BUSINESS STUDIES II (TIE3217)

CHAPTER FOUR – BASICS OF BANK LENDING

Lecture Notes Prepared by: Mr T. Bhiri

Department of Industrial and Manufacturing Engineering

Faculty of Industrial Technology

N.U.S.T

March, 2017
 PHILOSOPHY FOR LENDING “ART OR SCIENCE”

 The lender lends money with the hope that at some future date it will be repaid.

 The lender thus needs to look into the future and ask “will the customer repay by the
agreed date?”

 There will always be some risk that the customer/borrower will be unable to repay
and it is in assessing this risk that the lender needs to demonstrate both skill
(knowledge/expertise) and judgement (read between the lines and make a
determination).

 The lender’s objective is to assess the extent of credit risk and to try to reduce the
level of uncertainty that exist over the prospect of repayment.

 While there are guidelines to follow there is no “magic formula”.

 The lender must gather together all the relevant information and then apply his/her
skills to making a judgement.

 Number crunching will never be enough and this is why many experienced lenders
describe lending as an “art “rather than a science.

CREDIT RISK

 Credit risk is defined as the risk of default on a debt that may arise when a borrower
fails to make the required payments.

 Credit risk can arise:

i. either because the borrower or counterparty is unwilling to perform under the terms
of a contract or

ii. because the borrower’s ability to perform has been impaired.

 There is an element of uncertainty as to whether a given borrower or counterparty

will honour his obligations as and when they fall due.

DETERMINING ABILITY TO REPAY LOANS

 Credit analysis is the process by which lenders determine if a borrower has the
ability to repay the loan on a timely basis.

 Getting all the facts is all that is needed.

 After that, it is a matter of analysis and judgment.

 Analytical skills can be acquired.

 Credit judgment is a matter of common sense and perception.

 Analysts must however be guided by basic credit principles (guiding belief) and
the credit policies (course of action adopted by an organization), procedures (an
official way of doing things) and standards (level of quality) of the Bank.

BASIC CREDIT PRINCIPLES

 The most basic principles used to evaluate a borrower’s creditworthiness are

known as The Five C’s of credit.

 They are the absolute considerations of commercial lending.

 The Five C’s of Credit have worked very well in the past.

THE FIVE C’S OF CREDIT

 Character

 Capacity

 Conditions

 Capital

 Collateral

CHARACTER

 The lender must ensure that the person or company being lent money is of
honourable character (complex mental and ethical traits marking a person).

 Character refers to a borrower’s reputation where financial maters are concerned.

 Premised on the old adage that past behaviour is the best indicator of future
behaviour.

 Banks use quantitative and qualitative methods to evaluate the character.

 Qualitative methods involve calling references, reviewing employment history and

conducting personal interviews with borrowers to gauge his character.

 Quantitative methods include reviewing the borrower’s credit rating.

  Money is borrowed and repaid by people.

 Bank needs to know the people it is dealing with

 Character involves the borrower’s:

i. Willingness to pay its obligations

ii. Business character based on payment record

iii. Management quality, honesty, integrity, reliability, trustworthiness

CAPACITY

 The lender must ensure that the person or company being lent money has the
ability to repay the loan.

 Capacity is equated to potential, capability, adequacy, sufficiency, e.t.c

 A borrower’s capacity is his financial ability to fulfil a loan’s repayment terms.

 It is determined by his income and his other outstanding debts.

 Quantitative methods are used to determine the borrower’s capacity e.g. debt to
income ratio (states a borrower’s debt to income ratio.

 Other measures are debt to capital ratio, EBIT over interest (times cover – inflows
compared to outflows).

 Capacity means ability to run the business successfully and generate cash (liquidity)
to repay obligations when due.

 Strong cash flows from borrower’s normal business activities demonstrates

capacity to repay debt.

 To have liquidity, management must have products, markets, competitive position in

the market, and exercise cost control to generate profits.

 Capacity can be further assessed through the borrower’s payment history and
profitability track record.

 Capacity refers to management experience (know-how), training, and skills to

operate the business profitably
 CAPITAL

 The lender must make sure that the company being lent money is adequately
capitalized.

 Capital is the money used to start a business.

 It is the wealth in the form of money or other assets owned by a person or institution
available for the purpose of starting a business.

 Capital includes any money a borrower puts towards the investment for which he is
getting a loan.

