5/5/2016
1
WRITING AN EFFECTIVE CREDIT MEMO
Total Training SolutionsBankers Insight Group, LLCJeffery W. JohnsonMay 5, 2016
1Bankers Insight Group, LLC
COURSE OBJECTIVES
To make you a better banker
To understand the importance of good written communication
To improve clarity, conciseness and completeness of written communications
To increase emphasis on planning and organizing
To identify individual strengths and weaknesses
2Bankers Insight Group, LLC
5/5/2016
2
Clear communication is the cornerstone of any financial institution.
It is extremely vital because there is a high degree of “Trust” expected from us
Mistakes in communications can be very costly for financial institutions
Communication
3
What’s Stopping You From Writing That Perfect Memo
There is no such thing as a Perfect Memo
However, if anyone reading your write-up fully understands the facts you are trying to convey with minimum questions, that’s as close to Perfection as you will come.
Bankers Insight Group, LLC 4
5/5/2016
3
Credit Memo Blockers
Lack of Information or outdated information
Receiving too much information and not knowing where to start
Not knowing what to cover
Writer’s BlockBankers Insight Group, LLC 5
It is not only “What” we communicate, it’s “How” we communicate.
Don’t believe me? Check out the next few slides
Communications
Bankers Insight Group6
5/5/2016
4
FRESH VEGETABLES
Would You Buy From This Person?
Bankers Insight Group7
Flying Lessons
Would You Buy From This Person’s Sign?
Bankers Insight Group8
5/5/2016
5
ELEVATOR
UP
DOWN
SURGE
PLUNGE
Bankers Insight Group9
…The company is highly susceptible to an economic downturn and its decreasing financial performance is due in part to the present state of the economy………
Importance of Clear Writing(“Say What You Mean”)
10
5/5/2016
6
STANDARDS OF CARE
What would a reasonable and prudent banker have done under similar circumstances?
The primary purpose of loan documentation is to document your actions as being prudent and proper.
11Bankers Insight Group, LLC
ESSENCE OF THE CREDIT
Your credit files must document a consistently applied approval process. That process should address at a minimum the following points:
12Bankers Insight Group, LLC
5/5/2016
7
ESSENCE OF THE CREDIT
Purpose and basis of the credit Primary and secondary source of repayWritten repayment programCollateral valuationsConformity to credit policy Addresses the five C’s of credit Identifies strengths and weaknesses
13Bankers Insight Group, LLC
ESSENCE OF THE CREDIT
Justification for exceptions to underwriting
Makes recommendation
Grades credits
Contains information to make decision: Company Financial Statements
Tax Returns
Personal Financial Statements
Applications
14Bankers Insight Group, LLC
5/5/2016
8
CREDIT MEMOS
Primary means of communication within banking industry
Serves three functions: Supports or recommends action
Provides information on the condition and status of a customer relationship
Provides a record of thoughts and actions relative to a customer relationship
15Bankers Insight Group, LLC
Have You Addressed The Basics?
Who Are They?
What Do They Do?
Why Do They Do It?
How Do They Do It?
Who Else Does It?
Can They Make Money?
How Can We Help?
How Do We Get Paid?
16
5/5/2016
9
CREDIT MEMOS
Memos are to be succinct and to the point, but we violate this idea
Readers of credit memos are skilled bankers; therefore, it is not necessary to state the obvious.
Memos should present relevant, material facts and writer’s thoughts and opinions
17Bankers Insight Group, LLC
CREDIT MEMOS
The writer’s opinions should be supported by facts
Remember, anything you write in a memo will become public record if you end up in court with a customer
