credit memo ho 0912
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Bankers Insight Group, LLC
TOTAL TRAINING SOLUTIONS
September 2012
WRITING AN EFFECTIVE
CREDIT MEMORANDUMPreparing Successful Loan PresentationsJeffery W. JohnsonBankers Insight Group, LLC
jeffery.johnson@bankers-insight.com
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OBJECTIVES
To make you a better banker
To understand the importance of good written communication
To improve clarity, conciseness and completeness of written communications
To increase emphasis on planning and organizing
To identify individual strengths and weaknesses
Standards of Care
What would a reasonable and prudent banker have done under similar circumstances?
The primary purpose of loan documentation is to document your actions as being prudent and
proper
Your credit files must document a consistently applied approval process. That process should
address, at a minimum, the following points:
Essence of Credit
Purpose and basis of the credit
Primary and secondary source of repay
Written repayment program
Collateral valuations
Conformity to credit policy
The five Cs of credit
Strengths and weaknesses
Justification for exceptions to underwriting
Makes recommendation
Grades credits
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Contains information to make decision
o Company financial statements
o Tax returns
o Personal financial statements
o
Applications
Credit Memos
Primary means of communication within banking industry
Serves three functions:
1. Supports or recommends action
2. Provides information on the condition and status of a customer relationship
3. Provides a record of thoughts and actions relative to a customer relationship
Memos are to be succinct and to the point, but we violate this idea
Readers of credit memos are skilled bankers. Therefore, it is not necessary to state theobvious
Memos should present relevant material facts and writers thoughts and opinions
The written opinions should be supported by facts
Anything you write in a memo will become public record if you end up in court with acustomer
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ORGANIZATION
PlanningQuestions to consider:
1. What is my purpose?
To inform
To persuade
To get action
To recommend
To advise
To identify a problem
2. Who is my audience?
Key Audience
o Senior Credit Officer
o Loan Committee
o Manager
o Colleagues
Secondary Audience
o Consider their needs
o Use appropriate tone
o Avoid industry language
3. How can I best convey my message?
Logical presentation gives you credibility
Guides the reader in the direction you want them to go
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Positioning
Identify your position
o The main idea of your entire report
o All statements, conclusions or recommendations should support position
Establish your major discussion areas
o The major points that helped lead you to your position
o Begin by noting your major discussion areas early in your presentation
Results - helps writer to focus and the reader to comprehend the ideas that follow
Outlining
o Places topics in an orderly manner and will ultimately:
Save time
Improves organization and readability of your writing
Allows a step-by-step approach
Allows writer to avoid missing the most important facts
WRITING
Paragraph Development
o Breaks writing into single ideas
o Keeps writing in a uniform and orderly pattern
o Should have a topic sentence
o The topic sentence represents the main idea
o Topic sentences are often the 1stsentence
o Each sentence should contribute to paragraphspurpose
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o It is improper for business communication
o Indicates unclear or illogical ideas
o Indicates lack of knowledge by bluffing with complicated and wordy writing.
Utilize a simple writing style
o The more complex the subject, the more precise and simple the writing
o Understanding words and sentences should require little energy by the reader.
Wordiness say what you need to say with the fewest words possible
Instead of Why not write
At the present time Now / Currently
In the near future SoonA majority of Most
A number of Several / Many / Some
In the amount of For / Of
With reference to About
First of all First
On an annual basis Annually
FORM AND APPEARANCE
o Avoid producing a page of solid print. Readers like short, skim-able writing.
o Visual appearance should aid understanding, not hinder it.
o Make reports eye catching with headings, bold face, underlining, italics or
bullets. This method calls attention to areas that are important.
o Paragraphs should average 7-10 lines
o Use repetition for emphasis in long reports
o Graphics can add variety and professionalism to reports
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ALLISON WRIGHT BANK COMMERCIAL LOANS
GUIDELINES FOR PREPARATION OF CREDIT APPROVAL DOCUMENTS
July 25, 2012
Credit Approval Document Overview
The purpose of a standard Credit Approval Document is to promote a consistent approach towards preparingcredit approval presentations. The Credit Approval Document format is intended to convey to others the
lending officer's analysis and understanding of the inherent credit risk and strategies for the management of
that risk.
The three cornerstones of a successful credit portfolio are Soundness, Profitability and Growth, in that order.
Profitability and growth are meaningless if the underlying portfolio is not sound. This does not mean that a
sound portfolio has no credit risk. Rather, the underlying credit risk must first be understood and, once
understood, then managed.
Other purposes of the Credit Approval Document format are to present and document the following topics in
a consistent manner:
Credit approval rationale.
