BANKERS GUIDE TO SECURE LENDING

WAREHOUSE RECEIPTS, ORDER OR STRAIGHT BILLS OF LADING,

OTHER NEGOTIABLE AND NON-NEGOTIABLE DOCUMENTS OF TITLE,
INCLUDING WAREHOUSE AND BAILEE OR DOCK RECEIPTS

Lending Rationale
Introduction
The major purpose of credit analysis is to:

Identify risk in lending situations,

Draw conclusions as to the likelihood of repayment, and
Make recommendations as to the proper type and structure of the loan facility
Analysis of a loan proposition may involve three steps:
(i) Assessment to involve the following:

The historical performance of the managers of the business,

Determine the major risks factors, and
Evaluate how well these risks have been mitigated in the past.
The past performance evidences factors influencing the firms present condition and past
performance that may foreshadow difficulties, or indicate the likelihood of success, in the
borrower's ability to repay a bank loan at some future time.

(ii) Analysis of the loan proposition;

To enable reasonable projection of the probable future financial condition of the company
To estimate the company's ability to service proposed levels of debt.

(iii) Assessment of:

The firm's creditworthiness and a proposal for structuring a loan facility that can be
amortised given the firm's projected cash flows
The offer from the borrower of sufficient protection against loss and control of the lending
relationship.

Financiers are always faced with three generic lending situations, or rationales, based on:

The purpose of the loan,

The source of repayment,
The risk inherent in the situation,
The structure of the loan.

These lending rationales are:

Asset conversion
Cash flow
Asset Protection Lending

For each of the lending rationales, look out for the following identification factors:

Source of cash used to repay a bank loan. The specific source of repayment is dependent
on the purpose of the loan, or the use to which the proceeds of the loan are applied.
The specific financing need elicits the nature of the risk to the lenders, who must be certain
to evaluate carefully the factors that will mitigate that risk and protect them against loss.
The repayment source, loan purpose, and risks dictate the form of protection, monitoring
and control employed by the bank.
ACE primary purpose in distinguishing these three lending rationales is to provide the Bank
analyst with support for determining those areas or issues that might be of primary concern
when evaluating a particular credit and to provide an approach to analysis.
It is essential to recognise that lending rationales are used to characterise a type of loan
proposition or credit facility and not a type of borrower.
Thus, a company is not a "cash flow company" or an "asset Protection Lending Company".
The same company may have several different loans with the bank; each made on the basis
of a different lending rationale.

Asset Conversion Lending

For most businesses the flow of funds from the completion of sales transactions or the
rendering of services is the main source finance for the purchase of raw materials, wage / salary
payments, and other expenses involved in conducting business operations.
In many cases, this unevenness of the flow of funds is not of sufficient magnitude to create a
need for outside financing, as the firm's normal cash position is large enough to absorb these
short-term fluctuations.
In other cases, particularly in seasonal businesses a temporarily builds up of inventory and then
accounts receivable above normal levels, is expected at a given time of the year. There is then
a significant difference between the inflows and outflows of funds for short periods of time,
necessitating the use of short-term, temporary funds from outside sources.
Where provided by, say, a bank such short-term temporary financing derives payback from the
cash collected when the receivables arising from the sale of inventory are liquidated at the
completion of the asset conversion cycle. This form of Asset conversion lending is a main stay
of bank business lending to the commodity trade.
Asset conversion loans are short-term, self-liquidating loans and are made to finance a
temporary build-up of current assets - inventory and accounts receivable - above the permanent
level the firm normally keeps on hand.
The loans are generally unsecured, and the primary protection against loss is:
(i) The bank's confidence in management's ability to complete the asset conversion
cycle and
(ii) The liquidity of the assets being financed.

Credit Analysis Features

LOAN PURPOSE

To finance seasonal working investment build up, i.e. the difference between working
Investment at low point (the permanent level) and working investment at high point (the
seasonal peak).
PRIMARY SOURCE OF REPAYMENT

Cash received from the successful completion of the asset conversion cycle, i.e. the
recovery of costs at the end of a major selling season.
RISKS

Inability to complete the asset conversion cycle successfully due to risks in the supply,
production, sales, or collection segment of the asset conversion cycle.

PROTECTION

The quality (liquidity) of the working assets in the asset conversion cycle and the ability
of management to mitigate the risks inherent in cycle.
LOAN STRUCTURE AND CONTROL

Use of a line of credit, with borrowings on demand or short-term notes, which allows the
lender to review the financial condition of the company frequently during the cycle
before renewing the notes or adding new borrowings.
The series of notes should correspond to the length of the asset conversion cycle, that
is, the expected time needed to convert the assets to cash and repay the loan.

