CORPORATE LENDING

Learning objectives of the Unit

 Understand structure and process involved in corporate lending.

 Understand the risk assessment and credit scoring of corporate firms.
 Understand the securities required for corporate lending as per the regulatory
requirements and banking practices.

Learning Outcomes of the Unit

 Understand the different project appraisal methods

 Cary out a viability and risk assessment of corporate loans using the methods learned
 Be able to analyses and respond to the different scenarios for a corporate loan
 Be able to explain the different collateral and securities required for a corporate loan
i. Viability of the Project
ii. Risk Assessment and Credit Scoring
iii. Collateralization and Security Assessment

1 Introduction
Commercial and industrial borrowers are among the largest users of bank loan. Over the time,
banks have developed a wide array of business lending skills and are expert at tailoring loans to
businesses under varied conditions for a large number of purposes. Nearly every type of business
borrows bank funds at some time.

There are many other purposes for business borrowing. Each purpose creates a need for a more
or less unique loan arrangement. The business uses of bank credit include the following:
1. Seasonal working capital
2. Long-term working capital
3. New fixed assets
4. Replacement of fixed assets
5. Changes in payment patterns
6. Unexpected one-time expenses
7. Refinance of old debt

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1.1 Assessment of Viability of a Project

In assessing the viability of corporate loan it is important that we first distinguish the types of
loans offered. We can classify bank loans according to their maturity, type of collateral, and
other special features. This part classifies bank loans into four types: short-term loans, bridge
loans, revolving credit loans, and term loans. At any particular time, individual borrowers may
have any number of each type of loan.

1.2 Short term loans

(a) Source of repayment

More than half of bank commercial loans, are made for short term that is, for period of less than
a year. Most of these loans are for financing increases in inventory for seasonal borrowers. The
loan is repaid when the borrower’s inventory is sold and its receivables are collected.

(b) Analysis
Retailers and manufacturers are regular users of seasonal working capital lines of credit. Through
a line of credit, a bank indicates its intention to provide credit up to the amount of the line. The
lender analyses borrower- prepared projected monthly balance sheets and income statements.
The projections show the need for funds for financing seasonal bulges in working capital as
inventory, sales, and receivables expand in sequence. This sequence is known as the working
capital cycle. The projections should reveal the expected peak loan need, the timing of
takedowns, the link between bank and supplier credit, and the amount and time of the bank’s
maximum reliance on inventory support of its loan.
(c) Facility
A loan facility is defined as the structure and terms established in a loan agreement. In the case
of lines of credit, the facility is very flexible and overcomes the need to extend a series of short-
term loans. The borrower takes down only part of the line as the need arises. As a result, the
borrower is not left to borrow redundant funds. Interest is charged only on the amount actually
borrowed, and the loan is repaid as cash flows back into the firm with usual seasonal decline in
sales, inventory and receivables.

Seasonal lines of credit can “revolve” in the sense that amounts repaid can be reborrowed within
the line. Lines of credit should not be confused with loan commitment. Commitments are
enforceable obligations to advance funds under agreed-upon terms. By contrast, lines of credit
can be revoked without the consent of borrowers.

A letter of agreement may be used to specify the line amount; define how the proceeds against a
line are to be used; restricts the use of funds for other purposes, such as the purchase of fixed
assets or the repayment of other debt; and spell out the expiration date.

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(d) Collateral
Lines of credit borrowings usually are secured with inventory, account receivables and fixed
assets. Because inventory values often are difficult to determine, the bank is most exposed when
the borrower’s seasonal inventory reaches its peak. In addition, however, as the inventory is sold,
the lender must be concerned with the quality of receivables. This concern requires an
understanding of the firm’s credit policy, including how the firm checks on the credit of its own
customers, how it sets customers’ credit limits and denies credit, its collection procedures, and
other considerations.

1.3 Bridge Loans

(a) Source of Repayment

Another type of short-term loan is the bridge loan is the bridge loan. Such loan can be thought of
as project-type loans that bridge a period of time up to a specific event that generates sufficient
funds for repayment of the loan. For example, regional banks lend large sum to investment
bankers to bridge their underwriting and placement of securities issues until the issues can be
sold to investors. Sales to investors generate the fund needed to pay off the banks. Interim
construction and real estate loans are normally short-term loans to builders or land developers for
the purpose of acquiring and improving real estate. Such loans are secured by the subject real
estate and are conditional on a commitment of long-term takeout funds from a permanent lender.
The takeout funds are the source of repayment at the completion of the bank making the bridge
loan.

(b) Analysis
The bridge loan lender must make two kinds of evaluations. First, the lender must determine the
probability that the bridge event will occur as projected; for example, the lender should assess
the probability that construction takeout funds will, in fact, be forthcoming. Second, the lender
must analyze the ability of the borrower to repay the loan if the projected event does not occur –
for example, if the construction takeout commitment is not fulfilled.

(c) Facility
Bridge loan maturities are tailored to the timing of the payoff event. If repayment is not
completed at the time of the event, the lender must conclude that a failure has occurred.

