Glossary.

What are the 5 Cs of credit, and how does a credit desk actually use them?

The 5 Cs of credit are character, capacity, capital, collateral and conditions: the borrower's record and candour, its ability to repay from cash flow, how much of the business is the owners' own money, the security behind the loan, and the sector and economy it trades in. They are a coverage checklist that makes sure nothing is left out, not an order of reading. A credit desk covers all five but reads a file in a different sequence — the cash cycle and the source of repayment first, then the structure that protects the bank if those turn out wrong.

WORKED INAll five, in the order a desk reads a requestCharacter, read as a recordCapacity: whether profit becomes cashConditions: a sector as a bank reads it

What is a “second way out”, and why does a lender ask for one?

The first way out is the borrower's ordinary cash flow. The second way out is what repays the debt when that cash flow does not arrive — asset sale, refinance, sponsor support, guarantee — and a lender asks for it because the first way out is a forecast and the second is a structure. The useful version of the question is not whether a second way out exists on paper but what it would actually recover, and how quickly, in the state of the world where it is needed.

WORKED INIssue 03 — Kauri Dairy HoldingsThe In-Tray — files on a loan's protection

When does customer concentration stop being a fact and start being a credit issue?

Customer concentration is the share of revenue a business draws from its largest customers. It becomes a credit issue at the point where the borrower's capacity to service debt depends on a relationship the borrower does not control — and the tell is not the percentage but the terms: how the contract can be ended, how much notice it requires, and whether the assets funded against that revenue have any other use. A business can be one relationship with operations attached, and lending to it is a different proposition from lending to a diversified book of the same size.

CHAPTER 5 OF THE BOOKReading the Industry, Not Just the Borrower

WORKED INThe In-Tray — a one-minute file on it

What does it mean for a business to be “bankable”?

Bankability is not a feeling about a business and not creditworthiness in the narrow sense. It is a short list of claims that hold up when read by people who were never in the room: which parts of the story are already visible in statements and contracts, whether the institution's interest is a question of whether or a question of when, and whether the structure survives four quarters in which nothing improves. A business can carry excellent earnings and still present an unbankable situation, because the request is vague or the information arrives in a form no committee can process.

WORKED INWhat bankability really means

What is a risk grade, and what happens when a loan is downgraded?

A risk grade is the bank's rating of how likely a borrower is to default, set from its financial position, its industry, its management and its conduct, and reset at every annual review or whenever something important changes. The grade drives the capital the bank must hold, the margin it charges, the authority needed to approve the facility, and how often the file is reviewed. A downgrade can move all four — the margin when the facility next allows it to be reset — which makes the grade the most consequential line in a review, and one the borrower rarely sees.

WORKED INHow Banks Price a Business LoanWhy Your Bank Repriced Your LoanCredit Analyst vs Credit Risk Analyst

What is the primary source of repayment on a business loan?

The primary source of repayment is the cash a loan is expected to be repaid from in the ordinary course — for most business lending, the borrower's operating cash flow; for a development loan, the sale of the units; for a trade loan, the payment for the goods it financed. A credit decision is mostly a judgement about whether that source is real, sufficient and timed to the repayments. Security and guarantees are the second way out, and a loan whose only credible source of repayment is its security is a loan the bank expects to enforce.

WORKED INLVR, Security and CollateralHow Banks Approve Business LoansProduct file: LC Discounting

What does serviceability mean in business lending?

Serviceability is a borrower's ability to meet a loan's interest and scheduled principal from its own cash flow — tested on commercial lending through debt service cover where principal is scheduled, and interest cover where it is not. On a term loan it is almost the whole credit question, because the security matters only if serviceability fails. A desk tests it at a higher interest rate and against the weaker years rather than the average, and reads a forecast that services comfortably over the year but exhausts the facility in one month as a serviceability problem too.

WORKED INProduct file: Term LoanDebt Service Coverage (DSCR)How Banks Test Borrower ForecastsLoan Covenants, Explained

What is delegated lending authority in a bank?

Delegated lending authority is the personal limit a bank gives a named person — or a committee — to approve credit, set by the size of the exposure, the risk grade and whether the proposal sits inside policy. A decision above the holder's authority goes up a level, and anything unusual escalates regardless of size: an exception to policy, a watch-list client, a related party, a sector new to the bank. The structure is the point: every credit decision has a person who made it and answers for it later, which is also why an approval is not something software can hold.

WORKED INHow Banks Approve Business LoansCredit Analyst vs UnderwriterCredit Sanctioner, the seat

What is a policy exception in a credit approval?

A policy exception is a credit approval granted outside the bank's written lending policy — a loan-to-value ratio above the limit, a covenant looser than the standard, a sector the policy excludes — with the departure named and justified in the credit paper. It is not a failure: policy is written for the typical case, and an exception is how a strong file that does not fit is approved honestly. What makes exceptions dangerous is volume and silence, which is why a bank tracks them across its book, and why an exception takes a decision up a level of authority whatever its size.

WORKED INHow Banks Approve Business LoansPortfolio Manager vs Relationship Manager

What does a bank's credit committee do?

A credit committee is the group of senior credit officers that approves the exposures too large, too complex or too far outside policy for any one person's delegated authority. It reads the credit paper rather than the relationship — the recommendation, the risks the analyst has named and the mitigants offered — and it can approve, decline, or approve on different terms. Most commercial lending never reaches committee, and the papers that do are written to survive questions from people who have never met the client.

WORKED INIssue 10 — The DissentHow Banks Approve Business LoansHow to Write a Credit Paper

What is key-person risk, and how does a bank assess it?

Key-person risk is the exposure of a business — and of its lender — to the loss of one individual whose relationships, skills or decisions the business depends on: the founder who holds the customers, the one engineer who knows the plant. A bank reads it as part of management quality and asks what would happen in the week that person stopped: who signs, who sells, who the customers call. The answers that count are structural rather than verbal — a named successor, a second line of management, key-person insurance — and their absence in a small business is common enough to be structured for rather than declined.

WORKED INHow Banks Assess Management QualityThe In-Tray — a one-minute file on it

What is the cash conversion cycle, and how does a lender use it to size a facility?

The cash conversion cycle is the number of days between paying for inputs and collecting the cash a sale produces: debtor days plus inventory days minus payables days. A lender uses it as the arithmetic behind a working capital limit — the cycle in days, divided by 365, multiplied by revenue, gives the working capital the business carries at its current size (strictly, debtor days on revenue and inventory and payables days on cost of sales), and the same calculation run on the revenue increment gives what recent growth has absorbed. Sizing the need this way before reading the borrower's request is what makes the request legible: it is either inside that number, roughly equal to it, or a fraction of it, and each of those is a different conversation.

CHAPTER 3 OF THE BOOKReading Real Demand vs. Plugging Holes

WORKED INWorked example with the arithmeticWorking capital case studyThree Diagnostics calculatorThe In-Tray — a one-minute file on it

What does “quality of earnings” mean in credit, and how is it tested?

Quality of earnings is the question of whether reported profit is real enough to lend against. A profit figure is an opinion assembled by people with incentives; cash is a fact. The test runs three angles in parallel: whether profit converts to operating cash, whether the balance sheet is moving in a direction the profit story explains, and what the language of the disclosure itself reveals. Positive EBITDA alongside negative operating cash flow is not a funding gap — it is a conversion problem, and lending against it does not fix it.

CHAPTER 4 OF THE BOOKReading the Numbers Behind the Numbers

WORKED INIssue 01 — Pacific Premium FoodsThree Diagnostics calculatorThe In-Tray — six one-minute files on this chapter

What do debtor days (DSO) tell a lender that revenue growth does not?

Debtor days, or days sales outstanding, measure how long a business waits to be paid after invoicing. The level matters less than the direction: debtor days lengthening faster than revenue grew means customers are paying more slowly, not merely that there are more of them — and the difference decides whether a facility increase funds a growth cycle or funds a deterioration. A stable ratio can also conceal a moving composition, as ten balanced customers become three dominant ones at the same average.

CHAPTER 4 OF THE BOOKReading the Numbers Behind the Numbers

WORKED INIssue 01 — Pacific Premium FoodsThe In-Tray — a one-minute file on it

What is the debt service cover ratio, and how does a lender actually read it?

Debt service cover is the earnings available for debt service divided by the scheduled principal and interest for the period — the central serviceability test on term lending, and usually its lead covenant. The reading discipline matters more than the number: cover is assessed against the bad year, not the average one, because a multi-year loan lives through whole cycles and the average year repays nothing if the worst year defaults. There is no universal minimum — the cover a lender wants scales with the volatility of the earnings providing it, which is why a stable utility and a project builder are read to different standards.

NOT Not interchangeable with interest cover: DSCR includes scheduled principal and is therefore the harder test on any amortising loan.

WORKED INDebt Service Coverage (DSCR)Product file: Term LoanHow Banks Manage Credit RiskThe In-Tray — a one-minute file on it

What is interest cover, and how is it different from debt service cover?

Interest cover is operating earnings divided by interest expense: how many times over the business earns its interest bill. It ignores principal repayments, which makes it the natural test for revolving and interest-only structures where no principal is scheduled — and an incomplete one for amortising loans, where debt service cover does the real work. A desk reads the two together: comfortable interest cover with thin debt service cover describes a business that can afford its interest but not its loan, which is a structure problem before it is a credit problem.

WORKED INCredit analyst interview questions — the technical floorProduct file: Revolving Credit FacilityThe In-Tray — a one-minute file on it

What is debt to EBITDA, and how does a lender read a leverage ratio?

Debt to EBITDA is total debt divided by a year's earnings before interest, tax, depreciation and amortisation: how many years of earnings the debt represents, and the usual way a lender states leverage. The number depends on two choices made before it is calculated — the date, because a year-end can fall after seasonal borrowing has been repaid, and the definition, because total, net and senior debt, and reported or adjusted EBITDA, each give a different answer for the same business. A desk reads the direction and the cause of a movement rather than the level alone: a ratio that jumps because a loan arrived ahead of the volume it was built to fund is a different file from one that climbs because earnings are falling, and the question under both is whether the debt can come down.

NOT Not the same as gearing: debt to equity is also called leverage, but it asks who is funding the business, not how many years of earnings the debt represents.

WORKED INDebt to EBITDA and LeverageIssue 04 — Highview IndustriesLease-adjusted leverage, worked

What is a dividend payout ratio, and why does a lender care?

The dividend payout ratio is the share of a period's net profit paid to shareholders as dividends. A credit desk reads it against cash rather than profit: a payout policy set as a percentage of earnings is funded, in a year when earnings do not convert to cash, by the facility — which is why a lender's consent right over distributions exists, and why the quality of the earnings is read before the consent is given.

WORKED INIssue 07 — Coastline Retail GroupQuality of Earnings TriangulationLoan Covenants, Explained

What is debt per kilogram of milk solids?

Debt per kilogram of milk solids is the dairy lender's leverage measure: total farm debt divided by the farm's annual milk solids production. It expresses debt in the unit the farm earns in, so it can be read directly against the milk payout per kilogram and against the farm's breakeven — the payout at which cash covers costs, interest, loan repayments and drawings. Because production is steadier than land value, it is a steadier leverage measure for a farm than debt against land.

WORKED INAgricultural LendingIssue 03 — Kauri Dairy Holdings

What is fixed charge cover, and when does a desk use it instead of DSCR?

Fixed charge cover extends debt service cover to the other fixed commitments a business must meet whether or not it trades well — rent and operating leases above all. Earnings before rent are divided by rent plus scheduled debt service; some definitions, common in US lending, also deduct maintenance capital spending, tax and owner distributions from the earnings, and the facility agreement decides which applies. It is the more honest test for a business whose obligations to landlords rival its obligations to the bank, such as a retailer with many sites, because a lease default disturbs the business as surely as a loan default does.

NOT Not a replacement for DSCR where fixed charges are small: it is the same reading with a wider denominator, and on a business with little rent the two converge.