CASH FLOW LENDING

Cash flow lending is lending to finance a firm's permanent, i.e. long-term needs. Apart from
seasonal needs, permanent needs are associated with:
(i) Permanent level of working investment
(ii) Capital expenditures
(iii) Investment activities
Cash flow lending by a bank is usually medium-term, with loan terms of up to seven or eight
years in most cases
The "support" assets such as plant and equipment that are being financed are expected to
produce other, "working", assets which, when converted to cash through the successful
completion of successive asset conversion cycles, will generate sufficient cash to repay the
loan. For example new equipment, financed in anticipation of higher productivity to boost sales
and profitability.
In the case of permanent levels of working investment, an increase in sales volume will usually
require an increase in the permanent level of working investment. It is expected that the
increased level of sales will result in additional retained earnings that will repay the term loan.
Cash flow lending, then, is essentially lending to repeated asset conversion cycles, and payback
is dependent on the firm's ability to generate (and retain in the business) sufficient cash over a
number of years of profitable operations to make required interest and principal payments on
the loan.
Assessing a firm's creditworthiness for a term loan to be repaid out of cash flow requires making
reasonable projections of the firm's future sales prospects and cash flow and determining the
amount of cash that will probably be available to service debt in the future.
Long-term loans present greater risk to the lender than short-term loans since the longer into
the future that payback is scheduled, the greater the chance of unforeseen events intervening
and jeopardising the safety of the loan.
The primary justification for a cash flow loan is the reasoned expectation of the firm's future
ability to generate sufficient cash flow, not its historical ability to do so. Therefore, Covenants in
the loan agreement are often included a trigger to signal to the lender a deteriorating situation
so that corrective action may be taken.

Credit Analysis Features

Loan Purpose

To provide external financing for permanent needs, this will support or enhance the generation
of internal net cash inflows from profitable operations.

Primary Source of Repayment

Cash flow (primarily from additional profits) over time.

Risks

Inability to generate and/or retain sufficient cash from operations to amortise debt because of,
for example, selling problems arising from competition, product failure OR
Obsolescence or inability of management to efficiently and prudently manage the sources and
uses of cash.

Protection

Primary protection against loss is the stability of profit generation and preservation of the
strength of the firm's financial position.
Covenants in the loan agreement establish conditions necessary to preserve cash flow and
financial strength and serve to signal deterioration in these areas that may threaten payback.
Cash flow lending by a commercial bank is medium-term, up to 7 or 10 years (long-term loans
of up to 40 years are made by insurance companies, pension funds, governments, and the
public (through bond offerings).
Lenders are often willing to refinance the individual debt issues, depending on the perceived
ability of the firm to service the debt and, thus, a serviceable level of medium - and long-term
debt can be a "permanent" source of capital.
Usually term loans will call for amortisation of a portion of the loan annually or quarterly, and
each long-term debt issue will have a series of notes corresponding to the timing in the
amortisation schedule.

Form of Control

Covenants in the term loan agreement, which set parameters within which the borrower must
work to assure strength in the overall financial condition.

ASSET PROTECTION LENDING

Asset Based lending is a method of financing a relatively permanent need with a short-term
vehicle. The permanent need normally consists of a stable, but revolving, level of current
assets.
The asset based loan thus combines features of the asset conversion loan (a short-term
vehicle) and the cash flow, or term, loan (a permanent financing need), but is quite distinct from
these forms of lending.

ASSET PROTECTION LENDING COMPARED WITH ASSET CONVERSION LENDING.

Asset based lending differs from asset conversion lending, in which the financing need is
temporary and payback is expected in full at the completion of the asset conversion cycle.
The need financed by the asset protection loan is, by contrast, a permanent level of current
assets, and the bank is essentially financing an on-going stream of asset conversion cycles.
This position necessitates that the, loan is continuously rolled over. The loan could not be paid
back in full without reducing the normal level of the firm's current assets and thus seriously
disrupting the firm's operations.
The fundamental paradox of Asset Based Lending is that the repayment of a permanent level or
principal is not expected as long as the business is a going concern, although individual
transactions or promissory notes within that level are expected to be self-liquidating.
ASSET PROTECTION LENDING COMPARED WITH CASH FLOW LENDING

Asset Based lending also differs from cash flow lending. Although both finance a permanent
need, in an Asset Base situation, the company does not generate sufficient cash flow to
amortise a substantial term loan.
The bank, however, has confidence in the ability of the firm to repay the loan, if necessary, from
the liquidation of the assets being financed, and, therefore, makes funds available through a
short-term vehicle in order to exert greater control, similar to that inherent in asset conversion
loans.
It is therefore of critical importance that the creditworthiness of the Borrower company in relation
to competence and integrity of the firm's management is not taken for granted.
Ordinarily, the bank should lend only when it is assured of the firm's ability to successfully
complete rapidly successive asset conversion cycles and to continue in the future as a viable
concern.
Asset based lending also requires that the bank be assured that the net realisable value (in a
forced sale or liquidation) of the assets being financed is sufficient to fully satisfy the amount of
the loan, given sufficient senior creditor status.
This requirement of asset based loans is designed to protect the bank against loss in the event
of bankruptcy or liquidation.
Asset Based loans may be secured or unsecured depending on the strength of the borrower,
the quality of the assets being financed, and the nature of the transaction cycle.

