Bank Lending

The basic services offered by banks to their customers are:

i) Receive deposits from customers.

ii) Money transmission services.
iii) Lending

The largest item on the assets side of a bank’s balance sheet is loans and
advances to customers. This item also represents the largest source of income
for the banks i.e. interest from loans and advances.

While lending, banks do not use their own funds. Most of the funds lent out are
generated from customer deposits. A customer has a right to be paid if and when
he demands payment of the credit balance in his account. Borrowing customers
however do not repay on demand but after an agreed period of time since the
borrowed funds will be held in cash but in other less liquid assets e.g. cars,
houses, business debtors and stock.

Before advancing money to customers, banks take several factors into

consideration. The factors are as follows’

Character

The borrower has to be a person of good character, not a thief or a fraudster. He

should be creditworthy. He should also have his financial priorities in order and
not be just as spendthrift. Where the customer is not well known to the bank, the
bank obtains references from people who know the customer well and are well
known to the bank

Ability to repay

The bank should ensure that the customer has the ability to repay the principal
amount and the interest thereof. The customer should therefore be having a
source of income that will generate enough cash to finance his normal living
expenses and leave a surplus for loan repayments, in the form of business or
employment income.

Margin

How much interest will the bank charge? This will be determined by a
combination of market forces and risk inherent in the customer. The bank will
normally apply a margin above its base lending rate. The interest charged
represents

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Purpose of the loan

What does the customer intend to do with the funds? Is it a legal purpose?
Incase of a limited liability customer, is the purpose ultra vires? Will the customer
place the funds in an income generating activity?

Amount

Is the amount too little or too much? Has the customer drawn up a budget to
reflect future repayments?

Period of repayment

Is the repayment schedule realistic? How long should the customer repay the
loan? Too short a period could place a strain on the customer’s finances while
too long a period can leave the bank exposed to default risk.

Security for the loan

What is the banks fallback position incase things go wrong? Is the security value
enough? Is there sufficient margin to cater for interest rollover, decline in property
value and reduction in price incase of a forced sale?

Security – General Considerations

As noted earlier, banks need to take security for loans advanced to customers
just incase things go wrong. Before accepting an asset as security for and
advance, a bank needs to consider the following:

i) How easy is it to value the security:

ii) Does the asset’s value increase or decrease?
iii) Is the bank able to obtain a good legal title?
iv) Is the asset easily marketable & realizable?

Direct security

This is security deposited by a borrower in order to secure his own indebtedness.

Collateral Security

Security deposited by a third party to secure the indebtedness a borrower’s

indebtedness.

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Types of security for advances.

Guarantees

This is collateral security offered by a person to secure another person’s

indebtedness. Guarantees may be taken in the following situations:

i) From limited liability company directors to secure the company’s loans

and advances. This ensures that the directors are fully committed to
the success of the company and that they do not hide behind the
‘limited liability’ provision.
ii) From members of a club or society to secure the club’s indebtedness.
iii) From close relatives and/or friends in order to secure an individual’s
indebtedness.

Guarantees are easy to value since the maximum liability of the guarantor is
specified in the guarantee form. However, this value does not increase with
time. Its not easy to realize a guarantee unless the bank takes legal action.
Most guarantors never expect to be called upon to pay.

Banks normally request guarantors to support their guarantees with tangible

assets such as shares, houses e.t.c

A guarantor has third party liability on the loan. He is therefore only liable if
the borrower in unable to repay. To avoid the legal complications of proving a
borrower’s inability to repay, banks include an indemnity clause in their
guarantee forms. An indemnifier has primary liability.

Land

Land includes the land itself and any permanent structures erected thereon.

Mortgage over land involves complex documentation and procedures. In

addition it is expensive for the customer. Evidence of ownership comes in
the form of a title deed (freehold ownership) or lease certificate (leasehold
ownership). Freehold owners have no limit on the length of ownership.
Leases have a maximum period.

It is necessary to obtain professional valuation of the land being taken as

security. A personal visit by bank officials is necessary to verify its existence.

