Becoming Bankable: 5 Steps to Getting Money for Your Business - Case Study Example

Executive summary Commercial Equipment Financing (CEF) is a division under GE Capital Canada, which issues loans to trucking companies. Its loan recovery strategy is very tight, and only one percent of its portfolio has been lost to bad debts. The division is under pressure to attain high profit targets and hence it cannot afford to incur losses in bad debts or lose clients – the division tries all its level best not to expose the company to unreasonable levels of risk, especially by exercising strict minimum requirements for loan approval. Problem Statement Commercial Equipment Financing (CEF) is issuing loans to trucking companies that operate in a very volatile industry, hence increasing the chances of bad debts. This calls for very careful and prudent credit policies, to avoid losses when clients become bankrupt. Problems/Sub-problems/Issues The following are the minimum requirements that had to be met before CEF would approve any loan request: i. Any company that has operated for less than three years does not qualify for loan ii. For any company to be considered for loan, it must be able to generate adequate cash flows to repay the monthly interest. iii. Any company with debt/equity ratio, which is greater than 4:1 does not qualify for loan iv. The company that is being awarded some loan must be ready to finance 10 percent of the asset’s cost on its own v. Other considerations include the general economic conditions, the character of the business owner, and any asset of the company that is pledged as collateral. Challenges experienced by CEF, which increases the risk of bad debts The status of the transportation industry in southern Ontario The industry operated profitably from 1985 to 1988, but a considerable recession that hit the economy in 1989 caused instability. As a result, the trucking companies lost revenues as manufacturers were reducing their transportation requirements as they cut down their operations. In fact, most of the trucking companies became bankrupt and the few that survived the situation lowered their prices to remain competitive. Although the industry recovered from the recession in 1990s, the transportation industry in southern Ontario remained challenging as there were too many companies competing for few clients. By 2003, albeit the industry experiencing substantial growth, the profit margins remained very low since the prices were still very low. To survive with very low prices, the companies are forced to look for loans so they can operate at high volumes to increase their profits. Besides, the trucking companies maximize the time they spend on the road to increase sales so they can be able to repay the loans and their operating expenses. New legislation The Ministry of Transportation of Ontario (MTO) had introduced legislation that required all vehicles used by trucking companies to comply with strict safety standards. The ministry impounded any vehicle that failed to comply with these safety measures. Analysis 4 C’s of Credit Commercial Equipment Financing (CEF) carefully analyses its borrowers before approving loans, with the aim of increasing the recovery rate. This is particularly very important because the industry is undergoing very tough economic conditions and the chance of a company failing to repay the loan is very high. What CEF looks for can be summarized in terms of ‘4 C’s of Credit’ as analyzed below. 1. Character The financial History of the borrower is referred to as the character. It is in most cases identified by looking at the credit history of the borrower especially as pointed out in the credit score. Factors that affect the credit score of a borrower include delinquent accounts, late payments, total debt, and available credit. To attain high scores, the borrower should have very few problems. CEF fixes 4:1 debt/equity as the maximum for any company that can qualify for a loan – this is a very effective way of determining the character of the borrower. Furthermore, a company with too much debt is likely to be burdened with interest repayment and, therefore, the likelihood of not being able to repay the loan is very high. In this industry, the characters of most of the clients is likely to be affected by the fact that they are seeking more credit to increase the volume of their sales as a strategy to cushion themselves from poor economic conditions. 2. Capacity The ability of the borrower to make adequate profits in order to be in a capacity to repay the loan is referred to as capacity. In most cases, start up businesses performs poorly in terms of capacity because they do not have any ‘truck record’ to show and hence the financiers may shy away from offering them loans. In this regards, CEF does not award loans to the companies that have been in operation for less than three years for fear that they may not be able to pay them back. In addition, the company assesses the cash flows of the borrowers, to establish whether they are adequate enough to be able to repay the monthly interest. 3. Capital The capital assets of a business are referred to as capital. These may include truck vehicles for a transportation company, as well as store fixtures and inventory. CEF will want to consider the capital base for its clients; however, sometimes this is not a very good consideration because the assets of a company may depreciate when it goes under – leaving them with the option of selling the assets at liquidation value. As much as they consider the capital assets of the borrower, CEF also pays attention to the assets that are pledged as collateral with other loans to avoid losing them when the clients fall bankrupt. 4. Collateral Collateral are the assets that a borrower attaches as security for a loan. In addition to considering other factors such as credit rating, capital assets, and verified capability to make money, CEF will want to ask the borrower to pledge their personal assets on the loan. This is important because this is what they can fall to if the business fails, and hence forcing the clients to work hard to make sure their businesses are successful. If a business does not have any assets to pledge for collateral, then their loans are not approved (Kimberly 56). Alternative Analysis Despite the tight risk controls put up by CEF, sometimes, occurrence of bad debts is inevitable. The following are three alternatives that can be used to reduce the risk of bad loans. 1. Protection in advance Prior and in the process of processing of a loan contract, it is important for the company to assess all the potential risks that may occasion default of the loan by the borrower. These risks include the capacity of the borrower to repay the loan or the enforceability of the collateral. Based on the facts of the assessment of the risk, the company can decide whether to award the loan and the protection measures and conditions that should be spelt out in the loan agreement. This option may become difficult for loans without collateral; but in such a situation, the company can consider other factors such as its business relationship with the client or even request for the financial report before the loan is awarded. If the client has provided a guarantor as security, the company may face the risk because the guarantor may conspire with the client to apply for the loan illegally, or breach the security contract by claiming that the guarantor is bankrupt default the loan repayment. However, to minimize the risk on the loan agreement, the company may include as many legal measures as possible, once the decision has been made to award the loan to the applicant. 2. Monitoring the client during the loan agreement The company can stipulate that the borrowers occasionally serve them with a report of their businesses, assets or other financial circumstances for assessment. The loan agreement can also incorporate a requirement that the loan can be declared due immediately when some events take place, or else the asset can be auctioned to recover the loan. Such events may include the client’s failure to satisfy payment obligations. This option will significantly reduce the chances of bad debts; however, it could be difficult for the company to keep the track of every move of the borrower - making them to default the loan. 3. Collection of non-performing loans The company can file a claim against the borrower in the event that they default on a loan, or enforce the collateral in a court of law. Nevertheless, it is usually very difficult and costly for the company to exercise its rights through a court of law. Decision/Recommendation In consideration of the above three options of reducing risks of bad loans, it is recommendable that CEF focuses on the first option that involves protection before the loan agreement is executed. The second option is highly unsuitable due to the difficulties involved in keeping the track of the clients’ moves while the third one is also not very suitable because it is very costly and sometimes ineffective due to legal hitches. Furthermore, as the old adage goes ‘protection is better than cure’. Proper assessment of the clients’ risk profile before loans are issued to them is cheaper and a more effective way of avoiding bad debts, especially considering that the truck transport industry is very volatile - the company cannot afford to issue loans to a client before gaining a lot of confidence because the chances of recovering them after that could be very minimal. Work Cited Kimberly, Evans. Becoming Bankable: 5 Steps to Getting Money for Your Business. New York: iUniverse, 2005. Print. Read More