 Banks prefer a borrower with a lot of capital because that means the borrower has
faith in his project.

 Spending a lot of money towards an investment gives the borrower a sense of

ownership and provides an added incentive not to default on his loan.

 Capital refers to the borrower’s investment in the business and the adequacy of
funds the business needs to operate efficiently and generate cash to repay the loan.

 Capital reflects the borrower’s faith in the business, products, and future

 Capital broadly means borrower’s financial position.

 Synonyms of capital include: assets, means, resources, wealth, etc.

 Owners’ equity must exceed the amount of debt capital.

 More capital represents the borrower’s ability to withstand volatility.

 It demonstrates the commitment an owner.

 A strong capital position reassures a lender of repayment capacity in a borrower.

COLLATERAL

 The lender must make sure that collateral does not drive lending decisions.

 Personal assets pledged by a borrower as security for loan.

 Collateral include receivables, inventory, property or other fixed assets that can be
pledged to a lender to secure a loan.

 Other forms of collateral are: standby letters of credit, personal guarantees of

sponsors, corporate guarantees ( firm, parent or sister company)
 In a car loan, the car itself is the collateral. If the borrower defaults, the bank
repossess the car, sell it and the proceeds are used to pay off the loan.

 Collateral is a secondary source of loan repayment and the last protection against loan
loss.

 Collateral should not be the primary consideration for lending.

 Collateral is never there when it is needed (it vanish or become non-existent).

 Must be periodically inspected and valued by qualified individuals.

 Banks measure collateral quantitatively by its value and qualitatively by its perceived
ease of liquidation.

CONDITIONS

 The lender must extend credit with the understanding that business and
economic conditions can and will change.

 Conditions refer to economic and environmental factors that might adversely affect
the borrower’s operational and financial performance, and therefore its ability to
repay the loan.

 Include “the economy”, the business climate, the regulatory environment, the
national and world economic outlook, the business cycle, technological changes,
natural disasters, etc.

 Such conditions are typically beyond the borrower’s control

BASIC LENDING CONSIDERATIONS

 The following is the Seven-Point Approach to lending:

1. BORROWER

 The first consideration in any lending proposition must be of the standing of the
borrower.

 Whether dealing with a small personal account or a large company, the same
considerations will apply:
 i. Age

 For an individual borrower, the date of birth must be determined.

 There would be a very good reason to lend for a 20-year term to an individual aged
70, from law studies, special considerations apply when lending to a minor.

 In the case of a business, it is important to know for how long it has been trading.

 A company that has been trading over a long time e.g. 50 years will generally be
more creditworthy than one that has just been incorporated.

 It will have a more established reputation and would have survived many years of
trading.

ii. Experience/Ability

 Is the borrower experienced in the type of venture in which he needs financial

support?

 Does he have the ability to make the venture successful?

 An individual setting up his own business for the first time will be regarded with
caution whereas management of a company which has been successful trading for
many years will be highly regarded.

iii. Integrity

 Does the lender trust the borrower or the company’s management?

 This is basically subjective but can be obtained through previous track record i.e.
whether previous have been repaid without a problem.

 If any doubts exist in the mind of the lender concerning integrity, clearly lending
will not take place.

iv. Means

 This is the term applied to the net worth or wealth of the individual (asset less
liabilities) or to the resources of the company.

 It is obviously comforting to know that sufficient monetary reserves or assets are

owned by the borrower to repay the advance if repayment cannot be made from the
originally agreed source.
 v. Income

 The borrower must be generating or will generate sufficient income to repay the
advance, unless repayment is come from some other source.

vi. Track record

 If borrower the borrower has maintained a successful business and conducted a

good account with the bank, then this is a good indication of creditworthiness.

 If previous facilities have been repaid without difficulty, the lender will be more
inclined to assist with the new proposal.

vii. Connections

 Entails considerations of the value of the borrower to the bank.

 The borrower may be a director of a company which maintains considerable credit

balances with the bank, the lender will be more inclined to lend to him.

 The prospective borrower may have regularly introduced new accounts to the bank
e.g. new family members.

 While these factors must be taken into account, it should not be an excuse for bad
lending.

 It may be better to lose a connection than to lend where repayment is doubtful.

2. LOAN PURPOSE

 Clearly the lender must know the purpose for which the money is to be used.

 This must be legitimate and consistent with bank policy.

