Real Estate Appraisals: What is Your Property Really Worth?

A real estate appraisal provides an expert opinion on the value of the property.  If an expert tells you a property is worth $X, does that mean you can expect to receive exactly $X when it is sold?  I had an old boss who once said, "I haven't had one appraiser buy a foreclosed property for what they said it was worth!"  This brings up an interesting point to consider, which is, an appraiser can be wrong because it is not him who must buy or sell the property.  The reasons the sale price of a property and the appraised value differ have to do with several factors.

Instead of blindly accepting the value of an appraisal, a good lender must understand what an appraisal represents and how it should be used.  An appraisal for commercial real estate property will usually include three different methods for evaluating the property-cost approach, sales approach, and income approach.  The appraiser will either use one approach and explain why he didn't use the other two; or the appraiser will use multiple approaches and try to reconcile them.

Perhaps the easiest method to understand is the sales approach.  In this method, the appraiser finds comparable properties that have recently been sold, and evaluates how those properties are similar and different compared to the property he is appraising.  The appraiser attempts to adjust for differing characteristics in the set of comparables and explains whether the subject property's value should be higher or lower based on these differing characteristics.  This method works well when there are several similar properties that have recently been sold nearby, because this indicates a market for the property is established.  The use of this method becomes less valuable when comparable properties reside outside of the subject market or there are simply no similar properties being sold.

The cost approach is a method often used when it is challenging to find comparable properties.  The cost approach generally evaluates the cost of replacing the subject property.  This will include the cost of acquiring the land at market value and including materials and contruction costs necessary.  You should note this approach has little to do with market value, since the cost of improvements will likely exceed the cost of the land.  A value determined by the cost approach is more of less telling you the cost of the project, and not the price of similar projects that are being bought and sold.

The income approach evaluates a commercial property based on how much income it generates.  In this method, the appraiser treats the property like an investment that will yield an expected rate of return.  The value is usually determined by the way of a "cap rate", which is a relationship described as the property's income divided by its market value.  A good appraisal will seek out similar properties and adjust for differing characteristics, much like the sales approach; although the adjustments are made to reflect the expected income stream.  Then the appraiser looks at what the local cap rates are, by looking at the relation to income and value for similar properties.  With a market cap rate, and market adjusted income stream, solving for value is a simple algebra equation.

Often, I see appraisals that the cap rate is not derived by observing local market conditions; but rather, by looking at national investment trends.  Much like the sales approach, I feel considering data outside the local market weakens the appraiser's conclusion, since we expect the buyer is likely local, not a faceless, national investor.  It's not that the buyer couldn't come from outside the local market; it just isn't reasonable to assume this will be the most likely case.

I think the key to understanding the resale value of any property is to ask yourself who the potential buyers will be if the property needs to be sold.  The buyers will likely be local investors interested in marketable properties.  If a property is not readily marketable, i.e., can only be used for a special purpose, then the price will likely need to be discounted to attract potential buyers.

The appraisal is a tool which gives you some basis for understanding the value of the property, but it is still an opinion.  It is a mistake to use the appraiser's opined value without understanding the assumptions and methods he used to determine that value.  An institution should provide analysis with the appraisal which addresses whether potential buyers exist in the market and what the prevailing market conditions look like.  Know that if there are not easily identifiable buyers or an established market, it will likely take large discounts to attract potential buyers, rendering the appraised value moot.--Trevor Plett

Judging Farm Performance

For some farm producers, winter often allows a time of reflection of the performance of the harvest and planning for the next year.  For others where the work continues throughout the season, the close of one year and the beginning of another is a good time to perform some planning tasks.  There is value in that as my mom used to say, "Prior planning prevents poor performance."  Those words rang true in my ears as I finished a test in school.  How well I was prepared, often resulted in how well or poorly I did on the test.  But as I look at my career in finance, that saying applies to your farm producer as well.  It is a fearful situation when the farmer is just "winging it" and hoping for the best.  Oftentimes, the result is like my results on the test that I did not prepare for.

So what are some of the better ways to judge farm performance?  Clearly, one way is to focus on the revenue per acre or revenue per head.  But this can skew acutal performance as it does not take into account any input costs.  A farm with a $150 revenue per acre with cost of $50 is better than one with $200 revenue per acre with costs of $125.

I would suggest that some of the financial ratios we utilize in company analysis can also be useful here with farm analysis.  But a warning here is that just like when reviewing a company, none of these ratios should be used in a vacuum.

The first measure is Return on Equity = (Net Farm Income from Operations less Value of Unpaid Operator and Family Labor ) divided by Average Total Farm Equity.  This ratio measures the rate of return on the owner's equity capital used in the agricultural operation.  In high profit years the top third producers had ROEs as follows:  pork 23%, grain 18%, dairy 6%, and beef 12%.  The worst third had ROEs that averaged from 4.5% to -5%.

Focusing on ROE alone can overstate the performance of a highly leveraged producer.  This is since the denominator is abnormally low with the lack of equity in the farm.  So it is useful to also consider Return on Assets = (Net Farm Income from Operations less Value of Unpaid Operator and Family Labor) divided by Average Total Assets.  Here it may be good to have both a market valued balance sheet (which is useful in comparing one farm ot another) and a cost valued balance sheet (useful in comparing a farm to itself over time).

The Operating Profit Margin Ratio = (Net Farm Income From Operations + Farm Interest Expense - Value of Unpaid Operator and Family Labor) divided by Gross Farm Revenues.  The OPM measures the return on capital per dollar of gross farm income.  A farm can increase profits by increasing the profit per unit produced (with higher revenue or lower unit costs) or by increasing the production volume while mantaining the profit per unit.  OPM focuses on the first factor while Asset Turnover Ratio will focus on the later one.  Asset Turnover = Gross Farm Revenue divided by Average Total Farm Assets.  It is important in both these ratios to use the accrual basis. Some producers may deliberately hold back product from the market in seeking a better price or for tax planning.  The cash basis can provide some skewed numbers.

Another measure is change in earned net worth.  This is the accrual net income after taxes, less owner withdrawals.  In the business world it is the change in retained earnings.  This shows how the owners use their net income.  It will equal the change in retained earnings.  This shows how the owners use net income.  It will equal the change in the cost basis of net worth, with the exception of any capital contributions or distributions.

Sometimes, the profitable producer will go down the slippery slope of financial trouble when they extract more money from the farm than what it produces.  In these cases, it is important to note the "toy factor" or new cars, planes, tractors, etc. that lie around the ranch and have been purchased from the farm assets.  While there is nothing wrong with toys, there is a problem if the earnings do not support them.

There is also the trap of the farmer or rancher only looking at changes in market value net worth without questioning the actual change in owner equity of the farm.  Is the increase in equity from a windfall in land prices, which would have no relations to operating earnings?  Is your client a good or poor operator, a good or poor farm asset investor, both, or none?--Phil Love

Income: Is It Cash Flow?

In finance, we constantly hear about “cash flow.” This has to do with one particular reason, which is, only cash can repay debt. Therefore, we are preoccupied with tracing where the borrower’s cash is coming from, since the ability to pay debt will depend on the recurring nature of that source of cash.

So how hard is it to determine cash flow? That is basically income, right? Not necessarily. There are a couple of principles to bear in mind that distinguishes what we call income from cash flow. First, you have the Generally Accepted Accounting Principles (GAAP) which requires capital assets to be depreciated or amortized. Ignoring the reasons for this, what you should understand is the income statement of a business can contain several non-cash expenses that make income appear less than the actual cash flowing through the company.

The opposite can also be true when a large capital purchase is made. The income statement will not reflect the large cash expense to acquire a capital asset in the same year that expense occurred. Rather, only a fraction of that expense will actually be represented on the income statement as depreciation.

Because of GAAP, the income statement may not accurately reflect the true cash flow of the company. It is the duty of the underwriter to uncover which expenses were not actual cash expenses, and which expenses actually occurred that were not necessarily reflected on the income statement.

The other significant reason income cannot be equated to cash flow has to do with our tax system. Taxable income is not necessarily cash income. Individuals must pay taxes on their business income, which we already know is not cash flow because of GAAP. The individuals must pay taxes on that income even if they did not take any cash out of the company, and the individuals must pay taxes on that income even if the owners put money into the company!

Also, keep in mind other unique events happen as well. If people receive non-cash gifts, they must report that as income. If they sell assets at a gain or loss, only the gain or loss is reflected as taxable income, when in fact the cash proceeds from the sale were the actual cash flow. Certain forms of retirement income are not taxed. The list goes on. Just because income is taxable doesn’t mean it is cash in hand.

For these reasons, the underwriting process is not as simple as looking at an individual tax return or a business P&L. Rather, the underwriter uses these tools as a basis for analysis, and will likely formulate questions to be asked to the borrower to determine which sources of income can be counted as cash and which can’t. This may involve requesting K-1s for partnerships, which disclose cash exchanged between owners and their businesses. The underwriter will need to ask questions clarifying how cash moves to and from the individual from their accounts or other individuals, or how cash moves in and out of the business for operating purposes. This is because income, not cash, is what is being explained on income statements and tax returns.

In short, it would be easy and a luxury to be able to build a cash flow simply by using a tax return, or by assuming reported net profits are cash available for debt service. Unfortunately, the world we live in is full of caveats and special considerations. GAAP is not concerned with reflecting actual cash on income statements, and the IRS does not tax on a cash basis alone. It takes an understanding of both GAAP, IRS rules, the unique circumstances affecting the individual, and the operations of each business to truly determine what is occurring on an actual cash basis. --Trevor Plett

Cash Flow: A Good Predictive Indicator

One of the most overlooked accounting statements is the Statement of Cash Flows.  Using this can help transform a static balance sheet and accrual based income statement into a dynamic assessment of the company’s health.  An analysis of cash flow helps you know who did what to whom in the financial sense and an accurate cash budget is a good roadmap for what will occur in the future.