The bank needs to take a mortgage over the land and register the same with
the land registry. Before a mortgage is taken, it will be necessary to conduct a
search to establish whether the borrower has a good title.

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Land is easily realizable as long as the bank has taken a legal mortgage. The
bank will however be reluctant to sell the property especially where the
customer’s house is involved. The bank will therefore sell the land only as a
last resort.

Land and houses normally rise in value provided they are well maintained and
are easy to convert into various uses. Farmland and office premises also rise
in value over time.

It is necessary to insure houses and office premises against fire once they are
taken as security.

Life Policies

Banks can take an assignment of whole life or endowment policies as

security. The bank needs to ensure the following:

i) The insurance company is reputable and financially stable

ii) The bank should only take whole life or endowment policies and not
term assurance policies as security i.e. policies whose payment of the
sum assured in payable only if the life assured dies within a certain
period.
iii) Incase the life assured is not the beneficiary, the beneficiary(s) should
be joined in the assignment of the policy e.g. where a husband takes a
life policy on his wife with himself or their children as beneficiaries or
takes a life policy on his own life with his wife and children as
beneficiaries.
iv) The bank should check for restrictive clauses on the policy for example
clauses restricting travel by air or certain kinds of sport.
v) The bank has to ensure that the policy is ‘age admitted’. Before paying
a claim on a life policy, an insurance company needs proof of the
customer’s age to prevent age cheating that could result in a customer
paying lower premiums than required. Insurance companies will not
pay claims on policies whose age has not been admitted. The bank will
therefore send a certified copy of the customer’s birth certificate for
verification before advancing the money.

The bank should write to the assurance company in order to get the surrender
value of the policy. The longer the policy has been in force, the higher its
surrender value. Life policies can easily be surrendered to an insurance
company and payment obtained with little difficulty incase the customer
defaults.

As long as premiums are paid and up to date, the value of the policy
increases over time. In addition, if the policy is a ‘with profits’ policy, annual

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and periodic profits allocated to the policy will be added ton the sum assured
every year.

Banks will easily take a legal assignment of a life policy. They need to notify
the insurance company of the assignment and also ensure that the
beneficiaries are enjoined in the security document. It is also necessary to
ensure that the customer continues to pay the premiums. The bank can insist
that he uses its direct debit or standing order facilities. Incase the customer is
unable to pay the premiums, the bank can either pay the premiums and debit
the client’s account thereby increasing his indebtedness, surrender the policy
or request the insurance to convert it into a paid up policy on the basis of
already paid premiums.

Stocks and Shares

Banks can take legal title over shares and stocks listed on the stock
exchange. Unlisted shares are not suitable as security since they are difficult
to sell. In addition, private companies have restrictions on the transferability of
their shares which could make their shares difficult to realize.

The bank can obtain the value of the shares from the stock exchange listing.
The share prices fluctuate from time to time depending on demand, supply
and economic factors. They may not necessarily increase in value. The bank
should therefore ensure that the security margin is good and preferably not
less than 50% to ensure that the value of security does not fall below the
amount advanced.

Shares from blue chip listed companies are easy to sell but shares.

The bank also needs to notify the company of the assignment so that
dividends can be remitted to the bank.

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 Interpretation of financial statements

There are numerous ratios that can be used, but it is sufficient for our analysis
purposes to consider only the main ones.

Key ratio analysis

Ratios are a means by which the relationship between figures can be expressed
and as such, they are a useful tool in analysing a business's performance and
financial condition, over a period of time and also in relation to other businesses
in the same sector.

Ratios rely on information produced in annual reports and accounts and

consequently consideration must be given to the accounting principles from
which the figures have been derived. Where there is creative accounting or
differing accounting practices distortion may occur.

Profitability ratios

1. Sales Growth

Sales in Year 2 - Sales in Year 1 x 100

Sales in Year 1

The percentage growth (or decline) will be a factor of volume of sales,

selling price per sales unit and, if the sales are in foreign currency, of the
exchange rate. It is useful to compare this growth with previous year’s
trends.

