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代寫Ratio Analysis, Cash Flows Projections

CBL—: A Review
Announcements
•Where we are….
•Learning Objectives
LO#8 Conduct historical performance analysis of corporations and business firms
LO#9      Evaluate working capital needs of  corporations and business firms
LO#10   Assess cash flow capabilities of corporations and business firms.
•Relevant Readings
Main text, pp223–238
•Class Activity #1
What do you think could be the importance of past performance in evaluating a business loan
•Class Activity #2
What might some useful ratios be for the purpose?
•6.1 Evaluating commercial loan requests and managing credit risk
Important questions regarding commercial loan requests
1.What is the character of the borrower and quality of information provided?
2.What are the loan proceeds going to be used for?
3.How much does the customer need to borrow?
4.What is the primary source of repayment, and when will the loan be repaid?
5.What is the secondary source of repayment; that is, what collateral, guarantees, or other cash inflows are available?
•6.2 Fundamental credit issues
–A number of basic/fundamental issues need to be kept in mind
–Some are discussed in the following slides
•6.2.1 Two types of loan errors
–Type I Error
•Making a loan to a customer who will ultimately default
–Type II Error
•Denying a loan to a customer who would ultimately repay the debt


6.2.2 Character of the borrower and quality of data provided
  The most important issue in assessing credit risk is determining a borrower’s commitment and ability to repay debts in accordance with the terms of a loan agreement
•Good indicators include borrower’s financial history and projections, and personal references
Audited financial statements are preferred in determining the quality of the data because accounting rules are well established so that an analyst can better understand the underlying factors that affect the entries
–But just because a company has audited financial statements, however, does not mean the reported data are not manipulated
•6.2.3 Use of loan proceeds
Loan proceeds should be used for legitimate business operating purposes, including seasonal and permanent working capital needs, the purchase of depreciable assets, physical plant expansion, acquisition of other firms, and extraordinary operating expenses
–Speculative asset purchases and debt substitutions should be avoided
•  6.2.4 How much does the borrower need? The loan amount
Borrowers often request a loan before they clearly understand how much external financing is actually needed and how much is available internally
–The amount of credit required depends on the use of the proceeds and the availability of internal sources of funds
–For a shorter-term loan, the amount might equal the temporary seasonal increase in receivables and inventory net of that supported by increased accounts payable
–With term loans, the amount can be determined via pro forma analysis which is the projecting or forecasting of a company’s financial statements into the future
•6.2.5 The primary source and timing of repayment
Loans are repaid from cash flows:
•Liquidation of assets
•Cash flow from normal operations
•New debt issues
•New equity issues
Specific sources of cash are generally associated with certain types of loans
–Short-term, seasonal working capital loans are normally repaid from the liquidation of receivables or reductions in inventory
–Term loans are typically repaid out of cash flows from operations, specifically earnings and noncash charges in excess of net working capital needs and capital expenditures needed to maintain the existing fixed asset base
The primary source of repayment on the loan can also determine the risk of the loan
–The general rule is not to rely on the acquired asset or underlying collateral as the primary source of repayment
•6.2.6 Secondary source of repayment: collateral
Collateral must exhibit three features
1.Its value should always exceed the outstanding principal on a loan
–The lower the loan-to-value (LTV) ratio, the more likely a the lender can sell the collateral for more than the balance due and reduce loses
–Borrowers are “upside-down” on a loan if the value of the collateral is less than the outstanding loan balance
2.The lender should be able to easily take possession of the collateral and have a ready market for its sale
3.A lender must be able to clearly mark the collateral as its own
–Careful loan documentation is required to “perfect” the bank’s interest in the collateral
•If collateral is not readily available, a personal guarantee may be required
•The borrower’s cash flow is the preferred source of loan repayments
•Liquidating collateral is secondary
•There are significant transactions costs associated with foreclosure
•Bankruptcy laws allow borrowers to retain possession of the collateral long after they have defaulted
•When the bank takes possession of the collateral, it deprives the borrower of the opportunity to salvage the company
•6.3 Evaluating credit requests: A four-part process
1.Overview of management, operations, and the firm’s industry
2.Common size and financial ratio analysis
3.Analysis of cash flow
4.Projections and analysis of the borrower’s financial condition
•6.3.1 Overview of management, operations, and the firm’s industry
–Gather background information on the firm’s operations
–Write a Business and Industry Outlook report
–Examine the nature of the borrower’s loan request and the quality of the financial data provided
•6.3.2 Common size and financial ratio analysis
–Common size ratio comparisons are valuable because they adjust for size and thus enable comparisons across firms in the same industry or line of business
•Class Activity #3
Which financial ratio is the most important?
–Most analysts differentiate between at least four categories of ratios:
•Liquidity ratios
–Indicate a firm’s ability to meet its short-term obligations and continue operations.
•Activity ratios
–Signal how efficiently a firm uses assets to generate sales
•Leverage ratios
–Indicate the mix of the firm’s financing between debt and equity and potential earnings volatility
•Profitability ratios
–Provide evidence of the firm’s sales and earnings performance
[see Chipco, Ajax, Wades, etc. for examples]
•Class Activity #4
  There is a saying that in order to survive in the long-run, you have to survive in the short-run. What ratios can be used to determine if a firm can meet its current financial obligations?
•6.3.3 Analysis of cash flow
Cash pays a loan not net income
•Regarding  repayments, lender is interested in cash generated by business; what are the sources and uses
•Firm’s cash flow (CF) from operations can be determined by converting income statement to a cash basis
•CF estimates are subsequently compared with principal & Interest pay & discretionary cash expenditures to assess a borrowing firm’s capacity and financial strength
Four sections in cash flow statement
1.Operations
–Includes income statement items and all current assets and current liabilities.
–At a min, CFO must be sufficient to cover cash dividends and mandatory principal payments (indicated by current maturities of LTD); a good test of repay ability
2.Investing
–Includes all long term assets
3.Financing
–Includes all long term liabilities and equity (except retained earnings) plus cash dividends paid.
4.Cash
–Total of the above, but must equal the actual change in cash and marketable securities.
Equations may be used to determine if firm’s operational cash flows can pay off existing debt and support new borrowing:
  CFOt/(DIVt + CMLTDt-1)   

