. If this is the case there is no need
to blow up the balance sheet, but the analyst may want to weigh the asset mix
toward the particular current asset account which has a higher risk factor
associated with it. In the case where non-seasonal company has unused bank
lines, these should be taken down for liquidation analysis. In the example
below we assume that the extra debt taken down at high point (equals to
LE35M) is used to support additional inventory, the riskiest asset. An
alternative would be to take down unused bank lines and distribute the funds
pro rata amongst the existing mix of current assets. This method is usually
less conservative but maybe more realistic of high point distress conditions
where the risk is a “Shock” to the operations of the company rather than a
scenario of inventory speculation, for instance. At this stage we would have

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generated a pro forma balance sheet of what we expect the company’s asset-
liability level and mix to be at distress high point.

The third step is to quantify the net realizable value of the current assets at
high point. This is achieved by calculating the net realizable value of the
current assets at high point. This is achieved by multiplying the face value of
each asset category by the shrinkage margins, which gives the expected
pound shrinkage for each category. Deducting the shrinkage from the face
value gives the net realizable value for each asset category and the total net
realizable value with senior debt at high point. As long as net realizable value
is equal to or greater than senior debt then senior creditors can expect full pay
out in the event of bankruptcy. In the example, net realizable value is LE128M
and senior debt is LE125M so that senior debt is afforded sufficient protection.
When net realizable value is equal or greater than senior debt, true-working
capital is sufficient to absorb the expected shrinkage in current assets.

Algebraically:

If TWC > Expected Shrinkage

Then NRV > Senior Debt.

If TWC > Expected Shrinkage the unsecured asset protection loans are
justified based on adequate asset protection in the level of TWC under high
point distress circumstances.

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Example of Pro Forma Liquidation Analysis

High Point Forma Liquidation Analysis

A B (AxB=C ) (A –C)
High Margi
Fiscal Shrinkage NRV High Point
Point ns
Cash = 10 Due Banks = Cash = 0.00 -0- 10 Due Bank =
65 10 100
A/R = 50 Due Other A/R = 0.10 5 45 Due Other = 25
= 25 50
Inv.= 50 Inv. = 0.15 12 73
85
CA=110 Senior debt CA = 17 128 Senior Debit =
= 90 145 125
NCA= 40 NW 1 40 -0- NW =
A= 40
= 60 60
TOT. 150 L A= Totals 57 TL = 185
= 150 185

Fiscal High Point

Ratio CA÷ Senior Debt = 1.22 1.13
Leverage Senior Debt ÷ NW= 1.50 2.08
Conclusions: Since TWC > Shrinkage in CA (i.e., 20 > 17)
Then NRV > Senior Debt. (i.e., 128 >125)

Therefore the bank is justified in extending unsecured asset protection loans

to this company because TWC is adequate.

Two related points can be made before turning to the analysis of

secured asset protection loans. First the pro forma liquidation analysis is not
only valuable for screening existing loans but can be used as a marketing tool
to determine how much extra unsecured asset protection debt the company’s
TWC could support. The answer can be found by applying the following
sample formula:

Extra Unsecured Debt which could be accommodated by existing TWC +

(NRV-Senior Debt) ÷ Margin for the riskiest asset that might be supported by
the extra debt.

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Applying this formula to the above example and assuming that the extra debt
could be used to finance extra inventory under high point distress conditions,
we can see that the extra unsecured asset protection debt that could be
accommodated by existing TWC is:

TWC = (NRV – Senior Debt) ÷ Margin for inventory

= (128 - 125) = LE20m

0.15

Therefore, this company could support an extra LE 20 M of unsecured asset

protection loans without threatening full payout of senior creditors under
distress high point conditions.

The second way the pro forma liquidation analysis technique is valuable in
quantifying the extent to which the unsecured asset protection loan maybe a
“Management loan”. A management loan arises in the grey area situation
where NRV is marginally below the high point level of senior debt so that
senior creditors stand to lose some money. The question is how much and
whether unsecured lending is appropriate at all:

The above technique helps quantity the extent to which unsecured loans are
not supported by adequacy of TWC and therefore the extent to which we are
relying on management – to avoid losses. For example, assume that in the
above illustration NRV was estimated at only LE 120m instead of LE 128m so
that NRV could not completely satisfy all senior creditor claims. Under such
circumstances all senior creditors would receive only LE 120m or 96% of their
funds (ignoring priority payments in bankruptcy).
Nevertheless, creditors may extend the full LE 125m because of their
confidence in management’s ability to avoid the potential 4% loss. Under such
conditions the unsecured asset protection loan is justified 96% on pure asset
protection grounds 4% based on confidence in management to avoid distress
or liquidation circumstances.

