UNIVERSITY OF DAR ES SALAAM.

UNIVERSITY OF DAR ES SALAAM BUSINESS SCHOOL.

DEPARTMENT OF FINANCE.

GROUP ASSIGNMENT.

COURSE TITLE: LENDING ASSESSMENT AND MANAGEMENT.

COURSE CODE: FN 306.
FACILITATOR(S): MKWIZU E (DR).
PARTICIPANTS REG NO PROGRAMME
BENEZETH JUSTINE B 2018-04-07377 B COM IN BANKING AND FINANCIAL
SERVICES.
JOHN JASCO FRANSIC 2018-04-07838 B COM IN BANKING AND FINANCIAL
SERVICES.
KITUNDU WILSON JOSEPH 2018-04-06873 B COM IN BANKING AND FINANCIAL
SERVICES.
MBEDULE TYSON SIMPLE 2018-04-10137 B COM IN BANKING AND FINANCIAL
SERVICES.
MREMA RONALDO G 2018-04-02831 B COM IN BANKING AND FINANCIAL
SERVICES.
 1. AN ASSESSMENT OF CRITICAL ISSUES
i. Debt level of the company, sustainability and the extent to which the company’s equity
covers its debts

𝑻𝒐𝒕𝒂𝒍 𝒅𝒆𝒃𝒕 𝟐,𝟎𝟑𝟕,𝟓𝟒𝟕

Debt ratio = 𝑻𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕𝒔 = 𝟒,𝟖𝟑𝟕,𝟖𝟔𝟓 = 0.421167

The debt ratio of 50% is ideal for most businesses. ABC has a debt ratio of 42% which means 42%
of its assets are financed by debt.

𝑻𝒐𝒕𝒂𝒍 𝒅𝒆𝒃𝒕 𝟐,𝟎𝟑𝟕,𝟓𝟒𝟕

Debt to equity ratio = 𝑻𝒐𝒕𝒂𝒍 𝒔𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓𝒔 𝒆𝒒𝒖𝒊𝒕𝒚 = 𝟐,𝟖𝟎𝟎,𝟑𝟏𝟖 = 0.727613

The inclusion of total liabilities in the debt-to-equity ratio produces the results that the firm is
highly levered. But calculations to exclude the current liabilities would reveal that the debt-to-
equity ratio is;

𝑻𝒐𝒕𝒂𝒍 𝒍𝒐𝒏𝒈 𝒕𝒆𝒓𝒎 𝒍𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔 𝟓𝟗𝟔,𝟕𝟏𝟎

Debt to equity ratio = = 𝟐,𝟖𝟎𝟎,𝟑𝟏𝟖+𝟓𝟗𝟔,𝟕𝟏𝟎 = 0.1757
𝑻𝒐𝒕𝒂𝒍 𝒄𝒂𝒑𝒊𝒕𝒂𝒍 𝒊𝒏𝒗𝒆𝒔𝒕𝒆𝒅

This reveals that the company is very low levered. The bank can therefore grant credit to such a
firm since ABC would mostly likely be able to cover its long-term debts using equity. We do not
want a company to become overleveraged, that is, too debt heavy, because we assume that there
would be difficulties in servicing that debt.

Holding other factors constant, the inclusion of debt in ABC’s structure would be advised since
this would reduce the cost of capital for the company while still allowing the company to be
operating within optimal leverage that would allow it to maximize revenues.

ii. Liquidity level and cash flows

𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒂𝒔𝒔𝒆𝒕𝒔 𝟐,𝟐𝟑𝟏,𝟓𝟓𝟖

Current Ratio =𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒍𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔 = 𝟏,𝟐𝟓𝟒,𝟖𝟎𝟒 = 1.778

ABC has a current ratio above 1. This means that it is able to meet all its current liabilities using
its current assets. Holding other factors constant, this is a good liquidity position.

𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒂𝒔𝒔𝒆𝒕𝒔−𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 𝟐,𝟐𝟑𝟏,𝟓𝟓𝟖−𝟏,𝟗𝟎𝟑,𝟏𝟎𝟖

Quick Ratio = = = 0.261754
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒍𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔 𝟏,𝟐𝟓𝟒,𝟖𝟎𝟒

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Further examination of the liquidity position of ABC reveals that the company has most of its
current assets trapped in inventory and hence the removal of the inventory in the liquidity ratio
results into a low acid test ratio. It is important that the firm considers its inventory levels.

