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Warning signals for bad and doubtful debts


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									Control of Advances
Lecture Objectives :

1. To identify the warning signals for bad and
  doubtful debts
2. To identify the risks of overtrading
3. To review the lesson of credit risk learned
  from the Asian Financial crisis
Warning signals for bad and doubtful
   As lending is a risky business, a banker
    providing advance facilities to his customers
    should continuously monitor the
    performance of the loans and identify the
    signs that may indicate potential difficulties
    faced by the customers. In practice, all long-
    term advances should be fully reviewed at
    least once a year. If poor conduct such as
    delay in repayment of loans by the
    customers emerges, more frequent reviews
    are warranted.
Poor management
   The fundamental cause of business
    failure is usually attributable to the
    poor management of the business and
    its limited ability to cope with the
    changing environment. Strong
    competition, changes in fashion,
    unexpected economic downturn and
    political instability will intensify the
    pressure on management.
Poor management
Some indications of potential business failure
 involving poor management :
  a. Insufficient managerial personnel at various
 levels of operations
  b. Disharmony within the management team
  c. Chaos caused by major re-organization or
  d. Over-ambitious expansion of operations
  e. Lack of financial or operating controls
Industrial / Market conditions
   Industrial or market
    conditions, such as
    keen competition                                                          Production Costs

    among producers,
                                                   190                          Unit Price

                                    of Dolla
                                                  180                            Profits

    declining market                              175


    demand and
                                                         1990   1991   1992

    changes in the
    preference of
    consumers, may
    lead to business
Industrial / Market conditions
A lending banker should pay particular attention to
  the following :
  a. Adverse performance of the company compared
  to its competitors
  b. Advanced technology which is expensive to keep
  up with
  c. Changes in consumers’ preferences, tastes or
  d. Threat caused by new entrants to the market and
  deteriorating market shares
  e. Monopoly power created by mergers or
Economic and political conditions

   A business may be affected by the
    following unfavourable economic or
    political situations :
   a. Economic slow-down or recession
   b. Deteriorating political stability
   c. Adverse conditions due to social unrest
    or pressure groups’ campaigns
The implications of a client’s bank

A client’s bank accounts basically show the
  background and financial statistics which
  serve as a primary source for detecting
  possible problems in a client’s financial
  position. For examples :
  a. Static or hard-core overdrafts
  b. Growing numbers of cheques with
  “insufficient funds” claimed by the client’s
The implications of a client’s bank