The reason behind looking at cash flows is simple, as net income is a creation of accrual accounting.  While this is subject to well defined rules, which are sometimes violated by the small business, accrual accounting is open to interpretation by those that use it in company financial reporting.  The primary purpose of the statement is to provide relevant information regarding cash receipts and cash payments for a certain period of time.  The user can see the ability of the company to generate cash flow, both now and in the future with the use of a cash budget.  Cash is important to understand since obligations are paid for with cash.

The Statement of Cash Flows is divided up into three sections each focusing on a different classification of a source and use of cash:  operations, investing, and financing activities.  Cash flow from operations shows the receipt and disbursement of cash from items that occur in the course of business.  It will reconcile to net operating income once changes in receivables, inventories and payables are taken into account.  

The second section covers cash flows from investing activities. This would cover monies the company pays to purchase equipment, assets, or property.  Purchases are shown as a use of cash and receipts from sale of assets are shown as a source of cash.  It is valuable for the lender to inspect several years of cash flow statements to uncover reoccurring cash expenses for assets used in the production of income. A good example here would be a hotel.  The hotel would have a lot of items like beds, desks, chairs, dressers, carpet, and tables that are necessary in the production of income.  These items need to be replaced every so often.  Understanding when these cash expenditures are needed will help the lender see future cash requirements of the business.

The last section covers cash flows from financing activities.  Here cash paid out for loan payments, dividends, or owner distributions are shown as a use of cash while new borrowings and capital injections are a source of cash.  Understanding if a company requires a constant injection of cash from financing activities will lead the lender to analyze the probability of those funds continuing in the future. 

There are several different ratios that can be derived from the statement to give a picture of the health of the company:

Cash Power of Sales = Cash Flow from Operations / Sales.  This indicates how changes in sales impact cash flow and how much of each sales dollar is available to management.

Quality of Income = Cash Flow from Operations / Net Income.  Determines how much cash flow is represented by each dollar of net income.

Interest Coverage = (Cash Flow from Operations + Interest Paid + Taxes Paid) / Interest Paid.  This assesses a firm’s ability to keep its interest requirements current.

Comfort Level = Cash Flow from Operations / Financing & Investing Outflows.  This shows the borrower’s ability to meet its financing and investment commitments from cash generated internally.

Management Factor = (Cash Flow from Operations – Debt Repayment) / Cash Flow from Operations.  This determines just how much internal cash flow is left to management discretion. 

High cash flows and earnings are characteristic of financially strong companies.  On the other hand, weak earnings reports and miserable cash flow are symptoms of a weak company.  Young, fast growing profitable companies may tend to realize sizeable costs in order to keep receivables and inventory growing.  Cash flows from operations may fall short of net income in their start-up years.  Well-established companies may periodically encounter the same situation when experiencing a growth spurt, but it could show the potential for bankruptcy if this becomes an ongoing trend.  Measuring the strength in cash flow is the most effective means of using financial statements as a predictive tool of future performance and must be used by the lender in making the credit decision.--Phil Love

Risk Rating Jargon for Business Lenders

When an institution decides it will engage in commercial/business lending, it is required they have a firm grasp of the risk involved in this type of lending. How the risk in these loans is classified is unique, but universally applied throughout the commercial lending world.

When a loan has manageable risk and is generally considered an acceptable asset, the loan has a risk classification of “Pass.” A loan classified as Pass is one which is structured appropriately, pays on time, and likely has acceptable collateral margins. Often institutions will have several subcategories within their Pass classification to indicate a more precise amount of risk. These will range from a high Pass rating, which could be an excellent or superb loan to have, down to low Pass which is fair or minimally adequate.

The next classification of risk is the Watch List. These are loans that require continual monitoring, because there are problems that have arisen or foreseeable problems which may impact the loan’s ability to be repaid appropriately. Generally speaking, a Watch List loan is not a loan the institution would originate under the prevailing conditions. These loans will be reviewed every quarter, unless they are upgraded to Pass because conditions improve.

If a loan suffers deterioration in quality, it may be labeled Substandard. A Substandard loan is inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the bank will sustain some loss if the deficiencies are not corrected. In this way, a Substandard loan does not mean a loss will occur, but the likelihood is substantially elevated.

If a loan does deteriorate to the point where a loss is imminent, the loan will be classified as Doubtful. Loans classified Doubtful have all the weaknesses inherent in those classified Substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently known facts, conditions and values, highly questionable and improbable. Simply put, a loss will occur, but the magnitude of the loss is generally unknown.

The last and worst classification a business loan can have is a Loss classification. Loans classified Loss are considered uncollectible and of such little value that their continuance as bankable assets is not warranted. This classification does not mean that the loan has absolutely no recovery or salvage value; but rather, it is not practical or desirable to defer writing off this basically worthless asset, even though partial recovery may be possible in the future. Any loan or portion of a loan classified as Loss must be charged down to $0 within 90 days.

When a loan is classified Watch List or worse, an institution needs to reserve additional capital in a special Loan Loss Reserve. This capital must be set aside to absorb potential losses and cannot be used to leverage new loans. An institution needs to carry enough capital to remain both adequately capitalized based on its leverage, and have enough capital set aside in reserves to protect against loan losses. Regulators check both capital requirements, and they also check the risk rating classifications to see if the institution is accounting for their risk accurately.

As with any business decision, balancing risk is both an art and a science. Every institution wants as many high Pass loans as possible, and nobody wants Watch List loans or worse. Often the challenge is to grasp how strong the Pass loan can remain in stressed conditions, so that it won’t deteriorate to a point where the loan would ever slip below the Watch List rating.--Trevor Plett

The Six C's of Bad Credit

All experienced lenders have heard of the Five C's of Lending:  Character, Capacity, Conditions, Capital and Collateral.  Each of these is a factor, necessary factors in good loans and a lack of them can be a harbinger of problems to come.  But not as many people have heard of the Six C's of Bad Credit.  Avoiding these will help insure a higher probability of repayment.  In this post I will attempt to review these factors.

Complacency is the first factor.  It stems from the attitude, “I don’t need to watch this borrower; they have always paid on time.”  This blinds lenders from seeing the need to monitor the company which may end up with a nasty surprise when the default comes.  Complacency can come from an overreliance on past performance of the company, guarantors, or the economy.  Some may also look at the net worth of the sponsors of the credit and think there is no need to monitor the credit. 

Lenders tend to forget hard times of the past, in light of a good economy of the present.  Forgetting past losses and problems may cause the officer to be complacent in setting standards to properly monitor the credit.  A scarier factor is the lenders who have never seen hard economic times or had the privilege of working through a problem credit.  Without these experiences, the lender may not have a healthy degree of skepticism necessary to ask the tough questions to judge the merits and flaws of the credit request. 

Carelessness is the second factor.  One of the most popular forms of carelessness is sloppy, unorganized loan files with inadequate documentation.  In some cases, collateral is not properly perfected, resulting in the lender’s collateral position being compromised.  Sometimes, loan officers will fail to document conversations with borrowers and then are caught reconstructing the file at the last minute as the bank is taking the customer to court to recover the loan.  Or they may leave items out of loan documents that should have been in there to protect the lender.

Another popular form of carelessness is a failure to establish thoughtful, adequate covenants to monitor the company’s performance through the life of the loan.  Some lenders will treat a commercial loan just like a consumer loan, and that may be fine in the cases of smaller credits.  They may not worry about the file as long as payments are made.  Then when they finally get financials from the company, they are surprised the company has a debt coverage ratio below 1:1 and the company’s net worth has been drained from operational losses and owner withdrawals. Yet, with no covenants to enforce, the lender cannot take appropriate action to enforce the bank position. 

A Communication breakdown may be a simple problem, or it can bring down an entire institution.  The first breakdown may be between the officer and the borrower.  This can lead to a startled lender, when a seemingly good credit all of the sudden is incapable of making payments.  It is important to have good relationships with the borrower that fosters communication between your borrower and you as the officer.  Remember, you should have a commanding and current knowledge of your borrower.

But there can be a breakdown of communication within your credit union or bank as well.  There can be unclear credit quality objectives and desirable lines of business from the leadership to the front line lenders.  The organization may be plagued with an attitude by top management of “shoot the messenger” if any problems are reported from the field.  Thus issues may be covered up until the time to effectively deal with the problem is past and a real loss is staring the institution in the face.  All communication should be clear, concise, and yet comprehensive to include all pertinent information.

Contingencies are the next factor.  Lenders have one of the hardest jobs as they need to be correct 99.5% of the time.  Once your losses begin to creep up over that ½% level, it could begin to impair your capital.  Truly, commercial lending has one of the smallest margins of error of any profession.  Imagine what would happen in baseball if you had to get a hit that often to be successful! 

Lending is risk analysis.  We are to look at every bad thing that could occur and then decide on how likely any of those things can happen.  A lack of attention to a downside risk can hurt the ability of the loan to get repaid if the economy slows down, occupancy drops or company revenues fall.  This is why it is important to stress test the credit at underwriting in applying breakeven analysis, increase the loan interest rate, raise the cap rate, and also reduce company revenues to see how the credit will perform.

A focus on how to make the deal work is another way contingencies are avoided.  Instead of worrying about getting the principal paid back, bankers have worried about finding a way to get the money out the door.  Sales goals should never trump credit quality goals.  Also, the pricing for risk philosophy often times causes the lender to ignore if the risk is higher, so is the chance of default.

Competition causes lenders to do strange things.  Too often, credit decisions are based upon what the institution down the street is doing rather than concentrating on the merits and risks of the loan in front of them.  Unfortunately, this often leads to loosening credit standards down to the lowest common denominator.  When the losses begin to roll in, at least you will have company with other lenders who are in the same boat. 

Competition causes lenders to do strange things.  A competitive euphoria is a sickness that may cause the institution to lower the price or seek a reduced covenant or collateral position just to get the deal.  Oftentimes, the results of these closings are touted as the credit union having a stronger market share than its peers.  But higher market share with poor credits is not a way to build your shop.  The key here is the command, “Thou shalt not book loans just because the other CU does.”

Strong revenue growth objectives may cause the lender to be tempted to cut corners in order to get the deal on the books.  This is why attention also needs to be paid to the quality of the credit.  If you are operating on a 3% margin, just one $50,000 loss means another $1.67MM of good loans needs to be closed to make up for the loss. 

