Question

Question 6

search report that provides 6. As the Head of Credit of PQRZ Bank, you have just read a research report that a dismal outlook about the macroenvironment and warns about a possible recessid would be your future outlook on the profitability and liquidity ratios of your che the credit portfolio? Based on the historical financial statements, your team has clase! the credit portfolio (i.e. the customers) into the following categories: • Customers with very high net debt/EBITDA. • Customers displaying very high operating leverage, but low financial leverage. • Customers exhibiting both high operating leverage and financial leverage. • Customers with very tight liquidity ratios and high gearing levels Explain the steps you would take if the above customers are engaged in highly cyclical businesses. Would your views be different if they are engaged in moderately cyclical or non-cyclical businesses? Please elaborate.

Answer 1

The research report provides a dismal outlook about the economy and warns about potential recession. As the cyclical companies are the most and quick ones to get affected by economical changes, thus generally, the bank should tighten the terms on which these comapnies have been lent funds or increase the amount of provision made by the bank for expected losses. Cyclical industries include auto, consumer discretionary and bankin companies. To elobrate and specify category-wise:

• The customers classified as having high net debt/EBITDA : In a recession scenario, the cyclical companies would face a fall in thier EBITDA because of lower revenue i.e. there would be lesser amount of earnings available to serve the debt and interest. The companies already with a high net debt/EBITDA ratio would face further problems in meeting their debt obligations and thus would further shoot up the debt/EBITDA ratio of these companies. The banks should tighten lending terms and keep higher reserve for losses expected from these customers.
• The customers classified as having high operating leverage but low financial leverage: With high operating leverage, these companies have high fixed cost which do not change irrespective of recession and boom, though, earnings would definitely fall as a result of decrease in revenue. But showing low financial leverage, these companies do not have debt as a major part of their capital structure and the interest component would be very small proportion of their cost and hence do not pose as very high loss-making companies for the bank. The recession would result in further increase of the operationg leverage and no change in the financial leverage postion (in case of no further debt raised by the company). The bank may not make the lending terms very stringent and not keep very high reserves.
• The customers classified as having both high financial and operating leverage: As also described above, high operating leverage companies tend to show lower EBIT in recessional scenario. Then, the companies also having higher financial leverage further present lower profit after tax as these companies have higher amount of debt in their capital structure resulting into high interest costs. They show even lower amount of profit for the recessional period. The recession would result in further increase of the operationg leverage and no change in the financial leverage postion (in case of no further debt raised by the company). The bank should tighten lending terms with these customers and set aside high reserves on account of losses from these customers.
• The customers classified as having tight liquidity ratios and high gearing ratio: These companies having low liquidity and high amout of debt to be served fare worse in the recessional scenario. The unsold inventory would further lead to low liquidity and lower revenue, increasing the losses made by these companies. This in turn makes these companies unable to serve their high amount of inerest cost. The recession would hence worsen the liquidity ratios and an unchanged gearing ratio (in case of no further debt raised by the company).The bank should very much tighten lending terms with these customers and set aside high reserves on account of losses from these customers.

If these customers were non-cyclical or a moderate cyclical companies, they would not be impacted very much by the economical conditions, their revenues remain unaffected. Hence, bank need not take any major steps on account of these customers. Few examples of non-cyclical or moderately cyclical industries include consumer essentials, pharma and power industries.

Tightening the lending terms by the banks include the following steps:

• Increasing the rate of interest on lending further funds to customers
• Asking the customers to keep high value collateral
• Decreasing the loan to value ratio i.e. reducing the amount that can be lent compared to the value of collateral

Formulae for reference :

• Operating Leverage : Contribution / Net Profit OR Gross Profit / Net Profit
• Financial Leverage or Gearing Ratio : Total Debt (Long Term + Short Term) / Equity
• Liquidity Ratio : could be Current Ratio - Current Assets / Current Liabilities OR
  a Quick Ratio - (Current Assets - Inventory - Prepaid Expenses) / Current Liabilities