Assessing the credit risk of a client is tricky in the best of times. With the economic disruption caused by the spread of the Covid virus, it is essential now to fully understand the risks that are facing your borrowers. The core determination is whether your client is suffering from a temporary liquidity issue or an existential solvency issue. Understanding the tools you have available to both determine the survivability of your borrower as well as the best way to assist those that can survive is of the utmost importance right now.
A liquidity issue is considered a short term problem that will correct itself. The borrower with a liquidity issue will have the resources to sustain itself once the crisis is past. As a lender you see clients with liquidity issues all the time, they exhibit a cash shortfall which is covered by the financing you provide. The financing is thus repaid with the liquidation of the asset that is financed. Self liquidating assets include, accounts receivable, inventory or a long term asset.
A solvency issue is not so friendly. Typically marginal clients with high leverage, tight cash flow and limited reserves will fall into a solvency issue, particularly when a crisis arises. Borrowing more to a client in a solvency crisis is throwing good money after bad. They will not be able to repay the debt they currently have outstanding, let alone any new money that is provided.
Tools To Assess Liquidity vs Solvency Issues
There are three key tools to determine whether the borrower has a liquidity issue or solvency issue. First, assess how much cash is locked up in the 7 core cash drivers of the firm. How much of that cash can be drained out for repayment with changes in management behavior? Can management squeeze out funds from the gross profit margin? The operating expense margin? What about the collection days of the accounts receivable or moving of the inventory? Can they extend the accounts payable and for how long?
Second is the level of cash flow surplus. Most calculations look at cash flow coverage being 1.25 over the debt payments. In a time of crisis, when more debt is likely needed, the goal should be 1.5 to 1.6. That will give a cushion to sustain the firm through tough times as well as pay back the debt given. If a client is already beneath 1.15, they have no capacity for more debt, they are likely already facing a solvency crisis.
Lastly is leverage. The lower the leverage of the firm the more staying power they have. If leverage is currently under 2.0 they are in shape to withstand a couple of quarters of diminished business activity. Above 3.5 and they are likely to be unable to hold on for more than a month or two.
Tools To Assist Your Clients
There are a number of tools you have to work with clients that you deem will survive the Covid economic shut down. First are the government programs that have been proposed. This may be the Payroll Protection Program along with other grant or loan programs that are offered. They provide specific remedies and funds that may or may not have to be paid back.
There is a second tool that the FDIC released on April 7, 2020 detailing a statement on loan modifications and reporting for financial institutions. The statement shares that the regulatory agencies will not criticize financial institutions that work prudently with borrowers who are unable to currently meet their contractual payment obligations due to the Covid crisis. As long as you observe safe, sound credit practices in determining that the client is suffering a liquidity crisis and not a solvency crisis, you are able to work with your client in a number of ways. The statement details how an existing loan modification that meets three criteria under Section 4013 are not required to apply ASC Subtopic 310-40, avoiding the classification of a TDR. This will be a powerful tool to allow your clients some discretion in repayment abatement until their cash flow is back to normal while not being criticized for your approach.
Just giving your clients more money will not solve their problem during the Covid crisis. It is your responsibility to assess their ability to repay the new funds as well as their existing debt. For those eligible, work with them on the new programs that are offered, but do not forget that loan modifications are available without the past blemish of the red mark of a TDR. Use your tools wisely to help your clients.