Cluelessness is the final factor.  What is most scary is when either a borrower or worse, the lender does not even know what they do not know.  This can come from inexperienced staff taking on lending functions in a vacuum, without additional outside support. 

If these six factors are minimized—Complacency, Carelessness, Communication, Contingencies, Competition, and Cluelessness—the lender can hope for above average results with managing their credits.--Phil Love

Feasibility Studies: Do They Help in Underwriting?

A common theme I hit on when addressing commercial lending is more analysis is not always better analysis. Time and time again, I have stressed you shouldn’t use every tool in your toolbox just because it is there, because a one-size-fits-all approach will always result in white noise. Recently, the question has arisen whether we should be using a certain tool in our toolbox more often, that being the use of feasibility studies. Does it make sense to get a feasibility study for each construction project?

I strongly support any method that helps us understand and reduce risk. The question at hand is will a feasibility study help us assess, understand, and minimize risk? To answer that question, we need to understand what a feasibility study is. Note, “feasibility study” is not in the dictionary, so there isn’t a hard and fast definition of what one is. From context, we can assume it is a study or investigation into whether something is feasible, which is synonymous with “capable” “reasonable,” and “successful.”

Feasibility is not really a concrete idea, so it will mean something different to each person. To one person, a feasible project simply reflects the cost of accomplishing a project.  Another person may view a project as feasible if it meets certain goals, which may be unrelated to profit motive. Perhaps an investor will only view a project as feasible if it meets a certain benchmark for return on equity, and lower levels of profitability will not be deemed satisfactory. Determining feasibility is truly a subjective task.

I think it is not coincidental that there are not industry standards on feasibility studies, because the concept of feasibility in itself is subjective. Feasibility studies will need to employ whatever methods and whatever data they need to meet the request of the party that commissions the study. Because of this, there will not be methods or data that will necessarily be repeated in each study.

A feasibility study for a gas station will employ entirely different methods than a study that investigates low-income housing, and for good reason. A gas station needs to be profitable; whereas, low-income housing needs to meet the needs of a specific population, and perhaps only needs to break-even or may be allowed to operate at less than break-even to meet its goals. 

Note that this is unlike appraisals, which will have to conform to a cost approach, sales approach, or income approach; and there is an attempt to reconcile each method in the appraisal. Feasibility studies do not have to conform to a certain method. Like I mentioned, there simply won’t be a method that can universally conform to each feasibility study.

So, can a feasibility study help us assess risk? They may, and they may not. The feasibility study helps assess whether a goal will be met, which may or may not tell us something about risk. If we were to engage a third party to specifically assess the financial feasibility of a project, this would present a challenging obstacle. In the absence of standards, how do we determine who is qualified to undertake the task? If a report is prepared by somebody not qualified to assess the project, now the feasibility study is introducing additional risk into the decision making process, rather than mitigating risk.

To me, it is clear a feasibility study is not a tool that will regularly inform us about the risk, so to seek one out for every project would be cumbersome and pointless. It is a tool, however, that has a special purpose and is useful in sampling markets for which little is known or helping understand atypical requests. In this way, they will gather data that is not readily available and show how it could support a request. But, in this way, feasibility studies are reserved for special circumstances.

For established markets and standard requests, an appraiser will employ standard methods that show how markets are establishing the value of a project, which is far more practical for underwriting purposes. A feasibility study tries to project what will be, and trying to underwrite to a subjective projection is risky and should not be done.

Checking in on your Non-Profit

Many of our institutions provide financial services for various non-profit organizations.  Most of the time, this comes in the form of deposit accounts.  But it we may also have loans or even may serve on a board or committee for a non-profit. 

I once served as a treasurer for a non-profit that was recovering from an ex-president who had embezzled tens of thousands of dollars from the organization.  This soiled the reputation of the charity among its givers and also in the community.  The group went through a forensic audit to uncover how much was lost, why it was lost, and what could be recovered.  The group leadership learned quickly that a fun way of contributing back to the community soon became a serious drudgery as they worked to figure out how to survive. 

Dangers exist from many sources for non-profits.  Embezzlement and waste of funds from within can drain off precious contributions from where they should go and drive donors away.  Poor leadership can fail to rally adequate support and energy to keep the organization growing.  Reliance upon a small group of large donors can be painful if one decides not to contribute.  A lack of fresh volunteers can also doom the organization into failing to innovate and reach out to new people.  And for those who serve in leadership, board liability is real.  If liability is not there, then a poor reputation for the organization and its leaders may arise in the community.

Insist on top-notch financial reporting.  I fired the existing accountant when they could not explain the financials.  I also thought that whether or not the bookkeeper was involved in the embezzlement, the fact that it happened on their watch was enough to let them go.  We recruited and hired one of the best firms in town and also set up an audit, something I recommend for any non-profit, especially those with revenues over $200,000.  Your donors want to make sure their money is spent wisely.  Why would you give money to a group that was wasting it?

The financial reporting should include a monthly income statement with a comparison to budget and the past year.  If the revenue or expenses fluctuate, looking at the performance of this year’s period to previous years is valuable.  A balance sheet prepared according to GAAP should also be presented.  Finally, a statement of cash flows is also useful.  It is not only necessary to present these to the board, but they must be broken down and explained in terms that the board members can make educated decisions for the group.

Use top-shelf leadership talent.  I always think non-profit leaders have often one of the hardest tasks as they do not have the power of the wage to hold over the workers.  Since there are also so many good causes around, it is easy for people to leave one group and go work for another.   This makes it even more important for the successful non-profit to have excellent leadership.  An organization will not grow beyond the leadership capability of its head.  If your non-profit or church cannot grow or is losing lots of members, you need to look at the leadership capability. 

I once attended a church that suffered from a vacuum of good leadership at the top.  In the space of several months, the 1/3 of the other leaders left, the youth group went from over 60 to the single digits, and offerings dropped in half.  The worship team left and the attendance dropped by 2/3.  In this case, the inability of the leaders at the top were driving the organization into the ground.

Now if you are a leader or volunteer for a non-profit, find a cause or organization you can work passionately in.  Life is too short to live half-heartedly.

Keep the cause at the top of your mind.  I worked on a board that raised money for college scholarships for needy students.  We increased our donations and workers when we began to let our students become our best advertising piece.  They were at our telethon, golf tournament, banquet, and other fund-raising events.  We had some of them work in the office.  We put their stories on our website.  The story moved from the “traditions” of the institution to the needy kids.  Donations began to pour in.  Emotions and belief in causes will often cause people to open their hearts, and give their time, talent, and treasure. 

Member Business Lending--From Scratch

Working for a CUSO that specializes in Member Business Lending is an exciting opportunity. On an average day, I can work with credit unions that have decades of commercial lending experience and credit unions with little or no business lending experience. Fulfilling a unique role for each credit union’s level of experience is challenging, but fun and rewarding.

I am surprised that both our experienced and inexperienced credit unions are asking for training on commercial lending. The experienced credit unions want to further develop their staff and make sure all people involved in commercial lending understand how the loans are structured and managed. The credit unions that are inexperienced with commercial lending want to develop a new line of business to better serve their members while benefiting from better earning assets. This has also prompted a unique question for these credit unions new to commercial lending, which is, how does a credit union start a business lending program?

We had talked with one credit union that asked if we would help them advertise and do other things to attract new business, once we help them put a member business loan policy in place. This was an interesting question, and it really highlights the difference between consumer lending and commercial lending. While advertising and putting a banner up is a good way to attract new consumer borrowers, it would actually do the opposite for attracting commercial borrowers. The commercial borrowers you will likely attract are the types who were unable to get a loan at any other financial institution. Why is this?

Commercial lending requires a lot of work and understanding on the lender’s behalf, and a good commercial borrower knows this very well. To change relationships is to take a big risk and could lead to access to credit on different terms with a different lender. Commercial borrowers don’t like uncertainty, and going to a new institution brings uncertainty.

While occasionally a good commercial borrower will have a relationship soured by a bad lender, it is more often the case the relationship is soured by a bad borrower; thus, it is often the bad borrower on the hunt for a new lender. How is a credit union new to commercial lending supposed to weed out the bad borrowers from the good borrowers?

Really the answer is already right under your nose, and that is the credit union may already have good relationships with depositors or consumer borrowers who now have commercial borrowing requests. To their credit, I think most of our credit unions new to commercial lending already realize this. But still, the question remains as to how to attract new commercial borrowers.

I can really think of two primary ways to find new borrowers, and they both require patience. First, providing exemplary service to a borrower can often lead to additional business. When a borrower is happy, they are likely to do additional business with you and tell others about the great service you provide.

The second way to find quality borrowers is to get involved in the community. Serve on boards, join trade associations, and volunteer in community projects. This really ties back to providing quality service, but for your community. This is a good way to meet new people, and good borrowers will know who you are and take note. You will build relationships with them through work outside of the institution, and they will feel comfortable coming to you with their commercial requests in the future.

This is probably the best advice I can give as to how to grow your MBL portfolio organically, although it is always possible to hire seasoned commercial lenders or purchase participations as well. The key concept to understand is growing a strong MBL portfolio takes patience, because advertising commercial loans like consumer loans will often attract borrowers who were shunned by other institutions.--Trevor Plett

Does Your Use of “It’s Our Policy…” Hack Off Your Clients?

We all have experiences when we have had the term said to us, “I am sorry, I can’t help you.  Our company policy forbids us from…”  I would suppose from time to time we all have used that term where we work.  In almost every case, the use of these words reminds us of negative experiences when the customer left apathetic or as mad as a wet hen!

The most recent experience I had with this was when my wife and I were shopping for a new vehicle.  We were quite undecided as to what type of car or truck we wanted.  But one factor was how much we could get from our Trailblazer in trade.   We figured if we had a dealer that would offer us close to the NADA trade-in value; we would know we were getting a fair deal. 