  CFOt/(DIVt + CMLTDt-1 + S.T Debtt)

Where,
t = value for period being examined;
 t-1 = value for previous period;
CMLTD = mandatory principal payment on LT debt;
DIV = discretionary cash dividends;
S.T.Debt = payment on other debt.






If these ratios exceed 1, firm’s operational cash flows can pay off existing debt and support new borrowing.
For Wade (2008):

CFOt/(DIVt + CMLTDt-1) = -128,000/ 75,000 = -1.706 x

CFOt/(DIVt + CMLTDt-1 + S.T Debtt) = -128,000/ (75,000 + 892,000) = -0.132

•6.3.4 Projections & analysis of borrower’s financial condition
Pro Forma projections of the borrower’s condition reveal:
•How much financing is required
•When the loan will be repaid
•Use of the loan
Pro Forma Projections
–Determine critical and non critical assumptions.
–Use industry projections, internal projections and judgment to determine projections
–Should not use estimates to qualify/not qualify) a loan; need to examine potential positive/ negative events that might affect ability to repay
For the next period (t + 1), use last period’s figures (t) plus projection:
Salest+1 = Salest  × (1 + gSales)
where: gSales = Projected Sales Growth

COGSt+1 = Salest+1  × COGS % of Sales

Sell. Exp t + 1 = Sales t + 1 x Selling Exp. % of   Sales
       
Int. Exp t + 1 = (Bank debt t + 1 x rate on bank debt)
       +  (other debtt + 1 x relevant rate)
Accounts Receivablet+1 = Days A/R Outstanding × Average Daily Salest+1
Inventoryt+1 = COGSt+1/Inventory Turnover

Accounts Payablet+1 = Days A/P Outstanding × Average Daily Purchasest+1
Or
Accounts Payablet+1 = Days A/P Outstanding × [(COGSt+1 + ΔInventoryt+1)/365]
Projecting “Notes Payable” to Banks
–Rarely will the balance sheet “balance” in the initial round of pro forma forecasts
•To reconcile this, there must be a balancing item or “plug” figure
–When projected assets exceed projected liabilities plus equity, additional debt (assumed to be in the form of notes payable) is required
–When projected assets are less than projected liabilities plus equity, no new debt is required and existing debt could be reduced or excess funds invested in marketable securities
Financial Projections
–Sensitivity Analysis
•Best Case Scenario
–Assumes optimistic improvements in planned performance and the economy are realized
•Worst Case Scenario
–Assumes the environment with the greatest potential negative impact on sales, earnings, and the balance sheet
•Most Likely Scenario
–Assumes the most reasonable sequence of economic events and performance trends
•Also, total of all other expenses/income will be approximately 2% of sales in 2009 & 1.4% in 2010
•Interest on bank debt requires knowing the amount of bank debt;
•To find bank debt, need to complete projected BS, since bank debt would be the “plug figure”;
•Completing pro forma BS requires knowing amount of Retained Earnings;
•RE can’t be known until projected income statement completed

