Commercial and Industrial Lending A CPA Perspective April 2014
Overview Introductions and Goals of Presentation Commercial and Industrial Lending: Brief Background Covenants, Advance Rates, and Borrowing Base Reporting Considerations Collateral Examinations and Monitoring Collateral Considerations: Accounts Receivable, Inventory, and Machinery and Equipment Key Takeaways
Introductions and Goals of Presentation
Commercial and Industrial Lending: Brief Background
Call Report Definition Non-real estate secured loans Loans to manufacturing, construction, transportation, communications, wholesale and retail trade, and public utility companies Loans to service enterprises such as hotels, motels, laundries, automotive service stations Loans to customers in the legal, medical, insurance, and accounting/finance industries Loans for the purpose of financing capital expenditures, current operations, equipment, and other business assets Dealer flooring or floor-plan loans
C&I Loan Mix as a Percent of Average Gross Loans 13.60% 13.40% 13.20% 13.00% 12.80% 12.60% 12.40% 12.20% 12.00% 11.80% 2009 2010 2011 2012 2013 Source: State Average Report UPBR Report.
C&I Net Losses to Average Total Loans 2009 2010 2011 2012 2013 2.00 1.80 1.60 1.40 1.20 1.00 0.80 0.60 0.40 0.20 - Source: State Average Report UPBR Report.
C&I Non-Accrual and Past Due Loans 4.00 3.50 3.00 2.50 2.00 1.50 1.00 0.50 2009 2010 2011 2012 2013 0.00 Nonaccrual 30-89 days past due Source: State Average Report UPBR Report.
Structure and Purpose Short term working capital loans / asset based lending (financing accounts receivable, inventory, etc.) Seasonal loans Term loans (to finance capital assets) Other loans to individuals for various business purposes
Benefits of C&I Lending The C&I Lender typically has control of the entire banking relationship. Requirement of the relationship to hold deposits Cash management services Cross sell opportunities Highly profitable loan relationship if structured properly
Risks of C&I Lending Inadequate knowledge of business line Lax supervision and monitoring Weak management information systems Fraud Economic conditions Inappropriate loan structure Concentrations Tends to be more volatile
Covenants, Advance Rates, and Borrowing Base Considerations
Covenants Can provide an early warning system for emerging problems. Ensures that the risk related to the loan does not unexpectedly deteriorate prior to maturity Borrowers with higher risk should have more restrictive covenants Affirmative covenants Require the borrower to take certain steps Negative covenants May prohibit a borrower from taking particular actions Financial and informational covenants
Covenants Common financial covenants Maintain cash flow Preserve asset quality Control growth and leverage Maintain the borrower s net worth. Common nonfinancial covenants Require full and timely disclosure about the borrower s operations and financial position Ensure the continued viability of the borrower s operations.
Covenants Frequency of measurement of financial and nonfinancial covenants Monitoring of covenants Internal Tracking Documents Timely completion and review Non-compliance with covenants Penalty and fees Waiving of covenants, penalties, and / or fees Future compliance Understanding of reason for non-compliance
Advance Rates Advance rate is the percentage of face value a lender will lend on the eligible amount of a particular piece or class of collateral. The first step in determining how much the lender is willing to lend is to decide what collateral is eligible for inclusion and what collateral is ineligible.
Advance Rates Eligible Collateral is collateral that a lender is confident will convert to cash for loan repayment, and therefore will lend against. Ineligible Collateral is that portion or percentage of the collateral offered for a loan advance that a lender is not comfortable lending against and therefore excludes from availability.
Advance Rates Considerations for establishing accounts receivable advance rates: Accounts Receivable Advance Rates typically range from 75% to 85%. The higher the quality of accounts receivable, the higher the advance rate.
Advance Rates Considerations for establishing inventory advance rates: Inventory Advance Rates typically are much less than accounts receivable. Typical ranges are 25-35%. The more liquid or commodity in nature the inventory is the higher the advance rate.
Borrowing Base Reports Considerations for establishing required borrowing base reporting: Frequency (monthly, quarterly, or annually) Template Timely reviewed by lender or credit department to ensure accuracy Recalculation Review of accounts receivable aging and inventory reports.