WORKED INDebt Service Coverage (DSCR)Issue 07 — Coastline Retail GroupLease-adjusted leverage, worked

What is global cash flow in a credit assessment?

Global cash flow is the combined reading of a business and its owners as one economic unit: the business's cash flow after its debt service, plus the owners' personal income and commitments, plus any related entities that lend to, borrow from or trade with the business. A desk reads it wherever an owner's guarantee is part of the security, or where drawings, related-party loans and personal debt make the company's own accounts an incomplete picture of who can pay what.

WORKED INPersonal GuaranteesIssue 03 — Kauri Dairy HoldingsDebt Service Coverage (DSCR)

What is adjusted EBITDA, and which add-backs does a lender accept?

Adjusted EBITDA is reported earnings before interest, tax, depreciation and amortisation with items management regards as unusual added back — restructuring costs, a legal settlement, an owner's above-market pay. It is management's own number, outside the audit, and every add-back is a claim that a cost will not recur. A lender tests each one against the history: a cost that has appeared in each of the last few years is part of running the business whatever it is called, and goes back in before any ratio is calculated.

WORKED INThe In-Tray — a one-minute file on itThe Number — the sum worked outQuality of earnings

What do creditor days (DPO) tell a lender?

Creditor days, or days payable outstanding, measure how long a business takes to pay its suppliers: trade payables divided by cost of sales, multiplied by 365. They are the one part of the cash conversion cycle that funds the business rather than consuming it, which makes a lengthening trend ambiguous — better terms negotiated from strength, or suppliers paid late because the cash is not there. A desk tells which by asking whether the terms changed by agreement, and reads creditor days stretched to fund growth as borrowing from people who can stop shipping.

WORKED INCash conversion cycle, workedThree Diagnostics calculatorIssue 04 — Highview Industries

What are inventory days (DIO), and why does a lender watch them?

Inventory days, or days inventory outstanding, measure how long stock sits before it is sold: inventory divided by cost of sales, multiplied by 365. Rising inventory days can mean a business building ahead of confirmed demand, buying in bulk for a discount, or holding stock that no longer sells — and only the last is invisible in the accounts until it is written down. A lender reads the trend beside the sales, asks for an ageing of the stock, and lends against inventory at a fraction of its cost, because stock is the asset worth least on the day it has to be sold.

WORKED INCash conversion cycle, workedWorking capital case study

What is maintenance capex, and why does a lender separate it from growth capex?

Maintenance capex is the investment a business has to make just to keep its existing capacity working — replacing vehicles, plant and systems as they wear out — as distinct from growth capex, which adds capacity. A lender separates the two because maintenance capex is not optional: it comes out of cash flow before anything is available for debt service, and a business that defers it can show flattering cash flow for years while its assets age. The tells are capex running persistently below depreciation, and a request for growth capex that is partly overdue replacement.

WORKED INIssue 05 — Meridian LogisticsHow Banks Read LogisticsThe In-Tray — a one-minute file on it

What is gearing, and how is it different from leverage?

Gearing measures a business's debt against its owners' funds — debt to equity, or debt to tangible net worth once intangible assets are taken out. It answers how much of the business the lenders have financed and how much the owners have, and so how far asset values can fall before the lenders' money is at risk. A business can be lightly geared on a revalued balance sheet and heavily leveraged on what it actually earns, which is why a desk reads both.

NOT Gearing is not leverage in the lending sense: leverage usually means debt against earnings, debt to EBITDA, a measure of capacity; gearing is debt against equity, a measure of the cushion.

WORKED INDebt to EBITDA and Leverage

What is tangible net worth, and why do lenders test it?

Tangible net worth is the owners' equity less intangible assets — goodwill, capitalised software, brands and the like — and, in many facility agreements, less amounts owed by related parties as well. Lenders test it because intangibles rarely survive the failure of the business that created them: the equity that absorbs a loss on the day the bank needs it is the tangible part. A minimum tangible net worth covenant protects that cushion, and an acquisition paid for largely in goodwill can breach it on the day it completes.

WORKED INDebt to EBITDA and LeverageThe In-Tray — a one-minute file on it

What is a downside case or sensitivity in a credit paper?

A downside case is the borrower's forecast rerun on deliberately harder assumptions — lower sales, thinner margins, slower collections, a higher interest rate — to see whether the loan still services and stays inside its covenants. The credit question is not whether the downside is likely but whether the facility survives it, and with how much room. The more informative version works backwards: the fall in earnings at which cover reaches its covenant or the facility runs out, which turns an argument about the right shock into a measure of the margin for error.

WORKED INHow Banks Test Borrower ForecastsFixed vs Floating RateThe In-Tray — a one-minute file on it

What is a dairy farm's breakeven milk price, and how does a bank use it?

A dairy farm's breakeven milk price is the payout per kilogram of milk solids at which its working expenses, interest, loan repayments and the owners' drawings are just covered. A bank sets it against the range the price has actually moved through: a farm whose breakeven sits well below the low seasons can carry its debt through the cycle, and one whose breakeven sits near the average depends on the good years to repay. It is worked before drawings and after, because a family's living costs are as real a claim on the milk cheque as the bank's.

WORKED INAgricultural LendingWhen the Milk Price FallsIssue 03 — Kauri Dairy Holdings

What are debt-like items, and why does a lender add them to debt?

Debt-like items are obligations that are not borrowings but behave like them in a lender's reading: a defined-benefit pension deficit once a recovery plan sets the payments, deferred consideration on an acquisition, overdue tax, customer deposits that must be refunded, provisions about to become cash. Each competes with debt service for the same cash, so a desk adds them to debt, or takes their payments out of the cash available, before it calculates leverage or cover. A ratio that leaves them out describes a business with fewer claims on it than it has.

WORKED INThe In-Tray — a one-minute file on itDebt to EBITDA and LeverageFinancial Reporting, Read by a Lender

What is operating leverage, and why does it matter to a lender?

Operating leverage is how much of a business's cost base is fixed: the more of it there is, the harder a fall in sales lands on profit, and the faster a rise lifts it. Two businesses with the same profit today can have very different resilience — one owning its plant, with mostly fixed costs, the other buying capacity by the job. A lender reads it beside the debt, because fixed costs and debt service are both bills that do not shrink with the sales.

NOT Operating leverage is not financial leverage: it is about the fixed share of the operating costs, not the borrowing.

WORKED INThe In-Tray — a one-minute file on itHow Banks Test Borrower Forecasts

What is EBITDAR, and why do lenders use it for retailers?

EBITDAR is earnings before interest, tax, depreciation, amortisation and rent — EBITDA with the rent added back. It puts a business that leases its premises on the same footing as one that owns them and borrows, so that leverage and cover can be read with the leases treated as the borrowing they are. Lenders use it most for retailers, hospitality and other businesses whose largest fixed commitment is rent: fixed charge cover divides it by rent plus interest plus scheduled principal, and catches the business whose debt looks modest because its obligations are leases rather than loans.

WORKED INLease-adjusted leverage, workedHow Banks Read Retailers

What does a going-concern doubt in a set of accounts mean for a lender?

Accounts are prepared on the going-concern basis when the business is expected to keep trading for the foreseeable future, which is what lets its assets be carried at their ordinary book values rather than at what they would fetch in a break-up sale. When an auditor or reviewer draws attention to a material uncertainty about that, they are saying the business's survival depends on something not yet certain — very often the bank's continued support. A credit desk reads that note first, because it frequently describes the facility the bank is being asked to renew.

WORKED INAudited, Reviewed or CompiledProblem Loans and WorkoutThe In-Tray — a one-minute file on itGoing concern and bank support

What are management accounts, and why does a bank want them?

Management accounts are a business's own monthly or quarterly profit and loss, balance sheet and cash position, prepared for the people running it rather than for statutory filing, and unaudited. A bank asks for them because annual accounts arrive months after the year they describe, and the desk reads the movement between packs — margin, debtor days, the facility's shape — more than any single set. When they arrive, and whether they agree with the year-end accounts, is read as closely as what they say.

WORKED INThe Monthly PackAudited, Reviewed or CompiledHow Banks Assess Management QualityThe In-Tray — a one-minute file on it

Why do banks care about related-party transactions?

A related-party transaction is business done with someone connected to the owners or directors: a family member's company, another business the owner controls, a family trust. Lenders read them closely because they need not be at arm's length — sales to a related party can inflate revenue and receivables, payments to one can move cash out of the business, and loans between them can put value where the bank's security does not reach. Invoice financiers commonly exclude related-party invoices from what they will fund, for the same reason.

WORKED INProduct file: Invoice FinanceAudited, Reviewed or CompiledHow Banks Assess Management Quality

What are capitalised costs, and why do lenders look at them?

Capitalising a cost means recording it as an asset on the balance sheet, written off over time, instead of as an expense in the year it is paid. That is right for spending that will earn over years, but it also moves spending out of the profit and loss account and so lifts EBITDA, which is why a credit desk reads what has been capitalised and whether it is growing faster than the business. The cash has left either way, but capitalised spending is reported as investing rather than operating cash flow, so it lifts operating cash flow as well as profit.

WORKED INQuality of Earnings TriangulationDebt to EBITDA and LeverageIssue 07 — Coastline Retail Group

What are contingent liabilities, and how does a lender treat them?

A contingent liability is an obligation that depends on something that has not yet happened — a guarantee of another company's debt, a bank guarantee or performance bond issued on the business's behalf, a legal claim, recourse on receivables it has sold. It may never become a cash outflow, which is why the accounts disclose most of them rather than record them. A lender reads the note anyway, because contingent liabilities tend to crystallise together and in bad years: the bond is called in the same quarter the loan breaches its covenants.

WORKED INFinancial Reporting, Read by a LenderProduct file: Bank GuaranteeThe In-Tray — a one-minute file on it

What is a bank confirmation in an audit, and what does it include?

A bank confirmation is the bank's direct answer to an auditor's request, given under the client's authority, of what it holds for the client at the balance date: each account and balance, each facility and its limit, the security it holds, and contingent items such as guarantees it has issued on the client's behalf. It is the auditor's independent view of the client's banking, and its value lies in what the client's own records may leave out. A bank that answers only the question asked has confirmed the balance sheet the client wrote.

WORKED INThe Bank in Your Audit FileAudit and Assurance, Read by a LenderThe In-Tray — a one-minute file on it

What is a qualified audit opinion, and what does a lender do with one?

A qualified opinion — an 'except for' opinion — says the accounts are fairly presented apart from a stated matter the auditor could not verify or disagrees with: stock at one warehouse not counted, a valuation not supported. A lender reads the qualification before the accounts, because it marks the part of the numbers nobody has stood behind, and asks whether that part sits inside its collateral or its covenants. Many facility letters treat a qualified opinion as a review event, or as a default in its own right.

WORKED INAudit and Assurance, Read by a LenderAudited, Reviewed or CompiledThe In-Tray — a one-minute file on it

What is a subsequent event in a set of accounts, and why does a lender care?

A subsequent event is something that happens between the balance date and the day the accounts are signed — a lost contract, a declined facility, a major customer's failure — that either changes the numbers or has to be disclosed beside them. A lost bank facility goes straight to going concern. A lender reads the note, and reads its absence: accounts signed silent on an event the bank knows about were signed on an incomplete picture, and the lender's next question is what else the auditor was not told.

WORKED INThe Bank in Your Audit FileGoing concern and bank supportThe In-Tray — a one-minute file on it

Why can a covenant breach at year end turn long-term debt into a current liability?

Under the usual accounting standards, a loan in breach of a covenant at the balance date — with no waiver obtained by then that takes away the lender's right to demand repayment — can have to be shown as due within a year, however long its term. The balance sheet changes shape: working capital can turn negative, the going-concern assessment tightens, and the accounts tell every other reader about the breach. That is why waiver requests arrive in December, and why a lender reads the breach before it signs a letter dated to fix the accounts.