 There is need to know the real purpose of the loan in order to determine whether the
loan complies with existing laws and regulations e.g. national security, environmental
& social concerns.

 Broadly, advances may be broken into capital expenditure (purchase of an asset) and
revenue expenditure (replacement of a liability).

3. THE AMOUNT

 The amount requested must bear a reasonable relationship to the customer’s own
resources or means.
 It must be sufficient to achieve the stated purpose otherwise the lender will be faced
with the necessity of lending an additional amount to safeguard that already advanced
e.g. having lent USD20 000 to buy a new factory, the borrower may request for an
additional USD10 000 for factory alterations, purchase of equipment or for working
capital before the factory can start generating income from which the loan will be
repaid.

 Assess the customer’s income in relation to his commitments to establish whether the
client can afford to repay the loan requested.

 Request for a budget and decline to grant a facility which is demonstrably beyond the
client’s means to repay.

 When dealing with a company, request for financials and examine profitability in
relation to the amount requested.

 Finally the lender will rarely wish to bear the total cost of the project.

 Some contribution from the customer will be required.

4. SOURCE OF REPAYMENT

 With a private borrower, income of one sort or another is likely to be the main
source of repayment

 Every advance should include a second way out or bail out should the expected or
primary source of repayment fails.

 If a second way out is not apparent or reasonably assured, security will usually be
required e.g. if the loan is for the purchase of goods for resale, ensure that they are
saleable before granting the loan. If repayment fails from the sale of the goods, then
the second way out is from the future earnings of the business, failure of which
security will be required.

5. TERM OF ADVANCE

 This must be realistic, bearing in mind the capacity of the borrower

 The longer the term of advance, the more risky it becomes as the future is more
uncertain.

 The longer the term of the advance, the more likely security will be required in view
of the increased risk.
 The term of the advance will also dictate whether the advance is taken by way of a
loan or an advance.

 Overdrafts are for short-term accommodation while loans are granted for longer
terms.

 The term of the advance must not exceed the life of the asset being purchased.

6. SECURITY

 Although it is a good rule to obtain security whenever possible, between 15% and
45% of all bank advances are unsecured.

 A substantial number of individuals, partnerships and companies enjoy large facilities

on an unsecured basis.

 Reliance must be placed on the strength of their statement of financial position

 The security must be obtained at the outset i.e. when the advance is asked for.

 It is often much more difficult to do so when the customer has already received
funding. It must be taken before the advance is actually made.

 The customer must be charging his own property and should have the power to do
so.

 Ensure that on a forced sale valuation, the lender will have good margin over the
maximum advance required.

 Charge over the asset purchased by the advance may be taken e.g. security over
vehicle for which loan is being sought

 Security can be taken against a company’s trading premises.

 Security should always be one of the last considerations in any proposition.

 Lending should not be purely on the basis that good security has been provided.

 The proposition should stand on its own, with the security providing a cushion
should things go wrong.
  The following are characteristics of good security:

i. Should be easy to value

ii. Should be stable in value

iii. Should be easy for lender to obtain title

iv. It should be easy to control

v. Should provide a good margin over the amount lent

7. REMUNERATION

 Lenders expect some reward for the risk and work they undertake.

 The lender’s risk is rewarded by the interest charged on the advance.

 Lenders are also rewarded in the form of fee income charged e.g. establishment fees
and administration fees related to the facility.

Assignment Question One

Peter Smith is aged 25 and opened an account at your bank one month ago. He calls to
see you to tell you that he has been working with a firm of builders as a labourer for
the last 12 months. Next to his rented flat there is a freehold house for sale at USD10
000 which has been empty for two years. The house requires a substantial amount of
work to make it habitable but Smith thinks that he can complete this work in his spare
time over a period of six months. He estimates that the work will cost USD5 000 and
he should be able to sell the property for USD20 000. Smith requests a loan of USD15
000 to be repaid when the property is sold. Use the Seven-Point Approach to evaluate
the proposal and make a determination.

Assignment Question Two

Dr Dippy Duck is a local doctor, aged 45, who has maintained a satisfactory account
with you for 20 years. You know that his gross annual income is USD40 000. He calls
to see you to request your assistance with the purchase of a new car costing USD14
000. His existing vehicle has been sold for USD10 000 and Dr Duck requests a loan
of USD4 000to be repaid by monthly instalments over a period of three years. Use the
Seven-Point Approach to evaluate the proposal and make a determination.