(d) Collateral
When a bridge loan finances the acquisition or building of an asset for immediate resale, the
collateralization usually is as simple as taking a security interest in the asset itself. If the bridge
loan is for financing or bridging a security underwriting, the lender ensures that repayment is
made directly from the security offering. However, the lender must determine if the borrower can
repay from other sources if the sale or refinancing event does not succeed.

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1.4 Revolving Credit Loans

Revolving credit loans finance the expansion of current assets or retirement of current liabilities.
This type of credit often is called asset-based lending because the amounts borrowed are tied to a
borrowing base formula that limits the outstanding amount to a margin percentage on the
borrower’s receivables, inventory, or, in extractive industries, reserves owned. This credit is the
long term equivalent of short-term line-of-credit loans entailing a commitment to advance funds
up to a maximum line of longer terms, that is, as much such as five years. The need for funds
arises most often because the borrower cannot fund its increasing sales from internal sources
such as retained earnings.

(a) Source of repayment

During the life of the revolving credit loan, repayment is derived from collections from the
borrower’s customer. With revolving credit, however, further, advances are made when the
borrowing firm periodically increases its inventories. Thus, a repayment is indefinite and often
remains so until the loan is converted to a term loan with definite repayment schedule. Whether
the conversion to a term loan is appropriate or not depends upon the likelihood that long-term
earnings will be adequate to repay the loan. Another source of repayment may be refinancing
with an alternative lender or through a securities offering to market investors. The risk of
nonrepayment is greater for revolving credit than for other types of loans because of the
borrower’s unresolved earnings power and the duration of the borrower’s need.

(b) Analysis
It is imperative to analyze the operating capabilities of revolving credit borrowers because such
borrower maintains a tenuous balancing act that matches bank’s financing to growing
inventories, sales, and collections. This requires sharp internal control and reporting systems.
Debt ratios usually are higher than average and must be managed wisely so that financing costs
are tolerable. The lender must determine how the borrower can demonstrate long-term earnings
power capable of methodically repaying the current loan.

(c) Facility
Revolving loan credit is made on a revocable basis. A loan agreement specifies the credit limit
available and the condition under which funds are advanced and repaid. Advances are made
against evidence of adequate working collateral, with reports on the status of the collateral
submitted frequently.

(d) Collateral
Normally, revolving credit advances are made against a borrowing base of eligible receivables
and inventories. Advances support the growth of inventories or the decrease in current liabilities,
such as reduction of excessive credit outstanding. Experienced lenders determine the quality of
inventories and receivables and, therefore, the margin to be applied in a borrowing base advance
formula.

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1.5 Term loans

Term loans are loans (other than consumer and real estate loans) with maturities over one year.
Often they finance the purchase of fixed assets or the broad expansion of production capacity,
but they may also be made to finance a change in company control or an acquisition or take out a
revolving credit loan.

(a) Source of repayment

The repayment source of term loans must consist of stable, long-term sources of cash. In the long
run, sufficient earnings power is imperative, although cash flow arising from depreciation tax
shelters may be a significant source of capital-intensive borrowers with high rates of
depreciation. For loans made to finance fixed assets, repayment should be scheduled before the
end of the useful life of the asset.

(b) Analysis
The analysis of term loan borrowers focuses on what might be called the long-term income
statement. The lender must understand the long-term earnings potential of the company. This
implies a broad-based analysis of the firm’s products and management, its industry, and its
competitive strength within the industry. Long term earnings projections are required, as well as
sensitivity analyses that test the effect of unfavorable developments in sales volumes, profit
margins, asset turnover rates, and direct and overhead expenses ratios. In lending on specific
assets, it should be determined whether the assets will produce sufficient profitability to warrant
their purchase.

(c) Facility
Term loans typically are outstanding for specific period of time and are amortized with payments
of interest and principle on a quarterly or, ideally, monthly basis. Monthly payments have the
advantages of more frequent compounding of the interest rate earned. They also provide the bank
with more frequent confirmation that the borrower is remaining current on its debt and that its
ability to repay has not deteriorated. A formal loan agreement is prepared, with terms and
covenants spelling out the duties of the bank and the borrower, including certain rights that
accrue to the bank if the borrower fails to comply with the requirements of the agreement. Loan
proceeds are normally disbursed when the loan the loan agreement is closed or shortly thereafter.
In reality, term loans provide intermediate term credit; maturities are usually limited to 10 years
and more predominantly in the 2 – to 5-year range.

(d) Collateral
The bank loan is normally secured by the borrower’s fixed assets, including a mortgage on land
and structures or a perfected security interest on equipment. Working capital is less often used
for collateral in term loan but is used to support seasonal or revolving credit loans. The collateral
value of secured assets is the assets’ liquidation value, usually under assumed distress conditions.

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2 Risk Assessment of Corporate Loans
It is well understood that candidates fairly readily interpret accounting ratios and financial
information such as gearing, interest cover etc, to see whether corporate has a capital structure,
which contains high financial risk or not. Where they fall down is that they are not able to put
this high financial risk into a wider context and so are often unable to decide whether high
financial risk can be tolerated in the overall circumstances of the company. Here the interest to
have a wide understand that, corporate face not only financial risk, but what might be described
as “business risk”, i.e. threats and opportunities confronting a firm in its external environment.