WORKED INThe In-Tray — a one-minute file on itFinancial Reporting, Read by a LenderLoan Covenants, Explained

What is a working capital facility, and what is it actually sized against?

A working capital facility — usually a revolving limit rather than a term loan — funds the gap between paying suppliers and being paid by customers. It is sized against the cash conversion cycle applied to the revenue base, not against the borrower's stated need and not against the value of security. The most common structural failure in commercial lending is a working capital need financed as term debt, or a limit set to a round number that has no relationship to the cycle it is meant to bridge.

CHAPTER 3 OF THE BOOKReading Real Demand vs. Plugging Holes

WORKED INProduct file: Revolving Credit FacilityIssue 01 — Pacific Premium FoodsIssue 04 — Highview Industries

Why does a lender care which currency a facility is drawn in?

A multi-currency facility lets a borrower draw in more than one currency under a single limit. The credit question is not the convenience but the match: an exporter paid in one currency and carrying costs in another has an exposure that a facility can either hedge or amplify, depending on how the sub-limits are drawn. A borrower who cannot produce a currency schedule is not creating a documentation delay — the reluctance is information about the exposure.

WORKED INIssue 02 — Aoraki Trade ExportsThe In-Tray — files on currency and trade

What is a clean-down requirement on a working capital facility?

A clean-down is a covenant requiring a revolving facility's balance to return to zero, or a stated low watermark, for a continuous run of days, or by a stated date, every year — Issue 06's seasonal line must be back to zero by the last day of February. It is the bank's working-capital lie detector: a business whose cash cycle genuinely revolves passes through a natural low point annually, so the clean-down merely evidences what is already true. A facility that cannot clean down has told the bank, in data, that the need is permanent — and permanent needs are priced and structured as term debt, not carried indefinitely on a working capital line.

WORKED INProduct file: Revolving Credit FacilityIssue 06 — a seasonal facility with the covenant intact

What does self-liquidating mean in trade finance?

A facility is self-liquidating when the financed transaction itself generates the repayment: a trade loan clears from the buyer's payment, a discounted letter of credit clears from the issuing bank's settlement at maturity. The phrase describes a design, not a guarantee — self-liquidation holds only if the trade completes, the payer performs, and the money actually routes to the account the bank controls, and a credit desk assesses those conditions separately. When the mechanism fails, the loan does not disappear; it degrades into an ordinary exposure on the borrower, at a price that was set for something safer.

NOT Not a synonym for low-risk: the repayment logic is cleaner than other lending, and precisely because everything rides on one transaction, the failure of that transaction is the whole risk.

WORKED INProduct file: Trade LoanProduct file: LC Discounting

What is a balloon payment on a business loan?

A balloon is the larger amount left owing at a term loan's maturity because the scheduled instalments deliberately do not amortise the debt to zero. It is legitimate where the financed asset retains real value at the end, or where a credible refinancing genuinely exists; it is dangerous where it is simply how an unaffordable loan was made to look affordable. A credit desk reads every balloon as a deferred credit decision — someone, at maturity, in conditions nobody can see today, must refinance or repay — and asks who is carrying that refinance risk and whether they know it.

WORKED INProduct file: Term Loan

What is amortisation on a term loan, and why do banks insist on it?

Amortisation is the scheduled repayment of principal across a loan's life, usually inside a level monthly instalment covering principal and interest together. It does two jobs at once: the bank's exposure falls in step with the ageing of whatever was financed, and the borrower's total interest cost falls dramatically, because interest is charged on the outstanding balance and amortisation roughly halves the average balance over the term. On a five-year loan, full amortisation can cost close to half the total interest of an interest-only structure with principal repaid at maturity.

WORKED INProduct file: Term Loan, with the worked arithmetic

What is hardcore on a business overdraft?

Hardcore is the portion of an overdraft that never repays — the floor under the fluctuation. A healthy overdraft oscillates through zero as receipts and payments pass; one that has not seen the right side of a certain balance in a year is really a core debt of that size with a smaller true overdraft on top. Hardcore is the overdraft's version of a failed clean-down: permanent need wearing a short-term product, on the most expensive and least dependable money available — and the desk's response is the same in both cases, which is to name it and restructure the permanent part into a product built for permanence.

WORKED INProduct file: Business OverdraftProduct file: Term LoanThe In-Tray — a one-minute file on it

What does it mean to term out part of a working capital facility?

To term out is to move the part of a revolving line or overdraft that never repays into a term loan with a repayment schedule. It is the usual remedy when a line meant to swing back to zero has quietly become permanent, because a term loan says honestly what the debt is and sets a date by which it goes. A term-out restores the line to its purpose; it does not fix whatever made the need permanent, and the desk will ask what that was.

WORKED INTemporary or Permanent Working CapitalLine of Credit vs Term LoanProduct file: Business Overdraft

What is a club facility, and how does it differ from a syndicated loan?

A club facility is a loan shared by a small group of banks, usually each with its own relationship with the borrower, on one set of terms negotiated together. A syndicated loan is the larger version, arranged by lead banks and sold down to a wider group, with an agent bank administering it. In both, each bank holds a share and votes on consents and waivers, so one lender's view counts only as far as it persuades the others.

WORKED INIssue 07 — Coastline Retail GroupCorporate Banking vs Commercial BankingCorporate Lending and Credit Risk

When will a bank lend to a business unsecured?

An unsecured loan is one where the lender holds no charge over the borrower's assets and relies instead on its cash flow, its balance sheet and its covenants, usually including a negative pledge. It is common in corporate lending to large, rated or listed companies and rare for owner-managed businesses, where security and the owner's guarantee carry much of the second way out. An unsecured lender ranks behind every secured creditor in a failure, and the margin is priced for that.

WORKED INCorporate Banking vs Commercial BankingWhat Your Bank Holds as Security

What is a cash sweep on a business loan?

A cash sweep is a term that applies a set share of the cash a business generates above an agreed level to repaying the loan early. It lets a loan be sized to a cautious base case while the strong years pay it down faster, which suits a business with volatile earnings such as a farm or a commodity processor. How the swept cash is defined decides how hard the sweep bites, and that definition is where the negotiation belongs.

WORKED INWhen the Milk Price FallsProduct file: Term Loan

What is the difference between a finance lease and an operating lease?

A finance lease leaves the financier owning an asset while the business pays most of its cost over the term and pays or guarantees a residual at the end — the economics of a loan, in a lease's form. An operating lease or rental leaves the financier with both the asset and its residual value; the business pays for the use and hands the asset back. A credit desk reads both as fixed commitments beside the business's debt, whatever the accounts call them.

WORKED INEquipment Loan vs LeaseProduct file: Equipment FinanceThe In-Tray — a one-minute file on itLease-adjusted leverage, worked

What is a drawdown on a business loan, and what has to happen before one?

A drawdown is the borrower taking money under an approved facility — the whole of a term loan on the first day, or a development loan in stages as the building goes up. Each drawdown is a fresh point of control: the conditions precedent must be met before the first, and on a staged facility every later one waits on its own evidence, typically a quantity surveyor's certificate that the work has been done and that the money left will finish the job. A bank can refuse a drawing while a default is continuing, which is why a breach matters most on a facility that is not yet fully drawn.

WORKED INDrawing a Development LoanProduct file: Development Loan

What is an interest-only period on a business loan?

An interest-only period is a stretch at the start of a term loan, or one agreed later, during which the borrower pays interest but no principal. It suits an asset that takes time to earn — a new plant commissioning, an orchard coming into bearing — or a business through a bad season. Its cost is that the exposure does not fall while the clock runs, so the debt is still at its peak when the period ends, and a desk reads a request to extend one as a question about whether the repayment schedule was ever right.

WORKED INProduct file: Term LoanWhen the Milk Price Falls

What is the tenor of a loan, and how does a lender choose it?

The tenor is the length of a facility — the time until it must be repaid or renewed. A lender matches it to what is being financed and how it repays: a working capital line on a twelve-month review, an equipment loan over the working life of the equipment, a trade loan to the length of the trade cycle. A tenor longer than the asset's useful life lends against something that will be gone before the loan is, and one shorter than the repayment capacity builds a refinancing into the structure.

WORKED INProduct file: Term LoanProduct file: Equipment FinanceProduct file: Trade Loan

What does a facility's utilisation tell a bank?

Utilisation is how much of a facility's limit is drawn — at a point in time, and as a curve across the year. A bank watches the curve more closely than any single balance: a seasonal line that rises and falls with the trade is doing its job; one that sits near its limit all year has become core debt; one that is never used is a commitment the bank holds capital against for nothing. Sustained changes in utilisation, in either direction, are among the first things raised at an annual review.

WORKED INProduct file: Revolving Credit FacilityThe Bank Annual Review

What is a bullet repayment on a business loan?

A bullet loan repays its whole principal in one amount at maturity, with only interest paid along the way. It keeps the exposure at its peak for the life of the loan and makes the final payment a refinancing in all but name, which is why commercial lenders keep it for borrowers with strong access to other lenders or a clear source for the lump sum. A weak read of a borrower changes the structure first, and an amortising facility in place of a bullet is one of the first things a desk asks for.

NOT A bullet is not a balloon: a balloon leaves a large final payment after some principal has been repaid along the way; a bullet repays none until the end.

WORKED INDebt to EBITDA and LeverageHow Banks Assess Management QualityThe Six Months Before Your Loan Matures

What is a seasonal facility, and how does a bank size it?

A seasonal facility funds a cash need that builds and unwinds once a year — stock bought ahead of a retail peak, a dairy farm's costs before the milk is paid for — and is expected to come back down as the season's sales are collected. A bank sizes it against the season's proven peak rather than a forecast of a better one, and checks each year that it returns to its low point, often through a clean-down. A seasonal line that no longer comes down has stopped being seasonal.

WORKED INIssue 06 — Kowhai Retail GroupAgricultural LendingWhen the Milk Price Falls

What is a syndicated loan, and why do banks share deals?

A syndicated loan is a single facility funded by a group of lenders on identical terms, arranged by one or a few banks, documented once and administered by an agent. Banks share deals that are too large for one balance sheet, or for one bank's limit on a single name. A bank holding a share works from the arranger's information rather than its own diligence, and votes on waivers alongside lenders whose appetite differs from its own, so its view counts only as far as it persuades the others.

WORKED INCorporate Lending and Credit RiskCorporate Banking vs Commercial Banking

What is a maturity extension, or amend-and-extend, on a business loan?

A maturity extension moves a facility's final repayment date out — a few months on the same terms to let a refinancing complete, or, in its larger form, an amend-and-extend that pushes the maturity years out in exchange for changed terms, a fee or a higher margin. For a bank it is a way to see an exit happen rather than force it; for a borrower it is time bought with evidence. Asked for without a credible plan for the new date, it is the same refinancing problem with a later deadline.

WORKED INThe Six Months Before Your Loan MaturesRefinancing and Switching Banks

What is mezzanine finance, and how does a senior lender read it?

Mezzanine finance is debt that ranks behind the senior lender and ahead of the owners' equity, priced well above senior debt because it takes much of the loss if the business or project disappoints. To a senior lender it can be more capital beneath it or a warning: it raises the total debt the business must service, and its rights against the senior lender are set in an intercreditor agreement — the document a senior desk needs before it can read the file at all. A new mezzanine lender on 'very favourable' terms, whose intercreditor terms never arrive, is a question rather than a cushion.

WORKED INInterview quizBank Loan vs Private Credit

What is refinancing risk?

Refinancing risk is the chance that a loan cannot be repaid or replaced at maturity — that a balloon cannot be paid from cash, the same bank will not roll it, and another will not take it on acceptable terms. A desk assesses it when the loan is made, not when it falls due: a large residual at the end of a term loan is a risk it prices and structures for, which is why a balloon usually comes with a plan for how it will be met. For the borrower the work starts months before the date, because another bank's process takes time that cannot be bought back at thirty days.

