5.1 Preparing for the Workout Process
As the first step after receiving a new NPL, the workout team should ensure collection of all relevant and necessary information on the borrower’s loan and financial details to enable the selection of an appropriate workout plan. The Corporate/MSME team should ensure that the file is transferred with all necessary documentation and a case update summary is attached. In the best-case scenario, the bank should aim at achieving a consensual solution that satisfies the interests of both parties and results in a successful restructuring. Adopting such perspective implies not only a self-assessment of the bank’s options and legal position but also an analysis of the existing options and situation for the borrower. A comprehensive approach requires a thorough preparation process on both sides, which, if done properly, will maximize the chances of achieving a successful and mutually beneficial solution. All workout exercises should adhere to principles of restructuring outlined in Appendix 3 of this document and abide by Section 5 of the “Rules on the Management of Problem Loans”.
On the bank’s side, a thorough preparation includes:
i. Gathering all relevant information available on the borrower;
ii. Perform a thorough review of the borrower’s historical financials, business viability, business plan and forecast loan service capacity.
iii. Accurately assessing the value of the collateral securing the loan; and
iv. Conducting a detailed analysis of the bank’s legal position.
These aspects are further explained in the sections below.
5.1.1 Gathering of Information About the Borrower
All borrowers and guarantors should be informed promptly (within 5 business days) that responsibility for their relationship has been transferred to the Workout Unit. This notification should be in writing and contain a complete and accurate description of all legal obligations outstanding with the bank, the amounts and dates of all past due amounts together with any fees or penalties which have been assessed. The Workout Unit should intimate the borrower with any violations and loan covenants or agreements observed at the time of information collection.
The borrower should be requested to submit the following information, preferably in electronic format:
i. Information on all loans and other obligations (including guarantees) outstanding.
ii. Detailed contact information (mail, telephone, e-mail), including representatives, if applicable.
iii. Detailed latest financial statements of the company (balance sheet, income statement, cash flow statement, explanatory notes). MSME’s and financially less-sophisticated enterprises may submit only aggregate financial figures.
iv. Updated business plan and the proposal for repayment/restructuring of loan obligations.
v. Individual entrepreneurs (for example sole proprietors), should also submit information about the household. The two additional parameters for determining the loan servicing ability of such borrowers are: (i) the borrower’s family composition (number of children, number of earners in the family) to determine justified expenses; and (ii) total net earnings.
Updated financial information, together with a detailed listing of all guarantees outstanding, if any, should be also collected from the guarantors (natural or legal persons) of loans. In addition, the bank should exercise all legal efforts to acquire additional information from other sources to form an accurate, adequate, and complete view of the borrower’s loan servicing capability.
During the file review, the Workout Unit should pay close attention to identifying any other significant creditors. These may include other banks and financial institutions, Zakat/Tax authority, utilities, trade creditors and loans to shareholders, related parties, or employees.
For any missing key information identified during the file review, the Workout Unit should develop a corrective action plan to ensure collection of these documents with the help of the business team. Some of this information should be requested promptly from the borrower or third party sources such as Credit Bureaus.
5.1.2 Identifying Non-cooperative Borrowers:
The Workout Unit should define non-cooperative borrowers and carefully document their non-compliance. Useful criteria to be used to identify these borrowers are:
i. Borrowers who default on their loans while having the ability to pay (“strategic defaulters") in hopes of receiving unwarranted concessions from the bank.
ii. Failure to respond either orally or in writing to two consecutive requests from the bank for a meeting or financial information within 15 calendar days of each request.
iii. Borrowers who deny access to their premises and/or books and records.
iv. Borrowers who do not engage constructively with the bank, including those that are generally unresponsive, consistently fail to keep promises, and/or reject restructuring proposals out of hand.
Non-cooperative borrowers are more likely to be transferred to the legal team as it would be difficult to reach a consensual restructuring solution if the Borrowers are not willing to cooperate with the Banks.
However, banks would have to maintain an appropriate audit trail, documenting the rationale for classifying a borrower as “non-cooperative"
5.1.3 Determining the Bank’s Legal Rights and Remedies
The banks having reviewed and understood the borrower’s business plan, but before initiating restructuring negotiations with a borrower, must prepare for these negotiations and have a very clear understanding of its bargaining position from a legal standpoint.
The Workout Unit should perform a thorough review of all documents relating to the borrower, with special emphasis on the loan agreement and the security package that was formalized when the transaction took place. An accurate assessment of the bank's rights will have a critical impact on determining the resolution strategy to be adopted.