The analysis of business risk is about looking at a company’s place in its market, its strategy for
addressing its market position and its ability to manage its resources to defend/exploit its
position. The analysis of business risk is difficult, as it calls for subjective judgements on
qualitative issues. Basically it is critical review of non-financial factors; as opposed to the
financial analysis.

2.1 Financial Risk

The financial risk analysis requires the analysis of the historic data, the forecast of progress and
the capability of the borrowing company to repay the debt. It is this analysis that will enable the
lender to comment on the cash generation and sensitivity of the forecasts.

It is very important to use audited accounts (income statement, balance sheet and cashflow
statement figures). Check if the auditor is a reputable organisation.

Characteristics of a financially successfully Business:

1. Profitable
2. Good cash flow
3. Well structured Balance sheet
4. Adequate return to owner
5. Value that is transferable.

(a) Balance Sheet Relationship

(i) SOLVENCY/LIQUIDITY
Defined as: A company’s ability to pay current liabilities
Measured by: Current Assets, Quick Ratio
Typical Problems: Poor solvency/Liquidity
Caused By Resulting Effect Possible Solutions
1. Fixed assets purchased 1. Reduced cash 1. Finance fixed assets with long term
from operating cash or 2. In ability to liabilities and equity capital

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 short-term borrowing meet maturing 2. Sell fixed assets, pay down current
2. Loses obligations liabilities
3. Excessive stock 3. Business 3. Make profit
9inventory) levels failure in 4. Better buying
extreme cases
4. Excessive collection 5. Reduce stocks (inventory) levels
period and/or account receivables
6. Increase collection efforts
7. Add equity capital

(ii) SAFETY/RISK
Defined as: The degree to which assets are financed by debt (leverage). A
measure of the perceived risk in a business.
For example:
A=L+E
1 = 0 + 1 (no leverage)
1 = 1 + 0 (leverage)
Measured by: Debt to Equity, Debt to total assets.
Typical Problems: Risk Too Great (Too much Leverage)
Caused By Resulting Effect Possible Solutions
1. Insufficient equity 1. High interest cost and 1. More equity capital
capital principal payments that put into business
2. Rapid growth reduce company liquidity (friends, relatives,
2. Pressure to purchase more partners, investors).
3. Losses
assets (Account 2. Reduce assets, (sell)
receivables, inventories and pay down debt.
etc) and incur additional Control growth:
expenses reduces liquidity - Increase profits
and in extreme case can - Manage assets
cause liquidity problems
and failure. 3. Produce profits

Most cases businesses are funded with the mixture of capital (shareholders’ fund) and borrowed
monies. The relationship between the two is known as gearing/leverage.

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(b) Income Statement Relationship
PROFITABILITY
Defined as: What is left over after all costs including wages to
employees and owners. It is an indication of how
effectively the assets are being used to generate profit.
Measured by: Gross Profit Margin, Net Profit Margin, return to total
assets.
Typical Problems: Low Profits
Caused By Resulting Effect Possible Solutions
1. Low Gross Profit Margin 1. Less profit and less Increase price
- Low pricing cash Reduce COGS/ increase
- High cost of goods 2. Reduces ability to efficiency
grow Examine product mix
- Improper stock mix
3. Cannot pay debt Reduce expenses
2. High Operating Expenses
4. Lower liquidity Increase sales volume
3. Low Sales
5. Balance sheet
deterioration

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(c) Income Statement and Balance Sheet Relationship
ASSET MANAGEMENT
Defined as: Efficiency with which managers use assets to generate
profit
Measured by: Stock Turns, Debtor Turns, Sales to Assets
Typical Problems: Low stock turns
Caused By Resulting Effect Possible Solutions
Over – buying 1. Tides up cash 1. Increased stock
Sudden down turn in (liquidity) Control
sales 2. Leads to: 2. More planning
Holding price too - Shrinkage 3. Better buying
long - Obsolescence 4. Eternal vigilance
No control - Spoilage 5. Improve
Poor planning 3. Reduce gross profit management
Poor managing margin
4. Reduced profitability

(d) Ratio Analysis

The overall objective of ratio analysis from a banker’s perspective is to examine a firm’s
financial position and returns in relation to risk, with a view to forecasting the firm’s future
prospects.
However it is very important to remember that a ratio contains little meaningful information on
its own. For a ratio to be effectively interpreted, it needs to be either compared to several other
ratios in a structured analysis, to historic ratios in order to identify trends, to ratios of other
companies in the same industry, or to management’s goals and standards.

(i) Strengths of Ratio Analysis

1. Each ratio calculated focuses on a specific area of the company’s activities and in this way
the importance of individual items from the balance sheet and income statement is
highlighted.
2. By comparing ratio calculated from a company’s balance sheet with those of previous years,
the direction that company is travelling in is easily identified, i.e. is the financial position
improving or deteriorating?
3. Comparison of ration between companies in the same industry illustrates possible strengths
and weaknesses in the individual companies.
4. Ratios provide a clear and objective measure of the company’s ability to meet its financial
objectives.