There seems to be overcapitalization where working capital is too high. This indicates that a
portion of long term (equity and debt) capital is stuck into the working capital which exceeds its
required needs for present business activities and company bears opportunity costs on these over
invested funds. On the other hand, overtrading results in a decrease of levels of working capital of
a business. This does not mean that the current working capital is depleted rather business is
somehow unable to fund the expansion of its operations. This scenario may lead to poor
management of receivables, payables and inventory cycles.

Working Capital = Current assets – Current liabilities

Working Capital = 2,231,558 – 1,254,804 = 976,754

Cash Flows. The cash flows of the business look at the inflows and outflows of the business. Since
a comprehensive cash flow statement is not provided it makes it difficult to make an in-depth
analysis. Looking at the financial statements provided by the company then it would be possible
to comment on their cash sources based on the following sources;

Primary sources
Net income 97,476
Depreciation accruals 663,988
Increase in deferred taxes (if significant) 74,056
TOTAL 835,520
Primary uses
Capital expenditures -
Debt principal repayments (593,200/3) = 197,333
Acquisition costs -
Dividends -
TOTAL 197,333

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 If the primary sources exceed the primary uses consistently then ABC can finance its activities
using internal fund. If the primary uses exceed the primary sources consistently then ABC should
access external funds (loans). For ABC the primary sources exceed primary uses and hence they
can use the internal funds (retained earnings) to finance expansion activities.

iii. Concerns on the balance sheet

• The tangible net worth of ABC = Total equity – Intangible assets = 2,800,318 – 743,824 =
2,056,494

𝑫𝒆𝒃𝒕 𝟐,𝟎𝟑𝟕,𝟓𝟒𝟕
= = 0.991 = 99.1%
𝑻𝒂𝒏𝒈𝒊𝒃𝒍𝒆 𝒏𝒆𝒕 𝒘𝒐𝒓𝒕𝒉 𝟐,𝟎𝟓𝟔,𝟒𝟗𝟒

The ratio above shows that ABC has Tsh 1 of tangible assets to cover 99 cents of debt. This is a
concern because if the company went bankrupt then the assets that would be used to repay the loan
would be physical assets. It would not make sense for a lender to provide a company with a loan
that exceeds 100% of its physical assets.

• The level of retained earnings is high - Tsh 1,747,599. This is a concern since for a company
that has such high retained earnings, why would it go for a loan?
• Inventory levels. The firm has too much inventory, leading to low inventory turnovers

𝐶𝑂𝐺𝑆 661,720
Inventory turnover = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 = 1,903,108 = 0.3times

This is very low and basically would increase the cost of carrying the inventory for the firm.

iv. Profitability, Primary internal sources vs Primary internal uses

𝑷𝒓𝒐𝒇𝒊𝒕 𝒃𝒆𝒇𝒐𝒓𝒆 𝒕𝒂𝒙𝒆𝒔 𝟏𝟓𝟖,𝟒𝟕𝟔

Return on equity = = 𝟐,𝟖𝟎𝟎,𝟑𝟏𝟖 = 5.66%
𝑻𝒐𝒕𝒂𝒍 𝒆𝒒𝒖𝒊𝒕𝒚

The return on equity of ABC seems to be low, by generating only 5% of the profits before taxes.
This means that the management of ABC is not taking enough profitable investments to generate
adequate returns for its shareholders.

𝑷𝒓𝒐𝒇𝒊𝒕 𝒃𝒆𝒇𝒐𝒓𝒆 𝒕𝒂𝒙𝒆𝒔 𝑷𝒓𝒐𝒇𝒊𝒕 𝒃𝒆𝒇𝒐𝒓𝒆 𝒕𝒂𝒙𝒆𝒔 𝟏𝟓𝟖,𝟒𝟕𝟔

Profit to tangible net worth = =
𝑻𝒂𝒏𝒈𝒊𝒃𝒍𝒆 𝒏𝒆𝒕 𝒘𝒐𝒓𝒕𝒉 𝑻𝒐𝒕𝒂𝒍 𝒆𝒒𝒖𝒊𝒕𝒚−𝑰𝒏𝒕𝒂𝒏𝒈𝒊𝒃𝒍𝒆 𝒂𝒔𝒔𝒆𝒕𝒔 𝟐,𝟖𝟎𝟎,𝟑𝟏𝟖−𝟕𝟒𝟑,𝟖𝟐𝟒

= 0.077 = 7.7%

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The profit to tangible net worth is similarly presents the same information as ROE that the
management of ABC is ineffective in generating profits from the funds that investors have
invested.