  c. Excessive number of post-dated
  d. Frequent drawings against uncleared
  e. Frequent excesses over agreed credit
  f. Deficiencies in loan repayments
  e. Past due import bills
Financial position
   If a company’s
    financial position
    deteriorates, the
    problem will be
    reflected in its
    financial statements.
    A lending banker
    should be alert to
    the results of
    financial analyses.
Definition of overtrading :
The level of activity of a company is too
 high for the financial resources available
 to the business and profitability being
 earned; or the maintenance of a scale of
 operation with insufficient cash resources.
Signals of overtrading
 1. Sales are increasing rapidly.
 2. Gross trading profit margin is
 3. Operating expenses are increasing.
 4. Liquidity is declining.
 5. Stock and stock turnover days are
Signals of overtrading
 6. Debtors and debtors turnover days are
 7. Creditors and creditors turnover days
 are increasing.
 8. Amounts due to bank are increasing.
 9. Gearing ratio is increasing.
Causes of overtrading
 1. Over-optimistic outlook of the market
 2.      Aggressive business expansion
 without careful planning
 3. Debt collection and terms of payment
 are out of control.
 4. Insufficient capital base
Causes of overtrading
  5. Speculation on inventory
  6. Inflation causes costs out of control
  7. Misapplication of cash resources, e.g.
 in capital expenditure, dividend payment,
 speculation in stock market, etc.
Credit risk during the Asian
Financial Crisis
A review given by Mr. David Carse, Deputy Chief
  Executive, Hong Kong Monetary Authority, at the
  Asian International Conference & Trade Credit
  Workshop 1999.
The Asian Financial Crisis happened in 1997 and
  affected every economy in the region. The
  exchange rates of the currencies of Thailand,
  South Korea, Indonesia and the Philippines
  dropped rapidly and the stock markets of the
  region almost collapsed. The external shock
  severely damaged the confidence in the banking
  systems with non-performing loans increasing.
Credit risk during the Asian
Financial Crisis
Banks lost domestic deposits and found themselves
  unable to rollover short-term external borrowing.
  The capital outflows continued to put downward
  pressure on the exchange rates, forced up
  interest rates and drove down assets prices.
  Many customers got into financial difficulties and
  this further weakened the position of the banks.
  The Asian Financial Crisis revealed the weakness
  of the banks in the region in credit policies and
Credit risk during the Asian
Financial Crisis
1.Banks overlent to the unproductive sectors,
  notably the property and stock markets, with the
  loans funded by short-term capital inflows. When
  the asset bubble burst, the banks, companies and
  individuals who had borrowed foreign currencies
  to finance their investments were unable to repay.
  The problem was compounded by the
  depreciation of domestic currencies that
  increased the real burden of debt repayments.
Credit risk during the Asian
Financial Crisis
2.Banks in a number of economies were
  ordered or persuaded by governments to
  lend heavily to companies that were not
  commercially viable. This “policy” lending
  destroyed the banks’ incentive to exercise
  credit judgment and allowed the companies
  concerned to become overleveraged and
  thus vulnerable to economic downturn.
Credit risk during the Asian
Financial Crisis
3.Much lending in the region was politically
  influenced or insider in nature, there was not
  much opportunity to develop a proper credit
  culture or adequate credit skills. There was also
  an over-reliance on collateral which sharply
  diminished when asset values collapsed.
4.The lack of credit skills was a failure to recognize
  bad debts and to face up to the full scale of the
  bad debt problem. Banks did not classify loans
  properly or make adequate provisions against
Credit risk during the Asian
Financial Crisis
The Asian Financial Crisis has demonstrated
 weaknesses in banks’ credit controls.
 Improvements need to be made to deal with
 the aftermath of the crisis and to reduce the
 chances of similar problems in the future.
 Mr. David Carse recommended the
 following points :
Credit risk during the Asian
Financial Crisis
1. Financial institutions (Fis) should be clear
  about their lending strategy, including the
  types of risk and the degree of risk to be
2. FIs should know their customers, their
  business and their financial commitments.
3. FIs should keep track of how their loans
  are actually used for.
Credit risk during the Asian
Financial Crisis
  4. FIs should lend on the basis of cash flow
  rather than collateral.
  5. FIs should maintain an effective early warning
  system for problem loans and make sure that
  the loan portfolio is properly graded.
  6. FIs should devote sufficient resources to debt
  recovery and make sure that their workout staff
  are properly trained.
  7. FIs should approach debt workouts in the right
  spirit of compromise and consensus.
Credit risk during the Asian
Financial Crisis
 To conclude the lesson we have learned from the
 Asian Financial Crisis and the subsequent effect on
 the financial system, financial institutions should get
 back to the fundamentals of creditworthiness and
 apply conventional lending standards.           Banks
 should have a thorough knowledge of their
 customers’ business and of their real funding needs.
 Lastly, in granting credit, banks need to undertake
 proper financial review of their customers based on
 reliable information. Particular attention needs to be
 paid to cash flow and the ability to service debt in
 normal conditions as well as in stress situations.
Tutorial Case Study
 Porche Watches and Clocks Manufacturing
 Company Limited was one of the participants
 in the Swiss Watches and Clocks Exhibition.
 Because of the Atypical Pneumonia, Hong
 Kong companies were unable to participate
 in this exhibition in Switzerland. Indeed,
 one-third of Porche’s orders are used to be
 acquired from joining this exhibition.
Tutorial Case Study
 The company imports the electronic parts
 and components from Japan and Europe to
 manufacture its watches and clocks which
 are mainly sold to the medium and lower
 stream markets in the United States and
 As the company’s major banker, discuss
 what problems will be faced by this company
 and what actions should be taken by the
Suggested Answers
Students can feel free to advocate their
Firstly, the refusal of the Hong Kong
  participants by the Swiss government was a
  change in the political condition because of
  the outbreak of the Atypical Pneumonia.
Secondly, the estimate of loss of orders is a
  change in the market condition.
Suggested Answers
Will these changes affect the company’s
 financial position ? It will certainly be a big
 challenge to the company’s management.
As the company’s banker, you can talk to the
 company’s top managers to find out how
 they forecast the adverse effect of the
 problem on their business volume and how
 they will deal with the problem. Will they use
 other methods to contact their buyers to
 place orders ?
Suggested Answers
Will the company explore new markets for their
  products ? If the forecast is pessimistic, will
  the company adopt a retrenchment strategy
  to reduce its operation scale so as to lower
  operational costs ?
The banker should be alert on the company’s
  financial position through analysing its
  financial statement and keeping an eye on
  the performance of the company’s bank

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