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(ii) Weaknesses of Ratios
1. Many, if not most, ratios are calculated from balance sheet figures, which show a company’s
position at one specific time during the year, and this may well not be an average position.
This is a particular problem for companies which are subject to seasonal fluctuations. The
balance sheet information on which ratio is calculated is historical and often relatively stale.
2. Balance sheet figures can be misleading if looked at in isolation. Accounting practices allow
a wide variety of principles to be used in areas such as assets valuation and classification of
liabilities.
3. The quality of assets is not reflected in the ratios.
4. In making inter-company comparisons or comparing against industry averages, the effect of
different accounting policies must be considered.

2.2 Business Risk Analysis

The framework which is very popular in undertaking he business risk analysis is the SWOT
analysis. SWOT complements and extend the CAMPARI mnemonic by looking at a business in
a wider context. It stands for Strength, Weakness, Opportunities and Threats.

Strengths/Weaknesses
When looking at the strength and weaknesses of a business a lender will concentrate on the
internal view of the performance of the business. The following illustrate the sort of topics which
can be reviewed, although the list is not exhaustive:
MANAGEMENT
- What is the level of Management skills? - Have (or have access to )
- What is the level of expertise and management, financial and
Experience? Marketing skills?
- Clear credit record? - Any other assets? What value? Paid
- Do owners own fixed property? for?
- Any contingent liabilities? - What level of drawing for personal
- Is the life cover already held to liquidate needs?
the debt? - Owners; ages and what succession
- In full time employment of the plans?
business? - What business insurance held?
- Computer literate
Profile of a successful Entrepreneur
- High energy, health and emotional
stability
- Goal oriented - Enthusiastic
- Sense of urgency - Self control
- Status – less important than - Self confident
achievement. - Realistic
- Moderate risk taker - Need for control (not good at
- Creative and innovative delegating)
- Ability to deal with failure - Hungry for accomplishment –
money follows
- Support of family.

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 ENVIRONMENT
- Who are competitors? What are our client’s key differentiating factors?
- Who are the suppliers? Alternatives? Do they offer reasonable terms?
- Are there substitute products that will affect business/industry?
- If foreign trade is involved, is forward cover taken?
- What are the entry barriers in the industry? (E.g. high capital requirements,
regulations, strong brand identification etc.).
- Is the business subject to seasonal fluctuations?
- Is the business subject to change from possible political events, e.g. tax, inflation
rate and interest rate policies, government objectives, etc?
- Who and where are the business; clients and has the target market been correctly
identified?
- Where is the business located? Are the premises owned/leased? Room for
expansion? Will the Improvements be required in the near future?
- Is the labour force unionized, skilled, and ready available? What is their relationship
with management?
- Does the business have manufacturing capacity? Is the machinery in good
condition? What is the cost of replacement? What stock and quality control
procedures are in place?
- How is the business affected by current and anticipated state of the economy?
Opportunities and Threats
When looking at the opportunities and threats which faces the business, a lender will concentrate
on the range of factors external to the business which can influence performance. These are the
factors over which the business has no control. However, an understanding of the extent to which
these factors can affect a business can be vital in assessing accurately the quality of the business
and the ultimate credit risk. The following illustrates the issues which can be covered:

Competitiveness What is the level of competition?

Economic Changes What will be the impact of economic change? Most firms are
affected by pressures from business cycles, exchange rates,
interest rates and inflation.
Social Changes What will be the impact of changes in demographic, lifestyle
etc? Changes in birth rate, the number of children per family
and the average age of the population may affect a business’s
market. Trend in social and cultural patterns can have
unpredictable effects on business, e.g. food producers reacting
to trend towards health-consciousness.
Political Changes What will be the impact of changes in government legislation?
Technological What new technology developments will affect the business?
Changes Some may be faced with obsolescence of major assets as better
processes are developed.
Ecology Ecological “friendliness” had become on of the most visible
influences on business activity in recent years. E.g. firms that
discharge high levels of effluent face greater fines than before
and consumers are more biased towards eco-friendly products.
Labour Markets Demographic changes and workforce skills can affect the
availability of suitable labour.

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High Risk Industries: - (Need extra care)
Restaurant Property owning companies
Hardware retailers Insurance Brokers/Finance
Motor dealers/Repairs Consultants
Gyms, Clubs Transport Services
Petrol Service Station Fashion Design
Building Contractors Film/Video Production

3 Collateralization and Security Assessment

3.1 Taking a security Interest

When a bank takes a security interest in collateral of the borrower, the bank obtains the right to
sell the collateral assets and apply the proceeds to the loan if the borrower cannot repay the loan
as agreed. Most bank loans to businesses are made on this basis. Although short-term loans to
high quality borrowers are not secured, most long-term loans are secured. In fact, the loan
policies of many small and medium sized banks generally forbid most unsecured term loans.
Large banks, in dealing with large prime borrowers, are more liberal in granting unsecured loans,
because such borrowers tend to have stronger equity support in their capital structures, more
stable cash flows, and more certain investment opportunities. Banks follow precise procedures to
establish and document their legal claim to the proceeds of collateral assets in the event of
default. Different procedures and documents are required for real as opposed to personal,
property.