Purpose of proposed credit presentation.
Proposed loan quality rating rationale.
Key risks and structural issues.
Strengths and weaknesses (i.e. cash flow, collateral, guarantor) of the borrower and the credit facilities.
Sources of repayment and plans for monitoring.
Comparison of the proposed credit presentation with approved credit policies, underwriting standards and
underwriting guidelines.
Total ALLISON WRIGHT BANK relationship and relationship strategy, including a risk management
strategy for the subject credit exposure.
The Credit Approval Document is an internal document used primarily to clearly communicate conclusions
of the lender. The reader should not be left to hunt for or ascertain the author's conclusions. Conclusions
should be clearly stated and logically supported by the rationale for the conclusions.
The Credit Approval Document is intended to be a self-contained, stand-alone document which a
knowledgeable, experienced lender who is not a specialist in the specific industry being addressed
should be able to understand. The Credit Approval Document should fully support and explain the credit
request without the need for verbal explanation or reference to external documents. All lenders should
remember that it is in their best interest to convey their message and conclusions in an easy-to-read format.
The audience will include the following readers:
Chain of authority required to approve or concur with the transaction (e.g. Approval Matrix)
Credit examiners, including the ALLISON WRIGHT BANK Credit Review Officers, FDIC, State,
external auditors, etc.
Other lending personnel who need to brief themselves on the relationship, e.g. as account
management responsibilities change
Counsel representing ALLISON WRIGHT BANK and others responsible for preparing loan
documentation
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Objectives of Credit Approval Document
Focus on Objective Analysis Supported by Facts and Data
The analysis included in the Credit Approval Document should allow the reader to completely understand the
transaction, the financial and operating condition of the customer, and the ALLISON WRIGHT BANKrelationship goals with the customer. It is important to keep the analysis based on facts and data. Use
exhibits to clarify important topics such as projections, proposed covenants and so forth. All terms referring
to financial calculations should be defined because not every reader may use the term in the same way. For
example, the terms Debt Service CoverageandBalance Sheet Leveragehave been used to refer to a variety
of different calculations.
It is ALLISON WRIGHT BANK credit policy that Credit Approval Documents and quality assessment
ratings (QAR) will not be made available to anyone outside ALLISON WRIGHT BANK (except those
identified above) unless subpoenaed by proper court order. This prohibition applies as well to the borrower
or its principals, representatives, etc. If subpoenaed by proper court order, Credit Approval Documents are
discoverable in litigation and certain administrative proceedings. Because their contents will be read to ajudge or jury if subpoenaed, Credit Approval Documents should be written with such third-party review in
mind. Credit Approval Documents generally should not contain legal opinions obtained in connection with
the lending relationship.
Credit Approval Documents Reflect Your Standard of Excellence
The Credit Approval Documentshould reflect the lending officers best work. Based on the data contained in
the Credit Approval Document, signers in the approval process are asked to join with the lending officer in
being held accountable for putting the banks capital at risk. Accordingly, individuals involved in the
approval process need to understand exactly how the lending officer really feels about the overall credit and
the substantive risk issues. All relevant facts, assessments, conclusions, etc.etcmust be put out in the open
for the benefit of everyone involved in the approval process. Full, complete and balanced disclosure is afundamental requirement in writing a Credit Approval Document.
Following are some points of advice to the lending officer/author of the Credit Approval Document:
Question and challenge the data, don't just "report" it. Talk about "missing" information, not just that
which was provided.
Be concise. Use salient facts to support conclusions and structure.
Use all available resources.
Create order and understanding out of the "data". Everythingwritten should point toward a conclusion
necessary to reach a decision. Don't make the reader wade through unnecessary material that does not
lead to a conclusion or is not essential to the decision.
Do not state conclusions without showing the logic that leads from the data to the conclusion. One
overused conclusion, which is often totally unsupported, is "The quality of management is excellent".
Be balanced. Be totally honest. "Tell it like it is". Discuss the bad and the ugly, not just thegood--i.e..
discuss concernsyou have about the borrower or the debt and the objective basis for your concern; dont
just discuss thegoodaspects of the credit.
Identify the real issuesthat make a difference to us.
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View everything from the perspective that we are putting ALLISON WRIGHT BANK capital at risk.
Do not assume the impartial perspective of an external rating agency that has no capital directly at risk in
the transaction.
Be reader-friendly. Act as a guide to lead your reader through your data and logic to reach your
conclusions. Use charts when needed.
Be consistent. Check your Credit Approval Documentto make sure that the facts and opinions you state
are consistent throughout all portions of the Credit Approval Document.