The concept of the management loan should not be abused to rationalize weak
credits. The management loan component of an unsecured asset protection
loan should instead satisfy the criterion that management’s track record,
and/or new policies substantially mitigate the risks identified in the risk
analysis and quantified in the liquidation analysis.
B. Secured Asset Protection Loans

Secured asset protection loans may be relevant under two sets of

circumstances: either the company has negative TWC/or the pro forma
liquidation analysis indicates a high point shrinkage in current assets in excess

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of TWC to such an extent that the management loan component of an

unsecured loan proves unacceptable. Under these circumstances the banker’s
options include requiring the company to raise more equity, subordinate
some debt, require a guarantee, or seek collateral for the loans.

The pound amount of equity injections and/or debt subordination necessary

to create adequate TWC to justify unsecured asset protection loans can be
quantified by the pro forma liquidation technique.

The credit justification of the secured asset protection loan are twofold. First,
the banker must expect the company to continue as a going concern so that
regulated credit obligations are paid in a timely manner.

Second, the banker must structure the loan to satisfy the three goals of secured
lending. The three goals of secured asset protection lending are:

ㄱ Asset protection

ㄴ Seniority

ㄷ Control

If one of these goals is not satisfied, the credit is unsound. Together, they form
a set of criteria which provides a basic framework to screen existing secured
loans and to design the structure of new loans.

The rest of this unit is devoted to defining and interpreting these goals and to
a brief discussion of how a typical secured loan is structured so as to realize
each of the goals.

Asset Protection

The collateral supporting the loan must first afford asset protection. This
means that the net realizable value of the specific collateral, upon liquidation,
must be sufficient to repay the bank’s exposure. NRV may be less than face
value because of various reasons including price declines for marketable
securities, commodities, real estate, etc. and discounts necessary to liquidate
the collateral. Bank exposure can be defined as the principal outstanding plus
accrued interest until the loan is liquidated less any legally offsettable
deposits and collection expenses. If this goal is achieved the bank is assured
that it will not lose money (assuming the other two goals are met).

The methods by which the banker can achieve this goal when the facility is
structured are:

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Attach margins to specific collaterals to accommodate the expected risk

shrinkage associated with that collateral. The bank only finances say 80% of
the face value of the asset.
Maximize the level of legally off settable deposits so as to minimize the net
principal outstanding.

Minimize the time taken to liquidate the collateral assuming constant NRV to
minimize accrued interest. Time typically erodes asset protection.

Seniority

This means that the bank must have a legally enforceable priority claim
against its specific collateral. It is useless achieving asset protection if the
courts will honor the claims of other creditors with proceeds of the banks
supposed collateral.

The methods adopted to achieve seniority when the facility is structured are:

Possession of title documents in the case of marketable securities, bills of

lading, warehouse receipts, mortgage, etc. The case of non-possessor collateral
seniority is commonly achieved by means of a security agreement between the
bank and the borrower.

Control

This means that the collateral, bank exposure and seniority are periodically
monitored and policed so that the collaterals’ existence and quality as well as
the banks claim to it is continuously maintained. Failure to realize this
objective will ultimately jeopardize the achievement of asset protection and
seniority.

The method adopted to achieve control can be divided into automatic and
discretionary, automatic controls are built into the actual structure of the
facility. Examples would include choice of a demand note as the financing
vehicle, attaching tenors to trust receipts and acceptances; financing
receivables on a notification basis etc. Discretionary controls are more time-
consuming and are supplemental to the facility structure.
Examples would include request for and analysis of interim statements; more
frequent collateral valuation and loans outstanding reports; spot ware house
checks and trust receipt audits. The extent to which discretionary controls are
employed varies directly with the financial condition of the borrower.

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When all three of the above goals are realized, then the secured asset
protection loan is considered creditworthy and justified. Realization of these
goals permits banks to extend safe loans to companies whose credit might not
justify unsecured asset protection loans.

In summary, we have defined the asset protection loan as a paradoxical

combination of short-term lending vehicle financing a permanent need. The
logic of this combination was elaborated in terms of the unsuitability of
seasonal lines of credit and term loans given the needs of both banks and
many corporate borrowers. We specified criteria and tests by which to judge
the creditworthiness of asset protection loans. Asset protection loans were
considered justified when:

Confidence exists that the corporate borrower will continue as a viable, going
concern, and

When the corporate borrower’s true working capital affords a sufficient

cushion to merit unsecured asset protection loans under distress
circumstances. This criterion is tested by means of a pro forma liquidation
analysis. The second and alternative criterion to justify secured asset
protection loans, is when the goals of secured lending have been realized. This
criterion shall be elaborated by discussion of common methods of structuring
a credit facility to realize these goals.

