Credit Risk Analysis for Black Gold Ltd - Case Study Example

FACULTY OF BUSINESS, GOVERNMENT & LAW Assignment Coversheet Student Name And ID number Unit name/number International Financial Management Name of assessment International Financial Management report Word Count Date of submission Student declaration I certify that the attached assignment is my own work. Material drawn from other sources has been acknowledged according to unit-specific requirements for referencing. Executive Summary One of the difficulties faced by the banking institution relates directly to credit risk. Credit risk can be explained as the possible of loss that the bank might incur as a result of a borrower defaulting from paying his or her loan and as the terms of the loan agreement. This paper gives the recommendation concerning the loan, which is to be advanced to the Black Gold, risk return on the loan to be advanced. Submission letter Internal report To: Mr. Widodo The bank Managing Director P.O Box 452 From: Loan evaluation officer Dear Sir/Madam RE: PROCESSING $ 5BILLION LOAN FOR BLACK GOLD COMPANY LTD In reference to the above topic, I would like to submit the my evaluation report and recommendation concerning the processing $ 5billion loan for the Black gold company for purchasing coal mine. Find attached copy of detailed report and analysis of the report and the recommendation on the same concerning my view. Thanks Yours faithfully Introduction One of the difficulties faced by the banking institution relates directly to credit risk. Credit risk can be explained as the possible of loss that the bank might incur as a result of a borrower defaulting from paying his or her loan and as the terms of the loan agreement (Antwi 2014). One of the primary goals of credit risk management is to maximize a bank risk-adjusted rate of return for maintaining credit risk exposure within acceptable parameters. There is a need for the banks to manage the credit risk inherent in the entire portfolio and the risk of individual credits or transactions (Dewandaru et al. 2015). The credit managers should also be in a position to consider the relationship between the credit risk and another risk (Beatty & Liao 2014). The efficient and effective credit risk management is a critical component of a comprehensive approach to the risk management in a bank, and this will ensure long term success of the Bank. In the banking sector, loans are the largest and the most common source of the credit risk. Other banks activities are also a potential source of risk to the bank, which should be considered (Beatty & Liao 2014). The paper discussed loan credit risk using the case study of Black Gold Company, which intends to borrow $5 billion to pay after 20 years (Harrison et al. 2014). The banks managers and credit officers should be in a position to draw lessons from the experience, as the banking sector continues to get credit risk continues. The managers should be able to establish appropriated risk environment, they should be able to determine the operation under sound credit process, maintaining a proper credit administration and ensure proper and adequate controls over credit risk (Harrison et al. 2014). Credit risk evaluation process In analyzing risk return process, it generally starts by analyzing of the borrower's ability to repay and support provided by the structure and any other credit risk mitigation measures (Kitzing 2014). Some of the factors to be considered in analyzing the risk the bank will experience from Black Gold Ltd include The expected present the borrower condition, which includes liquidity, cash flow, liquidity, leverage and the free assets The ability of the borrower to withstand adverse environment conditions The history of the borrower of servicing the debt, whether the historical projections of loan repayment are correlated in any way with the willingness of the borrower to pay The elements of underwriting in the loan agreement including amortization and reporting requirements Control over the collateral, pledge and other credit risk mitigants and lastly Qualitative factors such as the caliber of the borrowers management, strength of its industry and the condition of the economy The management should be in a position of establishing appropriate credit risk environment (Kitzing 2014). The amount of money the Black Gold intends to borrow must pass through the board of directors which should review its viability. The credit manager must have proper analysis of borrower's financial statements. This includes the income statement, balance sheet, and cash flow statement as they are very important in making decisions (Deegan & Ward 2013). Any act, which affects capital structure, investment decisions, and the portfolio risk, should not be taken in isolation (Deegan & Ward 2013). Most theories provide conflicting prediction concerning banks optimal asset and activity mix; the banks best funding and the most favorable