WORKED INThe Six Months Before Your Loan MaturesRefinancing and Switching Banks

What is covenant headroom, and why does the test date matter as much as the ratio?

Covenant headroom is the distance between a borrower's current performance and the level at which a covenant is breached — enough room that ordinary volatility does not trigger extraordinary process. Headroom is only half the question. A covenant tested on calendar dates against a business running on a trade cycle can print its worst ratio at the same point every year while nothing is deteriorating, because the test lands when the facility is drawn and the receipts have not yet arrived. Before repricing or declining, ask whether the covenant date is the problem.

CHAPTER 6 OF THE BOOKSpotting Trouble Before It Spots You

WORKED INThe 90-day mismatchThe In-Tray — a one-minute file on it

What is a negative pledge in a loan agreement?

A negative pledge is the borrower's undertaking not to give security over its assets to anyone else without the lender's consent. It protects the lender's position whether or not the lender takes security itself, which is why it is the backbone of much unsecured corporate lending and why secured lenders include it too. In practice it is the clause a growing business trips on by accident: an equipment lease or a supplier's registered interest can count as a new security interest, and unless the agreement carves it out, each needs consent first.

WORKED INReading Your Facility LetterWhat Your Bank Holds as SecurityEquipment Loan vs LeaseThe In-Tray — a one-minute file on it

What is a condition precedent in a facility letter?

A condition precedent is something that must be done or delivered before the bank will let the borrower draw: signed security, a valuation, evidence of insurance, a director's certificate, sometimes an equity injection or a subordination deed. The list is the credit approval turned into a to-do list, and drawdown waits on its last item. A condition subsequent is the same idea with a deadline after drawdown, and missing it is a breach.

WORKED INReading Your Facility LetterProduct file: Development LoanIssue 08 — Basalt Ridge Developments

What counts as an event of default on a business loan?

An event of default is one of the listed circumstances that entitle a lender to act: typically non-payment, a covenant breach, a false statement, insolvency, a default under another lender's facility, a change of control, and often a material adverse change as the lender judges it. What the lender may then do — stop drawings, reprice, demand repayment, enforce its security — is set out in the agreement. A first breach usually starts a conversation rather than enforcement, but the clause is what gives the bank its seat in that conversation.

NOT Not the same as a review event, which obliges the two sides to talk and lets the lender vary terms; it does not let the lender act at once, though many review clauses let it require repayment on notice if no agreement is reached.

WORKED INReading Your Facility LetterLoan Covenants, ExplainedWhen Your Loan Goes to the Workout Team

What is a covenant waiver, and what does it cost?

A covenant waiver is the lender's written agreement not to treat a particular breach as a default, usually for one test date and on conditions. Waivers commonly come with a fee, a margin increase, more frequent reporting or a reset covenant, and a lender reads a request made before the test date very differently from a breach it discovers afterwards. A waiver repeated at every test is a sign that the covenant was set in the wrong place, or that the business has changed.

WORKED INLoan Covenants, ExplainedThe Monthly PackProblem Loans and WorkoutThe In-Tray — a one-minute file on itThe Bank in Your Audit File

What is a reservation of rights letter from a bank?

A reservation of rights is a lender's written statement that, although it is not acting on a default now, it is not giving up its right to act later. It exists because a lender that knowingly carries on as normal after a default can be argued to have waived it. Receiving one means the bank has noticed and recorded the breach; it is often the first letter a business sees as its file moves toward a specialist team, and it is not in itself a demand.

WORKED INWhen Your Loan Goes to the Workout TeamProblem Loans and Workout

What is a term sheet in commercial lending, and how binding is it?

A term sheet sets out the proposed shape of a facility — amount, purpose, tenor, pricing, security, covenants and conditions — before any documents are drafted. In commercial lending it is usually indicative until credit has approved it, and even an approved term sheet is normally subject to documentation and conditions precedent rather than a commitment to lend. Its real value is as the place where structure is argued: a point conceded on the term sheet is very hard to win back in the facility letter.

WORKED INIssue 11 — The Term Sheet WarReading Your Facility Letter

What is a condition subsequent in a loan agreement?

A condition subsequent is something a borrower must do or deliver within a set period after the facility has been drawn — a security registration still in process at drawdown, an updated valuation, insurance noting the bank's interest, the first audited accounts. The bank has lent on the promise, so missing the deadline is a breach in its own right, and usually an event of default once any cure period has run. Conditions subsequent let a deal close on time without the bank giving up what it approved; their weakness is that nobody diarises them.

NOT A condition subsequent is not a condition precedent: a condition precedent must be met before the first drawing, a condition subsequent within a deadline after it.

WORKED INReading Your Facility Letter

What is a review event in a facility agreement?

A review event is a circumstance written into a facility agreement — commonly a change of control, the loss of a key licence or contract, a change in the business's main activity, a qualified audit opinion — that entitles the bank to review the facility rather than to declare a default. On review the bank may carry on, reprice or ask for more security, and if the two sides cannot agree within the stated period it may require repayment. For a borrower it is the better clause to have wherever something outside its control could happen: a review event opens a negotiation, where an event of default would hand the bank its remedies.

NOT A review event is not an event of default: it gives the bank a right to reconsider and, failing agreement, to require repayment after notice — not an immediate right to enforce.

WORKED INReading Your Facility LetterAudited, Reviewed or Compiled

What does “repayable on demand” mean on an overdraft or business facility?

A facility repayable on demand — most overdrafts, and some facilities that look committed — can be called by the bank at any time, without a breach to point to. In practice banks rarely call a demand facility that is performing, and the annual review is where the decision to keep the money available is actually made. What the words change is the borrower's position on the bad day: a demand facility gives no promise to rely on, and a business funding a permanent need with one is borrowing its future from the bank's goodwill.

WORKED INThe Bank Annual ReviewProduct file: Business OverdraftReading Your Facility Letter

What is a material adverse change clause in a business loan?

A material adverse change clause lets a lender treat a significant deterioration in the borrower's business, assets or prospects as an event of default — or, in its milder forms, as a reason to refuse a further drawing — without any specific covenant having been breached. Because what counts as material is usually left to the lender's opinion, borrowers negotiate to narrow it, and lenders rarely rely on it alone: a MAC is hard to prove and invites a dispute, so it is usually invoked beside harder breaches. Its practical work comes earlier, as the clause that keeps a deteriorating borrower talking.

WORKED INReading Your Facility Letter

What is a cross-default clause in a loan agreement?

A cross-default clause makes a default under any of the borrower's other debts — another bank's loan, a lease, an asset finance contract — an event of default under this facility too. It stops one lender waiting while another is paid down or enforces, because whatever happens to one obligation happens to all of them. The detail is in the threshold and the trigger: a clause that bites only above a minimum amount, and only when another debt has actually been accelerated rather than merely missed, gives the business room to settle a dispute without bringing every lender in at once.

WORKED INCorporate Lending and Credit RiskReading Your Facility Letter

What is a change of control clause in a business loan?

A change of control clause lets a lender act — require repayment, or review the facility — if the ownership or control of the borrower changes without its consent. A bank lends to a business and to the people running it, and a sale can change both the risk and the strategy the loan was approved for. It is the clause that turns the sale of a business into a refinancing question, which is why the bank is one of the first calls a seller needs to make, well before the deal is signed.

WORKED INReading Your Facility Letter

What is a cure period, or grace period, in a loan agreement?

A cure period is the time a facility agreement allows a borrower to put a breach right before it becomes an event of default — a few business days for a missed payment, longer for a late report or a breach that can be remedied. It is negotiated, not given: whether a breach can be cured at all, and in how long, is one of the few clauses that decides how a bad quarter plays out. Some agreements also allow an equity cure, in which the owners inject money to bring a financial covenant back into line, usually a limited number of times over the life of the loan.

WORKED INReading Your Facility LetterLoan Covenants, Explained

What is a compliance certificate on a business loan?

A compliance certificate is the borrower's signed statement, delivered with each set of accounts the facility requires, that it has met its financial covenants — with the calculation showing how. It is where the covenant definitions meet the numbers, and where a lender first sees a test tightening. A desk reads the workings rather than the conclusion, and treats a certificate that arrives late, or with a definition quietly reinterpreted, as information in itself.

WORKED INLoan Covenants, ExplainedHow Banks Manage Credit RiskReading Your Facility Letter

What are information undertakings in a facility agreement?

Information undertakings are the borrower's promises about what it will tell the bank and when: management accounts monthly or quarterly, annual accounts at a stated level of assurance within a stated number of days of year end, compliance certificates, budgets, and prompt notice of anything material. They are how a lender keeps reading a file between reviews. Breaching them is rarely what makes a loan go wrong, but late or thin reporting is one of the earliest signs that something already has.

WORKED INAudited, Reviewed or CompiledThe Monthly PackHow Banks Manage Credit Risk

What does releasing a personal guarantee actually cost the bank?

A personal guarantee release removes a named individual's obligation to repay if the borrower cannot. It reads as an administrative amendment and behaves as a one-way door: the guarantee does not come back when conditions worsen, and the request usually arrives at a cycle high, when the numbers make it easiest to say yes. The disciplined form is to stage a release against demonstrated performance rather than granting it against a good year.

WORKED INIssue 03 — Kauri Dairy Holdings

What is a general security agreement, and what does it give the bank?

A general security agreement is a charge over all of a company's present and future assets — receivables, stock, plant, equipment and the proceeds of all of them — registered so that it ranks ahead of lenders who register later, though a supplier or equipment financier registered over the goods it financed can rank ahead of it on those goods. It is the usual security for a trading business's bank facilities in New Zealand and Australia; other markets reach the same place with a fixed and floating charge or a blanket lien. What it is worth to the bank is what those assets would realise in a failure, which is usually well below what the balance sheet shows.

NOT Not a guarantee: it reaches the company's assets, not the owners'. The personal guarantee is a separate document that reaches outside the company.

WORKED INWhat Your Bank Holds as SecurityLVR, Security and CollateralIssue 04 — Highview IndustriesThe In-Tray — a one-minute file on it

What does it mean to subordinate a shareholder loan to the bank?

Subordination is an agreement that one creditor's claim ranks behind another's — most often, that money the owners have lent their company will not be repaid until the bank has been. A lender asks for it so that a director's loan behaves like equity: it stays in the business, supports the balance sheet, and cannot be withdrawn ahead of the bank when cash is tight. It is usually done by deed, and it often appears in a facility letter as a condition precedent.

WORKED INReading Your Facility LetterBank Loan vs Private CreditThe In-Tray — a one-minute file on it

What is an intercreditor agreement?

An intercreditor agreement sets out how two or more lenders to the same borrower rank against each other and what each may do: who is repaid first, over which assets, who can enforce and when, and what either needs the other's consent for. It matters most when a bank and a second lender — a fund, a mezzanine lender, a vendor who has left money in the business — rely on one cash flow. A bank reads it as closely as its own facility letter, because it decides who controls the outcome if the business struggles.

WORKED INBank Loan vs Private CreditCorporate Lending and Credit Risk

What is a loan to value ratio?

The loan to value ratio is the loan divided by the value of the security behind it — the share of the asset's value the bank has lent against. Banks set maximum ratios by type of asset, lower for assets that are harder to sell or lose value faster, because the gap between the loan and the value is what absorbs a fall in price and the costs of a forced sale. A ratio is only as good as the valuation under it, which is why a desk asks which value — market, forced-sale or the borrower's own — it was struck on.

NOT Not loan to cost: a development lender measures the loan against the cost of the project as well, because the finished value is still a forecast.

WORKED INLVR, Security and CollateralWhat Your Bank Holds as SecurityProperty Development FinanceThe In-Tray — a one-minute file on it

What is forced-sale value, and why does a bank use it?

