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Commercial and Industrial Loans: Analyzing Cash Flow
As firms seek growth opportunities, many firms are pursuing commercial and industrial (C&I) loans. Sixth District State Member Bank (SMB) C&I loans grew $6.9 billion, or 10.5 percent as of September 30, 2013, when compared with the prior year. Further analysis reveals that of the 45 SMBs, growth occurred in only 31 percent of firms of varying asset size, with growth ranging from as low as 2.5 percent to as high as 45.7 percent. The increasing C&I loan growth requires sound and consistent underwriting practices in the assessment of credit risk, particularly in regard to analyzing cash flow.
What are C&I loans?
At the most basic level, banks accept deposits and use these deposits to extend credit, including for C&I loans. Typically, C&I loans are made to businesses or corporations to provide working capital or finance capital expenditures. C&I loans rely on the borrower's ability to generate sufficient cash flow from operations to repay loans. Prudent and sound risk-management practices should include the analysis and underwriting of a loan request to assess the adequacy of the source of repayment and evaluate a borrower's ability to service the debt. For term or amortizing loans, debt service is defined as principal payments that are due to be paid, typically within one fiscal year, plus interest expense.
Purpose drives structure
Loan structure includes many elements. However, we will focus on purpose, types of loans, and sources of repayment. Simply stated, the planned use of the loan proceeds is the purpose. A common purpose is the financing of capital expenditures. Also, C&I loans are extended to finance working capital, and these loans also finance receivables and inventory, which are spontaneous assets. Loan types include lines of credit for working capital needs, revolving credit facilities to finance spontaneous assets, and term loans for capital expenditures.
Sources of repayment
Cash repays debt. The question is, how? Frequently loans are secured by collateral. However, collateral does not repay debt. The collateral must be converted to cash to repay debt, which raises the question of conversion of assets versus liquidation of assets. Conversion of assets, specifically conversion of spontaneous assets, occurs during the normal operating cycle of a viable business entity. The operating cycle is the day-to-day activities required to produce and/or sell goods and services resulting in cash from trading that flows through to net cash after operations (NCAO). Operating cash flow is not cash from the sale of non-operating assets, or what is commonly referred to as liquidation of assets.
Term debt or amortizing loans are repaid from NCAO if the borrower is a viable operating entity. Understanding the source of cash flow is crucial.
NCAO versus traditional cash flow
Consideration of the adequacy of the cash flow as the repayment source for amortizing loans with a focus on a sufficient debt service coverage ratio (DSCR) is fundamental. Approaches to this analysis include calculating what is often referred to as the traditional DSCR, and the DSCR based on NCAO.
Prior to the use of the Uniform Credit Analysis (UCA) NCAO when calculating DSCR, credit analysis heavily relied on the traditional approach to calculate the DSCR for the repayment of amortizing loans. The traditional DSCR is calculated by determining the numerator, which is the sum of net income and noncash charges (depreciation and amortization), divided by the denominator, which is the total principal and interest payments, for the period being reviewed. The traditional approach is based on the assumption that all operating activities are cash with no accruals, and that the calculation yields results that reflect actual cash available to service debt. However, if the borrower's operating activities are not all cash, and the balance sheet includes spontaneous assets, the traditional approach does not accurately reflect the cash available to service debt.
NCAO captures the changes in spontaneous assets and the impact on cash flow, as well as changes in production costs and other operating expenses. As we know, increases in receivables and inventory that reduce cash flow are captured by the NCAO DSCR calculation. However, these increases are not captured in the traditional cash flow calculation and results in overstated cash flow (see the table).
C&I loan growth heightens concerns regarding underwriting. Lenders should have skills commensurate with the types of lending pursued consistent with a firm's business strategy. Understanding the source of repayment and the sufficiency of cash generated to service debt is essential. Finally, credit analysis and underwriting should be consistent with sound credit fundamentals.
This article was written by Vanessa Cameron, a senior examiner and risk council secretariat in the Atlanta Fed's supervision and regulation division.