𝑷𝒓𝒐𝒇𝒊𝒕 𝒃𝒆𝒇𝒐𝒓𝒆 𝒕𝒂𝒙𝒆𝒔 𝟏𝟓𝟖,𝟒𝟕𝟔

Return on assets = = 𝟒,𝟖𝟑𝟕,𝟖𝟔𝟓 = 3.28%
𝑻𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕𝒔

The assets of ABC also seem to be generating inadequate profits for the firm. The he machinery
may not be increasing production efficiency or lowering overall production costs enough to
positively impact the company's profit margin.

The general profitability of ABC may be a result of the low leverage that ABC has. It should be
remembered that use of leverage in a company would help magnify profits and losses for the firm.
The addition of leverage to the company might help boost both the ROE and ROA ratios and in
turn the profitability levels of the company.

Primary sources vs Primary uses

The primary sources generate funds internally for a company, before a company goes for external
sources (debt). The primary uses reduce the primary sources of a business and consequently its
capital base.

The primary sources therefore include all cash inflows (their netted results represented by the net
income) and any other activity that allows a company to have more cash at its disposal such as
depreciation and increase in deferred taxes.

The primary uses include all cash outflows that result from activities that require the company to
spend cash (apart from those already netted in the net income) such as dividends, capital
expenditures, debt principal payments and acquisition costs. The primary internal sources and
primary uses include;

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 2020
Primary sources Primary uses
Net income 97,476 Capital expenditures -
Depreciation accruals 663,988 Debt principal (593,200/3) = 197,333
repayments
Increase in deferred taxes (if 74,056 Acquisition costs -
significant)
Dividends -
TOTAL 835,520 TOTAL 197,333

v. Interest coverage ratio

𝑷𝒓𝒆 𝒕𝒂𝒙 𝒊𝒏𝒄𝒐𝒎𝒆 (𝑬𝑩𝑰𝑻) 𝟏𝟔𝟖,𝟒𝟒𝟓+𝟑𝟗𝟔+𝟓𝟏𝟒 𝟏,𝟔𝟗𝟑,𝟓𝟓𝟓

= = = 15.567
𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒆𝒙𝒑𝒆𝒏𝒔𝒆 𝟏𝟎,𝟖𝟕𝟗 𝟏𝟎,𝟖𝟕𝟗

Most companies an interest coverage ratio of 2 are usually acceptable. ABC has an interest
coverage ratio of 15%. This means that ABC can meet its current interest expenses 15 times
without any difficulties. Importantly, it implies that ABC has adequate operating income to meet
its current interest expenses. Therefore, if a loan is advanced to ABC, they would not have
problems to pay interests.

vi. Capital intensity

Firms that are capital intensive have high proportions of plant, property and machinery
investments. Capital-intensive industries use a large portion of capital to buy expensive machines,
compared to their labor costs. The capital intensity of a firm may be evaluated by looking at the
following;

The comparison of capital expenditures and labor costs. Since ABC Company leases most of
its assets then there are fewer capital expenditures for the firm. This implies that ABC is not a
capital-intensive firm.

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 The level of operating leverage. Capital-intensive industries tend to have high levels of operating
leverage, which is the ratio of fixed costs to total costs. For ABC though there are inconclusive
data to comment on the operating leverage levels of the company. It is evident that the fixed costs
that ABC incur mainly relate to the operating leases sum up to Tsh 226,049. The comparison to
variable costs that are partly made up of COGS of up to Tsh 661,720. This suggests that ABC is
not capital intensive.

𝑻𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕𝒔 𝟒,𝟖𝟑𝟕,𝟖𝟔𝟓

Capital intensity ratio = = 𝟏,𝟐𝟖𝟎,𝟎𝟔𝟕 = 3.7794
𝑺𝒂𝒍𝒆𝒔

This ratio tells how much assets (capital) is needed to generate Tsh 1 of sales. Therefore, for ABC
almost Tsh 3.7 is needed to generate Tsh 1 of sales. Though the ratio is high, for ABC the issue is
with inventory and not fixed assets.

High capital intense vs Low capital intense industries

Lenders would prefer lending to low capital intense firms This is because such firms are by default
low leveraged and hence would not be exposed to high-risk situations by an increased leveraged
position.