•Sales growth will determine growth in receivables, inventory and profit
•Net Income varies directly with sales in a stable environment
•The difference in projected asset base and total funding without new debt determines additional credit needed or the “Plug figure”
–If Assets2009 > (Liabilities2009 + Net worth2009)
  →Additional financing is required (notes payable plug):
  Notes payable2009 = A2009 – (L2009 + NW2009)  
–If Assets2009 < (Liabilities2009 + Net worth2009)
  → Surplus cash, invest (marketable securities (plug):   Mkt. securities 2009 = – (A2009 – (L2009 + NW2009))
•Class Activity #5
•Would you approve Wade’s request?
•What is the request?
•On March 1,2009, Marcus Wade, president and majority owner of Wade's Office Furniture, met with you and requested an increase in the company's credit line from $900,000 to $1.2 million and a term loan of $400,000 for the purchase of new equipment.
•Wade's Office Furniture is a small manufacturer of metal office furniture.
•It has been in business for more than 25 years and has been a good customer of the bank for the last 10 years.
•Mr. Wade was very positive about the firm's present condition, having just reported a 50 percent increase in sales for 2008 after two consecutive years of slow growth.
•He attributed this recent success to a new product line and marketing program and claimed it would continue-evidenced by backlogged orders totalling $250,000.
•In support of his request, he provided you with three years of historical income statement and balance sheet data for 2006-2008 as well as two years of pro forma data (2009-2010), which appear in Exhibits 14.5 and 14.6.
•Wade projected sales to increase another 50 percent in 2009 and felt that this would quickly reduce the outstanding note payable to the bank and help repay the term loan.
What does the analysis tell us?
(Remember, this is only one possible scenario, but realistic!)
•If projected CFO is realised, it will be $318,000 in 2009 and $463,000 in 2010, considerably more than CM of LTD (?) (dividends ?)
•CFO increases with sales because new trading assets are presumably financed entirely with trade credit
•Bank’s STL in 2008 is: $892,000.  This will decrease to $697,000 in 2009 and $359,000 in 2010.

The Five Questions Answered for Wade’s
1.What is the character of the borrower and quality of information provided?
2.How much does the customer need to borrow?
3.What are the loan proceeds going to be used for?
4.What is the primary source of repayment, and when will the loan be repaid?
5.What is the secondary source of repayment; that is, what collateral, guarantees, or other cash inflows are available?
Question 1: What is the character of the borrower and quality of information provided?

•Character: assumed sound (good customer of the bank for the last 10 years)
•Quality of information provided: assumed reliable
•Question 2 :How much does the customer need to borrow?

Question 3:  What are the loan proceeds going to be used for?

Answer: to finance working capital needs and purchase of new equipment

Note:
•Wade requested an increase in the company's credit line (working capital finance) from $900,000 to $1.2 million
•The company needs much less
•The lower sales growth of 20% compared to Wade’s forecast of 50% means WK needs do not grow as rapidly as they did in 2008 and profits from operations are sufficient to cover increase in WK
Question 4: What is the primary source of repayment, and when will the loan be repaid?

•At end of 2010, Wade’s will have $338,000 in excess CFO (463-75-50) after paying principal payments on debt
•Clearly, CFO is primary source of repayment
•If this CF continues, Wade’s could repay its remaining debt of $709,000 by 2012
•Question 5: What is the secondary source of repayment; that is, what collateral, guarantees, or other cash inflows are available?
The Credit Process: some comments
•The analysis of Wade’s Office Furniture we have covered so far presents a systematic application of the credit evaluation procedure
•It emphasizes using the procedure to evaluate a term loan request that requires forecasts of cash flow from operations
•It focuses on how to interpret data and make a loan decision rather than on how the model works
•The analysis addresses each of the four key issues
•The non-quantitative aspects of the evaluation have generally been ignored
•Sensitivity analysis
–Above is only one possible outcome
–Lender should perform sensitivity analysis by adjusting assumptions regarding key factors, such as sales growth and receivables collection, and recalculating the projected financial statements
•Learning Objectives
LO#8 Conduct historical performance analysis of corporations and business firms

LO#9      Evaluate working capital needs of  corporations and business firms

LO#10   Assess cash flow capabilities of corporations and business firms.
•Next week/lecture…
•Thank you!
See ya next time!

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