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Stress Testing for Atheletequip Firm

Discuss About The Credit Lending Decision Atheletequip Firm.

The paper intends to perform stress test and 5Cs evaluation on Atheletequip firm. The stress test would be based on a worst-case scenario that the firm will experience a 10% drop in sales. The 1992 would be base scenario. Firstly, before conducting the two analyses, it is important to give some reasons why Atheletequip firm needs this level of financing. From the financial statements, it is apparent that the firm finances most of its operations through external borrowing. The money generated does not allow the firm to cover all financial needs. Having known the reason why Atheletequip firm needs external backup, the next section will evaluate if the firm is credit worthy.

Before giving credit to Atheletequip firm, a number of evaluation ought to be done. The first is stress test. A stress test is used to identify the effects of a possible crisis on equity and the solvency of institutions (Ro?sch & Scheule, 2008). In this respect, the institutions tested must have sufficient capital and liquidity to be able to absorb unforeseen events at any time.

Principally, it is assumed that a bank must have sufficient capital to absorb a certain percentage of losses in its credit and investment operations-asset impairment-while still being able to respond to its obligations with depositors and depositors (passive) (Dowd, 2015). For this to happen, the condition must be met:

Stress tests measure precisely this condition: starting from a baseline scenario in economic terms and assuming conditions of economic growth, unemployment, etc., stress tests subject to simulation what would happen to the assets of banks in different conditions, how much they would deteriorate, and what capacity the bank would have to assume those losses with its own capital (Chorafas, 2007).

To determine Atheletquip stress test, we need to determine extreme left tail events. In this paper, we shall do stress testing based on the assumption that there would be hard economic times due to unemployment in Singapore and that these conditions would lead to drop in sales.

Here, we shall be testing whether drop in sales will allow Athletequip firm to repay its liabilities and loans. If the sales in 1992 drop by 10%, we get the following results from horizontal analysis

This means that the new sales would be 1554,092. Since sales has direct impact on profitability, the equivalent change in profit would be as follows. The impact of 10% drop in sales would be detrimental. The net earnings would change from 30,511 to -142,166.

Effects of 10% drop in sales

Base scenario (1992)

Profit Margin

-9.1%

1.8%

Return on equity (%)

-29.0%

6.2%

Return on assets (%)

-20.4%

4.4%

Evaluation of the 5Cs for Atheletequip Firm

Given that the net income or earnings dropped from 30,511 to -142,166, it means that the retained earnings will reduce. Initially, the retained earnings was  397,043  in 1992. Using the formula, of calculating retained earnings, it is possible to establish the new retained earnings under the new worst scenario.

Initial retained earnings + net income/profit= ending retained earnings

X+ 30511=  397,043

X= 397,043-30511

X= 366532

Using the assumption that Athletequip firm dividends is 0, then the initial retained earnings is 366532

Now, suppose the net income is -142,166. The final retained earnings for the worst scenario would be obtained using the formula

Initial retained earnings + net income= ending retained earnings

366532 + (-142,166)= ending retained earnings

Ending retained earnings for the worst scenario would be 224,366

Now, by replacing this value in excel, a number of changes would be realized. The major change concerns the leverage ratio. Initially, at base scenario, the leverage ratios were as shown below.

1992

1991

1990

Low 10%

Average

High 10%

Leverage ratios

           

Total debt to equity (%)

42.4%

34.0%

42.3%

351.0%

168.0%

94.0%

At worst scenario caused by drop in sales by 10%, the leverage ratio will change from 42.4% to 65.5%

This means that a 10% drop in sales due to unemployment will make it hard for Athletequip firm to meet its debt obligations. In conclusion, a 10% drop in sales makes Athletequip firm unfit for credit because the leverage ratio would be too high.

The evaluation of the 5 "Cs" is a method used by lenders to determine the solvency of companies. This method weighs 5 criteria of the company and tries to evaluate the risk of default. Below is an analysis of Athletequip firm based on 5 Cs’

As far as the character is concerned, the lender looks at the character of the leader and the company before anything else (Abdou, et al 2016). In most cases, the lender will look at the quality of the managers in place. Even in difficult times, a competent team of managers will manage the company's activities and make the necessary decisions to maintain profitability. The case shows that Athletequip firm had long term relationship with banks such as Thirst First State Bank and Commercial National Bank. This means that the Athletequip firm character is not bad.

The second criterion is the ability to make repayments (where the ability to meet the debt service) (Joseph, 2007). When evaluating capacity, it becomes important to demonstrate the profitability of your business, one of the most important foundations, and it is up to Athletequip firm to justify that her income and the quality of costs management will allow Athletequip firm to generate profits in order to repay the debt when it matures. Given the worst scenario of 10% drop in sales, we saw that the profitability dropped significantly. This means that if such assumption is to be used by bank, Athletequip firm may not meet the requirements because the profitability dropped to negative level.

Conclusion

As far as capacity is concerned, it is important to demonstrate to the lender a realistic repayment ability. The lender must believe in Athletequip firm financial forecasts. If this index would be used by the potential lender, then Athletequip firm stands a second chance of being reconsidered for loan.