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SUBORDINATIONS
Analysis of the firm’s creditworthiness in the asset protection lending requires
a determination of whether the liquidating or net realizable, value of a firm’s
assets will be sufficient to cover the firm’s total senior liabilities. The essential
issue in this analysis is the ability of the equity base to absorb business risk. In
many cases, the equity cushion is insufficient to absorb potential shrinkage,
and the bank may judge the proposition to be un-creditworthy or
creditworthy only on a secured basis.
Subordinated debt is one of the ways that company can reduce its senior
liabilities and bolster its capital base, thus giving senior creditors an
additional cushion of protection in liquidation. The following diagrams
indicate the effect of subordinated debt on the balance sheet.
Total
MRV
Senior
Liabilities
Total Current
The Current addition
Shrinkage of
Senior Cushion
Assets
Assets
Liabilities
TWC Shrinkage
Cushion
TWC

Subordinate
Non- d Debt
Current Equity
Assets
Non-
subordinated debt improves true working capital Current Equity
and provides the firm with a broadened equity Assets
base with commensurate increased debt capacity.
This could induce the bank to lend where otherwise it might not have
required security.
A subordination agreement is a legal instrument by which a specific creditor
or class of creditors agrees to a junior or subordinate position with respect to a
particular senior creditor or to all other senior creditors for the purpose of
ranking creditor claims. The subordination agreement ensures that in
liquidation senior debt will be paid in full before payments can be made on
subordinated debt. The part whose claims are priority over the claims of the
subordinated creditor in the agreement is known as the beneficiary; the party
that agrees to take a subordinate position is known as the subordinator. There
are two types of subordination agreements: complete and inchoate.

Complete Subordination

A complete subordination agreement is usually a two party agreement drawn

up in favor of one creditor with respect to another creditor or class of

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creditors. A typical complete subordination agreement is one between the

bank as the beneficiary and another creditor (or class of creditors) of the
corporate borrower who agrees to subordinate position with regard to the
bank. Creditors most likely to be subordinators in a complete subordination
agreement are interested parties such as: stockholders, parent and subsidiary
companies, and directors or owner-managers who have loaned funds to the
company. Indeed, subordination of inter-company debt or payables by parent
and subsidiary firms in order to attract or retain bank debt is quite common,
although the exact provisions of the arrangements may vary, of course. The
key features of complete subordinations are:

1. On a going concern basis, the subordinator agrees to accept no payment

of principal or interest on the subordinated debt while the corporate
borrower has debt outstanding to the beneficiary. Subordination
agreement will allow for the payment of interest to the subordinated
debt up to a specified limited amount.

2. In bankruptcy or liquidation, the subordinator agrees that all payments

or proceeds from the liquidation that would otherwise have been paid
to the subordinated debt holder must be paid over directly to the holder
of the holder of the senior debt – the beneficiary in the subordination
agreement. The beneficiary, therefore, will receive his pro-rata share of
the proceeds, plus the prorate share that would normally go to the
subordinator. The beneficiary cannot, however, receive more than his
original claim.

The following examples illustrate the distribution of proceeds in liquidation:

1. If no subordination agreement were in effect

2. If the bank was the beneficiary of a complete subordination agreement:

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Example 1: Liquidation proceeds are $150

Liquidation proceeds
Without
Creditor Claim With Subordination
Subordination
Our Bank $100 50 100

Trade $100 50 50

Subordinated $100 50 0

Total 300 150 150

Explanation
To fully satisfy Our Bank’s claim, 100% of the subordinator’s share goes to
Our Bank.

Liquidation Proceeds

Without
Creditor Claim With Subordination
Subordination
Our Bank $100 75 100

Trade 100 75 75

Subordination 100 75 50
Total 300 225 225

Explanation
Since only $25 of the subordinator’s share is needed to make Our Bank whole,
$50 remains for the subordinated creditor.

Note that in a complete subordination:

1. Those creditors who are not signatories to the subordination agreement
are not affected and will receive the same pro-rata share regardless of
the subordination agreement in effect between the particular
subordinated creditor and Our Bank.

2. The excess of the subordinated creditor’s pro – rata share of the

liquidation proceeds that remains after the our Bank loan has been fully
satisfied is not distributed to other creditors but goes to the
subordinated creditor.

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Complete subordination of debt has two broad effects that can improve the
safety of the loan:
1. The cash flow improves since complete subordination reduces cash
drain for interest and principal amortization on the subordination debt,
thus improving probability of loan repayment ongoing concern basis.

2. Asset protection improves since the beneficiary has the right to the
share of the subordinator, thereby improving the chances of payout in
liquidation.

The corporate borrower also signs the agreement as acknowledgment. The

major provisions of the agreement are:
I. No payment of principal or interest may be paid on the subordinated
debt until all of the borrower’s indebtedness to Our Bank has been
satisfied.

II. The subordinating creditor will not assign or transfer claims to other
parties.

III. The subordinating creditor’s pro-rata share in liquidation goes to Our

Bank (up to the amount of our Bank).