Forced-sale value is what an asset would fetch if it had to be sold quickly, by someone other than its owner, in the circumstances in which a lender would be selling it — usually a business that has failed. It sits below market value, sometimes far below for stock, specialised plant or a half-finished building. A lender reads security at forced-sale value because that is the only situation in which the security is ever used, and the gap between book, market and forced-sale value is where most disappointment about security comes from.

WORKED INLVR, Security and CollateralWhat Your Bank Holds as SecurityEquipment Loan vs LeaseThe In-Tray — a one-minute file on it

What is the PPSR, and why does a bank register on it?

The Personal Property Securities Register is the public register, in New Zealand and Australia, of security interests over assets other than land — receivables, stock, vehicles, plant, and the general security a bank takes over a company. Registration is what makes a security interest hold against other creditors and a liquidator, and priority between secured parties generally follows the order of registration, with exceptions for financiers of specific goods. A credit desk searches the register before it lends, because it is where a business's other lenders, lessors and suppliers on retention of title show up, whether or not anyone mentioned them.

WORKED INWhat Your Bank Holds as Security

What is a retention of title clause, and why does it matter to a lender?

A retention of title clause — a Romalpa clause, in the older name — lets a supplier keep ownership of goods it has delivered until it is paid for them. For a lender it means some of the stock in a borrower's warehouse may not be the borrower's to give as security: a supplier whose interest is properly protected can recover its goods or their proceeds ahead of the bank. A desk lending against inventory asks which suppliers sell on these terms and discounts the stock for it; in New Zealand and Australia it also searches the PPSR, where a supplier must register the interest for it to hold.

WORKED INThe In-Tray — a one-minute file on itThe Bank in Your Audit File

What is a purchase money security interest, and why can it rank ahead of the bank?

A purchase money security interest is security taken by whoever financed the acquisition of a particular asset — the supplier selling stock on retention of title, the financier or lessor of a piece of equipment — over that asset and its proceeds. Under the personal property securities regimes of New Zealand and Australia, a purchase money interest registered in time can rank ahead of an earlier general security over the same goods, so a bank's charge over all of a company's assets does not reach the stock and plant that others financed. A desk reads the register for them, because they explain why security over everything can recover much less than everything.

WORKED INWhat Your Bank Holds as SecurityEquipment Loan vs LeaseProduct file: Equipment Finance

Who are preferential creditors, and why do they matter to a secured lender?

Preferential creditors are the claims the law pays ahead of ordinary unsecured creditors in an insolvency — chiefly employees' unpaid wages and holiday pay and, in some countries, certain taxes. In New Zealand, Australia and the United Kingdom they also rank ahead of a lender's security over circulating assets such as stock and receivables. That is why a desk reads a borrower's wage bill and tax position as a deduction from what its security over working assets would recover: that security can be worth much less on the day of failure than its book value, before a single debtor disputes an invoice.

WORKED INThe In-Tray — a one-minute file on itWhat Your Bank Holds as Security

What is a letter of comfort, and is it a guarantee?

A letter of comfort is a statement of intention that stops short of a binding promise — a parent company saying it intends to support a subsidiary, or a bank saying it has no current intention of withdrawing a facility. Its value is exactly what its words say and no more, and courts in several countries have held that a letter of comfort is not a guarantee. A lender that needs a parent's support takes a guarantee; an auditor reading a bank's letter reads the dates and conditions in it, not its warmth.

NOT A letter of comfort is not a guarantee: it records an intention, and a lender relying on one has nothing to enforce if the intention changes.

WORKED INGoing concern and bank support

What is a cross-guarantee in a group of companies?

A cross-guarantee is a guarantee given by each company in a group for the bank debt of the others, usually backed by each company's own security, so that the lender can look to the whole group's assets whichever company borrowed. It is how a bank lends to a group whose cash, assets and borrowings sit in different entities. Its consequence is the one most often missed: a subsidiary with no debt of its own can be liable for all of the group's, and its accounts should say so.

WORKED INThe Bank in Your Audit FileIssue 07 — Coastline Retail Group

What is a floating charge, and why can it shrink without anyone breaching anything?

A floating charge is security over a changing pool of assets — stock, receivables, cash — that the business keeps buying, selling and collecting in the ordinary course, so its value at any moment is whatever the balance sheet holds that day. Its weaknesses arrive together on the day it is needed: those assets have usually run down before a failure, and in many countries preferential creditors are paid from them first. In New Zealand and Australia the general security agreement does this work, over circulating assets, beside a fixed charge on named ones.

NOT A floating charge is not a fixed charge: a fixed charge sits on a named asset that cannot be sold without the lender's consent; a floating charge lets the business deal with what it covers until the charge is enforced.

WORKED INThe In-Tray — fixed against floating securityThe In-Tray — preferential creditors and the floating chargeWhat Your Bank Holds as Security

What is structural subordination?

Structural subordination is the position of a lender to a holding company whose assets are shares in operating subsidiaries with creditors of their own: it reaches the subsidiaries' assets only through those shares, after the subsidiaries' lenders and trade creditors have been paid. No document ranks it behind anyone; the group's structure does. Lenders close the gap with guarantees and security from the operating subsidiaries themselves, and read a group's debt by where it sits as well as by how much there is.

NOT Structural subordination is not contractual subordination: no agreement ranks the holding company's lender behind anyone — the corporate structure does it.

WORKED INThe In-Tray — a one-minute file on itFinancial Management, Read by a LenderFinancial Reporting, Read by a Lender

What is a recovery waterfall in an insolvency?

A recovery waterfall is the order in which the money realised from a failed business is paid out: the costs of realising it, then each secured creditor from the assets its security covers — with preferential claims ahead of security over circulating assets where the law says so — and whatever is left shared among unsecured creditors in proportion to what they are owed. A secured lender whose security falls short ranks alongside the unsecured creditors for the shortfall. It is a sum, not a principle: the same loan can recover nearly everything or a fraction, depending on what sits above it.

WORKED INThe In-Tray — the recovery waterfall, workedProblem Loans and WorkoutLVR, Security and Collateral

What is a first mortgage, and why does a lender insist on ranking first?

A first mortgage is security over land and buildings that ranks ahead of any later mortgage over the same property: on a sale, the first mortgagee is repaid in full before a second mortgagee receives anything. Lenders against property ask for it because their loan-to-value ratio only means something if no one stands between them and the value — a second mortgage over the same asset carries most of the risk of a fall in price. On a development loan it covers the land and everything built on it, and its release unit by unit is how the sales repay the loan.

WORKED INProduct file: Development LoanIssue 08 — Basalt Ridge DevelopmentsLVR, Security and Collateral

What does pari passu mean in a loan agreement?

Pari passu means ranking equally: creditors whose claims are paid in proportion to their size, none ahead of the others. In a club or syndicated facility the lenders' shares rank pari passu, so a recovery is split by share rather than by who acts first; in unsecured lending, a pari passu undertaking promises the lender it will not rank behind the borrower's other unsecured debt. Equal ranking is not an equal outcome — it settles the order, and what each lender recovers still depends on what there is to share.

WORKED INIssue 07 — Coastline Retail GroupThe In-Tray — the recovery waterfall, worked

What is a borrowing base, and when is it the wrong answer?

A borrowing base ties a facility limit to the eligible assets behind it — typically a percentage of current receivables and inventory, reported and recalculated monthly. It is the right structure where the risk is that the asset pool shrinks faster than the limit does. It is the wrong structure on a clean file: conditions cost the borrower administrative weight every month and tell a good client the bank read a template rather than the numbers. Intensity of structure is a scarce resource priced in relationship currency.

CHAPTER 3 OF THE BOOKReading Real Demand vs. Plugging Holes

WORKED INIssue 04 — Highview Industries

What is dilution in invoice finance?

Dilution is the percentage of invoiced value that never converts to cash — eroded by credit notes, rebates, disputes, returns and adjustments rather than by debtor insolvency. It is the number non-specialists miss when they look at a receivables book, and the one that sets the honest advance rate: a ledger that quietly dilutes at eight percent cannot safely support a ninety percent advance, whatever its aging profile looks like. Financiers study dilution history before setting terms because it behaves like a trading characteristic of the business, not a one-off event.

WORKED INProduct file: Invoice Finance

What is an advance rate in receivables and trade finance?

The advance rate is the percentage of eligible collateral value a financier will fund — in Issue 02, the senior read caps the USD sub-limit at 80% of eligible USD receivables. The unfinanced margin is structure, not meanness: it keeps the client's own money in the transaction and absorbs the uncontrollables — disputes, currency movement, dilution — before the facility goes underwater. A request to finance one hundred percent of anything is itself information, and the question it raises is why the client has no margin of their own in a deal they expect to profit from.

WORKED INProduct file: Invoice FinanceProduct file: Trade Loan

What are eligible receivables in invoice finance or a borrowing base?

Eligible receivables are the invoices a financier will lend against once its rules have excluded the rest — typically invoices past a stated age, amounts owed by related companies, debtors who are also suppliers, disputed or foreign debts the financier will not take, and any share of one customer above a set limit. The advance rate applies only to what remains, so the funding a ledger supports is often well below its face value. The eligibility rules are the financier's reading of which debts will actually turn into cash, and a business should read them before it plans around the headline limit.

WORKED INProduct file: Invoice FinanceIssue 02 — Aoraki Trade ExportsIssue 13 — Tasman Crest Foods

What is a concentration limit in lending?

A concentration limit caps how much exposure may build in one place. Across a bank's book the limits run by sector, geography and single name, and they are why appetite can close against a whole industry while an individual business in it has changed nothing. Inside a receivables facility, a concentration limit caps the share of the borrowing base any one debtor may make up, so that a ledger dominated by one customer cannot be financed as if it were spread across many.

WORKED INHow Banks Manage Credit RiskProduct file: Invoice FinanceThe In-Tray — a one-minute file on it

What does “with recourse” mean in invoice finance and discounting?

Recourse is the financier's right to come back to its own client when the debtor does not pay: under recourse invoice finance, an invoice still unpaid after a set period is recycled back to the client and its advance repaid; under recourse discounting of a letter of credit, the bank can claim the advance back from the exporter. Recourse is cheaper because the client keeps the credit risk of its customers, and that risk stays on its balance sheet as a contingent liability. Non-recourse finance moves the risk to the financier, usually with credit insurance behind it, and is priced for it.

WORKED INProduct file: Invoice FinanceProduct file: LC Discounting

What is invoice discounting, and how is it different from factoring?

Invoice discounting is receivables finance in which a business borrows against its unpaid invoices but keeps collecting its own sales ledger, so its customers never know the invoices are financed. The confidentiality is both its appeal and its risk: the financier is trusting the client's own collection conduct and bookkeeping, so it offers discounting to businesses whose ledger and controls deserve that trust, and checks them through regular audits of the ledger.

NOT Invoice discounting is not factoring: under factoring the financier takes over the sales ledger, the debtors are told and pay the financier directly, and collection becomes the financier's job.

WORKED INProduct file: Invoice Finance

What is trade credit insurance, and why does a bank care about it?

Trade credit insurance pays a seller a stated share of an invoice if the buyer fails to pay through insolvency or, under most policies, prolonged default. For a bank lending against receivables it changes what is being underwritten: the insured part of an open-account ledger leans on the insurer as well as the buyer, so it can be financed where uninsured paper would not be. The desk reads the policy as closely as the ledger — the buyer limits, the exclusions, the claims conditions — because cover that lapses on a late notification is not cover.

WORKED INIssue 13 — Tasman Crest FoodsProduct file: Invoice Finance

What is a performance bond, and what does a bank take on when it issues one?

A performance bond is a bank guarantee that a contractor will perform a contract: if it does not, the principal who required the bond — the developer or the owner — can call on the bank for a stated amount, often a percentage of the contract value. The bank pays on demand and then claims the amount from its own customer, so issuing a bond is lending in waiting, approved and secured as if the money might be drawn. A bond that should have lapsed at practical completion but was never returned is exposure the business has forgotten and the bank still carries.