After test driving some models, we settled on one to get our quote.  We handed them the keys to our vehicle to review it and see what they would do for our trade-in.  After 20 minutes or so, the salesman came out to the table that we were sitting at and handed us a piece of paper.  He began to go over the deal line by line and sped quickly through the trade-in value.  My eyes widened when I noticed the trade-in value they were giving us was less than a quarter of the value we had looked up.  I questioned where he got such a low value.

He replied, “I noticed some concern when I showed you this value.”  (No duh Sherlock, I saw the value and was ready to slap sense into you).  He continued, “Based on the age and condition of your vehicle, it is our company policy that this is what we will give you.”

My wife was clearly agitated and also restraining her desire to slap the salesman as well, as she asked more of why the value was so far below the actual value.  All in all, I think we both did a great job in being calm.  The salesman retreated to his finance manager for another 20 minutes and came out with another offer.  Now we were at least over 25% of the value but were not even at half the book value.  He painstakingly explained what they could do.  We decided to leave and were met on the way out by the sales manager.

“It is our company policy to not put vehicles as old as yours on our lot. We wholesale them to other lots, so we cannot offer as much as the value of your vehicle,” he explained.  Now I have two incidents of someone throwing out the “company policy” excuse to us.  As we left, I asked my wife if she thought it was their company policy to hack off their potential customers.

Two weeks later, we bought a truck my wife loves from a different dealer.  We never heard back from the salesman.

I can never think of a time when I had the words “our policy” thrown at me that turned into an enjoyable experience.  I am interested if anyone else has had any positive experiences when the phrase was used on you.  I think that we, in the credit union world, have an edge on our banking brethren in that we view our members as players on the same team.  But I still bet we slip up and use the “policy” explanation when we cannot do what a customer wants. 

Note, I am not advocating that we give the customer whatever he wants.  There are clearly things our members will want that we cannot or will not do.  But we need to change our attitude toward our customers, and stop using the “policy” word.  We need to act on principles instead.

Remember, the member is why you get a paycheck.  Your attitude toward them will determine the level of service you give and ultimately, your own success.  Every interaction with a customer is an opportunity to deepen or slowly kill the relationship.  Members contact you when they need help, and their value is much more than the annual revenue you will get from them.  Once your interaction with your member is complete, that is when they will start talking.  And customer testimonials are much more powerful than the money you spend in marketing.

Take responsibility for why you will not be able to meet your member’s request.  Act on principle; do not hide behind policy.  People respect you when you shoot straight with them.  Realize how you want to be treated, and treat others the same.

Jeffrey Gitomer once wrote, “’Give me liberty or give me death’ is a principle.  People are willing to die for their principles; very few are willing to die for their policy.  Are you?”

Why We Should Fear Default on Government

No matter your political stripes, I think it is important to understand we all lose if the government defaults on its debt. I fear there is an attitude that the world hasn’t fallen apart due to a government shutdown, so how much worse would things get if we defaulted on payments?

A default would be a lot worse; worse than any of us could imagine. Let me try to explain.

The debt the United States generates is considered risk-free to investors. Why? The American economy is an awesome, flexible force not matched by any other in the world. Based on our population size, no other economy comes close in terms of productivity per person, innovation and income. This means our economy is robust, and our government should have little problem collecting taxes and repaying anything they borrow. Investors do not fear that we cannot repay our debt. The problem we are facing is whether or not we want to repay our debt.

If we don’t pay our debt, or at least don’t pay timely, US debt will no longer be considered risk-free. This means investors will demand a higher interest rate on our debt for taking more risk. Why is this a big deal? It will force interest rates everywhere to go up. Interest rates are really the price of money.

To better understand the pricing model, imagine for a second we weren’t talking about money but were talking about a different product, like gasoline. Say you pull up to a gas station pump, and you see you have three different grades of gasoline. The price for the cheapest grade is $3.00/gallon. The next cheapest grade is $3.20/gallon, and the most expensive grade is $3.40/gallon. Now say there was a shock to the oil market, and suddenly the cheapest grade is $3.50/gallon. You know that the other grades are going to move up in price. You will probably see the mid-range grade jump to $3.70/gallon and the premium jump to $3.90/gallon. The point is, with US debt being the baseline for the least risk and the cheapest debt out there, if the price of our debt increases, the price of all debt will also rise. If interest rates rise on our government debt (because now it is “riskier” due to a default) debt everywhere will become a lot more expensive. Car loans, home loans, business loans or any loan will increase in price via the interest rate.

How this will affect the economy can be best understood with the simplistic model put forth by economists, which says Economic Output = Government Spending + Investments Made + Consumer Spending + Net Exports. Now, we see with sequestration and the government shutdown, that government spending has decreased. That has a negative impact on economic output. But, this hasn’t caused backwards movement of economic output. Why? Because consumer spending has increased at a faster pace than government spending has decreased. Like I said, the American economy is robust! But a default will have different consequences. This is because it will also greatly impact consumer spending.

It would be helpful to understand how much each piece of the model contributes to economic output. Here are the numbers I was able to readily find for the annualized 1st quarter of 2010 (I couldn’t use 2013 data since the government shutdown has led to a denial of access their current databases):

                Total Economic Output :   $14.6 trillion

                Government Spending :      $3.0 trillion (21% of the economy)

                Consumer Spending:         $10.3 trillion (70% of the economy)

                Investments Made:             $1.8 trillion (12% of the economy)

                Net Exports:                          -$0.5 trillion (-3% of the economy)

As noted earlier, a default will cause interest rates to rise. When interest rates rise, that will decrease both government spending and consumer spending. The government will need to use more of its funds to pay interest and will have less money to spend on public works and services. Likewise, consumers and businesses will use more of their money to pay interest and will have less money to spend on products and services. Remember, consumer spending is 70% of the economy, and government spending is 21% of the economy. That means a default will certainly impact 91% of total economic activity. A recession, which is when economic output shrinks, would result. If interest rates rise suddenly, government spending and consumer spending will drop suddenly. The immediate recession could be far worse than the housing crises we experienced 5 years ago.

How bad the recession would be will depend on how high the interest rates go. Nobody knows how high the interest rates will go. Frankly, I don’t think it is worth the risk to test it. One default will be enough to permanently shift interest rates, and the U.S. will likely never be considered risk-free again. In this sense, one default opens Pandora’s Box, and there will be no going back, as we will always be stuck with higher interest rates.

There is another idea floated which suggests the government could make its debt payments but not make domestic payments due to government agencies or citizens. This is a weak argument within the financial community. In finance, when we look at someone’s ability to make debt payments, we look at total cash flow. We expect the borrower to be able to pay all expenses and pay all debt. If we know the borrower does not have enough money to pay both, we will likely not grant them a loan. Would you give a loan to someone who argues they make enough money to pay their debt, but cannot pay utility bills and employee wages? This is risky, and that means interest rates are sure to go up in this circumstance anyway.

One certainty about the impact of increased interest rates is it will impact all of us. Unlike the housing recession that hit some regions harder than others, the increase in interest rates will infiltrate every community in America. The extent as to how much it will impact our Congressmen and Senators is harder to predict. As of 2011, the average net worth of a representative in the House is $6.5 million, and the average net worth of a Senator is $11.9 million. While members of Congress will also be impacted, it will clearly impact the average American household far worse whose average net worth is estimated to be $77,300, which is 1% of that of the average member of Congress. Perhaps this is why Congress fears the default less than us of the general public.--Trevor Plett

Farmer Mac as a Balance Sheet Management Tool

We recently closed a Farmer Mac loan financing crop land on a long term fixed rate.  There were lots of benefits to the credit union member which included a long term fixed rate on the loan, a lower annual payment than what the couple previously had, a loan that does not balloon, and the ability to complete a contract for deed.  The borrower was quite happy at the closing.

As credit union folks, we do enjoy finding ways to serve our members by meeting their financial needs.  But have you considered the benefits to the credit union?

The correspondent credit union received a portion of the origination fee at the closing. All finance people are looking at ways to generate more income.  The origination fee will provide extra earnings.  But, the non-interest income is not the only source of income for the credit union.  The credit union priced the loan so they would earn money with each payment. MWBS allows for each correspondent to add up to 75 basis points to the interest rate.  This provides an annuity stream of income for the credit union through the life of the loan.  In the first year, the CU will recognize over $4,200 of income on a loan that is under $500K which is not even carried on their books! 

It is easy to see the non-interest income benefits to Farmer Mac once the checks come in.  The benefits to the balance sheet of the credit union are often overlooked.  The first benefit is the elimination of the duration risk associated with the long term fixed rate.  No institution should feel comfortable with giving a 25 year fixed, knowing that at some time the margin will be compressed or may even be negative compared to the cost of funding.  So off-loading longer term agricultural land and facility credits that want fixed rates will be a wise asset-liability management strategy.

Next, consider concentration risk.  The credit union may want to provide as many services as it can for the good ag member.  What do you do when the farmer’s borrowing needs exceed your capacity?  Do you send him to the banking institution down the street?  Well that is often the path that is chosen.  An alternative is to allow MWBS to provide secondary market financing with Farmer Mac to off load the farm or ranch land and facilities financing and allow the credit union to continue financing the equipment and operating lines.

Another benefit is getting a loan off the books that the credit union should not have done in the first place.  This does occur from time to time.  There are cases of a credit union closing an ag loan for a member when they do not have the regulatory blessing to do business lending.  In this case or in the case of a concentration limit, moving loans to Farmer Mac provides a way to clean up the balance sheet.  In our recent closing, enough debt was moved off the credit union balance sheet to leave a small balance below the $50,000 limit.  This can be managed easily by the CU. 

The next time your farm or ranch customer has a land or facilities financing need that you either cannot or do not want to do because of balance sheet management goals, consider MWBS.  We can help the client with good secondary market financing that will keep you in the customer relationship and also allow you to continue to make income through the life of the loan.--Phil Love

Conditions: Understanding the Market and Understanding the Borrower in that Market

When considering a request for a commercial loan, we are concerned with mitigating all possible things that could go wrong. We try to corral all risk into 5 categories which are called the 5 Cs of credit. If our 5 Cs are strong, the loan probably has a high chance of success. The 5 Cs are Character, Capacity, Collateral, Capital, and Conditions. Character examines the borrower’s experience and capability to remain in good standing. Capacity evaluates whether the business can generate enough income to repay the debt. Collateral provides a contingency plan should the income from business fail to pay the debt. Capital is also evaluated to assure the business has resources to fall back on in unforeseen events, and capital assures the lender is not taking all the risk in the transaction.