18Bankers Insight Group, LLC
5/5/2016
10
19
ORGANIZATION
PLANNING
POSITIONING
WAYS TO ORGANIZE
OUTLINING
Bankers Insight Group, LLC
20
PLANNINGQuestions to Consider
1. What is my purpose?1. To inform
2. To persuade
3. To get action
4. To recommend
5. To advise
6. To identify a problem
Bankers Insight Group, LLC
5/5/2016
11
21
PLANNINGQuestions to Consider
2. Who is my audience?• Key Audience
Senior Credit Officer
Loan Committee
Manager
Colleagues
• Secondary Audience Consider their needs
Use appropriate tone
Avoid industry language
Bankers Insight Group, LLC
22
PLANNINGQuestions to Consider
3. How can I best convey my message?
• Logical presentation gives you credibility
• Guides the reader in the direction you want them to go
• Keeps your purpose and audience in mind
Bankers Insight Group, LLC
5/5/2016
12
23
POSITIONING
1. Identify your Position• The main idea of your entire report• All statements, conclusions or recommendations
should support position
2. Establish your major discussion areas• The major points that led you to your position• Note your major discussion areas early in your
presentation
3. Results• Helps writer to focus and the reader to comprehend
the ideas that follow
Bankers Insight Group, LLC
24
OUTLININGBENEFITS Outline places topics to be covered in an
orderly manner. Benefits include:
Saves time
Improves organization
Allows a step-by-step approach
Allows writer to avoid missing the most important facts
Bankers Insight Group, LLC
5/5/2016
13
25
PARAGRAPH DEVELOPMENT
1. Name the purposes of a paragraph?• Breaks writing into single ideas• Keeps writing in a uniform and orderly pattern
2. Paragraph Structure• Should have a topic sentence• The topic sentence represents the main idea • Topic sentences are often the 1st sentence
• Each sentence should contribute to para. purpose
Bankers Insight Group, LLC
26
TRANSITIONS
1. What are Transitions?
• Show the relationships between ideas
• Helps the flow of your ideas: they act as signals for the reader to follow
• Rid your writing of the “choppy” sound
Bankers Insight Group, LLC
5/5/2016
14
27
Examples
Without Transitions“Profits have been below average for the past three
years. Asset growth has been nearly twice that of its peer group. Net worth has decreased by 20%.”
With Transitions“Profits have been below average for the past three years. During the same period, asset growth has been nearly twice that of its peer group. As a result, net worth has decreased by 20%.”
Bankers Insight Group, LLC
28
SUMMARIES
Principles of Summaries Should not introduce any new ideas
Not always necessary, unless the situation warrants it. It may be redundant
Summaries are helpful when: Your position is very controversial
Your position may be unpopular with your reader
The report is very long
The structure of the report is very complex
Bankers Insight Group, LLC
5/5/2016
15
29
WORD USAGE
1. Choose the right words always• Write to express, not to impress
• Avoid stuffy and vague words
2. Avoid using a “Heavy Style” of writing• It is improper for business communication
• Indicates unclear or illogical ideas
• Indicates lack of knowledge by bluffing with complicated and wordy writing
Bankers Insight Group, LLC
30
WORD USAGE
3. Utilize a “Simple Writing Style”
• The more complex the subject, the more precise and simple the writing
• Understanding words and sentences should require little energy by the reader
Bankers Insight Group, LLC
5/5/2016
16
31
WORDINESSSay what you need to say with the fewest words possible
Instead of:
At the present time
In the near future
A majority of
A number of
In the amount of
With reference to
First of all
On an annual basis
Why not write:
Now, currently
Soon
Most
Several, many, some
For, of
About
First
annually
Bankers Insight Group, LLC
32
FORM AND APPEARANCE
Avoid producing a page of solid print. Readers like short, “skim-able” writing. Visual appearance should aid understanding, not hinder it.
Make reports eye catching with headings, bold face, underlining, italics or bullets. This method calls attention to areas that are important.
Paragraphs should average 7-10 lines
Use repetition for emphasis in long reports
Graphics can add variety and professionalism to reports.
Bankers Insight Group, LLC
5/5/2016
17
Memo Policy
The purpose of a standard Credit Approval Document is to promote a consistent approach towards preparing credit approval presentations.
The Credit Approval Document format is intended to convey to others the lending officer's analysis and understanding of the inherent credit risk and strategies for the management of that risk.
33Bankers Insight Group, LLC
Cornerstones of a Good Loan Portfolio
Soundness, Profitability & Growth
Bankers Insight Group, LLC 34
5/5/2016
18
Other Purposes of Memo
Credit approval rationale.
Purpose of proposed credit presentation.
Proposed loan quality rating rationale.
Key risks and structural issues.