3.2 Real Property

When the real asset (land and improvements, including structures) collateral is offered, the bank
must record the associated mortgage with a public agency. This recording or filling protects the
bank against subsequent claims by third parties. Evidence of insurance on the property is needed,
including the designation of the bank as payee in the event of loss.

3.3 Personal property in the bank’s possession

A security interest in the property of the borrower is perfected when the bank or its agent
actually takes physical possession of it. A borrower completes a pledge agreement, which
authorizes the bank to hold the collateral and to derive cash from it in the event of default.
Because the asset is already in the banks possession, it is not necessary to file a pledge agreement
publicly.

4 Problems with corporate lending

In this part we will explain how to identify problems at an early stage, what action to take when
problem arise, and most of how to minimize loss when corporate lending goes wrong.

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4.1 How to identify problems early

Unlike most retailers, lending bankers cannot sit back and relax once the product has been sold.
The risk continues until the following is fully repaid, and regular monitoring of the accounts is
necessary to spot the vital early warning signs which may indicate that a formerly profitable
account is about to turn into an expensive write-off. The earlier problems are identified, the
sooner corrective action can be taken. It should be obvious that the bank must automatically
monitor the customer’s actual performance against his budget and cash flow forecast, and to this
end a condition of lending is often that up-to-date management figures be produced to the bank
within a certain period. At the same time assessments of debentures values should be updated,
and formulae monitored. Any excess over agreed limits must also be investigated promptly. But
what other areas can the conscientious banker keep an on to help him avoid unpleasant surprises?

4.2 Dander Signs

The following areas need to be watched. If any of the signs appear it does not automatically
signify problems but could do, particularly if several appear close together.

4.2.1 Internal records

1. Unauthorized excesses.
2. Turnover increasing or decreasing unusually.
3. Hardcore borrowing appearing on current accounts.
4. Unpaid cheque in or out.
5. Cheque for round amounts.
6. Uncleared effects – possible cross firing.
7. Special collections in or out.
8. Status enquiries in or out.
9. County court judgments.
10. New standing orders. Direct debits to finance companies.
11. Stopped cheques in or out.
12. Unusual cash withdrawals.
13. Local news, rumour, information from staff, about problems.

4.2.2 Visits or interviews

1. Difficulties in getting hold of director.
2. Lack of long term plans.
3. Failure to meet orders.
4. Reliance on one customer or supplier.
5. Buying bargains on the cheap.

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6. Diversification.
7. Delays in cash coming in.
8. Request for release of security (particularly third party).
9. Changes in terms of trade.
10. Idle assets (affect on return on capital employed).
11. Dead stock.
12. Pressure from creditors.
13. Management changes, succession, balance, ability to react to changes.
14. Changes in attitude since last meeting.

4.2.3 Audited Accounts

1. Evidence of new borrowing elsewhere.
2. high gearing
3. Small surplus or losses.
4. Accounts late or only draft.
5. Two sets of accounts.
6. Auditors’ changes or unusually high audit fee.
7. Auditor’s certificates qualified.
8. Other bankers.
9. Revalued assets.
10. Figures not trying in with management accounts or debenture figures.

4.2.4 Management accounts

1. Late, no-existent or sketchy.
2. (a) Debenture formula breached.
(b) Figures not trying in with previous figures or with last audited accounts.
3. increase in preferential creditors
4. Targets not met.
5. No assumptions with forecasts.
6. Losses.
7. Margins of safety small or reducing.
8. Customers lost, or not well spread.
9. Pricing by guesswork.
10. Arithmetic wrong.

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5 Summary of the Unit
On completion of this unit, students should be able to
(i) To assess the financial viability of a corporate loan
(ii) Appreciate the relevance of non-financial information in assessing a loan.

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Self Assessment Questions

1. How do you differentiate between a large business firms from a small business firm.
2. Give a brief explanation the types of loans applied by corporate customers?
3. Using ratios explain the importance of ratios in analyzing a corporate customer.
4. What is the importance of non-financial information in assessing company’s loan
application?
5. In what cases may higher gearing levels be acceptable?
6. Mention some of the problems which may cause a bank to face a liquidity problem?
7. Set out the ratios used to assess the company’s liquidity position.
8. What are the ratios used to assess the financing level of a company?
9. To a bank what is important a profit making firm or a liquid firm?

Problem 1
Outline and describe the processes of credit evaluation in commercial lending. Use a process
diagram to support your answer.
Problem 2
In the course of financing working capital, it is a common practice for banks to protect their
interests with a fixed and floating charge over the borrower’s assets.
(a) Explain what a “floating charge” is.
(b) Under what circumstances will a floating charge crystallise into a fixed charge?