The remaining C that needs to be discussed is Conditions. Conditions are concerned with the business environment in which the borrower is operating. But what is unique about business conditions is they can be both external and internal. It is not difficult to understand that if the business is in a struggling industry, the business itself may be struggling.

Understanding “conditions” starts by understanding the current market. Every market will have two basic components, which are supply and demand. It will likely be impossible to exactly determine supply and demand in the specific market, but that doesn’t mean market conditions should be ignored! There are often various reports that can be used for different business types. Hotels will have Smith Travel Research (STR) reports, and there are several real estate research firms that help determine supply and vacancy of various real estate types. In dealing with commercial and industrial operations (C&I), supply and demand will be more challenging to determine.  Detailed reports will not always exist for every industry in a specific market. The burden is on the lender to better understand who the borrower’s customers are, and whether they will have a continued demand for the borrower’s products or services.

One of the common mistakes I have observed is too much faith placed in reports that are available. There are firms that specialize in producing reports on specific industries, but what these reports provide is a broad overview of the national market that will not capture unique local conditions. For example, perhaps the fertilizer market will face a downturn if the national economy experiences a recession because of overbuilding in residential real estate. Several people leave their homes or are foreclosed upon, and then the lawns of those homes will be left unattended. While national data may show the fertilizer business is struggling because fewer people are buying fertilizer for their lawns, in the agricultural states like the Dakotas, the need for fertilizer for crops may be booming because of high commodity prices.

The internal conditions of the business are important too. We are interested in knowing if the business looks and operates like similar businesses in the market, and if the business can restructure itself if the market were to change. Internal conditions we are most interested in are profit margins and operating leverage. Profit margins tell us about the health of the business, as well as, the market that business is in. Stable profit margins from year to year indicate the business is effectively operating in its market and that market is likely stable too. Erratic profit margin reflects the opposite. What an ideal profit margin should be is hard to speak to, since this will vary depending on industry type. Generally speaking though, I think net profit margins that are 5% of revenue or less are concerning, no matter the industry type.

Profit margins will also be affected by operating leverage, which is the degree to which expenses are fixed. High fixed expenses means high operating leverage. This means as revenue increases, expenses will remain relatively the same, and profit margins will increase. This will also mean the business will suffer if revenue declines, because it will be unable to lower costs. In an ideal world, most expenses would be variable so they can track upward or downward with revenue to preserve a constant margin. It is the lender’s responsibility to understand the borrower’s operating leverage, so it is understood how well the borrower will handle changes in the market.

Just like there are reports that tell us about different industry markets, there are reports that compile different business operations to give averages and benchmarks. You can consult these reports to see typical profit margins and operating expenses for similar businesses. Again, we need to take these reports with a grain of salt, because the operation of a business should be put in context of the local market and not national averages. Nationally, widget manufacturers may have small profit margins because of strong competition, but if there is less competition in your local market coupled with strong demand, you would expect to see the local widget manufacturer to have a bigger profit margin.

To summarize, understanding the conditions of the business are also important because it gives us insight into the viability of the borrower. We should be careful to lend to borrowers in struggling markets or borrowers who have poorly structured operations. To understand the market, we need to understand supply and demand. Obtaining local data is paramount, and even though exact supply and demand will likely not be determinable, local studies by economic development bureaus and local information from federal agencies is helpful in understanding the market. To understand the internal conditions of the borrower, it is the lender’s responsibility to work with the borrower to know the business’ primary customers, the extent to which expenses are variable or fixed, and what the profit margins of the business are. If a lender cannot adequately understand the profit margins and expenses of a business, the lender is taking a big risk by extending credit without fully understanding his/her situation.

To wrap up the 5 Cs discussion, it is important to understand that extending credit really boils down to common sense.  In reality, the 5 Cs are an exercise in sound judgment and common sense. Don’t the 5 Cs seem like readily obvious questions to address?

The goal of credit analysis is to assess whether credit can be repaid. If there is a concern that a loan may not be repaid, it can likely be articulated as a weakness in one of the 5 Cs that has been addressed.  It is impossible to anticipate all of the reasons a loan could go bad, but if the 5 Cs are strong, it is likely the borrower will be well positioned to handle those risks, which means the institution will be well positioned to be repaid.--Trevor Plett

Stress Testing

Every now and then, a topic will become in vogue with regulators.   It can make them more excited than my dogs when I have some rib bones left over from a BBQ.  One topic in recent years has been stress testing loans or the loan portfolio.  Sometimes, the examiners will ask if stress testing has been done but not give any advice as to what kind of stress testing should be performed.  I have heard from several institutions that these questions we recently made by their auditors.

Putting a loan under “stress”, is to change some of the variables of the loan or the financials of the company and see how those changes will impact the performance of the credit.  These items should be done at the initial loan underwriting, at some term loan reviews and also during exam or audit time.

For individual loans, one of the most common ways to stress the credit is to imply a higher interest rate on the loan and measure how the loan will perform.  Will the company be able to make debt service?  How much free cash is left over?  Clearly, this stress is not applicable for a fixed rate loan.  The lender may not have the same need to stress the rate on a loan that has a locked rate for a reasonably long period of time, as compared to a variable rate loan.. 

Common interest rate stressors would be to increase the by 100 or 200 basis points.  Some large institutional lenders will impose an artificial interest rate upon all their loans to see how they act.  Recently, this rate was between 6-6.5% for most commercial real estate loans in the capital markets. That is, all loans would have a rate of 6.5% imposed on them to measure their debt coverage.  If the credit would  pass the minimum threshold for DSCR, the credit was acceptable. 

Another way to look at as individual credit is to check changes in the LTV with changes in the cap rate.  An increase in the cap rate will result in a decrease in the value and a subsequent increase in the LTV.  Increasing a cap rate to a more normal market rate could show a possible loss and the extent of the loss if the loan were to go bad. 

A third way to sass a loan is to reduce top line revenues that will result in a decrease of net operating income and subsequent impairment of the firm's ability to make its obligations   Some options here would be to use an average of a growing firm’s NOI over several years or take the worst year's performance of the several years that are reviewed.  In some cases, a percentage drop in the NOI will be used.  If the firm is able to produce an adequate DSCR, the loan is deemed to be good. 

This option is tricky.  Just an across the board reduction of a certain percentage of gross income will not necessarily equate into the same drop in the bottom line money available for debt service, owner’s profit and capital improvements.  The same percentage reduction in the top and bottom line assumes that all expenses for the firm are variable, when actually only some of the operating expenses will be variable, some a fixed and some are a mixture. 

Another factor in stressing a loan is to look at the balance sheet of the firm and the guarantors.  We recently looked at a loan that would be considered marginal if the rate or the revenue were stressed.  Yet the company and the owner had a year’s worth of payments in cash.  This cash helps mitigate any surprises in the cash stream. 

Some creditors will do a “breakeven-analysis”.  This measures how far the cash flow available for debt service can fall or how high rates can rise until a DSCR of 1:1 is reached.  The larger the gap between the actual performance and breakeven limit, the safer the credit.

It is valuable to stress the loans during underwriting.  It also may be valuable to stress test loans at term loan review time.  I would suggest utilizing a possible combination of the methods listed above and use it thoughtfully.  Follow sound logic behind the stress testing and you will not only be able to please the auditor, you will also be managing the credit better. 

Capital: Borrowers Must Share in the Risk of Their Loan

I am continuing to talk about the 5 Cs of Credit. Already, I have addressed Character, Capacity, and Collateral. In this piece, I address Capital.

Capital is best understood through the accounting equation of Assets = Liabilities + Capital. In a simplistic financial institution, assets are loans and liabilities are deposits. Capital is funding provided by the owners. Now, let’s say a $1 million loan goes bad and is not repaid. Assets will be reduced by $1 million. Since Assets = Liabilities + Capital, that means Liabilities or Capital must also be reduced by $1 million. Since the Liabilities are deposits provided by other people, regulators will force the institution to reduce $1 million in Capital, so the owners take the entire loss and not the depositors.

Capital, in a commercial lending transaction, is the investment the borrower has at risk. When an institution makes a large commercial loan, they are putting millions of dollars at risk. Even though Capacity, Collateral, and Character may look great, the bank should not provide financing unless the borrower has some of his/her own money at risk as well. Why? Because if a project goes bad, then the lender will experience all the loss and the owner will lose nothing if they have invested nothing.  And if the owner has something at stake, the owner does not only suffer part of the loss should it go bad, but it he/she will also have incentive to make the loan work.

A common ratio used in C&I and Agriculture is the debt-to-net worth ratio, although a debt-to-assets and equity-to-assets are also used, and they all effectively measure the same thing. When we look at debt-to-net worth, we are dividing total liabilities by net worth to determine how much of the balance sheet is funded with debt, and how much is funded with owner’s capital. Going back to the equation of Assets = Liabilities + Capital, we can tell all assets are funded with either Liabilities or Capital. Liabilities are someone else’s money; Capital is the owner’s money. The more assets are funded with capital, the more risk the owner is assuming. The more assets are funded with liabilities, the more someone else is taking the risk.  Naturally, we would like to see the owners take as much risk as possible with their own capital and as little as they can with liabilities from someone else.

For example, let’s say we have $10 in assets and $5 in liabilities, which gives us $5 in capital. Debt-to-net worth, which is total liabilities divided by capital, comes to $5/$5 or equals 1.00. This means for every $1 of debt, the owner contributes $1 in capital to fund all assets. Now let’s say we still have $10 in assets, but now have $9 in liabilities, which means we have $1 in capital. Now debt-to-net worth is equal to $9/$1 which is 9.00. As you can tell, Liabilities (or other peoples’ money) are funding almost all of the business assets, and the owner is contributing very little of his/her own money. The owner is only providing $1 for every $9 he/she borrows! Generally speaking, the larger the ratio, the less risk the owner is taking and the more risk others are assuming.