Strengths and weaknesses (i.e. cash flow, collateral, guarantor) of the borrower and the credit facilities.
Sources of repayment and plans for monitoring.
Comparison of the proposed credit presentation with approved credit policies, underwriting standards and underwriting guidelines.
Total relationship and relationship strategy, including a risk management strategy for the subject credit exposure.
35Bankers Insight Group, LLC
Purpose
Intended to be a self-contained, stand-alone document which a knowledgeable, experienced lender who is not a specialist in the specific industry being addressed should be able to understand.
Should fully support and explain the credit request without the need for verbal explanation or reference to external documents. All lenders should
36Bankers Insight Group, LLC
5/5/2016
19
Audience
Chain of authority required to approve or concur with the transaction (e.g. Approval Matrix)
Credit examiners, Credit Review Officers, FDIC, State, external auditors, etc.
Other lending personnel who need to brief themselves on the relationship, e.g. as account management responsibilities change
Counsel and others responsible for preparing loan documentation
37
Confidentiality
Credit Approval Documents and quality assessment ratings (QAR) will not be made available to anyone outside (except those identified above) unless subpoenaed by proper court order.
38
5/5/2016
20
Confidentiality
Credit Approval Documents should be written with such third-party review in mind.
Credit Approval Documents generally should not contain legal opinions obtained in connection with the lending relationship.
39
Reflect Your Standard of Excellence
Should reflect the lending officer’s best work.
Based on the data contained in the Credit Approval Document, signers in the approval process are asked to join with the lending officer in being held accountable for putting the bank’s capital at risk
40Bankers Insight Group, LLC
5/5/2016
21
Points of Advice
Question and challenge the data, don't just "report" it.
Be concise. Use salient facts to support conclusions and structure.
Use all available resources.
Create order and understanding out of the "data". Everything written should point toward a conclusion necessary to reach a decision.
41Bankers Insight Group, LLC
Points of Advice
Do not state conclusions without showing the logic that leads from the data to the conclusion. One overused conclusion, which is often totally unsupported, is "The quality of management is excellent".
Be balanced. Be totally honest. "Tell it like it is".
Identify the real issues that make a difference to us.
View everything from the perspective that we are putting BANK capital at risk.
Be reader-friendly. Act as a guide to lead your reader through your data and logic to reach your conclusions. Use charts when needed.
Be consistent.
42Bankers Insight Group, LLC
5/5/2016
22
What Should be in a CM?
Transaction Description
Economic & Competitive Environment
Management
Critical Financial Development / Trends
Evaluation of Repayment Sources / Projections
Collateral Evaluation
Primary Risks in Order of Priority / Mitigators
43
What Should be in a CM?
Covenants Tracking
Plan for Monitoring
Comparison with Policy
Relationship Strategy / Compensation
Strengths & Weaknesses
44
5/5/2016
23
RATIO DEFINITIONS, CALCULATIONS & INTERPRETATIONS In order to write about financial issues
effectively, you must know:
1. What to measure
2. How to measure it
3. What it means
4. How to tell someone
45Bankers Insight Group, LLC
SIX C’S OF CREDIT
CHARACTER
CAPACITY
CAPITAL
COLLATERAL
CONDITIONS
CAN WE?
46Bankers Insight Group, LLC
5/5/2016
24
LLAM-OP-CA-FLOCC
LIQUIDITY
LEVERAGE
ASSET MANAGEMENT
OPERATIONS
CASH FLOW
CHARACTER
CONDITION
47Bankers Insight Group, LLC
LIQUIDITY
Current RatioCurrent Assets or Quick AssetsCurrent Liabilities Current Liabilities
Accounts Receivable TurnoverAccounts Receivable X 365 Days
Sales
Inventory TurnoverCost of Goods Sold X 365 Days
Inventory
Accounts Payable TurnoverCost of Goods Sold X 365 Days
Inventory48Bankers Insight Group, LLC
5/5/2016
25
Net Working InvestmentA/R Turnover (days) 49 $1,280,000+ Inventory Turnover (days) 116 $2,205,000
= Operating Cycle 165 $3,485,000
- A/P & Accrued Expense turnover 27 ($ 506,000)
= Net Working Investment 138 $2,979,000
- Prorated Cash Flow From Oper ($ 265,000)
- Adjusted Working Capital ($2,525,000)
- Bank Line of Credit $ 189,000
49Bankers Insight Group, LLC
LEVERAGE
Leverage refers to the proportion of funds invested in an entity by the creditors in the form of loans and the owners in the form of equity.