IV. Breach of the subordination agreement will put Our Bank’s loan to the
borrower in default.

Inchoate Subordination

In an inchoate subordination, one creditor or class of creditors assumes a

subordinate position with regard to all other creditors of the corporate
borrower. Inchoate subordination is a feature of various public bond or
private placement issues (i.e., subordinated debentures).
An inchoate subordination is a contingent subordination; that is, the
subordination does not become operative until a voluntary or involuntary
distribution of assets of the debtor is made to its creditors. The specific event
that triggers the subordination, such as bankruptcy or insolvency, will be
specified in the agreement. Until such financial distress occurs, the
subordinated debt may be redeemed or refunded by the debtor through other
means in accordance with the terms of the loan agreement. The benefit to the
senior creditor is realized only upon liquidation. Because junior debt may
have amortized by the time insolvency strikes the debtor, inchoate
subordination is less desirable to the senior creditor than complete
subordination.

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The key features of an inchoate subordination are:

1. Ongoing concern basis, interest and principal amortization payments
continue to be made to the subordinated creditors.

2. In bankruptcy or liquidation (or whatever event specified in the

agreement that triggers the subordination), the senior creditors receive
their own pro-rata share of the proceeds that would otherwise have
gone to the subordinated creditor (i.e., the pro-rata share of the
subordinated creditor is distributed among all senior creditors).

The following examples show how liquidation proceeds would be distributed,

first without inchoate subordination and then with inchoate subordination:

Example 1: Liquidation Proceeds are $150

Liquidation Proceeds

Without With
Creditor Claim
Inchoate Inchoate
Subordination Subordination
Our Bank $300 150 180

Chemical 100 50 60

Trade 100 50 75
Subordinated 100 50 0
300 150 150

Explanation

Without subordination, each creditor receives his prorate share of the

liquidation proceeds:

Creditors Claim X Total Proceeds = Creditor’s Share

Total Claims

To determine Our Bank’s share:

100/300 X 150 = $50

With inchoate subordination, each senior receives his pro-rata share of the
liquidation proceeds as above, plus a pro-rata share of the proceeds that

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would have gone to the subordinated creditor had there been no

subordination:

(Creditor’s Claim/Total Claims X Total Proceeds) +

(Creditor’s Claim/Total Sr. Claims X Subordinate Proceeds)
= Creditors Share

To determine Our Bank’s share:

(100/300 X 150) + (100/200 X 50) = 50+25=75

Alternatively,

Creditor’s Claim/Total Sr. Claims X Total Proceeds = Creditor’s share

For Our Bank,

100/*200 X 150 =$75

Example 2: Liquidation Proceeds are $300

Liquidation Proceeds

Without With
Creditor Claim Inchoate Inchoate
Subordination Subordination
Our Bank $300 $150 $180

Chemical 100 50 60

Trade 10 50 60

Subordinated 100 50 0

600 300 300

Explanation

Without subordination, using the same formula as in the explanation for

Example 1 above, Our Bank’s share would be calculated:

(300/600 X 300)+ (300/500 X 50) =150+30=$180

Alternatively,

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300/500 X 300 =$180

The implications of inchoate subordination are;

1. Cash outflow is not reduced since

payment to subordinated creditors
continues as long as the firm is a going
concern. Therefore, probability of
payback of senior creditors is not Liabilities
improved with inchoate
subordination. Assets

2. Asset protection erodes normal

Subordinated
amortization of the subordinated debt
on a going
Equity
Liabilities
concern basis will gradually eliminate the
cushion of protection provided at the
Subordinated outset of the loan, as illustrated in the
Assets
following diagram:

Equity
Time

If, however, the company were profitable and

able to replace the subordinated debt with equity, the cushion of protection
would not erode.

Subordination
When the bank enters into a lending situation where other creditors have
given an in Choate subordination, a special agreement must be drawn up
(with the assistance of legal counsel). Such an inchoate subordination
agreement will:
 Describe the outstanding subordinated debt.
 Acknowledge the bank debt and its senior status in liquidation.
 Contain a promise by the corporate borrower not to prepay or redeem
the subordinated debt.
 Contain a promise by the subordinator not to secure the subordinated
debt.
Any violation of these provisions will trigger an immediate acceleration of Our
Bank’s debt.

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Summary

The bank has traditionally treated subordinated debt as near-equity in that in

liquidation the subordinated debt will be paid out after all senior debt is
repaid and before equity holders are paid. In fact, in liquidation, completely
subordinated debt affords the bank greater asset protection than equity since
equity claims are junior to all senior creditors, while the claims of completely
subordinated debt holders are usually junior to the back exclusively.
In this sense, and also because the addition of subordinated debt does not
dilute voting powers, and interest on the subordinated debt is tax deductible
while dividends are not, completely subordinated debt is considered “high –
powered equity”.
Subordination of debt can be an important factor in the bank’s decision to
lend on an asset protection basis, especially when dealing with small, closely
held corporations, partnerships, or proprietorships. The bank prefers
complete to inchoate subordinations. It is, however, very rare to see a
complete subordination agreement and inchoate subordination is usually
acceptable especially in a company with an established and dependable cash
flow.
The paying back of subordination debt on a going concern basis in such a case
is not critical since it can usually be replaced by equity through the retention
of profits.