The appropriate amount of capital for C&I operators will depend on the specific industry. For example, service providers will likely have only a small amount of fixed assets like computers and telephones, but they will have a high amount of A/R and accounts payable (A/P). Because A/R and A/P grow rapidly together, debt-to-net worth may also increase rapidly. A/P is a liability, so if A/P increased and capital remains relatively constant, debt-to-net worth will increase. In general, a high debt-to-net worth ratio for a service provider is 3.00 or higher.

For C&I operations that require a substantial amount of fixed assets, like land and large machines, there will be a more stable level of assets constantly on the balance sheet and any resulting term debt should remain at a stable level too. Because of this, we would expect debt-to-net worth to remain more stable.  But, we want to see the ratio lower because the asset values of these fixed assets are subjective and can vary, and they may be specialized and illiquid. It is normal for capital-intensive C&I operators and Ag operators to have a nominal debt-to-net worth ratio of 1.50 or less.

In commercial real estate (CRE), there are also ratios to judge a borrower’s capital position. The most common you hear of is loan-to-value, or LTV for short. As the name would imply, this means dividing the loan amount by the value of the real estate to obtain a ratio. Generally, we like to see an LTV between 70% and 75%, but this could be higher or lower depending on several circumstances. This implies the owner would have 25% to 30% equity invested into the property. This seems good in theory, but consider the following example: An investor needs to borrow $1 million to purchase land and $1 million to construct an apartment building. An appraiser estimates the finished apartment building will be worth $3 million. The investor comes to your institution and wants to borrow $2 million, and can prove he will have a 67% LTV loan ($2 million loan / $3 million finished value). With an LTV of 67%, does the borrower really have 33% of his capital invested in the project? No, he doesn’t, because he is asking for 100% of the cost of the project. This brings us to the second CRE measure of capital; loan-to-cost or LTC.

LTC is the loan value divided by the cost of the project. Much like LTV, we like to see LTC around 75%, and it could be higher or lower depending on the circumstances. Often with CRE, there can be some unique wrenches thrown into the LTC calculation. When we want to see an LTC of 75%, what exactly constitutes the 25% capital that the owner has to provide? Total cost is made up of several components: land, materials, labor costs, developer fees, architectural work, engineering, etc.

Capital is a tricky element to assess in this situation, but instinctively, we like to see cash up front before any costs are incurred. Cash has a determinable value, and having to forego other uses for that cash really ties the borrower to the project. Other sources of equity are less desirable, but may be considered, depending on special considerations. One example is allowing a developer to contribute equity in the form of land. That may be acceptable, since land has an easily determined value, but the true value of the equity is less reliable than seeing cash in hand. Other forms of equity deserve more scrutiny and generally should not be considered under normal circumstances.

Now that we have looked at the role of capital in both C&I and CRE, we see that capital actually serves two unique purposes. Capital ensures that the borrower also shares in the risk by facing the same consequences and losses the lender faces, and capital also provides a buffer for the unknown and unexpected. For C&I, when debt-to-net worth is adequate, borrowers can fund a significant amount of assets themselves and not rely entirely on borrowing. This should provide borrowers with the ability to handle any unforeseen events.

Equity in real estate is measured differently. As discussed in my Collateral article, I noted adequate LTV protects from changes in market value or unforeseen issues with real estate. In this way, LTV assures equity remains in the property and also serves as a buffer for the unknown. Capital should also be controlled through LTC to prevent 100% financing.

To summarize, Character assures us the customer can remain in good standing and continue to repay. Capacity evaluates whether the borrower’s business operations are satisfactory to repay the proposed debt. Collateral provides us with a contingency plan, if cash flow from the business is unable to repay the debt. To assure the customer is well invested in their business and can handle the unknown, we like to see an adequate level of Capital. The last C we need to investigate is Conditions, which we will look at next week.--Trevor Plett

Interest Rate and Cap Trends--Fall 2013

Last Friday, the Federal Open Market Committee (FOMC) announced their decision to leave the monthly $85B bond buying program unchanged for now.  This action is countered with the consensus that the Fed will begin tapering its bond buying program within the next year, thus lowering demand for bonds and increasing the interest rate.  The Fed realizes there are significant struggles in the economy and different signals that are opposed to each other.  While unemployment is down, the labor force participation rate is the lowest it has been in decades and new job growth has largely been part-time in nature.  While inflation seems to be in check with the Fed’s measurements, anyone who has gone to a store recently can tell you otherwise.  While housing seems to be recovering, the impact of higher mortgage rates and underwriting standards tend to mute those gains. 

The decision to continue the Quantitative Easing caused a steep drop in 10 year rates, which have raised over 100 basis points this year.  This should benefit the residential sector.  If underwriting standards ease, this expanded access to credit is a prerequisite for a sustainable economic expansion.  A continued accommodative lending environment will aid in the refinance and restructuring of maturing loans and more capital will favor real estate as a sound alternative to low-yield bonds and volatile equities. 

But even with the sharp increase in rates this year, Treasuries remain close to their 50 year low and are at less than half of their long term average.  Cap rates on real estate, defined as the net operating income divided by the price, have declined to an average of 7.2% on all commercial real estate.  The gap between the 10-Year Treasury and commercial cap rates has fallen from 490 bps down to its present level of 440 basis points.  This is still 60 bps above the long term average.

A wide range of factors have come together to change the structure of commercial real estate values.  The intertwining of the US and world economies, deep integration of debt and equity markets, and the addition of financing vehicles such as REITs and CMBS have all contributed to the change.  Data transparency, deeper liquidity and broader investment strategies have also helped better measure investment risk.  All these factors have pushed overall cap values down for the past 20 years. 

Cap rates tend to remain within a certain range during economic peaks and valleys, with typical variances of 100 to 130 basis points.  Cap rates behaved quite similar in the last two recessions, though the duration and severity of the economic downturns were different.  Current cap rate trends have also differed between major metropolitan markets and other markets. So far for this year, apartment cap rates are down 20 bps in the major markets and 40 bps in the secondary markets; retail is down 10 bps in the primary markets and 40 bps in the secondary; office is down 30 bps in the primary and 40 in the secondary; and industrial is down 40 bps in the primary markets and 80 in the secondary.  Here in the Dakotas, we would be classified as a secondary market.  We can also attest to possibly more cap rate decreases in this area due to the strong economic growth prevalent in our area.

If you believe the consensus of the experts, we can expect interest rates to stay low in the short term and begin to rise as the Fed slows down its bond buying.  Cap rates should continue to decline slightly which will continue to increase commercial real estate values.

Collateral: Plan B

To recap on the 5 Cs of Credit so far, we’ve mentioned Character matters, because your borrower can’t repay you from jail. We learned Capacity should be about selecting the right credit structure and then focusing on cash flow as a primary source of repayment. So if you have an honest customer with a good ongoing source of repayment, what is there to worry about? Realistically, there will be little reason to lose sleep. But we do live in a world of infinite risk, and there is always something unforeseen that can happen that neither you nor the borrower could have ever conceived. Unfortunately, even the best loans can go bad for reasons nobody could have envisioned.

Recently, the CEO of Goldman Sachs, Lloyd Blankfein, summed it up best during a seminar he participated in. He said, “Most risk management is really just advanced contingency planning and disciplining yourself to realize that, given enough time, very low probability events not only can happen, but they absolutely will happen.” This is why, even with the best loans with no repayment problems, there is still a need for a contingency plan in case they do go bad. The most common solution is taking collateral which could be sold as a secondary means of repayment. Collateral is really “Plan B” to your initial credit decision. All good credit decisions have at least one good backup plan if the first source of repayment disappears, and really good credit decisions will have more than one backup plan.

Because collateral may have to be used as a source of repayment one day, it will command a lot of attention and analysis just like cash flow. I can think of a handful of times where I had to spend more time analyzing the collateral than I did cash flow. By now, it should not come as any surprise that there is no one-size-fits-all analysis that assesses collateral, but rather, each underwriting project will be tailored to the lending type and credit facility of the specific loan.

For revolving lines of credit, the collateral tends to be the output from the resulting business operations. Take a widget for example. A finished widget could be used as collateral, but let me ask you, what is a widget worth? I’m really not sure, and that makes me a little nervous to take a widget as collateral. I suppose it really depends on how easily I could sell that widget, which is described as “marketability.” Good collateral is marketable. How can you be repaid from selling collateral, if you have collateral nobody wants to purchase?

A widget is effectively inventory. Inventory can be broken into three components: raw materials, work-in-progress, and finished goods. Some guidance suggests finished goods are most marketable, but logically, raw materials could also be just as good, if not a better source of collateral. If the demand for widgets disappears, there may still be demand for the materials that were used to produce a widget (say for example, if raw materials were metals and aggregates). I believe it is universally agreed upon that work-in-progress is a poor source of collateral. What is half a widget worth, and who would need one anyway?

Once those widgets are sold, the business is waiting to collect on an account receivable. Those receivables can also be used as collateral. There are people who will purchase accounts receivable, and they are called “factors.” An account receivable is really only as good as the business or person who has to pay it, and the lender may have no way to know a receivable’s wherewithal to pay. In an ideal situation, receivables will be from several individuals or businesses, so if one didn’t pay, it would only represent a small loss to the business collecting the receivable. Concentration of receivables is a big risk, because one large customer struggling to pay could lead to large losses if they prove uncollectable.

Turning to term debt, the marketability issue becomes a large concern when financing equipment and machinery. For example, say a lender finances a widget-stamping machine. Naturally, he or she will take the stamping machine as collateral. What if the lender had to foreclose and take the stamping machine? What is a widget-stamping machine worth, and what else could it be used for? Some equipment is highly specialized and could have even been designed especially for the defunct business in foreclosure. This could leave the lender with nobody to resell the machine to. Because of these issues, it is not uncommon that equipment and machinery will require large down payments, and that often, this debt may also be secured by additional collateral the business owns, like real estate.