2. Gross Profit Margin

Gross Profit x 100 = Gross Profit %

Sales

An increase in gross profit margin indicates that variable costs, raw

materials, labour, power etc are not rising as quickly as selling prices,
whilst a decrease will indicate the opposite. Changes in the gross profit
margin should be analyzed to identify the cause.

3. Operating Profit Margin (PBIT)

Operating Profit x 100 = Operating Margin %

Sales

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 This will differ from the gross profit margin in that selling, general and
administrative expenses and depreciation are deducted and control of
these overheads can be determined by comparing any difference in the
relative movement in operating profit level.

4) Pre-tax Profit Margin

Net Profit before tax x 100 = Pre-tax Profit %

Sales

An analysis of the causes of changes in this percentage should be

examined to see whether any particular costs are responsible e.g.
exceptional items or interest expenses.

Liquidity/efficiency ratios

The ability of a company to pay its obligations as and when they fall due (its
liquidity) is a major concern of any credit analysis.

1. Calculation of working capital

Working Capital = Current Assets - Current Liabilities.

A working capital surplus represents a cushion of protection for current

creditors; it indicates the amount by which the value of current assets
could decrease and there would still be sufficient to repay current liabilities
from the sale of current assets. The resulting amount of working capital
varies considerably from business to business and from industry to
industry, thus the nature of the company's business and the quality of its
assets must be considered.

2. Current Ratio

Current Assets = Current ratio : 1

Current Liabilities

A current ratio of over 1:1 indicates that a company has a higher level of
current assets than current liabilities and should, therefore, be in a position
to meet its short term obligations as and when they fall due. However,
some companies function adequately on current ratios of less than 1:1
whilst others need a much higher ratio.

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3. Quick Ratio

This ratio sometimes also known as the acid test reveals how easily a
company can meet its current obligations using funds raised from quick
assets (those assets which can be converted quickly into cash).

Current Assets which may be easily liquidated = Quick Ratio: 1

Current Liabilities

Often defined as Current Assets - Stock = Quick Ratio: 1

Current Liabilities

This definition assumes that the company's stock is not easily turned into
cash.

4. Credit given in days

Debtors x 365 = Receivable days on hand/Debtor Collection Period

Sales

Providing sales are evenly spread throughout the year the ratio will
indicate how effectively debts are being collected.

5. Stock turnover in days

Stock x 365 = Stock days on hand

Cost of Goods Sold

This ratio gives us a broad indication of how quickly the business is

turning over its stock. If possible a breakdown between raw materials
work in progress and finished goods should be obtained.

A higher number of days stock could indicate holdings of obsolete or un-

saleable stock (different businesses require different stock levels).

6. Credit taken in days

Trade Creditors x 365 = Payables days on hand/Creditor payment

Cost of Goods Sold

If purchases are spread evenly throughout the year, this ratio will show the
length of credit the business is taking. An increase in the ratio may
indicate that more reliance is being placed upon the suppliers to finance
the business.

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7. Asset Efficiency

Sales = Efficiency Ratio:1

Total Assets

This is the overall measure of the efficiency of a business in generating

sales from its investment in assets.

Financial ratios

1. Interest Cover

Net Operating Profit = Interest Cover : 1

Interest Expense

Indicates the number of times profits exceed interest expense.

2. Leverage

Total Liabilities = Leverage : 1

Tangible Net Worth

This ratio shows the relationship between internal and external funding
e.g. a leverage ratio of 1.5 : 1 indicates that for every 1 unit of
shareholders' funds the company has 1.5 units of external funding. The
ratio therefore reveals the reliance a company places on external
creditors.

3. Gearing

Total Interest bearing debt = Gearing : 1

Tangible Net Worth

Gearing is a more widely used ratio than leverage in that debt implies an
interest cost which leverage does not highlight. An increase in this ratio
usually indicates that borrowings are increasing faster than Tangible Net
Worth.

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