The third criterion of analysis is the capital of the Athletequip firm. In most cases, the lender is looking for a company with a solid capital (equity) structure. This is important for the lender for two reasons.  First, the company must have sufficient capital as a cushion to resist any anomaly in the ability to generate "expected cash flows". For example, if the company becomes unprofitable for any reason, it will start burning cash to finance its operations. Financial institutions are never interested in lending money to finance the losses of a business. A strong capital structure allows the lender to ensure that there is sufficient capital to weather a temporary storm. Secondly, when it comes to capital, the financial institution is looking for business owners who have invested enough of their personal assets in their business, so that if things should go wrong, the owner will be motivated to work with the financial institution during a turnaround.  There is no specific measure as to the capital structure sought. Generally, financial institutions prefer companies with a total debt to equity ratio of less than 3. Depending on the type of business, this ratio may vary.  Currently, Athletequip firm total debt to equity is greater than 3 percent and this means that it may not qualify.

The collateral consists of collateral (accounts receivable, inventory, equipment, building, etc.) that you offer to your lender and are risk mitigants for the lender (Joseph, 2007). The lender will very rarely finance assets up to 100% of their fair market value. Risk sharing between the lender and the company is therefore necessary.  The financial institution is interested in the collateral as a secondary source of repayment of the loan if collateral is realized. In addition, the financial institution may require an evaluation of some of your assets, normally for real estate financing. Keep in mind that you will be responsible for the cost of third parties in the valuation of assets, and remember to take into account the time required to complete the required valuation. Finally, the type of collateral is all the more important because in a liquidation scenario, goodwill, prepaid amounts, investments, etc., will not be considered significant because they generate little or no cash. In 1992, the Athletequip firm collaterals were as follows. The accounts receivable was 169,734. The inventory was 301,184 and the prepaid expenses 5,272. This means that Athletequip firm stands a chance to get a loan if collateral is anything to go by.

The final criterion of analysis relates to market conditions and loan conditions. Concerning the market conditions, the lender will evaluate the general conditions surrounding your business and industry to determine the main risks and how the company is working to mitigate them (Joseph, 2007). Although the historical financial performance is strong, the lender wants to ensure the future viability of Athletequip firm. Here are some of the risk factors that the lender can take into account in their analysis. The competitive landscape: What are your competitors? How do you differentiate yourself from the competition? How does your company access capital compared to your competitors? How are the identified risks mitigated? What are the risks of seeing your customers go to the competition? (Brooks, Cunha  & Mosley 2015). Concerning competition, Athletequip firm have fewer competitors. It should also be noted that the lender will also look at the nature of Athletequip firm relations with customers. They will ask such questions as: Does one of Athletequip firm clients represent more than 10% of firm’s turnover? If so, how do you protect your relationship with this customer? What does the company do to diversify its revenue sources? What is the longevity of the relationship with your client? Are some customers subject to financial constraints? Is the business sufficiently capitalized to withstand any significant impairment of a bad debt? The case shows that Athletequip firm has good relations with customers. This will increase the chances of the firm getting a loan.  The lender will also consider supply risks: Is the company subject to supply shortages from a key supplier? How the company is able to mitigate this risk. What is the nature of the relationship with its key suppliers? In addition, the lender will check aspects related to the industry problems: Are there macroeconomic or political factors that could affect the business? Could the passing of a pending legislation affect industry or the economy?  Apart from market condition, the lender will look at Athletequip firm’s credit condition. Here, the lender may require compliance with certain financial ratios, including debt, debt service coverage, and so on. If certain conditions or requirements are not satisfactory for you and your company, it is better to discuss it with your lender, see to renegotiate clauses that do not satisfy you. It is important to keep your freedom of action. Athletequip firm have satisfactory financial ratios so far.

Conclusion

Using the worst-case scenario that Athletequip firm will experience a 10% drop in sales, we established that the firm may not meet the requirements to get the loan. However, the 5Cs evaluation showed that Athletequip firm stands a chance of getting the loan.

References

Ro?sch, D., & Scheule, H. (2008). Stress testing for financial institutions: Applications, regulations and techniques. London: Risk Books.

Chorafas, D. N. (2007). Stress testing for risk control under Basel II. Oxford: Butterworth-Heinemann.

Joseph, C. (2007). Credit risk analysis: A tryst with strategic prudence. New Delhi: Tata McGraw-Hill.

Athelequip Company Inc (nd.). Case II: Athelequip Company Inc. Pp 551-527

Brooks, S. M., Cunha, R., & Mosley, L. (2015). Categories, Creditworthiness, and Contagion: How Investors' Shortcuts Affect Sovereign Debt Markets. International Studies Quarterly, 59(3), 587-601. doi:10.1111/isqu.12173

Abdou, H. A., Tsafack, M. D., Ntim, C. G., & Baker, R. D. (2016). Predicting creditworthiness in retail banking with limited scoring data. Knowledge-Based Systems, 10389-103. doi:10.1016/j.knosys.2016.03.023

Dowd, K. (2015). Central Bank Stress Tests: Mad, Bad, And Dangerous. CATO Journal, 35(3), 507-524.

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