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Chapter Two
CREDIT FACILITIES

The following are four major types of credit facilities

Short – Term Credits (maturities less than one year)

1. Offering Basis Short-Term Notes

2. Lines of Credit

Term Credits (maturities in excess of one year)

3. Term Loans

4. Revolving Credits

Loans funded from short-term credits are generally used for short-term
purposes, and repayment of such loans comes from sources that can generate
cash quickly. Conversion of liquid or current assets to cash, thus provides the
usual repayment source for short-term credits. Term credits, on the other
hand, are commercial funds, usually used for purposes with long-lasting
benefits to the company, such as the supplementing of permanent working
investment, the acquisition of fixed assets, the financing of long-term
investments, or the retiring or refinancing of long-term debt. Term credits are
characteristically repaid from cash flows over a period of years.

Offering Basis

A loan made on an offering basis is an arrangement under which the bank

grants a loan in a specific amount, for a particular purpose for a stated period
of time, usually less than one year. The note is written for not more than 90
days, even when repayment is not expected within this length of time. This
facilitates management of the loan, since it must be reviewed every 90 days.

An offering basis loan is appropriate for specific transaction financing, where

the borrower has a one-time or occasional need for funds or where the lender
is not familiar enough with the borrower’s condition or abilities to justify a
line of credit. Offering basis loans are made without any indication to the
borrower of the bank’s willingness to make additional loans. Each loan
decision is for a single transaction when the opportunity to lend is offered by
the prospective borrower.

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Line of Credit

A line of credit is an arrangement whereby the bank agrees to lend up to a

certain amount on a short – term basis, as needed to meet its needs. The
company may borrow, repay, and re-borrow at the bank’s discretion during
the life of the accommodation. The line of credit is an informal agreement
between the bank and its customer with respect to the maximum amount of
credit the bank will permit the company to owe it at any one time. In form, the
line of credit is simply a letter stating that the bank stands ready to grant loans
up to a maximum limit during the coming year. Legally, it is a declaration of
intent and not a legal commitment and thus may be cancelled or amended by
the bank at anytime. The line of credit is subject to annual review and re-
approval. The annual review allows the bank to re-evaluate the company’s
needs and financial condition and to readjust the limit if necessary.

There are two types of lines of credit the advised/confirmed line and the
guidance line.

1. Advised/Confirmed Line of Credit: Under the advised/confirmed line

of credit, the bank agrees to make funds available to the borrower, upon
request, up to a specified amount. The bank then advises the customer of the
maximum amount available.

2. Guidance Line of Credit: A guidance line of credit is a facility that

combines aspects of offering basis loans and the advised/confirmed line of
credit. Under the guidance line, the bank sets an internal limit in the amount it
will provide the borrower under the line of credit. The borrower is not
informed of the limit and usually is not even aware there is a line of credit
arrangement.

The guidance line is a tool that facilitates the handling of loans to companies
that do not warrant an advised line of credit and is most appropriately used
when the borrowing need is frequent – seasonal or periodic. The undisclosed
loan limit allows the officer to exercise control over the loan; each request for
an advance of funds must be approved by the loan officer. Having a guidance
line available enables a loan officer to make a decision on the spot if all
conditions remain at least as strong as when the line was approved. In this
sense, the guidance line provides a marketing tool as it allows the officer to
respond quickly and positively to a customer’s request for funds.

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Lines of credit usually require one to three months of clean up a year,

during which time the firm have no borrowings against the line. Clean-ups
provide an element of control and ensure that the borrowed funds are
being used for short-term use. If the funds were being used to make up for
inadequate equity, then the company would not be able to do without the
funds for the required clean up period. Firms will sometimes clean up a line
by borrowing against a line from another bank. An “evergreen line: one in
which a clean up is not required may sometimes be made available, usually
in asset protection situation.

Pricing

Lines of credit are priced at either prime or fixed percentage of the rate,
such as “prime + 2%.”

Documentation

Documents issued for a line of credit arrangements include the following:

Letter of Confirmation: The letter of confirmation is the letter notifying the

customer that the bank holds available a certain pound amount that the
customer may draw against. The letter should advise the customer that the
availability of the credit is an indication of a willingness to lend, not a
legally binding commitment, and, as such, can be withdrawn at any time.

Promissory Note: the promissory note is the document the customer signs
to borrow against the line. The tenor of the note is usually 90 days, but may
be on a demand basis as well.

Bankers’ Acceptance: The Bankers Acceptance is an alternative to the use of

a promissory note. Under acceptance finance the customer first signs an
agreement and then draws a draft on the bank payable to himself at a given
date in the future. By stamping “accepted”, signing, and dating it, the bank
accepts this draft, which then becomes a Bankers Acceptance (BA). The
customer endorses the draft over to the bank, and the bank then credits the
customer’s account with the discounted proceeds of the acceptance with the
discount rate determined by the market rate for prime bankers’
acceptances. The cost to the customer is the sum of the discount rate and
the acceptance commission charged by the bank for accepting the draft.

Under the provisions of the acceptance agreement, the customer is obliged

to reimburse the bank for the face value of the acceptance one day prior to
its maturity.

