There are sources of financing other than loans. If you have outstanding receivables (also called invoices), you can sell them to a third party at a discount. As discussed in Chapter 3, the amount you can get from selling receivables depends mainly on their quality. The quality is determined by several factors the most important of which is the age of the receivable. The rule is the more current your receivable, the greater its value. Thus, the longer the term of the receivable, say, 90 days or more, the less likely you will get financing. The quality of a receivable also depends on the reputation of the company that owes the money. The more established that company, the better the chances that you will get receivable financing and at a better value. Receivables financing is a quick way of raising cash. The process and requirements for a loan application, discussed above, do not apply. The only consideration is the quality of the receivables. The speed and convenience that receivables financing offers can be very attractive, especially to businesses encountering cash flow shortages or the need to expand their business by filling new orders. But there are disadvantages the most important of which is the cost. The discount rate can be so deep and the service fee so expensive that the cost of receivables financing may be higher than the interest of a standard loan.
A good business plan will help establish if receivables financing is a good strategy, and its impact on the profitability and sustainability of your business. Receivable financing is a short-term, stopgap measure until you are able to obtain a regular credit facility from a bank. As discussed in Chapter 4, you may approach a bank or a factor for receivables financing. The critical documents are the proofs for the receivables, e.g., invoices, sales contract, etc.
Related to receivables financing is inventory financing, also known as warehouse financing. It is essentially a credit line from a bank with inventory as collateral. Like receivables financing, the process in obtaining inventory financing is faster than a loan because the main consideration is the quality of the inventory. This financing requires substantial inventory of ready for sale goods. Like receivables financing, this is a short-term solution to cash flow problems, not a prudent long-term financing strategy. The important papers for the financial institution provide proof that the inventory exists, either from an accredited inspection company or through warehouse receipts. At times, it is necessary to provide information on your accounts payable, especially for inventory financing, because in many legal jurisdictions suppliers have prior liens on inventories.
Unlike the above two alternatives to loan financing, the procedure for documentary credits transactions can be meticulous and involves considerable documentation. This is so due to the need to protect the interest of all parties to the transaction. Fortunately, many of the documents have been standardized to a great extent by the International Chamber of Commerce (ICC). The ICC publishes helpful guidelines on documentary credit operations and develops what are known as Incoterms (international commercial terms), which are trading expressions used worldwide in international sales contracts and are governed by precise rules and regulations. You have the option to adopt the ICC terms or not, but because of their wide international application, adopting them facilitates mutual understanding, especially if foreign counterparties with different laws and commercial usage are involved.
The documents listed below are those most frequently referred to in documentary credit transactions. Specimens of some of these documents are presented in the Appendix. The documents are:
Draft or bill of exchange.
Commercial invoice. Certificate of origin. Insurance certificate. Inspection certificate. Transport documents.
Application evaluation
Loans
Once all the documents have been submitted, the lender undertakes a credit risk assessment to identify and control its risks. The lender performs a standard credit analysis from the income statement, balance sheet, and cash flow statements, along with an analysis of the character and capacity of the borrower. It also identifies the primary source of debt repayment and evaluates the availability of secondary sources, such as collateral. Lenders place paramount emphasis on the quality of collateral.
Typically, the bank prepares an appraisal report that summarizes: the background and history of the enterprise; the business and its prospects in relation to the business cycle and regulatory vulnerability; the product lines and target market; management structure and competence (for SMEs, succession is an important element); continuing viability; financial condition, and previous dealings with the bank. The bank evaluates the collateral, all possible risks related to the financing requested, credit structure, and special conditions (i.e., whether the bank needs to exercise special controls over the collateral). Most of this information should be presented in your business plan. For relatively sophisticated banks, the evaluation exercise is usually summarized in a credit scoring process. Credit scoring is a credit risk assessment tool that translates credit evaluation analysis into an alphanumeric code. This process assesses the probability of default and, if defaults occur, the risk of loss by the bank. The probability of default is assessed from the borrower’s risk rating (BRR), which is usually based on the borrower’s financials, management, and market, independent of the credit structure or collateral.
