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
Source: State Average Report UPBR Report.
2012
2013
C&I Net Losses to Average Total Loans
2.00
1.80
1.60
1.40
1.20
1.00
0.80
0.60
0.40
0.20
2009
2010
2011
Source: State Average Report UPBR Report.
2012
2013
C&I Non-Accrual and Past Due Loans
4.00
3.50
3.00
2.50
2.00
1.50
1.00
0.50
0.00
2009
2010
Nonaccrual
2011
2012
30-89 days past due
Source: State Average Report UPBR Report.
2013
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.
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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
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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
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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
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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
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Recorded on a daily basis
Use of a lockbox, electronic funds, etc.
Documentation of sales process (shipping documents, bill of
lading, etc.)
Collection efforts
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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
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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.
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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
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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
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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.)
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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:
2.
Invoices generated monthly
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?
9.
Standard sales terms.....
Special Terms (if any)
10.
Does company have cash sales?
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?
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?
Monthly
Annually
0
Average amount per invoice:
Where are they deposited?
Average Monthly $ 0
22a. Any O/S Vendors invoices on billed
tooling jobs?
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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:
33.
Unissued Credit Memos? (Review returns area/authorization forms)
Goods Returned
Invoice deduction by customer
Approx. $ Amount:
$0
Are debit memos/chargebacks on aging?
34.
Credit Policy:
35.
Collection Policy:
36.
Write-off History:
37.
Invoice Process:
38.
From which bank account are payroll taxes paid?
39.
Do you have a backlog report?
Sales Backlog As Of
Current Year
Prior Year
Subsequent
Date:
Amount
Amount
Amount
Amount:
Period
$
$
$
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Inventory Questionnaire
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?
Page 33
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.