WORKED INProduct file: Bank GuaranteeBank Guarantee vs Letter of CreditDrawing a Development Loan

What is a standby letter of credit, and is it the same as a bank guarantee?

A standby letter of credit is a guarantee written in the form of a letter of credit: payable when the beneficiary presents a document stating that the bank's customer has not paid or performed, rather than on shipping documents. It does a guarantee's work, and it is common in markets where banks were historically restricted from issuing guarantees, and across borders where the beneficiary wants the international rules that govern letters of credit. For the bank that issues it the exposure is the same as a guarantee's — contingent until called, then a loan to its customer.

WORKED INBank Guarantee vs Letter of CreditProduct file: Bank Guarantee

What is a documentary collection in trade finance?

A documentary collection is an export payment method in which the seller's bank sends the shipping documents to the buyer's bank, which releases them — and with them control of the goods — only when the buyer pays (documents against payment) or accepts a bill to pay later (documents against acceptance). The banks handle the documents but do not promise payment, which makes it cheaper than a letter of credit and riskier for the seller: if the buyer refuses the documents, the goods are on a wharf in another country. A desk lending to an exporter reads which of its sales run on collections, and to whom.

WORKED INBank Guarantee vs Letter of CreditIssue 02 — Aoraki Trade Exports

What is a letter of credit, and when does an exporter need one?

A letter of credit is a bank's undertaking to pay an exporter on presentation of the documents the credit specifies — invoice, transport documents, certificates — whether or not the buyer is still willing to pay. It exists because the two sides of a cross-border sale do not yet trust each other enough to trade on open account, and it moves the credit risk from the buyer to the bank that issued the credit. Its protection is exact rather than generous: documents that do not match the credit's terms can be refused, so an exporter can ship perfectly and still not be paid.

WORKED INBank Guarantee vs Letter of CreditProduct file: LC DiscountingIssue 13 — Tasman Crest Foods

What is a sub-limit within a business facility?

A sub-limit is a ceiling, inside a facility's overall limit, on one use of it — drawings in a particular currency, lending against one buyer's invoices, guarantees issued under a trade line. It lets one facility do several jobs while the bank controls how much of it any single risk can take up. In Issue 02 the senior read builds the line as an NZD core sized to local costs plus a USD sub-limit capped at 80% of eligible USD receivables; in Issue 13 the move to open account is underwritten through a buyer sub-limit set off a file on the buyer itself.

WORKED INIssue 02 — Aoraki Trade ExportsIssue 13 — Tasman Crest FoodsProduct file: FX Facility

What does trading on open account mean for an exporter and its bank?

Open account is selling on credit terms with nothing between seller and buyer but the invoice: the goods ship, and the buyer pays at the agreed date. It is the cheapest and simplest way to trade and the riskiest for the seller, which carries the buyer's credit risk in full — the reason exporters ask for letters of credit from buyers they do not yet know, and move to open account as trust builds. For the seller's lender the question moves with it: on open account the debtor it is relying on is the buyer, so the buyer is what gets underwritten, often with credit insurance behind it.

WORKED INIssue 13 — Tasman Crest FoodsBank Guarantee vs Letter of CreditHow Banks Read Exporters

What is a discrepancy under a letter of credit?

A discrepancy is any point on which the documents an exporter presents under a letter of credit fail to match the credit's terms — a date, a quantity, a description, a missing signature. The issuing bank may refuse discrepant documents and the tolerance is exact, so an exporter can ship perfectly and still not be paid until the buyer agrees to waive the discrepancy — by which time payment depends on the buyer again. A clean presentation record is therefore part of an exporter's credit: years without a discrepant document are evidence of a back office a bank can rely on.

WORKED INBank Guarantee vs Letter of CreditProduct file: LC DiscountingIssue 13 — Tasman Crest Foods

What is documents against acceptance in trade finance?

Documents against acceptance is a documentary collection in which the buyer's bank releases the shipping documents — and with them the goods — when the buyer accepts a bill of exchange promising to pay at a later date, rather than when it pays. The buyer gets the goods and the credit period; the seller holds an accepted bill, a clearer claim than an invoice but still only as good as the buyer. A desk reads an exporter's ledger split between letters of credit, documents against acceptance and open account, because each puts the risk in a different place.

WORKED INHow Banks Read ExportersBank Guarantee vs Letter of Credit

What does an early settlement discount really cost a business?

An early settlement discount gives a customer a percentage off the invoice for paying sooner than the agreed terms — 2% for paying in ten days rather than forty, say. Giving up 2% to be paid thirty days sooner is borrowing for thirty days at about 2%, which over a year comes to roughly 25%, dearer than almost any bank facility. A lender also reads it as a tell: debtor days that improve because of a discount have been bought rather than earned, and the cost sits in the margin line.

WORKED INThe In-Tray — a one-minute file on itIssue 04, from the customer's chairFinancial Management, Read by a Lender

What is an aged debtors report, and what does a lender look for in it?

An aged debtors report lists what each customer owes, split by how long each invoice has been outstanding — current, then thirty, sixty, ninety days and beyond. It is the receivables ledger as a lender actually reads it: which customers make up the balance, how much is overdue, whether the overdue part is growing faster than sales, and which debts sit past the age a financier would count as eligible. Asked for in an interview or a credit review, it should come with a view of what it is expected to show, and why that would change the answer.

WORKED INIssue 01 — Pacific Premium FoodsProduct file: Invoice FinanceCommercial banking interview questions

What is a collection account, or trust account, in receivables finance?

A collection account — or trust account — is the account a financed business's customers pay into, held so that receipts reduce the lender's advance before the business can spend them. It is how a receivables or trade financier stays in control of the cash its collateral turns into. Its weakness is the client's own conduct: under confidential invoice discounting the client collects its own ledger, and receipts that stray from the trust account are usually the first sign that the arrangement is failing.

WORKED INProduct file: Invoice FinanceProduct file: Trade Loan

What is availability under a borrowing base or invoice finance facility?

Availability is what a business can actually draw under an asset-based facility at a given moment: its eligible collateral multiplied by the advance rate, less any reserves, and never more than the facility limit. It moves with the collateral — falling as customers pay, rising as new invoices are raised — so the headline limit and the money available can be far apart. Availability contracts exactly when a weakening business needs it most, as debtors age past eligibility and disputes grow.

WORKED INProduct file: Invoice FinanceBank Loan vs Private Credit

What is loan to cost on a development loan?

Loan to cost is the development lender's advance measured against the total cost of the project — land, construction, professional fees, financing costs and contingency — rather than against the finished value. It is a core test on a development loan because it fixes how much of the project's cost the developer's own equity carries, and that equity goes in before the bank's money does. The desk reads it beside presales and the cost contingency: a comfortable loan to cost with weak presales is still a loan repaid only if the completed stock sells.

NOT Not the same as loan to value: value is what the finished project is expected to be worth, cost is what it takes to build, and a lender who confuses them is lending against a valuer's opinion instead of a budget.

WORKED INProduct file: Development LoanIssue 08 — Basalt Ridge DevelopmentsProperty Development Finance

What are presales, and why does a development lender count them?

Presales are the unconditional contracts to buy units of a development signed before the bank funds construction, measured as the share of the debt — or of the units — they cover. They are the development loan's first way out: if the presold units settle at completion, that cash repays the facility before the lender depends on the open market. The desk reads the cover, the buyers and their deposits, and the settlement risk if values fall between contract and completion; a presale that does not settle is not a presale.

WORKED INProduct file: Development LoanIssue 08 — Basalt Ridge DevelopmentsProperty Development Finance

What is an interest reserve on a development loan?

An interest reserve is the part of a development facility set aside to pay the loan's own interest during construction, when the project has no income of its own. It is capitalised — added to the debt rather than paid in cash — so the facility grows through the build, and the reserve is a line in the project budget like any other. The desk sizes it from the build programme and the rate, and reads a delay as a draw on it: a project that runs late consumes its interest reserve, and the interest still to come becomes a cost-to-complete gap the developer must fund before the bank advances more.

WORKED INProduct file: Development LoanProperty Development Finance

What does a quantity surveyor do for a development lender?

A quantity surveyor is the independent cost professional a development lender relies on. Before the loan is approved they check that the budget will build the building; before each drawdown they inspect the site, certify the work claimed and its value, and confirm the cost still to complete. The lender funds against the certificate, not the builder's claim, and a certificate showing more cost to complete than money available stops the drawdown until the gap is filled.

WORKED INDrawing a Development LoanProduct file: Development LoanIssue 08 — Basalt Ridge Developments

What is a retention in a construction contract?

A retention is the share of each progress payment that the party paying for the work holds back from the contractor until the work is complete and its defects are put right. It gives the payer leverage over defects, and it means the contractor's cash lags its invoices. Lenders treat it accordingly: a development lender tracks retentions as cost still to be paid, and a lender to a contractor leaves retentions receivable out of any borrowing base, because they cannot be collected until the job is signed off.

WORKED INDrawing a Development LoanProduct file: Development Loan

What is peak debt?

Peak debt is the highest the borrowing reaches over the life of a facility or a season — on a development loan, usually just before the first sales settle; on a seasonal line, when the stock has been bought and not yet sold. Lenders size limits, security and interest reserves against the peak, not the average, because the peak is when the bank is most exposed and the project or season least proven. A forecast that understates the peak is a common reason a facility runs out before the plan does.

WORKED INDrawing a Development LoanIssue 06 — Kowhai Retail GroupProduct file: Development Loan

What is cost to complete on a development loan?

Cost to complete is the money still needed to finish a development — construction, fees, contingency and interest — as the lender's quantity surveyor estimates it at each stage. The test at every drawdown is that the undrawn loan plus any unspent equity still covers it; when it does not, the project is out of balance, and the developer must put in the difference before the bank releases anything more. It is the number that turns a building programme into a solvency test, month by month.

WORKED INDrawing a Development LoanProduct file: Development LoanIssue 08 — Basalt Ridge Developments

What is a sunset clause in an off-the-plan sale?

A sunset clause is a date in an off-the-plan sale contract by which the development must be completed and titles issued; if it is not, the buyer — and in some cases the developer — can cancel. For the lender the presales are the repayment, so the sunset dates are read against the building programme at every drawdown, and a delay that approaches them is a conversation, not a footnote. In a rising market buyers rarely walk away; in a falling one, a missed sunset date can turn a presold project into an unsold one.

WORKED INDrawing a Development LoanProperty Development Finance

What is practical completion in a construction project?

Practical completion is the stage at which a building is finished except for minor defects, can be used for its purpose, and is certified as such under the building contract. It sets off a chain of consequences: the builder's exposure to delay damages stops, the defects period begins and part of the retentions is usually released, bonds tied to construction often lapse, and on a presold development the clock starts on buyers settling. For the lender it is not repayment — the loan stays fully drawn until titles issue and the sales settle.

WORKED INDrawing a Development LoanProduct file: Bank Guarantee

What is a capitalisation rate, and why does it move a property's loan-to-value?

The capitalisation rate is the yield buyers demand from an income-producing property: value is the property's net operating income divided by the cap rate. Because the rate is set by the market rather than by the building, a rise in it lowers the value of every comparable property at once — a building earning US$1.0m a year is worth US$20m at a 5% yield and about US$16.7m at 6%. The loan has not moved, so its loan-to-value ratio rises without anything happening to the building, which is why property lenders test value at a higher yield than today's.

WORKED INThe In-Tray — a one-minute file on itLVR, Security and Collateral

What is a development feasibility, and how does a lender read it?

A development feasibility is the developer's projection of a project's economics: land, construction, fees, interest and contingency on one side, the expected sales on the other, and the margin between them. A lender reads it as the developer's argument rather than as a fact — testing the sale prices against presales and comparable sales, the build cost against its quantity surveyor's estimate, the programme against the interest it will consume — because every overrun and every price cut comes out of that margin before it reaches the bank.