Various lenders may give different weights to each of these three major criteria. Under financials, banks consider standard financial ratios for credit assessment, cashflow/cash drivers, as well as projections. Under management, lenders consider management integrity, court records and credit checking, business experience, management skills, and succession. Under market conditions, lenders analyze the enterprise’s stage in the business cycle, industry prospects, economic outlook, state of competition, and government regulation. This subjective assessment by the loan officer, which is like a rating on the submitted business plan, is then translated into an alphanumeric grade as shown in Table 5.1. The subjective assessment of your financials, management,
market and product prospects may be triple A (i.e., very low probability of default, highly desirable borrower) or double B (higher probability of default) or B, C or D grades, which likely will result in denial of the loan application. The risk of loss is determined from the loan exposure risk (LER), which is composed of the facility transaction risk and collateral risk. LER is an assessment of the amount of loss that the bank is exposed to if you default. The facility transaction risk is the probability of a loss associated with the transaction. This, usually, depends on the size of your loan and the term/ maturity of the transaction. For example, a small working capital loan has lower transaction risk than a large multi-year project finance facility.
Another factor that affects the exposure risk of the bank is the collateral risk, i.e., the risk that the collateral’s value will deteriorate over the term of the loan. Because different types of collateral have varying degrees of risk based on marketability and the degree of the lender’s control over the asset, the bank assesses the security you offer. For example, real estate in a prime locality presents lower risk of loss than equipment and machinery that may depreciate quickly. A loan guarantee from the government provides solid cover for the bank for any potential loss. As illustrated in Table 5.1, an LER rating of 1 means the loan is considered very low risk. With a rating higher than 5, the bank considers your loan as posing significant risk and will likely deny your application.
Table 5.1 Borrower risk rating and loan exposure risk
BRR Points Description LER Risk
AAA 91-100 Excellent, prime, highest quality 1 Low Risk
AA 81-90 High quality.
Low probability of default
2 Low Risk
A 71-80 Good.
With many favourable attributes of a good credit
3 Low Risk
BBB 61-70 Satisfactory.
With adequate debt service capacity within normal business cycle but with probability of default in case of disruptions to normal business cycle
4 Medium
Risk
BB 51-60 Below satisfactory.
May still be acceptable, but any prolonged unfavourable economic period may result in deterioration and impairment of repayment capacity
5 Medium
Risk
B 41-50 Marginal.
Credit lacks desirable characteristics
6 Medium
Risk
CCC 31-40 Below standard 7 High Risk
CC 21-30 Below standard 8 High Risk
C 11-20 Below standard 9 High Risk
D 1-10 Below standard 10 High Risk
Source: ADFIAP- member bank internal documents.
On the basis of the BRR and LER scores, the bank decides whether the overall risk falls within limits the bank can tolerate. Banks usually combine the BRR Acceptable
Liste de surveillance
and LER scores to determine whether the borrower is within its risk asset acceptance criteria (RAAC). If it is within the bank’s tolerance limit, the loan is submitted for approval. If not, the loan is either disapproved or submitted for approval, subject to strong justification.
Figure 5.2 summarizes the credit scoring process.
Figure 5.2 The Credit Scoring Process
Risk of loss
Risk tolerance limit
Risk of default BRR (Borrower Risk Rating)
LER (Loan Exposure Risk)
RAAC (Risk Asset Acceptance Criteria)
VS.
Financials Management Market/Industry Facility Transaction Risk
(FTR) Collateral Risk
(CRR)
Within? Below?
1. With strong justification
uCompensating business potential network Reject proposal Submit for approval FILE
Has the Eonomic crisis impacted the loan evaluation process? As previously discussed, though no widely spread lending restriction has taken place, many banks have become stricter in the evaluation of loans. The risk assessment has become tougher. Banks have also enhanced their scrutiny of borrowers’ backgrounds, returning to the old banking adage: “know your customers well.” As an SME manager, understanding how banks evaluate you and your proposal should help you prepare more adequately for the entire credit process. Knowing that business plan and collateral quality are important, you will know how to highlight your strengths and minimize attention to your weaknesses. For example, since you will likely not have sufficient collateral, you will invest more in preparing a convincing business plan. Knowing that your reputation is often the key to getting financing, you will likewise safeguard the your company’s reputational capital. (We will discuss this more in the next chapter).