Baker Hill Prosper 2017 - Financial Projections to Drive Sound Credit Growth
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presented by Josh Thompson "Financial Projections to Drive Sound Credit Growth” educated and instructed attendees on the usage and analysis of financial projections and sensitivity analysis - which have become vital components to sound underwriting, risk management practice, and heightened regulatory standards. The session covered the key drivers and assumptions that drive financial projection output. We explored best practices as well as the spectrum of benefits associated with adopting or enhancing a financial institution’s strategy around financial projections.
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Baker Hill Prosper 2017 - Financial Projections to Drive Sound Credit Growth
- 1. FINANCIAL PROJECTIONS & SOUND CREDIT GROWTH Presented by Josh Thompson
- 2. Confidential & Privileged Document Introductions • Josh Thompson, Baker Hill – Business Process Architect, Advisory Services
- 3. Confidential & Privileged Document Today’s agenda • Projections overview & benefits • Key cash flow drivers and impact • Future qualitative analysis • Potential areas of risk or opportunity • Sensitivity analysis • What’s next?
- 4. Confidential & Privileged Document 90% 60% 65% 70% 75% 80% 85% 90% 95% 100% Projected / Underwriten Actual Year-1 EBITDA 30% Workout 70% Probability of Workout Why look forward?
- 5. Confidential & Privileged Document Why look forward? 80% 20% Workout Transactions 12-18 months 28% 19-24 months 72% # Months Post-Funding
- 6. Confidential & Privileged Document Financial projections overview • Exist in multiple variations – Company “budget” – Income statement only – Cash flow projection – Pro formas (real estate, business acquisitions, recapitalizations) • Evaluate both scale and predictability • Obtain/analyze projections relative to risk
- 7. Confidential & Privileged Document Benefits of financial projections • Identify opportunities • Likelihood of achieving forecast – Holds Management accountable • Reduce “surprises” – address issues proactively • Portfolio credit quality • Published federal regulatory guidance
- 8. Confidential & Privileged Document Benefits of financial projections (continued) • Capacity to absorb deterioration • Guide loan structuring • Capacity to test (or set) covenant thresholds
- 9. Confidential & Privileged Document Key cash flow drivers • Sales Growth/Decline – Pricing and volume – Organic vs. M&A growth – Macro-economic environment • Margin expectations • Working capital requirements • Capital expenditures – Growth vs. maintenance
- 10. Confidential & Privileged Document Future qualitative analysis • Industry analysis – Porter’s Five Forces • Business model • Company strategy • Management
- 11. Confidential & Privileged Document Identifying risks or opportunities • Management case – Variance analysis
- 12. Confidential & Privileged Document Identifying risks or opportunities • Sensitivity case(s) – Bank case – Stress/Downside – Based on significant credit risk(s) • Reasonable probability • Significant impact
- 13. Confidential & Privileged Document Identifying risks or opportunities • Analyze the range of possible outcomes:
- 14. Confidential & Privileged Document Identifying risks or opportunities • Evaluate against deal structure – Covenant violation(s)? – Collateral shortfalls/borrowing base deficiency? – Additional capital required? – Interest rate environment? • Identify, articulate, and mitigate!
- 15. Confidential & Privileged Document What’s next? 1. Assess credit culture, risk appetite, & risk management practices 2. Does FI have a formal/informal process? 3. Determine criteria requiring projections & analysis 4. Consult cross-functionally, seek stakeholder buy- in 5. Training/process acceptance
- 16. THANK YOU! GROUP DISCUSSION / Q&A Josh.Thompson@BakerHill.com
Editor's Notes
- Good morning and welcome! Thanks for attending the Financial projections and Sound Credit Growth breakout Session I’m Josh Thompson and am a Business Process Architect in Baker Hill’s Advisory Services Group. I joined Baker Hill just about a year ago. Prior to joining the BH team I worked for BMO Harris Bank (Bank of Montreal) in Middle Market Commercial Banking as a Portfolio Manager/Underwriter
- What’s next – What actionable items can you take out of this session and bring back to your respective Financial Institutions?