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The bank can either hold the discounted BA in its portfolio or rediscount it
to a third party. It may choose the latter course in periods of tight money
To summarize, the key features of BA financing from the point of view of
the bank are:

By rediscounting the BA, the bank can finance a customer without lending
any of its own funds.

The bank’s profit from BA financing can be considerable, and can be earned
without the use of the bank’s own funds.

The instrument is extremely liquid and flexible. It does not have to be

rediscounted, but can be held in a bank’s portfolio. If necessary, it can be
easily rediscounted or sold to another bank.

It is a marketing tool since it can be cheaper for the customer than a prime
priced loan, although usually the discount rate plus the commission equals
the rate that the customer would pay for the loan.

Use of the Line of Credit

A line of credit is appropriate for use when the tenor of the loan matches
the tenor of the lending situation. Lines of credit are ideally suited to :

1. Meet a firm’s short-term seasonal needs as in asset conversion lending

situations.

2. Finance short-term transactions.

3. Provide coverage of commercial paper borrowings on a short-term basis.

Lines of credit can be used for both secured and unsecured loans.

Term Loans

A term loan is a formal, legal commitment to lend a specific amount, for a

particular purpose, for a stated period of time exceeding one year (usually
ranging from 3 to 7 years). Unlike a line of credit, a term loan does not
usually offer the customer the flexibility to borrow and repay at will.

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Advantages and Disadvantages

The advantages of a term loan arrangement to the customer as opposed to

other forms of financing include the following:

1. Unlike short-term financing, term loans represent a legal commitment

of funds and assure the corporation of a credit source as long as the
terms of the agreement are met.

2. Term loans can be negotiated faster, more confidentially and at less

expense than a public issue or debt securities. A term loan can be
arranged within several weeks, whereas a public issue takes a good
deal longer. Direct placement avoids typical public floatation expenses
such as registration, issuance, transfer fees and investment banker
margins. Finally, the borrower can deal confidentially with the lender
without revealing any information to the public.

3. Term loans can be tailor-made to meet the borrower’s needs and are
more flexible financing vehicles. Should the firm’s requirements change,
the terms and conditions of the loan may be revised. It is considerably
more convenient to negotiate with a single lender or a small group of
lenders than with a large diverse group of public security holders, as
there are with a bond issue. Publicly issued bonds usually require the
approval of two-thirds of the holds to change or waive any part of the
contract.

4. Term loans are suitable financing vehicles to meet medium – term

needs. The company is not locked into long-term financing (nor does it
suffer prepayment penalties with a call provision) at excessively high,
fixed interest rates when the projected duration of need does not
develop.

Term loans, however, have certain disadvantages, which include the

following:

1. Term facilities are relatively more expensive than short-term

borrowings because of the greater risk involved in the longer time
period.

2. Many borrowers find the maturities and repayment schedules on term

facilities excessively restrictive as compared to 20-25 year maturities
and liberal amortization provisions on public bond issues.
Maturities and Repayment Schedules

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Term loans are usually repayable in periodic installments each quarter or

yearly, with the particular amortization schedule determined by the
anticipated ability of the borrower to meet payments on specific dates.

There are various types of repayment schedules. These can be classified as

conventional, moratorium, unequal, balloon, and bullet forms of payback:

ㄱConventional – payback is in equal annual installments over the life of

the loan.

ㄴMoratorium – no payments are scheduled for the first one or two years,
with payback in equal annual installments thereafter.

ㄷBalloon – payback is made in small equal payments over the life of the
loan with a large lump – sum payment at maturity.

ㄹBullet – repayment in full is made at maturity.

These repayment schedules are illustrated in the following chart:

LE 50,000 Five – Year Term Loan

Repayment Schedule

YR 1 YR 2 YR 3 YR 4 YR
5
Conventional 10.000 10.000 10.000 10.000 10.000
Moratorium -- 12.500 12.500 12.500 12.500
Unequal 10.000 5.000 15.000 15.000 15.000
Balloon 5.000 5.000 5.000 5.000 30.000
Bullet -- -- -- -- 30.000

Disbursement: Straight and Stand – by Term Loans

Disbursement of the proceeds of a term loan may be made on a straight or

standby basis. Under a straight term loan arrangement, the entire amount is
borrowed on the first day and then repaid over the life of the loan. Under a
standby term loan arrangement, the bank specifies a period during which the
company can borrow all or a portion of the total term loan amount. At the end

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of the standby period, the outstanding loan is converted to a term loan, agreed
upon maturity, and the company has the option of borrowing the remaining
amount available. The term loan is then amortized according to the agreed
upon repayment schedule, which maybe any of the schedules outlined above.

The nature of the standby term loan makes it ideal for financing needs where
the amount is known but the timing of the need during the earlier stages is
uncertain. Typical uses of standby loans include:
1. acquisitions where the seller desires a good faith deposit as proof of
intention and additional installments during the negotiation and
transfer period; and
2. plant or building requiring progress payments during the period of
construction.