These points of advice are always subject to the general rule that facts and data must support conclusions.
All documented opinions, but especially those that are negative, must be based on facts you know
Credit Approval Document Narrative Highlights of Key Findings
Information presented should be precise but complete. Objective analysis is of primary importance. The
analysis is expected to be balanced. Balanced means to reveal all relevant data, good and bad, and arrive at
an objective analysis of the risks. The focus should be driven by the facts and data, with emphasis on why
and how the facts impact the customer and credit facilities made available by Allison Wright Bank.
1.Transaction Description:
The three cornerstones of a successful credit portfolio are Soundness, Profitability and Growth, in that order.
This does not mean that credit risk is to be avoided; rather, the underlying credit risk must be understood and
managed.
Summary (Reason for Request and Nature of Business)
Describe the transaction being considered. The Summary could be as simple as a new term loan for
equipment purchases or could be a complete description of a vertically integrated operation. Use exhibits to
further clarify discussions and refer the reader to separate exhibits as appropriate. Be detailed.
Credit Approval Rationale
This section should include a succinct rationale why the proposed credit action is being recommended from a
credit risk management perspective. Explain the critical creditfactors that support the recommendation for
approval. Any approval rationale based on relationship, profitability or business growth factors, although
important, should be clearly identified as such and discussed separately. In essence, discuss why the proposed
action makes sense.
Rate/Term
This section should discuss the rate and terms, and thoroughly explain any concessions made on either rate or
term. Consistency with Bank objectives should also be discussed.
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Highlight any specific accounting techniques that are important in analyzing the company (e.g. FIFO vs.
LIFO inventory valuation, etc.) If appropriate, compare company with industry standards or comparable
companies. When possible, briefly summarize the borrower's performance during the last recession. Discuss
the capital structure of the borrower (e.g., senior debt, subordinated debt and equity components).
Analyze the trends as opposed to simply reporting the numbers. Get behind the numbers; for example,provide your best analysis of the factors that caused a decline in sales and management's response, as
opposed to simply stating that sales declined.
Address historical fixed charge coverage or debt service coverage as applicable. Discuss cash flow adequacy
historically.
5. Evaluation of Repayment Sources/Projections:
This section is used to describe future repayment ability and should pick up where the above historical
analysis left off. This section should analyze the adequacy of stated repayment sources in quantitative terms.
Again, this Section could include three distinct sub-sections: Balance Sheet, Income Statement, Cash Flow.
A Bank Base Case (Most Likely) projection is expected when maturities exceed one year. Additionally, a
Management Case and a Downside Case are strongly encouraged in larger transactions when maturities
exceed one year. Please label each page of the projections (e.g. Management Case, Bank Base Case,
Downside Case.) Use exhibits to fully document the assumptions used to construct each case or scenario.
Depending upon the financial stability of the proposed credit, sensitivity analyses should also be presented.
If practical, present a "Break-Even" scenario showing the level of cash flow necessary to meet debt service,
mandatory capital expenditures and other fixed charges. It should be noted that Allison Wright Banks
official definition of fixed charge coverage (FCC) is (EBITDA cash taxes cash dividendsmaintenance
capital expenditures) (mandatory debt retirement + cash interest). Use MOODYS spread sheet format forhistorical and projected cases, where MOODYS is available. Maintenance capex should be thoroughly
explained.
Analyze the projections either in the body of the report or in an exhibit. Refer the reader to exhibits for
clarification. Use footnotes on the MOODYS spreads for further clarifications and refer the reader to the
footnotes. Discuss the impact of any sensitivity cases and why the credit risk remains acceptable.
A downside sensitivity analysis should not usually be based on growth assumptions resulting in improving
performance (e.g., increasing EBITDA, cash flow available for debt service, etc.). If a "Break-Even"
scenario is used for the Downside Case (e.g., holdingfixed charge coverage or debt service coverage equal to
1.0x), it would probably be helpful for the analysis to include a comparison of the "Break-Even" EBITDA toboth historic and Management Case EBITDA. For example, this comparison could illustrate the amount of
deterioration that could occur before operating cash flow would be insufficient to cover debt service
requirements and other defined fixed charges (or the amount of cash flow growth required to cover debt
service requirements).
If sale of assets is a material source of repayment, document what assets will be sold, the book value, the
estimated net proceeds, the source of the valuation, potential buyers, and the expected timing of the sale. If
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or to interest rate volatility), use these sensitivities in the "Downside" case in the Repayment Sources
analysis. If the likelihood of an occurrence is quantifiable, this should be included. Remember, not every
risk has a specific mitigator. Discussion of a specific risk is not a mathematical equation that requires a
specific mitigator. The important point is that the risk must be acknowledged and a plan articulated to
manage the identified risk.