Problem 3
Banking at your branch is a firm of chartered accountants which from time to time introduces
new business to you. One of the partners calls at the branch. He tells you the firm has been
asked to help draw up a business plan for a new venture to extract, bottle and market mineral
water. He asks you if your bank would be interested in providing finance for the venture.
The following information and figures show the main elements of the business plan:
 A new company called Pure Water Limited has been established, owned 50% by a Mr.
Spring and 50% by a Mr. Bottle.
 Mr. Spring (aged 42) is a farmer who owns land in the Lake District. He has planning
permission for the development of a bottling plant, and licenses from the National Rivers
Authority for the extraction of water from his land.
 Mr. Bottle (aged 45) has been involved in a number of mainly property –related business
ventures in the past. As one of these ventures, he recently agreed to acquire a bottling plant
in the South of Tanzania. The bottling plant had been used for bottling sherry but, following
a change in water regulations, all sherry has to be bottled in Uganda. The plant is in good
order and can easily be converted to bottler water.
 In return for his shares in Pure Water Limited, Mr. Spring will transfer the extraction licenses
to the company. The farm and land will be sold to Pure Water Limited for $360,000. A new
building will be erected by the company on the land transferred by spring.
 In return for his shares, Mr. Bottle will:

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  Transfer the plant and equipment from the south of Tanzania bottling plant to Pure
Water Limited:
 Cover the cost of moving the plant and equipment and installing in the new building.
 Market research shows the Tanzanian market for mineral water is expected to be worth
around $250 million in 20x1. 50% of the market is controlled by one large group, but there
are over 30 other companies with a significant stake. The overall market grew by more than
25% last year.
 Sampling of the water on the farm has been carried out on a regular basis. It has been of a
good and consistent quality.
 Agreement in principle has been reached with a large supermarket chain to take an
unspecified amount of the water.
 The production manager of the south of Tanzania bottling plant has agreed to join Pure
Water Limited.
 The bottling plant has the capacity to deliver the sales volumes in the financial projections.
 The financial projections assume that the new bottling hall will be completed in March 20x1,
with the first sales taking place in April. Sales would then increase steadily over the two-
year period of the forecasts. It is assumed that no profits will be earned until August 20x1,
but that they will then increase in line with sales.
 There is the usual disclaimer from the accountants that: This report has been based on
information presented to us by the directors of Pure
 Water Limited. We have not performed an audit or carried out any checks, tests or
verification work.’
Required
Prepare an analysis of the business plan and indicate the answer you will make to the
accountants.

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 Pure water Limited Balance Sheet
Start projection Projected Projected
31 Oct 20x1 31stDec. 20x2 31stDec. 20x3
(million) (million) (million)
Fixed Assets
Freehold property 360 360 360
Bottling hall - 200 200
Extraction licenses 631 631 631
Plant and equipment 493 1,484 371 1,562 249 1,440

Current assets
Debtors - 920 1,000
Prepayments 37 50 50
VAT receivable - 37 1
Cash at bank - 37 - 1,007 2,259 3,310

Current Liabilities
Creditors - 68 83
Bank overdrafts 330 (330) 843 (911) - (83)
Net Assets 1,191 1,658 4,667

Financed by:
Share capital 30 30 30
Surplus brought forward 1,161 1,191 1,658
Current year profit - 437 2,979
1,191 1,658 4,667

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 PURE WATER LIMITED
PROFIT AND LOSS SUMMARY
Year 1 ended 31/12/20x1 Year 2 ended 31/12/20x2
(million) (million)
Sales 2,618 6,588
Gross profit 1,575 4,104
Net profit (before tax) 437 2,979

PROJECTED ACCOUNTING RATIOS AND ASSUMPTIONS

31 Oct. 20x1 31 Dec. 20x2 31 Dec. 20x3
Net gearing % 59 82 -
Current ratio o.11:1 1.11:1 39.88:1
Acid test 0.11:1 1.11:1 39.88:1
Credit given (days) – (cash flow - 53 53
forecast assumption)
Gross margin % - 60 62
Net Margin % - 161 452

Cash flow forecast Summary (closing monthly balances) Million

20x1 Dec 330 DR
20x2 Jan 450 DR 20x3 Jan 683 DR
Feb 781 DR Feb 435 DR
Mar 874 DR Mar 291 DR
Apr 989 DR Apr 46 CR
May 941 DR May 262 CR
Jun 887 DR Jun 457 CR
Jul 872 DR Jul 622 CR
Aug 939 DR Aug 970 CR
Sep 1,003 DR Sep 1,326 CR
Oct 1,192 DR Oct 1,642 CR
Nov 967 DR Nov 1,931 CR
Dec 843 DR Dec 2,259 CR

Problem 4

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Convey, Litigate and Probate (CLP) is a firm of solicitors with eight partners, operating from
four offices in local towns.
In recent years the partnership has expanded rapidly by acquisition of other firms to reach its
present position. It long term aim is to expand its commercial client base and reduce reliance on
convincing. No legal aid work is undertaken.
Two of the four offices bank with you and you currently mark an overdraft limit of TZS.
250,000,000 for the firm. There have been occasional excesses over this limit and the account is
showing a hard core of borrowing which is on a rising trend. The other offices bank with two of
your competitors. You currently have TZS. 14 million of clients’ money on deposit.
In addition to the partnership itself, three of the partners bank with you in their personal capacity.
You are aware that each of these has a minimum equity in his house of TZS. 150,000,000.
The senior partner calls to see you. He is going to take sole charge of the firm’s finances and, as
part of process of tightening control; he wishes to deal with only one bank. He asks if you will
agree to an increase overdraft limit of TZS. 500,000,000 in return for handling all the firm’s
banking.
In conversion, you learn that the partnership is planning to make strenuous efforts to increase
income from fees and is seeking to recruit an extra partner for each office. Each new partner will
be expected to provide TZS. 35,000,000 in capital.
Required:
Make an assessment of the firm’s current financial position and plans for the future. Indicate,
giving reasons, the response you would make to the senior partner’s request for an increased
overdraft limit. (Balance sheets, Profit and Loss accounts and ratios are shown below.