WORKED INProperty Development FinanceIssue 08 — Basalt Ridge DevelopmentsDrawing a Development Loan

What is a release price on a development loan?

A release price is the minimum amount from each unit's sale that must go to the development lender before it releases its mortgage over that unit. It is set so that the loan is repaid faster than the security is sold — usually well before the last unit settles — and a developer who wants to sell some units below their feasibility price needs the lender's agreement if the net proceeds would fall below it. It is how the sales repay the loan in step with the bank giving up its security.

WORKED INDrawing a Development LoanProduct file: Development Loan

What is a construction contingency, and what happens when it runs out?

A contingency is the part of a development's budget set aside for costs that will arise but cannot yet be named — ground conditions, design changes, price rises. It absorbs an overrun first; once it is gone, the lender stops funding until the developer puts in more equity, because the test at every drawdown is that the money left still finishes the job. The lender's quantity surveyor sizes it for the project rather than to a rule of thumb, and watches how fast it is used: a contingency spent early is a forecast of the overrun still to come.

WORKED INDrawing a Development LoanProduct file: Development LoanIssue 08 — Basalt Ridge Developments

What is on-completion value in development lending?

On-completion value is a valuer's estimate of what a development will be worth once it is finished — the basis of the loan-to-value ratio on completion, which development lenders test beside loan to cost. Loan to cost asks how much of the project the bank is funding; loan to value on completion asks whether the finished asset would cover the debt if the sales did not. It is an estimate of a future market, so a lender reads it against what buyers are actually paying under the presales, not against the prices the feasibility hopes for.

WORKED INProduct file: Development LoanProperty Development Finance

What is a commitment fee, and why do banks charge for money that has not been drawn?

A commitment fee is the charge on the committed but undrawn portion of a facility, most visibly on revolving credit facilities. The bank must hold capital and plan funding against the whole committed limit — if every client drew in full tomorrow, the bank has promised to fund it — so the undrawn half of the promise has a real cost. Some banks charge it on the undrawn part alone, others as a line fee on the whole limit — Issue 03's seasonal line carries 0.40% on the limit. It is the item borrowers most often discover after signing rather than before, which is why an honest quote is the all-in cost at several utilization levels, never the headline drawn rate alone.

WORKED INProduct file: Revolving Credit FacilityHow Banks Work — why capital is scarce

What is a break cost on a business loan?

A break cost is the charge for repaying fixed-rate money before the end of its fixed period. When the rate was fixed the bank arranged its own funding or hedging at that rate for the whole term, and if wholesale rates have fallen since, unwinding that position costs it money; the break cost passes that loss to the borrower. It is a cost of refinancing rather than a penalty, and it can be nothing or a great deal depending on where rates have moved — which is why the facility agreement is read before the new bank's offer is accepted.

WORKED INRefinancing and Switching BanksPricing and FeesThe Six Months Before Your Loan Matures

What is a margin ratchet on a business loan?

A margin ratchet steps a loan's interest margin down as a stated ratio improves — usually leverage — and up as it worsens, according to a grid in the facility agreement. It rewards a business for paying debt down and prices the bank for the risk it actually holds, but it ties the interest bill to the covenant definitions: the same choices about what counts as debt and as earnings now decide what the business pays as well as whether it complies. Read the step points and the test dates; a ratchet that moves only at an annual review moves late in both directions.

WORKED INReading Your Facility LetterThe In-Tray — a one-minute file on it

What is a line fee on a business loan?

A line fee is charged on the whole limit of a facility — usually an overdraft or revolving line — whether or not the money is drawn: the price of the bank holding the funds available. It is easy to miss when comparing offers, because a lower margin with a higher line fee can cost more on a facility that is mostly undrawn; the honest comparison adds the two and re-expresses them against the balance the business actually expects to carry. A smaller limit is a smaller fee, which is the cheapest negotiation most borrowers never have.

NOT A line fee is not a commitment fee in the narrow sense: a line fee is charged on the whole limit, drawn or not, and a commitment fee on the undrawn part only. Facility letters use the two names loosely, so read what each is charged on.

WORKED INPricing and FeesWhy Your Bank Repriced Your Loan

What is an establishment fee on a business loan?

An establishment fee is a one-off charge when a facility is set up, and often again when it is renewed or restructured, for the bank's work in assessing, approving and documenting it. It is usually a percentage of the limit or a fixed amount, taken at the first drawing. Because it is paid once it weighs most on a short facility, and it is often more negotiable than the margin — especially at a renewal, where the bank's work is smaller and the alternative is a refinance.

WORKED INPricing and FeesRefinancing and Switching Banks

What is RAROC, and how does a bank use it?

Risk-adjusted return on capital is the return a loan earns on the capital the bank must hold against it, after the losses the loan is expected to cause: margin and fees, less funding and running costs and expected loss, divided by the capital it uses. Capital is the bank's scarce input, so two loans on the same margin can earn very different returns if one needs three times the capital of the other. It is how a bank compares a company loan with a home loan, and why the rest of a relationship can decide whether a thin-margin loan is worth making.

WORKED INThe In-Tray — a one-minute file on itHow Banks Price a Business Loan

What is risk-based pricing on a business loan?

Risk-based pricing sets a loan's margin from the risk it carries rather than from a rate card: enough to cover the losses the bank expects on that grade of borrower and security, and to pay for the capital it must hold against the loan, before funding and running costs. It is why two businesses borrowing the same amount on the same day can be offered different margins, and why a stronger risk grade or better security is the way to move a price a long way. The room to negotiate is in the fees and the structure; the floor is the arithmetic.

WORKED INThe In-Tray — a one-minute file on itHow Banks Price a Business LoanExpected loss, worked

What is the credit margin on a business loan, and what is it priced on?

The credit margin is the part of a floating loan's interest rate that the bank sets for the borrower, added to a base rate that moves with the market. The base rate is the price of money; the margin is the price of this borrower — its risk grade, its security, the capital the loan uses, and the bank's appetite for its sector. A swap or a fixed rate changes only the base-rate part, which is why a borrower that has fixed its rate still has a margin that can move at a review, if the facility allows it.

WORKED INPricing and FeesWhy Your Bank Repriced Your LoanA swap, from the borrower's side

What is a bank's cost of funds?

A bank's cost of funds is the blended price of the money it lends — deposits, wholesale borrowing, the bonds it issues — and the floor under every lending rate it quotes. It is why loan pricing moves when funding markets move, even for borrowers whose risk has not changed, and why a bank with cheaper deposits can price more sharply for the same risk. The difference between what a bank earns on its loans and its cost of funds is its net interest margin.

WORKED INHow Banks WorkBank Loan vs Private Credit

What does an interest rate swap do for a borrower?

An interest rate swap is a contract in which a borrower with a floating-rate loan agrees to pay a fixed rate and receive the floating base rate back, so that the base rate on the loan is cancelled out and the loan behaves as if it were fixed. The lending margin is not part of the swap and stays on top. If the base rate falls, the swap costs the borrower the difference; if it rises, the swap pays it. The hedge fits only while the loan it was written against is still there, which is why a loan repaid early leaves a swap to be unwound at a cost.

WORKED INThe In-Tray — a one-minute file on itThe Number — the sum worked outFixed vs Floating RateA swap, from the borrower's side

What does a forward exchange contract fix?

A forward exchange contract is an agreement to exchange one currency for another on a future date at a rate set today. For an exporter invoicing in a foreign currency, selling the expected receipt forward fixes the amount of home currency it will get whatever the spot rate does in the meantime; it removes the gain as well as the loss. The rate is not a forecast: it is the spot rate adjusted for the interest rate difference between the two currencies over the period. A forward hedges a transaction that will happen; one written against a receipt that never arrives becomes a position of its own.

WORKED INThe In-Tray — a one-minute file on itThe In-Tray — a one-minute file on itHow Banks Read ExportersA forward, from the exporter's side

What is the difference between transaction exposure and translation exposure?

Transaction exposure is the cash a business gains or loses when an amount it has agreed in a foreign currency — an invoice, a purchase order, a loan repayment — is settled at a different exchange rate from the one it was priced at. Translation exposure is the change in the home-currency value of foreign assets and earnings when they are restated in the group accounts; no cash moves. A lender's interest is in the first, because it reaches the cash that services debt, and in the mismatch underneath it: revenue in one currency, costs in another, with the margin carrying the difference.

WORKED INThe In-Tray — a one-minute file on itThe In-Tray — a one-minute file on itThe Number — the sum worked outHow Banks Read ExportersA forward, from the exporter's side

What is an interest rate cap, and how is it different from a swap?

An interest rate cap limits the base rate a floating-rate borrower pays to an agreed ceiling for an agreed period, in return for a premium paid upfront. Unlike a swap it removes only the upside of rates: if rates fall, the borrower keeps the benefit, and the most it can lose is the premium. That makes a cap simpler to hold — it never owes the bank money — and dearer to buy; the choice turns on whether the business needs certainty or only protection.

NOT An interest rate cap is not a swap: a swap fixes the rate in both directions and can owe the bank money; a cap is paid for once and only ever pays out.

WORKED INThe In-Tray — a one-minute file on itFinancial Management, Read by a LenderA swap, from the borrower's side

What is hedge cover, and how much should an exporter have?

Hedge cover is the share of expected foreign-currency receipts already sold forward at an agreed rate, usually expressed in months of cover ahead. A lender reads its level, its trend, and whether it follows a written policy or the owner's view of the exchange rate — cover that has quietly shortened is a business taking more currency risk without deciding to. Where the risk is material, the bank may write a minimum hedge-cover covenant into the facility, so that the protection cannot lapse unnoticed.

WORKED INIssue 02 — Aoraki Trade ExportsProduct file: FX FacilityA forward, from the exporter's side

What is a natural hedge?

A natural hedge is currency protection a business already has from its own structure rather than from a contract: costs in the currency it earns, or debt in the currency its customers pay in. An exporter earning US dollars that borrows US dollars against its US-dollar receivables repays from their remittances, and the exchange rate mostly cancels out of the loan. A desk starts from the natural hedge to find the net exposure, and only then asks how much of what remains the forward contracts cover.

WORKED INIssue 02 — Aoraki Trade ExportsHow Banks Read ExportersProduct file: FX Facility

What is translation exposure, and how is it different from transaction exposure?

Translation exposure is the change in what an overseas subsidiary's results and assets are worth when a group reports them in its home currency. It moves reported profit and equity, but no cash changes hands because of it. A lender cares first about transaction exposure — the cash a sale or a payment actually brings in or takes out — and tests a management explanation that a currency move hurt 'only on translation' by checking whether the cash agrees.

NOT Translation exposure is not transaction exposure: translation changes the reported value of overseas results; transaction exposure changes the cash a contract actually produces.

WORKED INThe In-Tray — a one-minute file on itFinancial Reporting, Read by a Lender

What is over-hedging, and why does a bank watch for it?

Over-hedging is holding hedges larger than the exposure they are meant to protect — a swap on more debt than the business has, forward contracts against sales that are no longer going to happen. The excess is no longer insurance but a position on rates or currency that gains or loses on its own, and a forward obliges delivery whether or not the sale it covered still exists. A bank sizes hedging lines to real exposures, and reads a hedge that has outlived its exposure as a position to be closed, not a protection to be kept.

WORKED INThe In-Tray — over-hedgingThe In-Tray — a hedge that outlives its exposureFinancial Management, Read by a Lender

What is a standstill agreement in a problem loan?

A standstill is an agreement by a lender — or by several lenders together — not to demand repayment or enforce security for a set period while a borrower in difficulty and its lenders establish the position and agree what happens next. It buys time on terms: usually current information, a milestone plan and sometimes a fee, in return for the lenders holding their rights rather than using them. A standstill is not a waiver; the default remains, and the lenders' rights return in full when the period ends.

WORKED INProblem Loans and WorkoutWhen Your Loan Goes to the Workout Team

What is expected loss, and how does a bank use it?