8.Covenants:
In this section the lender should identify and define the key or controlling covenants and analyze their
capacity to serve as tools for managing the proposed credit accommodation. The discussion should make
clear why the covenants are considered to be key or controlling. In table form with narrative comments,
indicate the flexibility inherent in the covenants. For example, "the company could only lose $1 hundred
thousand before the net worth covenant would trip," or "cash flow could decline by $300,000 before the debt
service coverage ratio would be in default," and so forth.
Continue to include the Loan Approval Requirements form in the package as a concise recap of all
covenants. Perform additional sensitivity tests here in Section 8 as appropriate.
A covenant compliance sensitivity analysis of "cash flow based" covenants should calculate the projected
cash flow trigger point (e.g., EBITDA or other defined cash flow level at which the subject covenant
defaults). This projected cash flow "trigger" could then be compared to the Management Case, as well as the
Break-Even Case, for purposes of assessing the effectiveness of the subject cash flow covenant.
Changes from previously approved covenants require re-approval as discussed in the ALLISON WRIGHT
BANK Credit Policy
All terms referring to financial calculations should be defined because not every reader may use the term in
the same way. For example, the terms Cash Flow andBalance Sheet Leveragehave been used to refer to avariety of different calculations.
Provide details of past covenant waivers and defaults, if relevant to the current situation, to allow the reader
to gain a historical perspective.
All term loan transactions over $100,000 should include at least a covenant for adequacy of debt coverage.
9. Plan for Monitoring:
List the steps to be taken to monitor the credit relationship, including such items as listed below and in each
case when delivery to the Bank is required:
Audited annual financial information
Interim reporting (monthly, quarterly)
Loan agreement compliance
Personal guaranty compliance
Covenant compliance
Borrower compliance certificate frequency
Borrowing base certificate frequency
Borrowing base audit frequency
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Frequency of collateral appraisals
Use of other specialists ( i.e. meetings with other professionals, internal specialists, etc.)
Frequency of lender regular calls on the borrower/borrower (including dates for Ag Field Inspections
when appropriate).
Construction loans should have a detailed breakdown of monitoring that will take place
Attempts should be made to ensure that our covenants are at least as stringent as the most restrictive credit
agreement for our borrower. If changes have occurred in the monitoring plan, they should be described.
10.Comparison with Credit Policy
The ALLISON WRIGHT BANK Credit Policy contains poli cies and standards that all credits must meet.
Exceptions to ALLISON WRIGHT BANK poli cies and standardsare expected to be rare and are subject toan exception approval process. Explain any exceptions to policies and standards in this section with
mitigators, if applicable.
Unless otherwise indicated, it is assumed that the transaction complies with all applicable underwriting
guidelines. Narrative should be provided on all areas of non-compliance with underwriting guidelines. List
the aspects of the transaction that fall outside of the applicable guidelines and explain the approval rationale,
together withrelevantmitigating factors.
11.Relationship Strategy/Adequacy of Compensation:
Briefly describe our business and credit risk management strategies regarding the client and what other
services/transactions may be considered in the near and intermediate future. Discuss how the proposedtransaction fits within the Bank's strategy for the client. Compare level of risk being undertaken with the
level of compensation for the transaction being considered. Demonstrate numerically the total relationship
profitability. For example, a new credit line may have thin pricing, but is justified because of profitable non-
credit business.
Credit Risk Management Strategy: When underwriting large exposures, whenever possible the lending
officer should attempt to structure the transaction in accordance with Market Conditions, even if we are not
planning to sell down the exposure at this time. This is both a marketing strategy and a credit risk
management strategy. Future liquidity or credit risk management conditions may make it desirabledesireable
to sell down a large exposure. When structuring a large transaction, the lending officer should consult with
the Credit Administration to be cognizant of current market conditions (i.e. the market hurdle) with a viewto preserving our option to sell down the transaction in the future.
12. Summary: Strengths and Weaknesses:
List noteworthy strengths and weaknesses of the proposed transaction, together with any known and relevantmitigators to the weaknesses.
13. Risk Rate and Rationale:
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List the RR and justify your rationale. Thoroughly explain the rationale behind the proposed RR, especially
if it is a new facility or if the rating has changed. Discuss what events need to take place for an increase or
decrease in the loan quality rating and the expected timing (if applicable) for those events to occur. This
section should thoroughly support and explain the proposed risk rating given the known credit factors (e.g.
cash flow, collateral, guaranty). The risk rating rationale should address and account for downside risks. It
should also explain what mitigators (strengths) exist that would preclude a lower rating. In other words, it isnot enough just to explain why the recommended RR is appropriate, but this section should also explain why
the recommended RR is not better or worse.