For lenders a capital intense firm would not be a good option. This is because;

• Capital intense firms usually have high leverage positions. Therefore, increasing such a
position would not be a viable option.
• Capital intense firms have high operating leverage and adding financial leverage gives greater
risk as losses would be magnified, should sales fall abruptly.
• Upon default, capital intense firms force lenders to sell their assets at fraction of their book
values.

vii. Fixed charge coverage

The fixed charge coverage ratio measures the firm’s ability to cover its fixed charges, such as debt
payments and equipment lease expenses. Generally indicating how well a company’s earnings can
cover its fixed assets. The fixed charge coverage is important to lenders as it indicates the firm’s
expenses such as interests and leases. Unlike a variable charge, the fixed charge remains the same
regardless of the business conducted.

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 𝐸𝐵𝐼𝑇+𝐹𝑖𝑥𝑒𝑑 𝑐ℎ𝑎𝑟𝑔𝑒𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝑡𝑎𝑥𝑒𝑠 168,445+126,223
= 𝐹𝑖𝑥𝑒𝑑 𝑐ℎ𝑎𝑟𝑔𝑒𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝑡𝑎𝑥𝑒𝑠+𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 = = 2.15
126,223+10,879

The 2.15 ratio of fixed charge coverage implies that the company’s earnings are twice as greater
than its fixed costs, which is acceptable. This is because the company may be only able to make
its payment twice with the earnings that it has, increasing the risk that it cannot make future
payments.

viii. The need for budgets and plans

It is important that we have access to the budgets and plans of ABC. This is because from the
budgets and plans we would be able to understand the following;

• The budgets and plans of the business would include a scenario analysis that would show
best, worst and normal case scenarios and how ABC is prepared to deal with it.
• The budgets and plans of the business would show any expansion prospects and if they are
plausible at all.
• The budgets and plans would most importantly show the utilization of the borrowed fund
in the firm, how it will boost returns, and how the cash flows generated thereof would be
adequate enough to repay the loan.
• For a lender the budgets and plans would help to determine the amount of loan to be lent,
alongside other credit terms such as loan duration, interest rates, repayment period and the
general riskiness of the loan

It is important to remember a failure to plan is a plan to fail, budgets and plans prevent this plan to
fail.

2. Lending to ABC unsecured.

It is evident that ABC company has a good shot at getting a loan. The low profitability that could
be increased with higher leverage, low current leverage ratios that attract further leverage, an
acceptable fixed charge coverage and interest expense coverage ratios, and low capital intensity
are all factors that are in favor of ABC’s loan request.

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 The issue of whether the loan should be secured or unsecured is quite tricky. An unsecured loan
would put the lender at the downside of the agreement but with ABC’s scenario it would be
unreasonable to deny such a request. If the lender is going to consider an unsecured loan then the
following issues should be taken into considerations;

• Unsecured loans are supported by the borrower’s creditworthiness rather than collateral. Hence
the decision to lend ABC unsecured without obtaining a credit report (from a credit reference
bureau or credit rating agency) would be inconclusive. If we operate that the credit rating of
ABC is good then we may proceed further with the unsecured loan request.
• The issue of unsecured debt is also risky for the lender, it would be wise for the lender to be
on the safe side and ask ABC to look for a guarantor for the loan. If ABC has subsidiaries, then
the bank can secure upstream guarantees from all the subsidiaries of the underlying loan. The
subsidiary guarantee would be joint and several.
• If ABC will be lent unsecured then it is important that the rate charged to be above the
benchmark by 50 basis point than would a secured loan be.

If the above considerations are met then lending to ABC unsecured would not be a bad option.

3. Important terms and conditions in the loan agreement and their reasoning.

The most important terms and conditions would be included in the loan covenants. This
would include;

Affirmative covenants Negative covenants

ABC should maintain the agreed minimum debt service ABC (or its subsidiaries) would not access any further loan.
ratio This can be translated as ABC should maintain its current
A debt service coverage ratio of 1 is the suggested leverage position.
minimum ratio. Rationale: This would increase the leverage position of the
Rationale: This would ensure that the lender is sure that business and change the lenders position especially that the
the business has sufficient operating income to pay the loan considered is unsecured. With higher leverage the
loan’s principal and interest. possibility of failure to repay is also high.
ABC should increase its activity turnovers (inventory ABC should not acquire any more fixed assets (capital
turnover). 0.3 inventory turnover times is very low, such expenditures).
that it would affect the firms cash conversion cycle.