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 CONVEY, LITIGATE & PROBATI
ALL OFFICES
Balance Sheets as at (Figures in 000 shillings)
30 June 20x1 6 month to 31 6 months to 30 June
December 20x1 20x2
Fixed Assets
Short leasehold property 29,528 28,712 27,897
Equipment & fittings 83,466 97,111 130,745
Motor vehicles 37,740 55,271 72,208
150,734 181,094 230,850
Current Assets
Work in progress 128,436 158,258 193,113
Debtors 289,290 267,036 352,159
Cash in hand, at bank and 5,299 64,498 56,603
building society 423,025 489,792 601,875

Current Liabilities
Bank overdraft 209,242 341,901 482,828
Bank loans 10,000 9,960 10,887
Creditors 208,016 223,486 274,020
427,258 575,347 767,735

Net current liabilities (4,233) (85,555) (165,860)

Creditors: due after more than
one year
Bank loan 20,846 18,613 15,013
Creditors 9,533 37,144 56,478
30,379 55,757 71,491
116,122 39,782 (6,501)
Client’s accounts
Bank balances 1,484,253 1,686,808 3,090,416
Amounts owing to clients (1,484,253) (1,686,808) (3,090,416)

Total net (liabilities) /assets 116,122 39,782 $(6,501)

Partners’ capital and current

accounts
Balance at start of period 132,756 116,122 39,782
Profit for period Drawings 201,260 40,114 95,858
(217,894) (116,454) (142,141)
Balance at end of period 116,122 39,782 (6,501)

Profit and Loss Account

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 12 months 6 month to 31 12 months
ended ended December ended 30 June
30 June 20x1 20x1 20x2
Income $ $ $
Free receivable 1,125,439 681,327 1,518,532
Commission receivable 10,661 5,758 14,069
Bank interest receivable 68,167 49,864 100,809
Rent receivable 18,728 16,047 29,350
1,22,995 752,996 1,662,760
Overheads
Staff salaries and pensions 492,188 334,518 745,756
Other personnel costs 21,310 19,127 45,108
Motors and traveling 31,264 16,670 37,874
Entertaining 11,892 9,082 18,853
Rent and rates 83,473 57,795 110,230
Heat, light and power 7,272 4,179 10,895
Leasing and maintenance of office equipment 30,538 13,453 59,256
Repairs and renewals 8,111 15,322 43,071
Insurances 34,998 21,164 43,015
Printing, postage, advertising and stationery 59,621 42,150 94,115
Telephone 34,549 25,614 51,187
Subscriptions, donations, books and courses 14,843 10,062 26,455
Sundries 20,130 14,230 24,427
Professional indemnity claims 14,584 5,800 5,800
Professional charges 18,254 10,377 14,751
Accountancy fees 15,445 8,564 20,871
Provision for bad debts 23,174 50,101 48,624
Bank charges and interest 49,276 18,361 48,125
Depreciation 50,813 36,313 78,375
1,021,735 712,882 1,526,788
Net profit for the year/period 201,260 40,4114 135,972

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 Balance Sheet Ratios

30 June 20x1 December 20x1 30 June 20x2

Current ratio 1:0.99 1:0.85 1:0.78

Acid test 1:0:69 1:0:57 1.0:68
Credit given (days) 93 72 85
Credit taken (days) 205 163 180
Net margin % 17.9 5.9 (6 months) 9.0
Interest cover (times) 4.1 2.2 (6 months) 2.8
Net gearing (%) 202 769 -

Case Study

FARMLAND INVESTMENT COMPANY LIMITED.

Part I

About the company

Established in 2008 as a limited liability company owned by Mr. James Tele, Ms. Miriam Habari, and
Mr. Barnabas Jema. Before the incorporation the company was incorporated as a sole business known as
Thomson Investments which was established in 2000. The company was dealing with animal feeds and
supply of animal feed materials. The company came into operation when Mr. Tesha failed to operate the
business and invited Ms. Miriam to consult him and find ways to move the company ahead. Ms. Miriam
after two years consultations (which were not fruitful to move the one man business ahead) agreed that
they form a company which will be a limited liability. Since she was not paid for the activities done, it
was agreed that Mr. James would take 55%, Ms. Miriam 15% and Mr. Barnabas 35% stake of the
company. Company capital was TZS 200 mil. The equivalent contribution of Ms. James was TZS 150mil
in assets and goodwill, of which it was agreed that the over and above the 15% contribution the rest will
act as a Director loan attracting 20% interest rate per annum. Ms. Miriam was to pay her shares based on
the consultation income to the company and 30% of which she would pay cash. Mr. Barnabas paid
straight to the bank his shares.