match between bank property and liabilities (Gassen 2014). Most information concerning financing decisions is received from the customers who help the banks in making credit decisions (Deegan & Ward 2013). The information from the balance sheet is very important. The balance sheet can provide an early warning concerning credit problems for the company. If the assets degrade or relative level of assets and liabilities changes from one year to another, the balance sheet will be able to tell the credit officer in charge (Deegan & Ward 2013). From the case study, the company long term loan has been stable for the past three years in which in the year 2014, it increased by 1600 from 2013, therefore, it is important for the bank to consider factors that surround the increase in the loan from the balance sheet perspective (Gassen 2014) Commercial borrowers generate their revenue from the assets; there is a need for loan examiners to analyze income account and liquidity account to establish the composition of these accounts and how they are proportional to change (Beatty & Liao 2014). The analyst should also pay keen attention to capitalization and liquidity as they help to determine the borrowers' ability to withstand an economic slowdown or unplanned events. Business cash flow is a very important since it is operating revenue which is derived from the ordinary business activities less operating costs paid plus non-cash expenses including amortization and depreciation. It is very important for working capital account to be analyzed since it helps in understanding the implication of cash flow. Harrison et al. (2014) states that a troublesome borrower will always try to reduce capital expenditure so that it can generate cash for debt services. However, this may prove vital in a short-term assistance as such action can be dangerous for long-term success for the business. For more detailed information, ratio analysis should be done so that investors like the bank can have full understanding of the company balance sheet. Some of the important ratios include debt to equity ratio, income to revenue ratio of another ratio. Horngren et al. (2012) states that comparing a borrower financial ratio with earlier periods and the industry ratios can prove very vital in identifying potential weakness and risk which might come as a result of advancing loan to such organization. Beatty & Liao (2014) states that whenever the borrower's ratios show greater deviation from other related companies in the same industry, then this is not healthy. Financial ratios Quick Ratio = (Cash + Debtors)/ Current Liabilities 2014 = 24120/12120 = 1.99 2013 = 25970/11550 2.25 2012 = 21160/14950 = 1.42 Higher quick ratio are preferred in terms of performance of the firm, from the analysis, in 2013 quick ratio is 1.25 while in 2014 is 1.99 during 2012, 1.42. Therefore, the company performance has declined in performance from 2014. Debt to Equity Ratio = Total Liability/Equity 2014 = 59620/23800 = 2.50 2013 = 57450/ 21500 = 2.67 2012 = 61650 / 18500 = 3.33 In 2014, debtor's ratio was 2.5 while in 2013 ratio was. This shows 2.67 while in 2012 it was 3.33. The result shows that the company debt management has improved throughout the three years. With the improvement in debt management, the Black Gold is in a better position to be given the loan to advance the project. Though the information given does not indicate anything to do with industry performance, the trend in ratio analysis gives important information on the loan risk. Gross profit margin = Gross Profit/ Sales 2014 = 2590/ 52750 = 4.90% 2013 = 1830/ 46990 = 3.39% 2012 = 3062/ 36290 = 8.44% From the analysis, performance in 2012 was much better compared to the other two years giving gross profit margin of 8.44% followed by 2014 recording gross profit margin of 4.90%. The margin was lower in 2013 giving low of 3.39%. The company has shown good progress in terms of profitability growth. Recommendation and conclusion Enhancing loan structure is one of the ways through which credit risk can be moderated. Individuals involves in loan borrowing can arrange for mitigants which include the use of collateral, guarantees, insurance among (Kitzing 2014). Even though these mitigants have similar influence, there are some crucial distinctions which include the amounts of loss protection, which must be taken into consideration when assigning risk ratings. Credit mitigants basically affect loss when a loan defaults and except for some particular reasons a guarantee do not necessarily lessen the risk of default, but they can help recover some part of the loan advances by the bank (Waegenaere, Sansing & Wielhouwer 2014). Therefore, before the bank gives out the loan, it should either ensure the loan by insurance company, partner with the company in the production of coal, or any other remedy which can be used to help in reducing the risk. 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