The obvious advantage of a standby over a normal term loan lies in

minimizing unnecessary interest expense during the initial financing period.

Pricing

Term loans are priced at increments over a floating prime (e.g, p + ¼ %)

A commitment fee is usually charged on a standby term loan and is assessed

on the unused portion of the commitment, usually at a minimum ½ of 1% per
annum.

A facility fee computed on the face amount of the commitment can also be
charged. The amount is negotiable. Whether or not a facility fee is charged is
dependant on market conditions and the strength of the borrower.

There are several pricing methods used in the medium term lending:

1. Linear pricing : a constant blended rate over time (e.g, p + ¾ % over the
life of the loan)
2. Step-up pricing : an increasing rate which is “stepped up” each year
3. ( e.g, p + ½% ) from inception for the amounts maturing in years 1
and 2; p + ¾% from inception for the amount maturing in 3 years
and 4 and p + 1% from inception for amounts maturing in years 5
and 6.

4. Incentive pricing: decreasing pricing provided the company meets

certain criteria agreed upon.

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5. Currently, linear pricing is used in most cases, unless market pressures

force the use of incentive pricing.

Documentation

Loan Agreement: This is the legal document that defines the relationship
between the customer and the bank. Understanding this document is critical
to understanding the relationship.

Promissory Notes: A note is signed evidencing the liability of the customer to

the bank.

Uses of the Term Loan

The nature of the term loan, which requires the initial sum to be taken on the
first day. Loan with the lack of flexibility to borrow and repay at will, usually
limits the term loan to financing needs where both the amount and the timing
of the need are known.

Term loan facilities are suitable for cash flow lending situations in which the
loan proceeds are used for long term needs, such as to finance equipment
acquisitions, permanent working investment, stock repurchases, as well as the
refunding of existing maturities of short term debt as they come due.

REVOLVING CREDIT

Revolving credit is a formal, legal agreement in which the bank agrees to lend
up to a certain amount for a specific purpose over a specified period of time,
usually 2 – 4 years. The borrower has complete flexibility in borrowing all or a
portion of the total amount as necessary and repaying any amount at any time
during the life of the commitment. In other words, revolving credit
arrangements do not have set repayment schedules. The amount repaid any
time during the period of the commitment is at the discretion of the borrower.
However, the amount outstanding at the end of the revolving credit is due
and payable on that date or, if stipulated, maybe converted into a term loan
whose term and repayment schedule is as stipulated in the original
agreement.
The revolving credit with a term loan option is the most commonly used
vehicle for medium term financing. It is preferred in many instances to the
standby term loan since it offers more flexibility.

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Pricing

Pricing for a revolving credit is essentially the same as for a term loan. A
commitment fee is usually required on the unused portion of the loan, usually
0.2 % p.a., as in the case with standby term loans.

Documentation

This is essentially the same as for a term loan. There is a loan agreement
whether or not there is a term loan option, since the revolving credit is by
definition, a legal commitment.

Uses of the Revolving Credit

The nature of the revolving credit makes it the most flexible financing vehicle
provided by the bank. It has the features of both a short term borrowing
agreement and term loan, for the company can borrow a fixed amount for the
entire duration of the commitment. This facility is used when both the amount
and the timing of the need are uncertain.

Though the revolving credit can be used in a wide variety of situations, two
typical uses include the following:

1. Financing semi permanent, fluctuating growth in working assets that

accompanies an extended period of growth in sales volume. In this case,
the amount and timing is not known and /or the company may have a
seasonal, as well as a growth need. At the maturity of the revolving
credit, that portion of increased working investment that is identifiable
as the new permanent level is converted to a term loan to be repaid
from future profits. If continued growth is expected, a new revolving
credit may be negotiated and the process is repeated.

2. “Bridge financing” of fixed assets that will be refinanced with long term
money at the completion of the project or when market conditions are
more favorable. (Such refinancing must be clearly specified).

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Chapter Three
EIGHTEEN CREDIT PRINCIPLES

Having analyzed the numbers you now need to make a decision, you can
never know everything about a borrower. Even if you could there would still
be unknowns since repayment of a loan depends on what will happen in the
future, not what has happened in the past. Credit decisions are a matter of
personal judgment, taken within the context of the bank’s overall policy
toward the balance between profitability and liquidity. Here are some rules
that may help you make the decision. Remember that no loan is free of risk
and no bank would be able to continue in business if it never made risky
loans.

The first seven relate to the lenders: the second eleven relate to the borrower.

1- Quality of credit is more important than exploiting new

opportunities. In other words any fool can lend money, but it takes a
lot of skill to get it back. Banks are not in the business of providing
risk capital. You cannot charge a high enough rate of interest to
compensate for loans that are likely never to be repaid. In times of
loan expansion it is easy to seek overriding this rule about credit
quality (as we have seen in the past). In analyzing the degree of risk
that the bank will assume in a loan, careful consideration should be
given to the borrowers management experience, capabilities,
policies, profitability, cash flow and net worth. As a lender you
must decide for yourself how much money the borrower should
borrow, how long it will take to repay the loan, and its true purpose.