Since credit facilities are individually rated, it is possible for a borrower with multiple credit facilities to have
multiple risk ratings based on different repayment sources, risk factors, structure, etc. If this is the case, it
should be thoroughly explained in this section. RRs may not be disclosed to borrowers or other parties
outside the Bank (including other financial institutions) absent proper court order or under other extremely
limited circumstances.
14. DDA and Other Product Offerings:Detail current DDA and other product offerings for the borrower. Explain any potential product risks and
plans to monitor and/or control those risks. Describe potential opportunities or future plans to expand these
non-borrowing products.
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CREDIT UNDERWRITING STANDARDS
What are credit underwriting standards? They are the guidelines, endorsed by the board of
directors through approval of the financial institutions credit policy, for determining the safety
and soundness of the credit-granting process. They include defining what lending practices andtypes of risks are acceptable and direct lending personnel on how to make choices between risks
and rewards. Critical factors need to be identified that significantly affect the safety, soundness,
and the repayment of a loan. These factors are called underwriting standards.
Underwriting Consumer Loans
It is suggested that the traditional Cs of credit be used as a starting point, namely:
Character
Capacity
Capital
Collateral
Condition Can We?
Character:
Character measures Human/Management Factors such as
!Borrowers moral character
!Determination to meet obligations
!Willingness to cooperate with lender
Capacity: Repayment Abil ity
While the analysis of character dealt with past performance, the analysis of capacity deals withfuture performance. Today, the ability to repay the credit per the terms of the contract is more
important than the banks having leverage to collect the credit through collateral. The difference
between a good loan and a charge-off lies in one word: repayment! It should be remembered thatit is not past performance but future performance that will determine the amount of repayment
available for the loan the lender is about to make.
The financial institution should include in its credit policy a defined method for determining
capacity to service debt and should provide guidelines that are acceptable (i.e., total housingexpense not to exceed 28 percent of the applicants disposable income; total housing and other
fixedpayments not to exceed 36 percent of the applicants disposable income).
Capital: F inancial Position
Capital can be analyzed and measured by reviewing net worth and down payment or the amountof equity invested by the borrower. The lender should make sure that every borrower has
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sufficient equity to enable total recovery of loan funds through the sale of assets if all else fails.Since problems do arise in loan repayments, lenders want assurance of adequate equity in the
borrowers assets to rely on in case repayment fails to materialize. Equity provides the cushion
against adversity and potential loss by the creditor. Down payment or equity guidelines are to be
established for each type of loan made by the bank.
Many lenders underestimate the importance of equity when making loans to commercial and
agricultural customers. The equity position is the best single indicator of the strength of abusiness and the commitment of its owners. A business with insufficient equity has little ability
to weather adversity or to take advantage of growth opportunities. It appears that, at a bare
minimum, equity would equal at least 20 percent of totalassets in almost any business.
Collateral: I dentif ication and Valuation
Collateral is the property-personal or real- against which the lender takes a lien in case the debtor
does not repay the loan as agreed. It is a secondary source of repayment.
The pledge of collateral normally adds safety to a loan, since the lender can sell the security toobtain repayment lithe debtor fails to pay. Collateral should cover interest during foreclosure,
legal costs, and reduced price due to fire sale conditions. If the loan is well collateralized, the
borrower will most likely liquidate the collateral, pay the loan, and retain the difference.
The market value of the collateral must be obtained and verified.
Split collateral (i.e., collateral of the same type in which two or more creditors each has a partial
security interest) should be avoided.
Condition: Economy
Condition of the economic environment and the impact that it has on the ability to repay the
credit to the bank must be taken into consideration in order to evaluate each credit properly.While the bank cannot abandon its customers whenever a sector of the economy becomes
depressed, extra caution must be exercised. When analyzing economic condition, determine the
stability of the source of repayment. Consider length of service, type of occupation, and stabilityof industry. The customers place of employment tends to be a concern only when the bank isaware of impending layoffs or conditions that could lead to a disruption of income, such as
seasonal employment. The loan officer must use good judgment along with the banks credit
standards and guidelines.
Can We? I ntr oduces the Credit Policy
After the traditional Cs of credit are established, one must consider whether the loan request isin line with the banks credit policy. A borrower may possess all five Cs but the purpose of
their loan request may be in direct conflict with the banks credit policy. It this occurs, a denial
of the request must be considered.