About the Management

Mr. James (42) was appointed as Managing Director and Ms. Miriam (35) Director of finance. Mr.
Barnabas (45) served as Board chairman. The board has only three people whom were also shareholders.
Operations of the company seem to run quite well in the beginning. Sales increased by more than 100% in
the first year of operation to over 300% in the third year of operation. Before the official incorporation of
the business, the sales volume was on average, TZS 35 mil per month.

Ms. Miriam, a business analyst and a freelance consultant with more than 10 years of working experience.
She is MBA holder, operating two small business and experience in consulting over 40 small businesses.
Mr. Barnabas holds B.Com degree from reputable institution in Tanzania, has worked with the Big 4
accounting firms in Dar es Salaam and operates several business lines. He has vast experience in running
small businesses.

In the diagnostic analysis of the company, Ms. Miriam was told by Mr. James that she was a graduate in
Medical studies, non practicing medical doctor. He has been in business for more than 7 years, the

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business which he started after his graduation. Ms. Miriam also heard rumours that Mr. James real name
was Mr. Thomas Tesha which reflected the name Thomson Investments. Either of the two allegations was
proved beyond doubt as Mr. James produces proof of the name, pending certification of his medical
doctor, which was not a big issue because several times Miriam’s daughter and Thomson staff were given
free medical consultations with Mr. James.

The company as restructured to have formal employments – employing more than 20 staff of which 5
professionals were employed in food production, marketing, finance and accounts, and veterinary
services. Initially, the company had only 8 employees most of whom were Mr. James relatives. The
salaries were very low, paid on weekly basis. Also the company developed formal weekly meetings,
working schedules, various policies and computerised accounting system, being new initiatives following
its restructuring.

Approaching the Bank

The increased sales triggered the need for business financing. In its second year of operation, the business
was in acute need for business financing. The management and board of directors approved that the
company should seek TZS 100 mil from financial institutions to finance the business operation. The
priority was to approach first the guarantee schemes available for agriculture as the company was doing
agro related business. These efforts failed. To rescue the increasing need for funding, the company agreed
that they should seek immediate fast loans from providers in town. They sought TZS 50 mil from a
microfinance institution owned by Mr. Barnabas close friend. No collateral was made. Also other
initiatives were made including borrowing from other vendors and Ms. Miriam and company assets were
pledged as securities. A total of 60mil were raised.

Increasing demand for the company products, inflation, interest rates from the microfinance companies
and other macroeconomic variables called for more financing need. The suggestion was to seek bank
loan. A total of TZS 150 mil was needed. The main challenge was collateral. Mr. James informed the
company on the friends’ agreement to offer third part collateral to the company. This was agreeable by
the company owners. A good business plan was drawn by Ms. Miriam and submitted to the bank for
consideration.

Questions:
1. How do you see the Farmland Investment Company business?
2. What is your comment on the management structure of the company?
3. Is Farmland a typical setup of most of small and medium scale businesses in Tanzania? Explain
4. If you were approached to advance the proposed loan as a loan office, what would be your
decision? Other factors remain constant.
5. What additional information is needed before considering advancing loan to the company?
6. What are the risks the bank is likely to face by advancing the loan to the company?

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FARMLAND INVESTMENT COMPANY LIMITED.
Part 2
The company requested an O/D of TZS 100mil. It was advanced TZS 80mil one year loan. The loan was
disbursed 10 months after the application.
1. The third part was taken as a collateral, valued at TZS 200mil
2. Company properties –3 original motor vehicle cards were filed to support the collateral which
bears company name
3. Directors’ personal liabilities were seconded to be part of the collateral.
4. Loan was 1 year, 20% basically to cover working capital needs. Loan start date 1st January 2010.

Aftermaths of the loan:

1. Ms. Miriam went for studies abroad for 3 months, few weeks after the loan was disbursed
2. Mr. James fired company accountant few weeks after Ms. Miriam went for studies.
3. Financial affairs of the company were not stable as Mr. James started not to bank company
monies to the bank account as previously, and as per the company policies and regulations.
4. Mr. Barnabas was busy with other activities and hence he was not able to strongly supervise the
affairs of the business, although he approved the financial transactions of the company.
5. Mr. James secretly started to construct his own house after three months of loan disbursement.
6. The owner of the third part collateral borrowed with the approval of the two Directors a total of
TZS 10 million being 10% of the funds sourced from the bank and justification being that it was
an agreement with his relative – Mr. James. He promises to return the funds. The issue was not
easy as it reached to the lawyers and the directors have to surrender.
7. Mr. James sold one of the company vehicles without the concert of other Directors – giving
reasons that the car was not fit for the road after minor accident.
8. Mr. James became a church goerer and creates friends within the church who some times make
regular visits to the business.
9. During the first six months the loan was served as scheduled but the company transactions were
just enough to cover the monthly instalment.

Discussion:
1. What did you think happened with the company?
2. What further information would you require as a bank should you be aware the possibility of
events post the loan disbursement?
3. What do you think will be the future of the loan disbursed and bank relationship?
4. What is the role of the loan officer/relationship officer on the current affairs of the company?

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