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Rationale: ABC has a lot of funds trapped in inventory Rationale: Lenders prefer less capital intense firms because
hence the firm should work on improving its inventory they are less risky. The purchase of new assets by ABC
turnover that would allow it to generate more funds. This would increase its operating leverage in addition to the
would help improve its liquidity and profitability position. increased financial leverage then there would a higher risk
for the funds lent.
ABC should ensure compliance with information ABC should not distribute dividends during the loan period.
requirements of the lender, and periodic reporting of This can be translated to ABC maintaining its current
financial and operating performance. dividend payout ratio (0).
Rationale: This would allow the lender to be aware of any Rationale: The lender wants to ensure that the loan
potential problems that the firm is facing or would likely advanced is repaid, and such any funds generated by the firm
face in the near future and hence create some measures should not be directed at any other activities prior the
that would mitigate such negative outcomes. completion of the loan repayment.
ABC should ensure that the funds are applied for the ABC should not sale any subsidiaries.
purpose for which they were intended. Rationale: Since any subsidiary of ABC would be joint and
Rationale: The loan was granted for a specific purpose several guarantors of the loan it would not be reasonable to
that was analyzed prior its approval, if the funds are sell any of them.
directed to other venture that were not initially assessed
then the likelihood of non-repayment becomes higher.
ABC should ensure compliance with the law, and ABC should not engage in any merger and acquisition
requirements required under statute. activities.
Rationale: The failure to abide to legal requirements Rationale: Any further expansion of the firm would require
poses legal conflicts of the firm with the law that would substantial amount of cash that would deviate such cash
cost them cash, or even lead to their termination. This flows from the lender.
would in turn hurt the lender, especially when the loan
granted is unsecured. It is therefore important that the firm
abides to any law requirement.

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Apart from the loan covenants following agreements have to be made;

• There would be no early payoff (Balloon repayments would be penalized)

Rationale: This would help ensure that the bank has steady cash flows. It is important that the
customer pays accordingly to agreed rates. This is because the lenders forecast would be
forecasted and more importantly the lender would have lost interest that would have been
earned during the loan maturity.
• There would be no cancellation of the credit facility.
Rationale: Since the facility is a revolving credit facility for a period of 5 years. It is important
that the customer also maintains the arrangement as this would be in the plans of the lender. If
the borrower decides to quit the loan, prior the 5 years, then there would be extra costs for
doing so.
• The interest rates would have a floor. A loan with an interest rate floor provision has a
minimum rate that must be paid by the borrower to protect the income for the lender.
Rationale: This is because by default the loan has a floating rate and at times would fall and
result to loss to the lender. Therefore, an interest rate floor would help reduce the loss to the
borrower.

4. Key risks of lending to ABC and how the terms and conditions in the agreement mitigate
them
• Liquidity risk. This is the inability of the firm to meet its maturing obligations. If the cash
flows of ABC would change there would possibilities that the firm would not be able to honor
its debt obligations.
In order to mitigate such a risk, the loan agreement includes a provision that requires ABC to
improve its activity ratios. Improving its activity ratios would allow the firm to generate more
cash promptly and ensure that the liquidity position of the firm is maintained or better off
improved.
• Interest rate risk. This is the potential for investment losses that result from a change in
interest rates. If the interest rate would fall then the lender would be vulnerable to large losses
in interest.
In order to protect the lender from this risk, the loan agreement would include a provision on
the interest rate floor that would ensure that the rate does not fall below a certain level.
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• Counterparty risk. This is the risk that a party in the loan contract would fail to honor the
agreement. In this unsecured loan the subsidiaries are expected to be jointly and severally
guarantee the loan. It is then important that the subsidiaries are not sold off.
In order to mitigate the counter party risk a negative covenant not to sell any subsidiaries is
included in the agreement.
• Credit risk. This is the risk that the borrower would fail to honor all the payment obligations
timely as required by the lender. All the loan agreements covenants aim at removing this risk.

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 REFERENCES

Peter Rose and Sylvia Hudgins (2010), Bank Management and Financial Services, McGraw Hill
International edition.

Sagner J. & Jacobs H (2011), Handbook of Corporate Lending: A guide for bankers and financial
managers.

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