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RATIO DEFINITIONS
For manufacturing, wholesaling, retailing and service companies, a review of the financial
statements to determine the following factors should be conducted.
LIQUIDITY
LEVERAGE
ASSET MANAGEMENT
OPERATIONS
CASH FLOW
LIQUIDITY
Liquidity is a measure of the quality and adequacy of current (short-term) assets to meet current
(short-term) obligations as they come due.
Current Ratio
Calculation: Current AssetsCurrent Liabilities
Quick Ratio
Calculation: Cash + Marketable Securities + Accounts ReceivableCurrent Liabilities
Accounts Receivable Turnover Rate
Calculation: Net SalesAccounts Receivable
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Accounts Receivable Turnover in Days
Calculation: 365 days (or the number of days in a period being measured)
Accounts Receivable Turnover Rate
Inventory Turnover Rate
Calculation: Cost of Goods SoldInventory
Inventory Turnover in Days
Calculation: 365 days (or the number of days in a period being measured)Inventory Turnover Rate
Accounts Payable Turnover Rate
Calculation: Cost of Goods Sold
Accounts Payable
Accounts Payable Turnover in Days
Calculation: 365 days (or the number of days in a period being measured)
Accounts Payable Turnover Rate
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ASSET MANAGEMENT (EFFICIENCY) RATIOS
Asset Management or Efficiency Ratios measures managements ability to utilize assets to
generate revenue or create value (i.e. generate a profit).
Asset Efficiency or Asset Turnover Ratio
Calculation: Total Sales
Total Assets
Net Fixed Assets Efficiency or Turnover Ratio
Calculation: Total Sales
Net Fixed Assets
Fixed Asset Usage Ratio
Calculation: Accumulated DepreciationGross Fixed Assets
Fixed Asset Life Ratio
Calculation: Net Fixed AssetsDepreciation Expense
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OPERATIONS (PERFORMANCE OR PROFITIBILITY RATIOS)
Gross Profit Margin
Calculation: Gross ProfitNet Sales
Operating Profit Margin
Calculation: Operating Profit
Net Sales
.
Net Profit Margin
Calculation: Net Profit
Net Sales
Return on Stockholders Equity
Calculation: Net IncomeStockholders Equity
Return on Investment (Assets)
Calculation: Net IncomeTotal Assets
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CASH FLOW ANDFINANCIAL RATIOS
Financial Ratios measure the ability of a borrower to meet its financing obligations including
Interest Expense, Principal Payments on Long-Term Debt and other fixed charges such as LeasePayments.
Interest Coverage Ratio
Calculation: Earning (profit) before Interest, Taxes, Depreciation & Amortization
Annual Interest Expense
This ratio is a measure of a firms ability to meet interest payments. It measures the number of
times all interest paid by the company is covered by earnings before interest charges and taxes. A
high ratio may indicate that a borrower would have little difficulty in meeting the interestobligations of a loan. This ratio also serves as an indicator of a firms capacity to take on
additional debt.
Cash Flow / Debt Coverage RatioCalculation: Net Profit
Plus: Non-Cash Charges
+ Change in Accounts Receivable
+ Change in Inventory
+ Change in Accounts Payable
+ Change in Accrued Expenses
= Cash After Operating Cycle
Minus: Dividends Declared
+ Change in Net Worth= Cash After Financing CostLess: Current Portion of Long-Term Debt
= Cash Available for Other Debt
+ Change in Gross Fixed Assets
= Financing Surplus (Requirement)
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REAL ESTATE
Underwriting Standards for Real Estate
Capacity of Borrower
Net Operating Income*
Debt Coverage Ratio (NOI / ADS) > 1.15
Value of Mortgage Property
Overall Financial Strength of Borrower
Hard Equity Invested into Property (Including unencumbered equity in properties) Secondary Sources of Repayment
Additional Collateral or Credit Enhancements
*Potential Gross Income (PGI)
Less: Physical Vacancy
Economic (Credit) Loss
Effective Gross Income (EGI)
Less: Operating Expenses
Real Estate Taxes
Hazard InsuranceRepair/Maintenance (Buildings)
Maintenance (Grounds)
DepreciationWater/Sewer/TrashElectric (Common)
Interest ExpenseManagement Fees