WHEN WOULD ASSET PROTECTION LENDING BE APPROPRIATE?

(i) Merchant businesses.
Where the business acts as an intermediary between buyer and seller, supplier and
manufacturer, saver and investor, etc. The Asset Based loan is then required to finance
the permanent level of current assets requirement.
In these businesses there is little value added during the asset conversion process and
there is, therefore, low profit per transaction and low retained earnings and equity, with
profits generated primarily by high volume. The high financial leverage that is
characteristic of these businesses implies high risk to the lender.
The lender, however, will advance under the Asset Based rationale if it is assured of the
viability of the business as a going concern and if the quality of the assets is such that, if
liquidated, the net realisable value would be sufficient to repay senior claims.
(ii) Uncertainty about the borrowers ability to generate sufficient cash flow to amortise a term
loan or, where the level of borrowing is so high that there is an unstable financial condition in the
near term.
Then the lender will take security in assets with a liquidation value adequate to repay the
loan, if necessary. For example a personal mortgage, which is amortised primarily by the
borrower's earnings but is also supported by the liquidation value of the home and
property being financed (other forms of asset-based financing, such as leasing, would
also fit this broad category).
(iii) Where the bank has reason to doubt the firm's cash flow potential.
An example would be a start-up manufacturer, for which the bank might finance plant,
equipment, or permanent working investment with a secured term loan, expecting
sufficient profits over time to pay back the debt, but due to the uncertainty of the new
enterprise, takes security in the company's assets to assure payback should the firm
prove unprofitable.
Another example might be a firm that had recently experienced cash flow problems that
injected new uncertainty into its prospects for future profitability to an extent that
disqualified if for consideration for an unsecured term loan.

Credit Analysis Features

LOAN PURPOSE

To finance permanent level of current or readily marketable working assets.

SOURCE OF REPAYMENT

On a going-concern basis, the successful completion of individual transactions in an amount

equal to the stated value of the working assets.
In a going concern, the loan is an evergreen one, in which payback in full of the principal is
never really expected).
In a distress situation, the liquidation of the assets being financed.
RISKS

Risks that - due to price fluctuations or other factors - the value of the assets shrinks below the
net realisable value necessary to pay out the bank as a senior creditor.

PROTECTION

Value and liquidity of the assets financed. (This must be assumed in both secured and
unsecured lending situations).
LOAN STRUCTURE AND CONTROL

Short -term secured or unsecured notes with tenors dictated by the expected length of the
financing need in the asset conversion cycle itself or in a specifically financed transaction.
Control becomes extremely important in secured asset protection lending.

*See Table Below containing a Summary for lending rationale

Rationale.

Asset
Conversion

Cash Flow

Asset
Based
Lending

Purpose

Source of Payment

Banks

Protection

Control

Financing shortterm
Seasonal build-ups
of working assets
Financing other
temporary,
transactional buildups of current
assets.
Financing of longterm assets or
permanent working
investment and
support assets

Cash received from

the successful
completion of the
asset conversion
cycle

Inability to recover
costs through
successful
completion of the
asset conversion
cycle

Asset liquidity.
Managements
ability to
complete cycle.
Short time
factor.

Short-term
notes.
Frequent
opportunity to
review situation
before renewal.

Cash from profits

generated and
retained in the
business over time

Inability to
generate a stable
level of profits
over several years

Managements
ability to
generate profits
Adequate
equity cushion
Unused debt
capacity

Covenants in
the term-loan
agreement to
preserve or
enhance the
financial
condition

Evergreen
financing of a
permanent level of
working assets.
Financing other
assets under
temporary condition
of increased risk,
as a secondary
lending rationale

If asset protection is
primary rationale, no
payback on an ongoing basis is
expected. If it is the
secondary rationale,
payback is expected
from asset
conversion or cash
flow. In both cases,
liquidation of assets
being financed will
pay back the loan in
a distress situation

Inability to recover
costs by
successful
completion of
asset conversion
cycle; inability to
generate profits
fast enough to
maintain a sound
financial condition.
Decline in the
value of the assets
below amount
necessary to pay
out senior
creditors

Managements
ability to
complete each
transaction and
to generate a
satisfactory
level of profits
over a number
of years.
Asset liquidity
and low
shrinkage in a
forced sale

Demand or
short term
notes.
Security and
proper
documentation.
Debt limitations
and covenants
where
applicable.