The following are general indicators that a Workout Unit could pay attention to when reviewing the documentation:
i. Whether the parties to the loan were adequately described in the loan documentation;
ii. Whether all key documents were signed by the duly authorized persons under Saudi governing law;
iii. Whether the bank is in possession of all original documents;
iv. Whether the collateral has been duly perfected, including registration at the applicable registry
v. Whether the loan documentation included non-compliance with certain financial indicators as ‘events of default’, and whether these indicators have been breached;
vi. Historical financial position, driver of historical underperformance and to what extent this is expected to drive forecast performance:
a) Current market challenges and outlook: The Banks should form a view on how this has impacted the borrower’s historically and how is it expected to impact its forecast performance and ability to repay the loan;
b) The capabilities of the borrower’s Management team and whether they are capable of turning around the business;
c) Strategy and turnaround initiatives: Does the borrower have a clear strategy or plan to turnaround the business? Has this plan been clearly documented and communicated to banks?
d) Business plan and financial projections: How is the borrower expected to perform of the medium to long-term? What are the borrower's cash flow projections, which should provide an indication of his loan service capacity going forward? What is the level of sustainable versus unsustainable loan;
e) Alignment with credit terms: To what extent are all of the above aligned with existing credit terms and repayment plan;
vii. Whether the loan documentation included a cross-default clause and whether there are other loans that may be considered breached and/or accelerated as a result of the breach of one single loan;
viii. Whether there was an obligation on the bank to notify the borrower or potential guarantors of major changes in the documentation or the terms of the loan, like changes in legislation, currency, interest rates, etc.
If the borrower is not fully equipped to provide such information or if the banks would like to independently review such information, they can seek to appoint a financial advisor to perform an independent business review and clarify the above.
Once the Banks have formed a good understanding of the above, it is expected to assist them in identifying sustainable and commercial restructuring options that could align the banks' interest with that of the borrower and maximize recovery. Such options should be continuously evaluated as the WU engage in restructuring discussions and gather further information.
5.1.4 Ensuring Collateral’s Validity
The workout team should ensure that the collateral taken at the time of loan agreement/origination was formalized and is still valid and enforceable. The banks should complete timely validation of legal documents to evade probable disputes or delay at the time of negotiating restructuring proposal. Furthermore, the banks should establish procedures around periodic (e.g. yearly basis) valuation and monitoring of acquired collateral
The Bank is required to perform detailed collateral analysis for all the accounts referred to WU. The workout team should perform this analysis as detailed out in section 7 of the “Rules on Management of Problem Loans"
5.1.5 Financial Viability Analysis
Banks need to conduct a thorough financial and business viability analysis of its borrowers especially MSME NPL borrowers to determine their ability to repay their obligations. In addition, it is important to obtain sufficient insight into the business plan and projected cash flows available with the borrower for loan service. This will entail determining the borrower’s forecasted loan service capacity and assessment needs to be performed by the banks to align this with the restructured credit terms.
This analysis serves as the foundation for making an informed decision on the appropriate resolution approach – restructuring, sale to a third party, change of loan type (loan-to-asset or loan-to-equity swap) or legal proceedings. This analysis is required to be conducted by WU not previously involved in the loan approval process.
A. Analysis of key financial ratios
Financial ratios, calculated from data provided in the balance sheet and income statement, provide an insight into a firm’s operations and are among the most readily available and easy to use indicators for determining the borrower’s viability. In case of MSME borrowers, in the absence of availability of audited and reliable financial information banks should focus on cash-flow based analysis and should also assess the reasonableness of financial information (where this information is available).
Below are four categories of financial ratios that banks may consider for their initial financial analysis (being illustrated below for indicative purposes and should not be considered prescriptive):
i. Liquidity ratios measure how easily a company can meet its short-term obligations within a short timeframe.
a. Current ratio (total current assets/total current liabilities) measures a company’s ability to pay current liabilities by using current assets. It must be recognized that the distressed borrower’s ratios will be considerably lower. The Workout Unit should assess how the borrower can achieve a more normal ratio within a reasonable time frame.
b. Quick ratio, which includes only liquid assets (cash, readily marketable securities and accounts receivable) in the numerator, is a measure of the firm’s ability to meet its obligations without relying on inventory.
ii. Solvency or leverage ratios measure the company’s reliance on loan rather than equity to finance its operations as well as its ability to meet all its obligations and liabilities.
iii. Profitability ratios measure the company’s growth and ability to generate profits or produce sufficient cash flow to survive, rate of sales growth, gross profit margin, and net profit margin are some of the key ratios to be considered.
iv. Efficiency ratios measure management’s ability to effectively employ the company’s resources and assets. These include receivable turnover, inventory turnover, payable turnover and return on equity.
Detailed financial analysis of the borrower needs is to be performed in order to ensure completeness and avoid ignoring important underlying trends. Banks should undertake detailed analysis to understand the interrelation of these financial ratios, which can enable identification of borrower’s real problems as well as probable corrective actions to restore the company’s financial health.