2- Every loan should have two options out that are not related and
exist from the beginning. The first way out in a trade related loan
would be the successful completion of the transaction i.e. the export
of goods, or in the case of a term loan, adequate cash flow to service
the debt from the companies normal operations. The second way, if
the transaction project fails, is an action by the borrower to either
realize assets or to draw on his resources which may mean raising
debt by other means in other markets. (This is an aspect covered by
the credit rating system).

3- The character and integrity of the borrower - or in the case of

corporations, the principal management and shareholders - must be
free of any doubt. If you have any doubts as to the integrity, or
honesty, or good intentions of the borrower, you should not approve
the loan. You must therefore check on the moral standing and style
of business before beginning negotiations. Remember that banks

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that knowingly associate with people of less than acceptable

character damage their own reputation far beyond the profit
obtained on the transaction.

4- If you do not understand the business do not lend to it. If you do not
understand the industry or sector, how can you evaluate the risks?
Also customers will have much more respect for banks that
understand their position.

5- It is your decision and you must feel comfortable with it according to

your own judgment. Credit decisions are personal and lenders must
exercise common sense and good judgment. You must also be sure
that it is your own independent judgment on each transaction and
that your associates do not unduly influence you. It is easy to forget
in times of economic growth that the business cycle also has a
downswing (1980-82 recession). It is clear that you must anticipate
situations and not merely react to them. You must be comfortable
with the situation because you will have to live with it.

6- The purpose of a loan should contain the basis of its repayment.

Obviously the shorter the loan the greater the liquidity. Short-term
finance is typically of a seasonal nature to cover seasonal asset
expansion where repayment arises from subsequent asset
contraction (or disposal). Loans to fund other assets of a non-current
nature carry greater risk. As liquidity diminishes, certainty of
repayment is reduced because of the longer time horizon. It is
obviously desirable, for both lender and borrower, to have a
realistically defined program of repayment agreed on in writing at
the time the loan is made. In the case of short term lines of credit for
working capital there should be evidence of seasonal or cyclical
needs for this purpose, and of the regular conversion of receivables
and inventories into cash.

7- If you have all the facts, you don’t have to be a genius to make the
right decisions. It pays to know - the more questions you ask, the
more you understand the case. You will also gain more respect from
the borrower.

8- The business cycle is inevitable. You must be aware of the current

point in the business cycle so that you can evaluate the risks likely to
arise when economic conditions change. Things are always getting
either better or worse (although at times the change will be
imperceptible).

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9- Although it is harder than evaluating financial statements, assessing

a company's management quality is vital. This can be displayed in
many ways: the choice of an appropriate style for the industry
(autocratic or democratic); the ease or difficulty with which senior
positions can be filled from outside the company; the style of the
company's offices; the reputation among competition etc. Asking
questions about others in the industry will also help you assess a
company's management quality.

10- Collateral security is not a substitute for repayment borrowing. If

the lending is based solely on the security you probably shouldn't be
lending at all.

11-Where security is taken, a professional and impartial view of its value

and marketability must be obtained. You must be conscious of
differences in market value, liquidation value and forced sale value.
A proper security margin is therefore vital.

12-Lending to smaller borrowers is riskier than lending to larger ones.

Although the same principles apply to both larger and small firms, in
small firms managerial resources are fewer. In large firms there can
be more jobs for good managers and thus a greater depth of
management. In small firms financial resources are more limited,
therefore access to new equity from shareholders is restricted.

13-Do not let poor attention to detail and credit administration spoil an
otherwise sound loan. A high proportion of loan write-offs are
associated with sloppy loan administration or documentation. Never
assure that loan agreements will not need to be relied upon.

14-Local banks should be participants in lending to local borrowers.

It is often a danger sign if local banks are not lenders to local firms.
In the same way be cautious with those who seek to change to a new
bank because they are dissatisfied with their present bank. New
accounts tend to go bad more often than old ones.

15-If a borrower wants a quick answer it is 'NO'. Anyone who rushes

you into a lending decision should be told this principle.

16-If the loan is to be guaranteed be sure that the guarantors interest is

served as well as the borrowers. You must ensure that the guarantor
is fully aware of his or her obligation. Guarantors should not sign if
they are not in principle willing to lend the money to the
borrower themselves since they may one day in effect have to do just

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that.

17-See where the bank's money is going to be spent. If you do not visit
the company, you will not get a feel for the atmosphere, corporate
style and other intangible effects. It often pays, especially with
smaller companies, to verify what the management tells you from
third parties.

18-Think first, as bank risk increases when credit principles are violated.
Good judgment, experience and common sense are the marks of a
Good banker.

The above principles are not perfect but are broken at your peril. If still in
doubt ask yourself - Would I lend my own money?

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