Real estate is a relatively preferred source of collateral for most term-debt financing, whether or not the subject debt was used to acquire real estate. Why do lenders prefer real estate? First of all, it is easy to find. To collect on inventory, receivables, or even some equipment, it will be challenging to locate where the collateral actually is. But as for real estate, you always know exactly where it is. Also, real estate usually has a readily determinable value, because there are several investors that usually establish a market for it.

With all collateral, although it is easily observed in real estate, there is a conundrum that can result with the market value of your collateral and the borrower’s ability to repay. If your customer is struggling, it may be an indication that the market value of your collateral is also deteriorating.

For example, say debt for Widget Inc. is secured by industrial real estate valued at $1 million. Widget Inc. goes out of business, because it is a recession and nobody is buying widgets. The lender forecloses on the industrial real estate, but finds nobody wants to buy industrial real estate. Why? Because it’s a recession, and no industry is expanding! The real estate was worth $1 million when demand was nominal, but now demand has dropped and buyers in the market won’t pay more than $650,000. Hopefully, the lender didn’t extend more than $650,000 in credit, even when he or she thought the property was worth $1 million. Generally speaking, it is unwise to lend the full value of the collateral. Leaving a margin between the value of the debt and full value of the collateral allows for changes in the market value of the collateral and any costs to foreclose and sell that collateral.

The costs to foreclose and sell are not only monetary, but they eat up a lot of time for several people at the institution. Depository institutions are set up to lend money and collect money, and liquidating property takes away from peoples’ primary job function. Cash flow should always be the primary source of repayment, and collateral should realistically be your contingency plan. If the reason for lending is based primarily on the fact that the collateral would have substantial value if liquidated, the institution isn’t accounting for all costs of the transaction and potentially originating a problem asset. It may be true the institution will not lose the principal being lent, but the time and effort to recover the principal will be costly and have unquantifiable burdens.

Collateral is really code for “contingency plan.” If there is no contingency plan for when your original plan for repayment deteriorates, then the likelihood of credit loss increases substantially. By asking yourself what your collateral position is if the worst possible scenario occurs, you actually think through a contingency plan to get repaid. Some institutions are in the practice of identifying three sources of repayment for each credit decision. The first source is usually the cash flow generated from the operating business. The second and third sources are typically reliance on selling collateral and having a guarantor provide some means of repayment. Additional sources of repayment could even come from collecting on cash or collateral from another source outside the business and its immediate owners. The important concept to grasp is the more means there are of getting repaid, the more likely it is the loan will be repaid!--Trevor Plett

The Economic Competitiveness of the Dakotas

Recently, the American Legislative Exchange Council produced its 6th edition of the ALEC-Laffer State Economic Competitive Index.  This study uses fifteen different policy variables to measure the economic competitiveness among the states.  Some of these variables are:  marginal personal and corporate tax rates, property and sales tax burden, estate taxes, recently legislated tax policy changes, public debt service as a share of tax revenue, quality of the state legal system, worker’s compensation costs, state minimum wage, right to work state, and tax or expenditure limits. 

I find the study fascinating.  The beauty of the American system is that states have a fair degree of autonomy to choose the best mix of policies for their own citizens.  It is as if we have 50 different small “laboratories of democracy” that produce test results to see what works and what does not.  The conclusion from the study is the states with growth as a primary objective continue to grow if they follow free market policies.  States with redistribution and regulation as their main objectives continue to lose jobs and economic vitality if they continue with their policies.  It seems there is a steady movement of human and investment capital from high tax, high regulation states to low tax, low regulation states.  This has been occurring for decades.

The Dakotas fared extremely well in the economic performance and outlook.  The economic performance is a backward-looking measure based on the states performance in three categories as listed below.  Note that in each case a “1” is the best and a ranking of “50” is the worst.

North Dakota ranked first in state domestic product growth with a 110.9% increase.  South Dakota ranked 12th with a growth rate of 59.1%.  In absolute domestic migration cumulative from 2002-2011, North Dakota lost 4,367 people, ranking 30th in the nation.  South Dakota gained 11,502 for a 27th rank.  North Dakota topped the states in Non-Farm Payroll Growth of 22.2%.  South Dakota came in 10th with a 7,7% increase.

Even though these results are impressive, the performance is more impressive considering that the majority of the growth in both states seems to have occurred since 2007.  If one were to look at this over the past five years, the results are much higher.

As important as it is to look at the past, using present policies will be a good predictor of the future economic growth for the states.  To do this, ALEC organized fifteen different variables and ranked the states accordingly.  Both states fared well with the lowest top marginal personal income tax rate.  South Dakota is one 9 states in the US with no personal income tax and North Dakota has the second lowest state personal tax rate at 3.99% as its top rate.  Between 2001-2011, the 9 states without income tax have seen a 15% increase in population, a 63.5% increase in GDP, a 12.7% increase in non-farm payroll employment and a 76.3% increase in state and local tax revenue.  Compare this to the 9 states with the highest personal income tax rates.  There population growth was only 40 percent of the no-tax states at 6%, GDP only grew 45.3%, non-farm payroll rose a small 4.9% and state and local tax revenues grew at 47.9%.  Clearly the economic growth trends favor those states with lower taxes.

On the corporate tax side, South Dakota comes in first with no corporate tax.  North Dakota came in a 11th with a rate of 5.15%.  North Dakota has the 10th smallest property tax burden at $25.30 per $1,000 of personal income.  South Dakota was 17th at $29.65.  Both states have higher than average sales taxes with North Dakota the 34th lowest in the nation and South Dakota at 43rd.  The remaining tax burden is close to the median of the states with ND 31st and SD 27th.  Neither state has estate taxes. 

The states tend to manage their money well.  Debt service as a percentage of state revenues is 5.9% in North Dakota, the 4th smallest in the nation.  South Dakota is at 8%, the 21st lowest.  Both states have a higher than average number of public employees per 10,000 residents with North Dakota the third largest in this category and South Dakota the 20th largest.  Perhaps some of this may be due to the smaller populations in both states. 

The states are friendly to business in that their score in the liability survey places them both in the top 10 of the country.  Average workers comp costs are low with ND at $1.01, the lowest in the nation, and South Dakota at $1.91, the 28th lowest.  Both states are right to work states.

Overall, the Dakotas fared extremely well again, with North Dakota with an Economic Outlook of 2nd best in the nation and South Dakota at 3rd best.  North Dakota has seen a steady climb in this index with the state increasing from 18th in 2008 to where it is today.  South Dakota has ranked between 2nd and 5th in the economic outlook over the past six years.

 It is also interesting to see how the states that surround the Dakotas:  Montana, Wyoming, Nebraska, Iowa, and Minnesota fared in the study.  Montana ranked 9th in economic performance but a dismal 42nd in the economic outlook category with additional regulations and burdensome requirements on business there.  The Bakken boom that is driving much growth in North Dakota is a mere trickle in Montana.  Minnesota ranked 34th in economic performance and 46th in the economic outlook.  High taxes and increased regulations are forcing businesses there to assess their location.  Iowa ranked 25th in both categories.  Nebraska ranked 21st in performance and 37th in economic outlook.  The legislature there is considering lowering tax rates which will improve the economic outlook there.  The best performing state contiguous to the Dakotas is Wyoming, with a ranking of 4th best in each category.

None of our neighbors, with the exception of Wyoming are close to the rankings of either North or South Dakota.  The lesson from the study is that a state with a low tax and regulatory burden is more attractive for a business to open its doors and operate in.  These opportunities create more jobs and hence, more wealth for that state’s citizenry.  We are truly blessed to live in wonderful states that have a pro-growth mindset coupled with abundant natural resources and hard-working people.  The future for the Dakotas is bright!--Phil Love

Capacity: The Right Loan for the Right Purpose

To recap, I have recently been writing about the 5 Cs of Credit. The world is full of infinite reasons why a loan could go bad, and we try to classify all those risks into 5 buckets: Character, Capacity, Capital, Collateral and Conditions. Generally speaking, if all the 5 Cs are strong, then risk should be well mitigated. In reality, some of the Cs will have weaknesses and others will have strengths, and a team of people will need to debate whether the balance is appropriate.

We have looked at Character and discussed why it is important to know your borrower personally, as well as conduct background checks and other independent investigations. We also discussed Capacity and the importance of making sure a loan matches borrowing cause and the timing of the asset conversion cycle.

The assessment of Capacity gets a little more complicated because the asset conversion cycle has both short-term and long-term components. Generally speaking, all business operations can be broken into the “operating cycle” and “capital investment cycle.”

The operating cycle tends to be a short-term cycle of production that generates cash or profit. An example of the operating cycle would be buying raw materials for widgets, stamping the widgets, packaging and selling the widgets, and repeating the process all over again.

The capital investment cycle is a long-term cycle of providing and replacing the means of production. An example would be purchasing the widget stamping machine. Recovering the expense of the machine will take several operating cycles; but that is okay, because the machine should last for several cycles.

Now that we have these key principles spelled out, we can really address how to assess capacity accurately! Borrowing cause that arises from the operating cycle will almost always be coupled with short-term credit facilities; whereas, borrowing cause tied to the capital investment cycle usually calls for long-term debt.

Commercial & Industrial Lines of Credit 

Let’s start by looking at borrowing cause associated with the operating cycle. For example, Widget Inc. invests all their cash into making widgets for a single order. Widget Inc. delivers the widgets and is waiting to get paid. Meanwhile, Widget Inc. gets a second order and needs to borrow cash to start production since they haven’t been paid yet from their first order.  The best type of loan to solve this problem is a line of credit. Think of this as a credit card with a high limit, but there is a catch.

The limit will always be determined by the amount of sales (accounts receivable) that are waiting to be collected; therefore, if there are no sales, Widget Inc. will not be allowed to borrow. To control the credit limit, Widget Inc. will need to send a report to the lender every month showing what sales (receivables) are outstanding and for how long they have been waiting to collect. The only payment required for the line of credit is interest on the outstanding balance. Actual repayment of the debt hinges on the expectation that the principal will be repaid once the sale is collected, which will be verified with the monthly report of sales (accounts receivable aging report) sent to the lender.