Collateral Examinations and Monitoring
Collateral Examinations New relationships and existing relationships (qualification purposes and assessing ongoing performance) Examination or review should be performed with nonbiased, factual information about custody, type, quantity, and valuation of the collateral
Collateral Examinations Goals of Collateral Examinations Bank has a general understanding of the operations and financial records of the Company. Verification that there have not been any changes. Internal records (ledgers, agings, etc.) agree to reports provided to the Bank Borrowing base reports are properly and accurately being reported to the Bank Actual assets exist and properly valued (test counts of inventory, price testing of inventory, confirmations of accounts receivable, physical inspection of key machinery)
Collateral Examinations Other Items Payroll and property tax analysis Accounts payable aging reviews and testing Cash analysis Subordinated debt review Miscellaneous asset and liability review Insurance policy review
Collateral Considerations: Accounts Receivable, Inventory, and Machinery and Equipment
Common types of collateral We will focus on the three most common types of collateral with C&I lending: Accounts receivable Inventory Machinery and equipment
Understanding the Borrower s Accounts Receivable Balance Steps in Evaluating an Accounts Receivable Balance Understand the Borrower s customers Cash or credit Does the Borrower require customer deposits? What are the Borrower s policies and procedures for granting credit to customers? Concentrations or size of services/sales Industry Related party receivables Terms Understand consistency of terms to customers 30, 60, 90 days Borrowers collection efforts
Understanding the Borrower s Accounts Receivable Balance Process and quality of borrower record keeping Recorded on a daily basis Use of a lockbox, electronic funds, etc. Documentation of sales process (shipping documents, bill of lading, etc.) Collection efforts Bad debt write-off history and allowance Who performs (Accounting, collection officer, President, sales person, etc.) How long is the collection cycle
Understanding the Borrower s Accounts Receivable Balance Conditions of sale Warranties Returns and Discounts Recourse Retainers Revenue recognition Recognized at time of shipping or completion of service Percentage of completion
Understanding the Borrower s Accounts Receivable Balance Allowance for Doubtful Accounts estimate of current and future bad debts Charge-offs Past due accounts Recoveries Accounts Receivable Agings: An Aging by Invoice Date will begin aging the account upon issuance of the invoice. An Aging by Due Date will begin aging the account after the invoice is past due according to established payment terms. Invoice Date agings tend to be more conservative.
Understanding the Borrower s Accounts Receivable Balance Consideration of completion of Accounts Receivable questionnaire by lender or by borrower Considers key process Considers internal control Considers ineligible accounts receivable
Understanding the Borrower s Accounts Receivable Balance Accounts receivable turnover ratios Receivables turnover ratio = net receivable sales / average net receivables Average collection period = 365 / receivables turnover ratio Calculates the number of times receivables are collected during a period Compare to previous years and projections along with industry trends
Standard Ineligible Accounts Receivable Standard ineligible categories for accounts receivable: Accounts over 60 or 90 days from invoice date Cross aged receivables - accounts that are such slow pay that the entire account is in question. For example, using a 25% cross age rule, if over 25% of the invoices on an account are ineligible, the entire account is ineligible. Receivable balances over predetermined credit limit. Contra accounts. Credit memos Foreign accounts Intercompany or affiliated accounts Progress billings
Accounts Receivable Collateral Examinations Collateral Examinations Considerations Independent calculation of ineligible accounts receivable Concentration review Shipping and invoice testing Proof of payment Trend analysis and Accounts Receivable Column Cross checks Confirmations Verbal (phone) Written
Understanding the Borrower s Inventory Balance Inventory Value Should be stated at the lower of cost or market value Obsolete or slow moving inventory should be written down to current estimated value FIFO First in First Out Assumes that inventory is sold in the order its made Better for today s costs LIFO Last in First Out Assumes that inventory is sold using the most recent made Typically used for tax reasons Disclosure required with comparison to FIFO
Understanding the Borrower s Inventory Balance Understand what makes up the inventory balance: Raw Materials Work in Process (WIP) Finished Goods Understand what must be done to prepare inventory for sale. Also, consider how long the inventory sales process is. Understanding of obsolescence or spoilage Physical versus perpetual counts and historical variances
Understanding the Borrower s Inventory Balance The quality of inventory is influenced by several factors. Volatility of price of inventory Whether further conversion must be done to sell Size and efficiency of potential sales market Regulatory restrictions in transfer Costs of liquidation and others
Understanding the Borrower s Inventory Balance Work in Process Only include when/if the lender has a full understanding of what is included How is WIP calculated? Understand monthly and annual accounting (including accounting policies) related to work in process How does the WIP have value and to who does the WIP have value? If WIP is excluded from borrowing base, ensure that it is not included in raw materials or finished goods inventory balances.
Understanding the Borrower s Inventory Balance Consideration of completion of Inventory questionnaire by lender or by borrower Considers key process Considers internal control Considers ineligible accounts receivable
Understanding the Borrower s Inventory Balance Inventory turnover ratios Inventory turnover ratio = cost of goods sold / inventory Average days to sell inventory = 365 / inventory turnover ratio A low turnover rate may point to overstocking, obsolescence, or deficiencies in the product line or marketing effort. However, in some instances a low rate may be appropriate, such as where higher inventory levels occur in anticipation of rapidly rising prices or expected market shortages. Compare to previous years and projections along with industry trends
Standard Ineligible - Inventory Standard Ineligible Categories for Inventory Work in Process. Goods that are not ready for sale, but must have additional product or work to complete. Inventory in remote locations. Consignment Inventory Obsolete Inventory
Inventory - Collateral Examinations Test Counts Consideration of surprise counts Blind counts Obsolete or dusty inventory Cost Tests Source of Value Analysis Inventory Turns and Margin Reviews
Understanding the Borrower s Machinery and Equipment Recorded at cost Impaired assets should be stated at fair value Items to consider Acquisition and installation costs Disposals Useful lives Depreciation methods Book purposes Straight line depreciation Tax purposes Section 179 and other accelerated methods
Machinery and Equipment - Collateral Examinations Observation Consideration of surprise observation Review of condition and value Identification numbers Understanding of mobility
Key Takeaways
Key Takeaways Obtain an understanding of client s business History of business Understanding of key products and lines of business Understanding competitive landscape of business Succession plans Significant changes or activity during the year Future plans Knowing background of key members of management Continuous discussion with key members of management Documentation of above consideration.