- “If the first year actual EBITDA is lower than 10% of the projected/“underwriting level” EBITDA, there is a 70% probability that the transaction will end up in Workout.” Thomas de Roque, CEO, Paragon Analysis Corp. Quick story re: formal credit training in Chicago w/ BMO. Tom de Roque (outside consultant) was training the group on cash flow analysis and value of accurate projections/assumptions Qualify these findings by explaining who Tom de Roque works with, what he does, and the array of FI’s that engage his services
- “80% of workout transactions were initially funded just 12-24 months prior to being sent to Workout.” Thomas de Roque, CEO, Paragon Analysis Corp
- Overview What are they? When to utilize? Ideally, projections are provided by the client, which can be a budget, income statement only, etc. As Lender, I would want to know that my clients or prospective clients are thinking about their future financial performance and the associated impact on the decisions/strategies they are planning to pursue. CF proj – “sources and uses of cash” Evaluate both scale and predictability of repayment source(s)
- Why utilize /analyze projections? – not just about risk, its about identifying opportunities and enhancing existing relationships Serve as a conduit to engage clients in meaningful dialogue Are your client’s thinking about their future financial performance? Certainly level of sophistication will vary between size/industry, however, bank should be privy to at least the general financial metrics the company is managing to Maintain or improve portfolio credit quality Regulatory Guidance All Federal regulatory bodies (NCUA, FDIC, FRB, OCC) have published guidance regarding “the use of formal forward-looking analysis in the loan approval process.” Incremental relaxation in underwriting standards can compound quickly, adding validity to the old saying, “bad loans are made during good times.”
- Analyze and understand capacity to absorb financial deterioration (“cushion analysis”) Guide appropriate loan structuring (or re-structuring) Term/amort Covenants Collateral Personal or corporate guarantees, etc
- 2 components of Projections: Quantitative Component – Key Cash Flow Drivers Qualitative Component (which we will talk about shortly) Sales Growth/Decline New product/service How economy performing? Margin expectations Gross Margins Input pricing, cost of goods/services – volatile to commodity pricing, direct labor (how workforce structured?) Operating Margins Is cost structure fixed, variable, or somewhere in between? Large determinant on effectively controlling or cutting costs and ability to adjust to industry trends, competition, or changes in the business cycle Working Capital Seasonality? (Inventory, A/R, A/P) – How does this impact borrowing needs? Capex Operations capital intensive? (ie, Trucking)
- Industry analysis Diversification of customers/industry Competitive position of company Strategy Sustainable and defendable competitive advantage Value proposition Management team’s composition and experience (perhaps most important because you cannot mitigate inadequate or inexperienced Management) Track record developing/implementing strategies Ability (past experience) to operate through various economic/business cycles
- Management Case Assumptions that were utilized, critical component Variance Analysis Mgmt forecast vs. actual results Accountability, serve as conduit for discussions with client What good are goals if they are not measured?
- So, I’m sure we can all recall multiple cases where a projection, budget, business plan, proforma comes across our desk. We start flipping through, bring out the old TI-83, do a few calculations, and then start scratching our heads in skepticism? Everybody knows what I’m talking about, right? Is the client in la-la land? All sunshine and rainbows? 15% sustained topline growth out of nowhere, margin and cash flow expansion…the whole bit We used to call these hockey stick projections! Downside case(s) to “model” one or more significant/key credit risk of the deal (reasonable prob. of occurring, significant impact on primary source of repayment) The stress factors vary upon the type of business and the industry in which it operates but could include: Loss of a key customer/contract, or the loss of a key supplier Economic downturn (“cyclicality of demand”) Material increase in input/commodity pricing Lawsuits/litigation New or increased levels of regulation (or deregulation) Manufacturing or quality issues resulting in widespread impact Unforeseen actions taken by competitors
- So in creating bank and or stress case, we are thinking critically about the range of possible outcomes. We are toning down Management’s assumptions, we are evaluating repayment sources when times are not so great. Again, looking at the range of possibilities, and honing in on scale and predictability of cash flow (or other reliable sources of repayment). Three projection possibilities, each with same expected performance outcome, but with very different ranges of outcomes: Contractual based revenue? Historical consistency of cash flow generation? Various “levers” at Mgmt’s fingertips to pull?
- Does your institution have a formal/informal process? If so, should it be revisited, revised, re-trained? What deal criteria will require projections/analysis? Use of funds, size, term, leverage, security, amortization, risk grade/rating Consult cross-functionally with Credit, Lending, Compliance to obtain main stakeholder buy-in Create the “burning bridge” necessary for Change Management Utilize benefits we discussed early as a basis for those discussions Training, process acceptance, communicating wins