Leasing CommissionsReserves for Replacement
_______________________________
_______________________________
Total Operating Expenses
Net Operating Income (NOI)
NOI = > 1.25 times
DCR
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Savannah Fresh Fish Compny
Balance Sheet
Years Ended December 31
(000)
ASSETS 12/31/09 12/31/10 12/31/11
Cash 195 126 69
Accounts Receivable, Net 475 683 994
Inventory 241 300 743
Prepaid Expenses 19 23 29
Other Current Assets 0 37 38
Total Current Assets 930 1,169 1,873
Gross Fixed Assets 782 856 1,076Less:Accumulated Depreciation (224) (323) (465)
Net Fixed Assets 558 533 611
Other Non-Current Assets 94 24 32
TOTAL ASSETS 1,582 1,726 2,516
LIABILITIES AND EQUITY
Notes Payable-Line of Credit 0 25 375
Long-Term Debt-Current Port. 26 23 15
Accounts Payable 138 231 465Interest Payable 2 2 3
Income Tax Payable 0 2 0
Accured Expenses 70 86 181
Dividends Payable 0 0 30
Other Current Liabilities 10 12 7
Total Current Liabs. 246 381 1,076
Long-Term Debt 302 280 265
Common Stock 150 150 175
Preferred Stock 0 0 0
Paid in Capital 0 0 0
Retain Earnings 884 915 1,000
Total Equity 1,034 1,065 1,175
TOTAL LIAB AND EQUITY 1,582 1,726 2,516
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Savannah Fresh Fish Compny
Income Statement
Years Ended December 31
(000)
12/31/09 12/31/10 12/31/11
Net Sales 5,937 8,481 11,025
Cost of Goods Sold 4,472 6,402 8,240
Gross Profit 1,465 2,079 2,785
Operating Expenses
Salaries 1,015 1,446 1,859
Utilities 50 70 93Insurance 21 28 36
Telephone 15 20 27
Other Taxes 5 6 9
Bad Debt Write-off 6 6 9
Advertising 88 132 171
Interest Expense 29 41 54
Delivery Expenses 99 147 195
Depreciation 84 111 154
Total Operating Expenses 1,412 2,007 2,607
Income Before Taxes 53 72 178
Gain (Loss) from Sale of Fixed Asset 0 7 (5)
Extraordinary Income 0 0 19
Income Taxes 20 28 77
Net Income 33 51 115
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RATIO WORKSHEETSAVANNAH FRESH FISH COMPANY
2009 2010 2011
Sales Growth % N/A 42.8% 30.0%
Current Ratio 3.78 3.07 1.74
Quick Ratio 2.80 2.18 0.99
Leverage Ratio (Debt/Worth) 0.52 0.62 1.14
Sales-to-Assets 3.78 4.91 4.38
Sales Net Fixed to Assets 10.6 15.6 18.0
Net Fixed Assets Usage Ratio 29.0% 38.0% 43.0%
Inventory Turnover (Rate) 18.6 times 21.3 times 11.1 times
Inventory Turnover (days) 19.6 days 17.1 days 32.9 days
Receivable Turnover (Rate) 12.5 times 12.4 times 11.1 times
Receivable Turnover (days) 29.2 days 29.2 days 32.9 days
Payable Turnover (Rate) 32.9 times 27.7 times 17.7 times
Payable Turnover (days) 11.1 days 13.2 days 20.6 days
Gross Profit Margin 24.7% 24.5% 25.3%
Operating Profit Margin 0.9% 0.9% 1.6%
Net Profit Margin 0.6% 0.57% 1.0%
Return on Equity 3.2% 4.8% 9.8%
Return on Assets 2.1% 3.0% 4.6%
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SAVANNAH FRESH FISH COMPANY
CREDIT ANALYSIS MEMORANDUM
February 25, 2012
LIQUIDITY
Liquidity as measured by the Current Ratio decreased from 3.78 to 1.74 over the threeyear period. The cause of the decrease can be traced to the rapid sales growth over thethree year period (72.8% combined).
The growth in sales was financed by short term debt as it increased from $246,000 to$1,076,000. This growth caused Current Liabilities to grow at a faster pace as a percentof Total Assets than Current Assets to Total Assets. This trend results in Liquiditydecreasing as described in the preceding paragraph
The Current Liabilities realizing the largest increase are Accounts Payable and NotesPayable, which is in response to the companys needs to support an ever increasing
investment in Accounts Receivable and Inventory. These assets grew faster than thegrowth in revenue thus indicating a slowdown in the Collection Period and the InventoryTurnover.
While sales grew by 30% at FYE 2011, the Accounts Receivable turnover slowed to 32.9days from 29.2 days over the year, while the Inventory turnover expanded from 19.7 daysto 32.9 days over the same period.
The financial impact of Accounts Receivable turning slower caused a funding need of$112,000 while Inventory turning slower caused a funding need of $300,000 over theyear. This again was funded by debt (short term) because Equity did not grow sufficient
enough to cover this need.