The workout team should exercise prudence in his analysis and utilize reasonable caps and floors for certain ratios, as these ratios vary across borrower segments and sectors as well as economic conditions.
B. Balance sheet analysis
In addition to computing and analyzing the key ratios, the workout team should carefully review the balance sheet to develop a basic understanding of the composition of the borrower’s assets and liabilities. Primary emphasis should be placed on developing a complete understanding of all obligations outstanding to the bank and other creditors, including the purpose of the credits, their repayment terms, and current status, to determine the total debt burden of the borrower and the amount of loan that needs to be restructured.
The composition of liabilities, particularly “other liabilities" and accrued expense items should be addressed. Wages payable and taxes are two particularly problematic accounts. Both represent priority claims against the borrower's assets and must be settled if a successful restructuring or bankruptcy is to take place.
C. Cash flow analysis - defining financial viability
When financial statements are prepared on an accrual basis, cash flow analysis ties together the income statement and the balance sheet to provide a more complete picture of how cash (both sources and uses) flows through the company. Cash is the ultimate source of loan repayment.
The less cash is generated by operations, the less likely the borrower will be able to repay the loan, making it more likely that the bank will need to rely on its collateral (asset liquidation or bankruptcy) for repayment. Thus, the primary emphasis when conducting the financial analysis of the borrower should be on its forecasted cash generation capabilities. The proper analysis of cash flow involves the use of both the balance sheet and the income statement for two consecutive fiscal years to identify the sources and uses of cash within the company. Changes in working capital and fixed asset expenditures are quantified and cash needs are highlighted, providing a clear view of the many competing uses of cash within the company.
With respect to MSME borrowers, in case reliable and timely financial information is not available, cash flow based assessment is recommended. Banks should incorporate a robust and efficient internal process of cash flow estimation for these borrowers.
D. Business Plan
A comprehensive financial analysis of the non-performing borrower includes an assessment of the company’s business plan containing a detailed description of how the owners and management are going to correct existing problems. While no one can forecast the future with certainty, a candid discussion between the borrower and the bank on new business plan and financial projections is an essential part of the viability assessment exercise. It provides both the bank and the borrower an opportunity to explore how the company will operate under different scenarios and allows management to have a contingency (or corrective action) plans in place should actual results deviate significantly from the projections. The focus of the Workout Unit will be on validating the assumptions (whether realistically conservative and in line with past performance) and performing a sensitivity analysis to see how results will vary under changed assumptions. Again, the emphasis should be placed on tracing the flow of cash through the business to determine the company’s ability to pay.
E. Cash budget
Cash budget is a powerful tool, which helps the borrower to limit expenditures and preserve cash to meet upcoming obligations such as taxes. It can also compensate for the poor quality of formal financial statements in the case of micro and small enterprises.
In a workout, the ability to generate and preserve cash is the key to the company’s survival. All borrowers should be encouraged to prepare a short-term cash budget. The cash budget is similar to the cash flow analysis and differs, however, in two important respects: (i) it is forward-looking; and (ii) it breaks down the annual sources and uses by month to reveal the pattern of cash usage within the company. It also clearly identifies additional financing needs as well as the timing and amount of cash available for loan service. For smaller borrowers, a simple listing of monthly cash receipts and cash disbursements will suffice. Actual results need to be monitored monthly and corrective actions are taken immediately to ensure that the company remains on plan.
5.1.6 Business Viability Analysis
Unlike financial analysis, which is highly quantitative, the business analysis is more qualitative in nature. Its purpose is to assess the borrower's ability to survive over the longer term. It focuses not on the borrower's financial performance, but rather on the quality of its management, the nature of the products & services, facilities and the external environment in which the borrower operates (including competition).
The primary cause of a business failure that has been acknowledged is the management of the business. The most common reasons include: (i) lack of necessary management skills required to run an organization; (ii) inability or unwillingness to delegate responsibilities; (iii) lack of experienced and qualified managers in key positions; (iv) lack of skills to run the business; and (v) inadequate management systems and controls.
Product assessment focuses on the nature of the product and its longevity potential. The main considerations include services or products, product mix diversified or reliant on a single product, technical obsolescence, and demand of the product/service.
The primary focus of the assessment of the facilities (physical plant, manufacturing units, etc.) is not on their valuation but rather on their capacity and efficiency. The attempt should be made to evaluate any requirements of significant upgrades or new facility to meet demand for the product presently and in the foreseeable future. The costs for the same should then be assessed and included in the base projections.
External factors include the assessment of the general macro environment as well as overall industry and market conditions. It focuses on assessing the potential impact on the borrower of changes in the economic as well as regulatory climate; analyzing the strength of the borrower's position within the industry (market share) and its competitors; and gaining a better understanding of the borrower's market and how changes within the market might affect the company's performance.