Key Takeways Obtain appropriate understanding of the borrower s collateral (accounts receivable, inventory, etc.) Understand the risks associated with the collateral Quality of the information Consideration of unusual or ineligible collateral Understand internal control and management process Seasonality of business Perform independent verifications or audit as deemed necessary to address risks
Key Takeaways Set appropriate parameters and monitor compliance Ensure appropriate parameters does it make sense and meet the goals and projections of the borrower Timely identification and timely response Ensure appropriate frequency of measurement Perform independent verifications or audits as deemed necessary to address risks Ensure appropriate tracking is in place
QUESTIONS?
A/R Questionnaire Page 6 Company: Audit Date: 1. Number of customers serviced: Monthly Annually 2. Invoices generated monthly 0 Average amount per invoice: - 3. Are Invoices issued in customer's name? 4. What is name of the billing company shown on the invoice? 5. Are billings sent electronically? 6. How are items delivered? 7. What type of documents are retained as proof of delivery? 8. Are payments received electronically? Where are they deposited? 9. Standard sales terms... Special Terms (if any) 10. Does company have cash sales? Average Monthly $ 0 11. Basis for AR Aging. Invoice date, due date, or other? 12. Does aging contain non-trade receivable? 13. Does aging contain affiliated / related receivable? 14. Does aging contain employee/officer receivable? 15. Does aging contain foreign receivable? 16. Does aging contain governmental receivable? 17. Does company sell on consignment? 18. Does company have guaranteed sales? 19. Are there progress billings? 20. Are items invoiced before shipment? 21. Does company receive or require deposits before shipment? If yes, is credit to A/R or Unearned income/liability Account? Are subsequent invoices assigned net of advance deposits? 22. Do contra accounts exist? 22a. Any O/S Vendors invoices on billed tooling jobs? 23. Are any accounts subject to Subcontractor Trust Fund Claims? 24. Who supplies your tooling or provides work on your tooling? 25. Are any accounts subject to PACA (Fruits &Vegetables), the Meat Packers Act or Poultry Act? 26. Does company have product provided by customers? If yes, how is the product tracked? 27. Are collections applied by invoice or on account? 28. Have you received any NSF checks from your customers? 29. Do month-end agings reconcile to general ledger?
30. Credit memos issued promptly? Average # of days before Issuance? 31. Are credit memos applied to specific invoice? or Account? 32. Credit memos issued when: Goods Returned Invoice deduction by customer 33. Unissued Credit Memos? (Review returns area/authorization forms) Approx. $ Amount: $0 Are debit memos/chargebacks on aging? 34. Credit Policy: 35. Collection Policy: 36. Write-off History: Current Year Amount $ - Prior Year Amount $ - Subsequent Amount $ - 37. Invoice Process: 38. From which bank account are payroll taxes paid? 39. Do you have a backlog report? Sales Backlog As Of Date: Amount: Period
Inventory Questionnaire Page 33 Company Name: Audit Date: 1. How is inventory valued? 2. By which method are the month-end G/L and F/S inventory figures determined? 3. Are the inventory figures stated at LIFO? 4. If so, what is the amount in reserve? 5. Comment on the cut-off procedures. 6. How often are complete physical inventory counts conducted? 7. What was the date and the result of the last physical inventory count? 8. Are spot or cycle counts performed by the client? 9. Are there any slow moving or obsolete items in the inventory? 10. How are slow moving or obsolete inventory items accounted for and disposed of? 11. What is the current reserve for obsolescence? 12. How are scrap and waste accounted for and disposed of? 13. What are the stages of work-in-progress?
14. How long does it take to convert work-in-progress into finished goods? 15. Does work-in-progress have any value in its current form? 16. Are there any items in the client's inventory that are not owned by the client? 17. How are these items accounted for? 18. Are there any salability factors which may affect bank's ability to liquidate inventory? 19. Are there any other factors which may affect the bank's ability to liquidate inventory? 20. Who are the major suppliers? 21. Who are the major customers? 22. Who are the major competitors? 23. Where, how and to whom could the inventory be liquidated? 24. What percentage of cost could one expect to get for each inventory item in a liquidation? 25. How much would the moving costs be to consolidate the inventory in a liquidation? 26. List all locations at which inventory is stored to determine what the monthly storage costs would be in a liquidation. Monthly Inventory Address Rent Lessor/Mortgagee Value
27. What is the condition of the warehouse or facility? 28. Recommended inventory control improvements to allow for better monitoring of inventory: 29. Compare the latest month-end inventory value to the latest month-end A/P aging to determine how much of the inventory the client has actually paid for.