As a result of the slowdown in the Accounts Receivable and Inventory turnovers, itcaused the Accounts Payable turnover to lengthen from 11.3 days to 20.6 days over thePeriod.
LEVERAGE
The leverage position, as measured by the Debt to Worth ratio, deteriorated from 0.53 to1.15 over the Period. This deterioration reflects the aforementioned increase in CurrentLiabilities, specifically, Accounts Payable and Notes Payable.
Once again, the growth in sales, fueled by the increase in debt caused Leverage toelevate. Although the Leverage position is deteriorating, it is still acceptable presently.The downward trend requires close monitoring.
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ASSET MANAGEMENT
Management utilization of its assets to generate revenue and profits is improving. TheAsset Turnover Ratio (Net Sales to Total Assets) improved from 3.75 to 4.35, while theReturn on Assets (Net Income to Total Assets) improved from 2.09 to 4.53 over thePeriod.
The Net Fixed Assets Turnover Ratio also shows signs of improving as it increase from10.64 to 18.04 over the Period.
OPERATIONS
Sales increased 73% over the Period (43% in 2009 and 30% in 2011). This increasereflects the market acceptance of SFF Quick Freezing Techniques, which allows thecompany to expand its market by selling fish as Fresh Frozen across the MississippiRiver.
In spite of the significant sales growth, the Gross Profit Margin actually improved from
24.7% to 25.3% over the three year period. The financial impact of the improving GrossProfit Margin was $66,150 over the three year period.
The improved Gross Profit Margin reflects SFF success in obtaining a higher sales pricefor the fresh frozen fish and controlling its direct costs.
Management was successful in holding Operating Expenses steady as a percentage ofSales over the Period at 23.2%. Holding the Operating Expenses constant in light of thesubstantial increase in sales is a display of good management. Consequently, theOperating Profit Margin improved from 1.4% to 2.1% over the Period.
As a result of the improvement in Gross Profit Margin and Operating Profit Margin, NetProfits increased from $33,000 to $115,000 over the Period.
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CASH FLOW
12/31/06 12/31/07
Net Profit 51 115
Plus: Interest (Assuming Interest is included in CPLTD)
Plus: Non Cash Charges (Depreciation) 111 154
+ Change in Accounts Receivable (208) (311)
+ Change in Inventory (59) (443)
+ Change in Accounts Payable 93 234
+ Change in Accrued Expenses 16 95
Cash After Operating Cycle 4 (156)
+ Change in Net Worth (20) (5)
(Change in Stock Accounts, Paid in Capital, etc)
Cash After Financing Cost (16) (161)Less: Current Portion of Long Term Debt (26) (23)
Cash Available for Other Debt (42) (184)
+ Change in Gross Fixed Assets (74) (220)
Financing Surplus (Requirement) (116) (404)
SFF experienced a negative Net Cash After Operations of $156,000 at fiscal year ending12/31/07 as a result of increases in Accounts Receivable ($311,000) and Inventory($443,000). This drain on cash was offset somewhat by the increase in AccountsPayable in the amount of $234,000; however, it was not enough to counteract theincrease in the trading assets. The Accounts Payable increase is reflected by their pastdue status.
The financial impact of the Accounts Receivable, Inventory and Accounts Payableturning slower is as followers:
A/R : $30,205 X 3.7 days = ($111,925)Inv : $22,575 X 13.3 days = ($300,252)A/P : $22,575 X 9.3 days = $211,640
Financial Impact ( $200,537)
This financial impact is the consequence of these accounts increasing at a faster ratethan the 82% increase in sales over the Period. It reflects managements inability tomanage these accounts by maintaining the historical turnover rates.
Cash After Financing Costs further increased to a negative $175,000 reflecting the
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negative $19,000 change in Net Worth while Cash Available for Other Debt furtherincreased to negative $198,000 reflecting the Current Portion of Long-Term Debt of$23,000.
In spite of the large negative Cash Available for Other Debt, SFF spent $220,000 toincrease Gross Fixed Assets, which resulted in a Financial Requirement of negative$418,000.
The Financial Requirement was funded by drawing $375,000 under the Line of Creditand raising equity of $25,000 from the sale of stock. The shortfall was funded by thecompanys own cash.
RECOMMENDATION
Although SFF is profitable, it is not recommended for the bank to entertain a request forterm financing. This conclusion is due to the inability to generate cash to service future
debts as a result of the high rate of sales growth and the growth in Accounts Receivableand Inventory beyond the rate of sales growth resulting in a huge drain of SFF cash.
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