Highly leverage firms (those with heavy debt in relation to net worth) are more vulnerable to business downturn than those with lower debt to worth positions.
50Bankers Insight Group, LLC
5/5/2016
26
LEVERAGE
Total Debt Ideal is < 2:1Tangible Net Worth
Total Debt Ideal is < 50%
Total Assets
-
51Bankers Insight Group, LLC
ASSET MANAGEMENT
Asset Management or Efficiency Ratios measure management’s ability to utilize assets to generate revenue or create value (i.e. generate a profit).
52Bankers Insight Group, LLC
5/5/2016
27
Asset Efficiency or Asset Turnover Ratio
Calculation: Total Sales Total Assets
Calculation: Total Sales
Net Fixed Assets
Calculation: Accumulated Depreciation Gross Fixed Assets
53Bankers Insight Group, LLC
ASSET MANAGEMENT
Calculation: Net Fixed Assets*Depreciation Exp.
54Bankers Insight Group, LLC
5/5/2016
28
OPERATION/PERFORMANCE RATIOS
Gross Profit Net Sales
Operating Profit Net Sales
Net ProfitNet Sales
ROE & ROA55Bankers Insight Group, LLC
MARGIN CHANGE ANALYSIS
Measures the financial impact of a margin changing from year to year
Each basis point change in a cost or expense equates to an increase or decrease in profitability
A basis point is the change in the interest rate or yield expressed as 1/100th of one percent
56Bankers Insight Group, LLC
5/5/2016
29
MARGIN CHANGE ANALYSIS
Sales 1,500 1,750
Cost of Sales 900 60% 1,085 62%
Gross Profit 600 40% 665 38%
Operating Exp 525 35% 613 35%
Net Profit 75 5% 52 3%
57Bankers Insight Group, LLC
MARGIN CHANGE ANALYSIS
40.0(38.0) 1,750,000
2.0bp100 = X.02
(35,000)
Company could have made an additional $35,000 if the Gross Profit Margin did not change. Profits should have been $87,000 instead of $52,000
58Bankers Insight Group, LLC
5/5/2016
30
FINANCIAL RATIOS
Interest Coverage Ratio
EBIT Ideal is 2:1
Interest Expense
59Bankers Insight Group, LLC
CASH FLOW / DCR
Traditional Method:
Net Income
+ Depreciation
+ Interest
Available Cash Flow
60Bankers Insight Group, LLC
5/5/2016
31
Adjusted Cash Flow AnalysisNet ProfitPlus: Non-Cash Charges+ Change in Accounts Receivable+ Change in Inventory+ Change in Accounts Payable+ Change in Accrued Expenses
= Cash After Operating Cycle
Minus: Dividends Declared
+ Change in Net Worth
= Cash After Financing Cost
Less: Current Portion of Long-Term Debt
= Cash Available for Other Debt
+ Change in Gross Fixed Assets
= Financing Surplus (Requirement)
Bankers Insight Group, LLC 61
*Potential Gross Income (PGI) – Less: Physical Vacancy – Economic (Credit) Loss
Effective Gross Income (EGI)
Less: Operating Expenses
Real Estate Taxes Hazard Insurance Repair/Maintenance (Buildings) Maintenance (Grounds) Depreciation Water/Sewer/Trash Electric (Common) Interest Expense Management Fees Leasing Commissions Reserves for Replacement _______________________________ _______________________________ Total Operating Expenses
Net Operating Income (NOI)
Bankers Insight Group, LLC 62
5/5/2016
32
Savannah Fresh Fish Company
Financial Statements
Ratio Analysis Worksheet
63Bankers Insight Group, LLC
LIQUIDITY
Liquidity is deteriorating
Receivables and Inventory are slowing
Payables are slowing
64Bankers Insight Group, LLC
5/5/2016
33
LEVERAGE
Leverage is rising, but still at a comfortable level.
