There is as many types of credit analysis, as there are banks. The same relates to credit rationale behind lending in trade finance. The trend has been also emerging since some time already of banks increasingly taking a role as an arranger of financing taking funds effectively from third parties or capital markets. Still, when tackling the question of financing a physical commodity trade we can discern some main approaches relating to the issue of repayment, namely: balance-sheet lending, cashflow lending, asset-backed lending and credit-enhanced lending.
Vast majority of commercial bankers prefers balance-sheet lending approach when assesing a repayment risk. Here a lot depends from dependability of accounting standards in the country in question (commodities trade after all strongly involves dealings with emerging or even frontier markets) and reliability of auditing bodies. However even if both of these factors are acceptable on the grounds mentioned before, financial professionals are aware of the facts that balance sheets are historical documents and that auditor’s judgement might be fallible.
Crudely speaking, the fundamental principle of balance-sheet accounting is that the shareholders funds with everything they can borrow equals liabilities that subsequently uphold the cost of all of the assets of the firm (fixed assets as buildings and mines or the current assets as inventory, receivables and cash in the bank).
As general principle, financiers look at the relationships between certain key items on the balance sheet, to asses if the balance sheet can support current or future levels of debt. Attention is being paid to the ratio of
the shareholders funds (such as equity, reserves/retained profits) and its liabilities, especially the current year portion of debt. There are also other ratios employed, as the quick ratio, leverage ratios, or liquidity ratio.
Banks also look on the valuation of the company’s assets (whether its proper or not), as well as levels of inventory in relation to company’s turnover, so they can see that company’s revenue from trade covers the costs sufficiently to make a profit at the bottom line.
In cashflow lending, financiers strive to identify cashflows of the firm, and then make sure to “put them aside” to get paid before everybody else. If possible even before the costs which company bears. It is a fine approach in commodities business, since certain specialized assets in emerging/frontier markets whose value could have assured an asset-backed lending are difficult to price. Hence in cashflow lending, financial companies seek debtors of company in question or the receivables due from companies of superior credit quality to the borrower. It is also seen as an advantage if they come from developed markets. So here banks secure a cashflow from a purchaser the client is trading. In such situation a creditor gets paid from revenues, not from bottom line profit.
In this scenario the main threat to the lender comes from the borrower’s performance risk. Question is posed, whether the economic activity of borrower will carry on and whether receivables due will keep on flowing. There is also certain structural risk to the creditor depending on how well cashflows coming from sales are going to be secured, so no other creditor may take advantage of them first. Assignment of the export contract is one of the ways, it is being done.
As far as asset-backed lending is concerned it should be to certain degree related to cashflow based lending, with additional physical collateral in place which liquidation should secure a repayment. Therefore the point is to take security over the raw materials and inventory, either in the producing country or offshore. In asset-backed lending a lender controls the collateral. The key issue remains for a lender to perfect his title to the goods. Here it is possible in certain cases to apply a SPV to take debt off the balance sheet. One way or the other in such situations, some banks seek to establish their own collateral management in the field (to dislike of trading houses, who tend to fully rely on their own people/business partners).
The credit-enhanced lending is about someone else possesing a good credit rating guaranteeing all or part of the facility. The role of third party guarantor is often being taken upon by Export Credit Agencies, whose role is becoming increasingly difficult because of pressures from home governments to make money on one hand and to back up trade with the high risk countries characterized by high default ratios in support of political agendas on the other. The credit enhanced lending also includes credit wraps and political risk insurance, where banks and traders decide for a commercial underwriting of the transaction. Naturally it generates further expenses and is possible to implement only when the deal is structured in a way that is acceptable to the underwriter.
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