A. Use of outside expertise to prepare business viability assessment
For large commercial or real estate loans, the business viability portion of the analysis may be performed or validated by an independent third party such as a consultant or a restructuring advisor.
i. Micro and Small Enterprises
In the case of micro and small companies and subject to the cooperation of the owner or the management, which is trustworthy and provides reliable financial and other information, the use of external consultants may not be efficient in terms of time and costs. Banks are, therefore, encouraged to build internal capacity (or engage with external service providers as necessary) to assess the business viability of this segment and enable reasonable decision making in this regard.
ii. Medium-sized companies:
Medium-sized companies should be analyzed in more detail and it may be reasonable to use a similar approach as in the case of large companies. This may require a guided and aligned coordination between the banks and the inclusion of an external consultant to prepare an independent overview of operations, particularly in the following cases.
The process can be followed in case where at least one of the following conditions are met:
i. There is doubt about the reliability of financial and other information;
ii. There is doubt about the fairness and competence of the management;
iii. Activity involved of which the bank does not have sufficient internal knowhow;
iv. There is a great probability that the company will need additional financial assets.
All banks should have clear procedures regarding the level of approval authority required and the process to be followed when contracting for an independent review. The procedure guidelines at a minimum should include qualifications of the advisor, selection criteria, evaluation process and approval for these appointments. Whenever possible, Workout team should request proposals from several firms. In addition, these procedures should require that the deliverables (together with their due dates) and the pricing structure, should be clearly laid out. To expedite and further standardize the onboarding process, banks may choose to establish a list of pre-approved vendors.
B. Documenting the results of the financial and business viability analysis
The findings of the financial and business viability analysis should be documented in writing and communicated to the credit committee for review. The documentation should have sufficient detail to provide a comprehensive picture of the borrower's present financial condition and its ability to generate sustainable cash flows in the future. Banks will have its own standard format for documenting the analysis but should ensure that it incorporates, at a minimum, the below information:
i. Minutes of the meeting with the borrower with a clear identification of the reasons for the problems and the assessment of the ability to introduce radical changes into the operations;
ii. Exposure of the banks and all other creditors (related persons, in particular);
iii. The analysis of the balance sheet structure - the structure of maturity of receivables and operating liabilities, identification of assets suitable for sale and assessment of the value of this property;
iv. The analysis of the trends of the key indicators of individual categories of financial statements: EBITDA margin, net financial /EBITDA, total debt/equity, interest coverage, debt service coverage ratio (DSCR), net sales revenue/operating receivables, accounts payable/total debt, quick liquidity ratio, cash flow from operations, costs of services etc. (these ratios are indicative, banks in practice are free to utilize such ratios, which they deem appropriate).
v. 3- to 5-year projection (time period is dependent based on the tenor of the loan) of cash flows based on conservative assumptions - the plan of operations must not be a wish list but rather a critical view of the possibilities of the company's development in its branch of industry;
vi. Analysis of the necessary resources for the financing of working capital and investments (Capex);
vii. Review of all indemnities (in the case of personal guarantees also an overview and an assessment of the guarantor's property);
viii. Overview of the quality and assessment of the value of collaterals and the calculations of different scenarios (implementation of restructuring or the exit strategy).
The results of the financial analysis should be updated at least annually or more frequently in conjunction with the receipt of the borrower's financial statements. The business assessment should be updated at least every three years or whenever major changes occur in either borrower's management or the external operating environment.
Based on the financial analysis, the business plan and the understanding of the borrower’s loan service capacity, the banks should consider various restructuring solutions that can offer a sustainable restructuring and align the credit terms with the cash flow forecasts of the business. These solutions could include, but are not limited to:
i. Grace periods.
ii. Reduced interest rates or in some cases payment in kind (PIK) (PIK is the option to pay interest on debt instruments and preferred securities in kind, instead of in case.PIK interest has been designed for borrowers who wish to avoid making cash outlays during the growth phase of their business. PIK is the financial instrument that pays interest or dividends to investors of bonds, notes, or preferred stock with additional securities or equity instead of cash) interest.
iii. Assessing sustainable versus unsustainable debt.
iv. Agreeing repayment profiles around sustainable debt in line with forecast sensitized cash flows of the borrower.
v. Agreeing an asset sale plan.
vi. Agreeing a debt to equity conversion.
vii. Agreeing a debt to asset swap.
viii. Agreeing a cash sweep mechanism (it is the mandatory use of excess free cash flows to pay outstanding debt rather than distributing it to the shareholders) to benefit from any upsides to the borrower's business plan.
ix. Longer-term tenors when the business plan and financial analysis suggest that this is necessary for a more sustainable restructuring