Must watch trend of leverage in the future
65Bankers Insight Group, LLC
ASSET MANAGEMENT
Assets are performing well in producing sales and profits
66Bankers Insight Group, LLC
5/5/2016
34
OPERATIONS
Sales are increasing at a rapid rate
Gross Profit Margin is improving, providing a positive financial impact
Operating Expenses were held steady in spite of rapidly growing sales
Resulting in a higher level of Net Profit67Bankers Insight Group, LLC
TRADITIONAL CASH FLOW
Net Income 115
+ Depreciation 154
Available Cash Flow 269
Annual Debt Service 23
Debt Coverage Ratio 11.7X
68Bankers Insight Group, LLC
5/5/2016
35
Cash Flow “The Right Way”
Net Profit 115+Depreciation 154Available Cash Flow 269
+ Chg. In A/R (311)+ Chg. In Inv. (443)+ Chg. In A/P 234+ Chg. In A/E 95
Cash After Oper. Cycle (156)69Bankers Insight Group, LLC
Cash Flow “The Right Way”
Cash After Oper. Cycle (156)
- Dividends/Withdrawals ( 19)
Cash After Financing Cost (175)
- Current Portion LTD ( 23)
Cash Avail. For Other Debt (198)
70Bankers Insight Group, LLC
5/5/2016
36
Cash Flow “The Right Way”
Cash Avail. For Other Debt (198)
- Chg. Gross F/A (220)
Financing Surplus (Shortage) (418)
71Bankers Insight Group, LLC
CASH FLOW
Cash After Operating Cycle
Cash After Financing Cost
Cash Available for Other Debt
Financing Surplus (Requirement)
72Bankers Insight Group, LLC
5/5/2016
37
CASH FLOW IMPACTTurnover In Days
2009 2010 2011
A/R 29.2 .2 29.2 3.7 32.9
INVENTORY 19.6 2.5 17.1 15.8 32.9
ACCTS. PAY. 11.1 2.1 13.2 7.4 20.6
73Bankers Insight Group, LLC
CASH FLOW IMPACT
1 DAYS SALES = $11,025,000365 DAYS
= $30,205
1 DAYS COGS = $8,240,000 365 DAYS
= $22,57574Bankers Insight Group, LLC
5/5/2016
38
CASH FLOW IMPACT
A/R: $30,205 X 3.7 Days = $111,925
INV: $22,575 x 13.3 Days = $300,252
A/P: $22,575 x _9.5 Days = $211,640
Net Cash Flow Impact = $200,537
75Bankers Insight Group, LLC
Samples of Real Estate Write-Ups
76Bankers Insight Group, LLC
5/5/2016
39
SUMMARY & RECOMMENDATION
77Bankers Insight Group, LLC
Bankers Insight Group, LLC 78
Thank You!Jeffery Johnson
TTS
Dan Heldmann
www.BankWebinars.com
800-831-0678
Upcoming Webinars
May 5th – All About Escrows
May 9th – Federal Compliance School OnDemand with Live Streaming
May 9th – Are They Really a Bank Prospect?
May 11th – Understanding Commercial Loan Documentation
May 11th – Lending 101
May 12th – Excel Explained: Minimized Spreadsheet Errors
May 12th – BSA for the Frontline
May 23rd – BSA Series: Alert! New CIP Rules on Prepaid Cards
May 24th – Officer Calling: Prospecting, Preparing & Presentation
May 24th – Marketing & Advertising Compliance, including UDAAP Expectations
Upcoming Webinars
May 5th – All About Escrows
May 9th – Federal Compliance School OnDemand with Live Streaming
May 9th – Are They Really a Bank Prospect?
May 11th – Understanding Commercial Loan Documentation
May 11th – Lending 101
May 12th – Excel Explained: Minimized Spreadsheet Errors
May 12th – BSA for the Frontline
May 23rd – BSA Series: Alert! New CIP Rules on Prepaid Cards
May 24th – Officer Calling: Prospecting, Preparing & Presentation
May 24th – Marketing & Advertising Compliance, including UDAAP Expectations