Because the operating cycle is likely to repeat several times, it would be a hassle to constantly get a new loan each time the company needs to start a new order and doesn’t have the cash. A solution is to allow the customer to repay their line of credit and re-borrow as the need arises. We call this a “revolving” line of credit. Again, it works just like a credit card with a high balance, except it is well-monitored.

Real Estate Construction

Not all lines of credit should revolve, because not all short-term needs are recurring or easily justified. For example, construction of an office building will require a short-term demand for funds. Because the building will not generate rent until it is constructed, it is not practical to require principal to be repaid in the short run. In this case, it makes sense to extend a line of credit for construction as well. In this way, the owner will only be charged interest on the amount of money they are currently borrowing until construction is complete, but once construction is complete, principal must be repaid.

The important concept to bear in mind is lines of credit are usually repaid from the conversion of an asset to cash. In real estate, this means permanent financing (which requires payment of principal) can replace short-term financing, or hypothetically, the building could be readily sold to an end user. In this case, if debt is fully repaid, it does not make sense to allow the customer to re-borrow for the same purpose. Why not? It is difficult to identify how real estate will be repaid, and before the project is started, there is substantial analysis of the market and/or end user of the real estate. This level of analysis should be completed for each real estate project because the market changes and/or the end user may be different. It is too risky to invest a large sum of funds into a single project to see it fail. A non-revolving line of credit is appropriate in this circumstance.

Term Debt and Useful Life

When machinery or equipment is needed, it is understood that cash received in one operating cycle is likely not enough to make the needed purchase. Since these assets will likely last for years, it is permitted to take years to repay them. All long-term assets have a “useful life,” and the loan for a long-term asset should not exceed its useful life. Ideally, a loan term should be shorter than the useful life of the asset to provide added protection to the lender.

Term debt characteristically has equal payments of principal and interest until maturity, although this does not have to always be the case. It is common for payments to be due monthly or quarterly, but could be due semi-annually or annually. Which is the best payment method? I would direct you to the operating cycle to answer the question. Structure regular payments to be due when you expect the customer to have the best ability to pay, which is when the operating cycle produces cash. It is fairly common to have predictable income on a monthly basis for most businesses, and a business could have several operating cycles complete in any given month.

A good example of matching term loan payments with the operating cycle can be observed in the hotel industry. The useful life of a hotel could be up to 25 years or more, so a good lender will expect the hotel to be able to repay on a 20-year plan (amortization). A hotel in a tourist destination may see a boom in summer months and be flush with cash, but the hotel may not be able to break even in winter months. Some hotel loans require 3 or 4 large payments during the summer months when the hotel has cash, and no payments during the rest of the year when they likely have little cash. In this situation, a hotel could even close down in the winter months to keep from losing cash without worrying about missing loan payments!

Recurring Cash Flow

Now we have established the need for a term loan arises because of the capital investment cycle and will take several operating cycles to repay the debt. We know the payments should retire the debt within the useful life of the asset, and the timing of the payments should coincide with the timing of the operating cycle. Now, how do we know if business is profitable enough to repay debt if the loan is structured correctly? We need to dissect the business’ income to understand this, because not all profits are cash.

Income can be recorded for a variety of reasons. When dealing with accrual accounting, income can be generated from completing a sale before cash is collected, it could be the result of appreciation of the market value of an asset, or a host of other reasons that don’t coincide with the inflow of cash. To truly analyze capacity, it is necessary to examine where cash is coming from and not necessarily income.

The most common way to approach cash flow is by adding non-cash expenses back to net profits - this calculation is called EBITDA (Earnings Before Income Taxes and Depreciation). But, this is problematic for several reasons. Taxes are a necessary expense that must be paid with cash, but it is often mistakenly added back. EBITDA is a business school concept of comparing cash flows of two similar businesses, and adding taxes back is done to filter out the distortions the local tax authority may place on cash flow when comparing two like businesses. When it comes to repayment of debt, taxes should be treated as a necessary expense that must be paid, and really, the focus should start with EBIDA (without T) instead of EBITDA.

EBIDA is still problematic, because it only adds back non-cash expenses and does not subtract out non-cash income. EBIDA also will fail to indicate whether or not the source of cash flow is recurring and misses other accounting distortions. Say you bought a widget-stamping machine for $500,000 and sold it for $300,000. EBIDA will reflect a loss of $200,000. However, the actual cash inflow to the company will be the $300,000 cash received from the sale. But, if we are constructing a pro-forma to demonstrate the recurring ability to repay debt, should we include the $300,000 cash inflow? We don’t want to depend on the constant sale of machinery to repay debt, do we? Really, we want the cash flow from the sale of widgets to repay debt! To make matters worse, say a new widget machine is purchased for $700,000. The entire purchase of the machine will not be reflected as an expense, but rather expensed through depreciation over its useful life. In reality, the company just experienced a $700,000 cash outflow that EBIDA did not catch.

If your head is spinning, that’s okay; it should be. The key takeaway is income does not equal cash flow, and EBITDA or EBIDA isn’t an accurate measure of cash flow for debt repayment. The only way to truly understand cash flow is through careful study of the financial statements and understanding how changes in the income statement and balance sheet are linked to cash accounts. This takes a fair amount of training. In accountant-prepared statements, these interactions will usually be reflected on a Statement of Cash Flow, but not all borrowers will have this quality of financial statements.

Putting it All Together

While this appears to be a large volume of information to digest, important principles should now be easy to identify. For example, term debt should not be provided to finance production of inventory or services, because those are related to the operating cycle and best matched with lines of credit. A revolving line of credit is practical for an operating cycle that constantly repeats, but isn’t appropriate when invested into one large project such as real estate construction. It doesn’t really make sense to measure repayment of lines of credit with cash flow models for term debt, because lines of credit should be repaid from collection of receivables, which should be extensively monitored through monthly reports.

Term debt should be evaluated based on recurring cash flow sources, not necessarily on booked income. Term debt should not extend past the useful life of an asset, and the repayment of the debt should coincide with the timing of the operating cycles. And lastly, EBITDA is not a catch-all for cash flow. The burden is on the analysts and other decision makers to understand what is occurring on the financial statements and where the true cash flow is. A good practice is to determine which sources of cash flow are recurring, and decide if it is acceptable for underwriting purposes.--Trevor Plett

The Web of Business Failure

When I was in grad school, one of my business classes showed a flowchart diagram that identified three major causes of business financial failure:  low gross margin, inadequate net operating income, and excessive leverage.  The picture showed causes and effects of each of these major factors.  It also identified how all these items are interconnected.  In the end it was a large web with the poisonous spider of business failure lording over the structure.  Unfortunately, many business owners do not have the ability to escape from the web when they are trapped in it.  If they could, they may be able to save their business instead of succumbing to the financial poison of failure.

A few years ago, I met with a business owner that had been on my problem loan list for several years.  They had made several moves to improve their business, but were still struggling.  I shared with him the financial spreads with industry comparisons for his business over lunch one day.  There we identified all three major causes of business financial failure, which happened to be present in his company.  It was my goal to help free him from becoming another statistic.

The first main factor of business financial failure is low gross margin.  The company had worked hard to build his client base, but had done sacrificing profit for business growth.  They focused only at the top line revenue.  The cause of the problem was inadequate pricing and high cost of goods sold (COGS).  The poor gross margin did not leave enough money for them to pay their operational expenses, thus a shrinking NOI.  To survive, they had to borrow more funds, putting too much leverage in the company.  They were losing money but were going to make up for it with higher volume!  (If you don’t make enough money for your product, selling more of it will only make the problem worse and not better.)  In this case, the gross margin was over 25% lower than the lowest quartile of the industry.

The owners learned to adequately price their work.  They installed minimum pricing standards and walked away from jobs that did not meet their requirements.  They also learned to not take low margin jobs in an attempt to build future business.  This construction company found that they chased after fewer jobs and the ones they pursued they were able to devote more time, performing the work at a higher standard and more profitably. 

The next major problem the company had was a negative NOI.  Causes of this began with the inadequate gross margin.  Other factors were operating and interest expenses were too high for the company.  The negative NOI required more money that had to be injected from the owners and additional, poorly structured borrowing.  The additional borrowing increased interest expenses, making the problem worse. 

The company had too many employees for their work.  Any owner hates to let people go, but if you can’t do something profitably, and do not have the ability to print money when you need more of it, you will eventually not be able to employ anyone at all.  My client also had kept excessive equipment, which had ongoing maintenance costs.  They began to sell equipment they did not use on a regular basis.  This not only reduced maintenance expense, but also reduced some of the principal of the debt they used to fund the equipment.

The third major problem was the high leverage.  The industry average was a debt/equity ratio of 3.5:1.  This company was close to 14:1.  The company needed equity and they needed it quick! 

The cause of the equity drought was from several factors.  First, excessive losses from poorly priced and jobs where they were not paid had eroded away their equity.  The next factor was increased borrowing.  The increased leverage and decreased equity took the company to a point of insolvency.  The expenses to maintain the debt also ate into cash flow, forcing the company to shuffle bills around and work payment plans for their accounts payable.

The solution came from two sources.  First, the owners raised money in from their family to put into the business as equity.  The increased equity injection did not cause any loss or control for the owners.  Next, the company identified a division of the company that was profitable, but also cost time and resources from their core business.  They sold the division, retired some of the debt, and put the rest of the money into equity.  This reduced the debt/equity of the company down to 2.8:1.

My last meeting with the owners came into a term loan review less than a year after all these changes were put in place.  We visited in the company conference room.  The company president leaned across the table and said, “Phil, we have a new problem with our company.  We don’t know what to do with all the excess money we have!”  The company was retiring debt at an accelerated pace, began to match employees contributions into the profit sharing fund, and, built a cash reserve of several months of all operating expenses. 

The job I had as a trusted financial advisor was complete.  The owners had freed the company from a web of financial failure.  I also won a bet I made with my head credit administrator that the company could survive.--Phil Love