Expected loss is what a bank expects to lose on a loan on average: the probability that the borrower defaults, multiplied by the share of the exposure the bank would lose if it did, multiplied by the exposure at that moment. Each factor is a separate reading — the rating grade gives the probability of default, the security and its realisable value give the loss given default, and the facility's shape gives the exposure at default. It is the number a risk margin is built from and the number provisions are held against, and it is why a well-secured loan to a weaker borrower can be priced below an unsecured loan to a stronger one.

WORKED INHow Banks Price a Business LoanHow Banks Manage Credit RiskCredit Analyst vs Credit Risk AnalystThe In-Tray — a one-minute file on itExpected loss, worked

What does it mean when a loan is on a bank's watch list?

A watch list is a bank's register of borrowers whose risk has risen enough to need closer attention than an annual review gives them, without yet being a problem loan. A file on it is reviewed more often, may have its grade and pricing revisited, and is read for whether the trend is recovering or worsening. Borrowers are not always told they are on it, but they usually notice the questions change.

WORKED INHow Banks Manage Credit RiskIssue 09 — The Tuesday ListProblem Loans and WorkoutThe In-Tray — a one-minute file on it

What is a loan loss provision?

A provision is the amount a bank sets aside in its accounts against loans it does not expect to recover in full. Under current accounting standards it is forward-looking: an allowance on performing loans drawn from expected loss, and a larger one once a loan's credit risk has increased significantly or it is impaired. A provision recognises a loss in the accounts; it is not a write-off, and the debt is still owed and still being collected.

WORKED INHow Banks Manage Credit RiskFinancial Accountant (Banking)Problem Loans and WorkoutThe In-Tray — a one-minute file on itProvision coverage, worked

What is receivership, and how is it different from liquidation?

Receivership is the appointment, usually by a secured lender under its security agreement, of a receiver to take control of the assets the security covers and realise them to repay that lender. The receiver acts for the secured creditor rather than for creditors generally, and may trade the business on for a time if a going-concern sale will recover more than a break-up. It differs from liquidation, which ends the company for the benefit of all its creditors, and from administration, which holds creditors off while the company's future is decided.

WORKED INProblem Loans and WorkoutWhat Your Bank Holds as SecurityThe In-Tray — a one-minute file on it

What is forbearance on a business loan?

Forbearance is a lender agreeing not to enforce its rights for now — accepting reduced or deferred payments, relaxing a covenant, extending a maturity — for a borrower in financial difficulty that it believes can recover. It gives the business time, and it is meant to be temporary and conditional. Banks track forborne loans separately, and supervisors expect them to, because forbearance can also hide a problem: repeated concessions to a borrower that cannot recover delay a loss rather than avoid it.

WORKED INThe In-Tray — a one-minute file on itProblem Loans and WorkoutProvision coverage, worked

What is evergreening a loan?

Evergreening is keeping a weak loan looking current by renewing, extending or topping it up so that the borrower meets its payments with new lending rather than its own cash — rolling a maturity that cannot be repaid, adding unpaid interest to the debt, raising a limit to cover the arrears. It postpones recognising a problem and usually makes it larger, because the exposure grows while the business does not change. A desk tells forbearance from evergreening by the plan: a concession with conditions and a route back is forbearance; a renewal with neither is a loss being carried forward.

WORKED INProblem Loans and WorkoutProvision coverage, worked

What is a non-performing loan?

A non-performing loan is one the bank no longer expects to be paid as agreed: by the common definition, a payment ninety days or more past due, or earlier where the bank judges the borrower unlikely to pay in full without the security being sold. Because the second test is a judgement, a loan can be non-performing before a single payment has been missed. The classification moves the loan to a larger provision and usually to the bank's recovery team, and the share of loans that are non-performing is the first number an analyst reads about a bank's book.

WORKED INProvision coverage, workedProblem Loans and WorkoutThe In-Tray — a one-minute file on it

What is probability of default in credit risk?

Probability of default is the estimated likelihood that a borrower defaults within a given period, usually a year, which a bank derives from the borrower's risk grade through its rating model. It is one of the three factors of expected loss, beside loss given default and exposure at default, and it describes the borrower rather than the loan: one company has one probability of default however its facilities are secured. A grade migration changes it, and with it the capital the bank must hold and the margin it needs.

WORKED INExpected loss, workedThe In-Tray — a one-minute file on it

What is loss given default?

Loss given default is the share of an exposure a bank expects to lose if the borrower defaults, after what it recovers from security, guarantees and the borrower's other assets, and after the time and cost of recovering it. It describes the loan rather than the borrower: one company can carry a low loss given default on a facility secured over property and a high one on an unsecured line. It is where a lender's security, its ranking and its realisable value become a number, which is why it is estimated at forced-sale value rather than at book.

WORKED INExpected loss, workedThe In-Tray — seniority and recoveryThe In-Tray — the recovery waterfall

What is exposure at default?

Exposure at default is how much a bank expects to be owed if a borrower defaults: the whole balance of a term loan, and for a revolving facility the drawn balance plus a share of the undrawn limit, because a borrower in trouble draws what it can before it fails. It is the third factor of expected loss, beside probability of default and loss given default. It is why an undrawn line still carries risk and capital, and why a limit larger than the business needs is not free to the bank.

WORKED INExpected loss, workedCorporate Lending and Credit Risk

What does it mean when a performing loan moves to stage 2?

Under expected credit loss accounting, a performing loan carries a provision for twelve months of expected loss; once its credit risk has increased significantly since it was made, it moves to stage 2 and carries the loss expected over its whole remaining life. The borrower may have missed no payment — the jump in the provision comes from the longer horizon, not from a default. A move to stage 2 is often the first place a borrower's deterioration shows in the bank's own accounts, ahead of any arrears.

WORKED INThe In-Tray — a one-minute file on itProvision coverage, worked

What is a loan write-off, and how is it different from a provision?

A write-off removes a loan, or part of it, from the bank's balance sheet once the bank judges there is no reasonable prospect of recovering that amount — usually after the security has been realised and the recovery has run its course. The loss has normally been recognised earlier, through the provision; the write-off uses the provision up. A written-off debt can still be owed and still be pursued, and anything recovered later comes back as income.

NOT A write-off is not a provision: a provision recognises a loss the bank expects while the loan stays on its books; a write-off takes the loan off them.

WORKED INProvision coverage, workedProblem Loans and Workout

What is a bank's workout team, and what happens when a loan goes there?

Workout is a bank's management of a loan in serious difficulty, usually by a specialist team separate from the one that made it: the banker who built the relationship is rarely the right person to enforce against it. The team's objective is recovering the bank's money rather than growing the account, which for a viable business usually means a restructuring — new terms, a plan, sometimes a standstill — and for one that is not viable an orderly exit. A borrower moved to workout is dealing with new people, who will read the file from the beginning.

WORKED INWhen Your Loan Goes to the Workout TeamProblem Loans and WorkoutHow Banks Manage Credit Risk

What is maturity transformation, and why is it a bank's central risk?

Maturity transformation is what a bank does by taking deposits that can be withdrawn at short notice and lending them for years. The spread between the two is most of a bank's income, and the mismatch is most of its liquidity risk: the loans cannot be called in to meet withdrawals, so a bank holds liquid assets and a spread of funding sources against the day depositors want their money back faster than it comes in. The same mismatch is why a bank's funding — how stable its deposits are, how much is borrowed in wholesale markets — is read as closely as its loans.

WORKED INThe In-Tray — a one-minute file on itThe Number — the sum worked outHow Banks Work

What are risk-weighted assets, and how do they set a bank's capital?

Risk-weighted assets are a bank's loans and other exposures each multiplied by a weight that reflects how likely it is to lose money on them: a loan secured on a house carries a lower weight than an unsecured loan to a company, and cash or government bonds carry little or none. A bank's capital requirement is set as a share of that total, not of its plain balance sheet, so two banks with the same assets can need very different capital. For a lending desk the weight is part of the price: a loan that uses more capital has to earn more to be worth writing.

WORKED INThe Number — the sum worked outThe In-Tray — a one-minute file on itHow Banks Manage Credit RiskRisk-weighted assets, worked

What is net interest margin, and what moves it?

Net interest margin is the difference between what a bank earns on its loans and other interest-bearing assets and what it pays for its deposits and borrowings, expressed against those assets. It is the engine of a commercial bank's earnings, and it moves when rates change faster on one side of the balance sheet than the other: a bank whose loans reprice quickly while its deposits lag gains from a rate rise, and one with fixed-rate loans funded by floating deposits loses. Reading a bank means reading which side reprices first — the repricing gap — and how much of a rate change its depositors are passed.

WORKED INThe In-Tray — a one-minute file on itThe In-Tray — a one-minute file on itThe Number — the sum worked outNet interest margin, worked

What is the credit cycle, and where in it is lending riskiest?

The credit cycle is the swing in how freely banks lend: terms loosen while losses are low and competition for borrowers is high, borrowers take on more debt on easier terms, losses rise, terms tighten, and the cycle turns. It runs alongside the economic cycle but is not the same thing — credit can be loose in a flat economy and tight in a growing one. The loans that go wrong are written near the top, when the last few years of low losses make every file look safe; the best are often written near the bottom, when few banks are lending at all.

WORKED INThe In-Tray — a one-minute file on itThe In-Tray — a one-minute file on itProblem Loans and Workout

What does the yield curve tell a lender?

The yield curve plots the interest rates the market demands for lending over different periods, from overnight to many years. Its usual shape slopes upward, because lenders want more for lending longer; when short rates sit above long rates it has inverted, which the market reads as rates being expected to fall, often because growth is expected to slow. A lending desk reads the curve twice: as the base on which fixed-rate loans and swaps are priced, and as a signal about the conditions its floating-rate borrowers will meet when their debt reprices.

WORKED INThe In-Tray — a one-minute file on itThe Number — the sum worked outFixed vs Floating Rate

What is an information barrier in a bank, and what does it protect?

An information barrier — a Chinese wall, in the older phrase — is the set of rules and the physical and system separations that stop confidential information held in one part of a bank from reaching another part that could use it: a lending team that knows a company is about to miss a payment, and a trading desk that deals in its shares. It is how a bank serves clients whose interests conflict without betraying either, and it holds only as long as the people inside it keep it; most breaches are a conversation, not a hack.

WORKED INThe In-Tray — a one-minute file on itThe In-Tray — a one-minute file on itThe In-Tray — a one-minute file on it

What counts as a conflict of interest for a banker, and what does disclosure do?

A conflict of interest arises when a banker's own interest, or a duty owed to one party, could influence a decision owed to another: a shareholding in a borrower, a referral fee from a broker, a relative on the client's board, a credit officer reviewing a loan they helped write. The conflict is not the wrong; acting on it undisclosed is. Disclosure moves the decision to someone without the interest, and a declaration is only as good as its date — a conflict that arose after the form was signed is undeclared.

WORKED INThe In-Tray — a one-minute file on itThe In-Tray — a one-minute file on itThe In-Tray — a one-minute file on it

What is material non-public information, and what may a banker do with it?

Material non-public information is information about a company that has not been released to the market and that an investor would consider significant — a result, a breach, a takeover, a lender's decision to pull a facility. Lending puts bankers in possession of it constantly, which is why the rules are strict: it may be used only for the purpose it was given, not traded on, not passed on, and not hinted at. The duty extends to tips a banker merely receives, and the usual remedy for being told something is not to act on it but to report that it was told.

WORKED INThe In-Tray — a one-minute file on itThe In-Tray — a one-minute file on itThe In-Tray — a one-minute file on it

What is tipping off, and why can a banker not warn a client?

Tipping off is letting a customer or a third party know that a suspicious activity report has been made, or that an investigation is under way, in a way that could prejudice it. In most regimes it is an offence in its own right, separate from the laundering it might protect, and it is the reason a banker who has raised a concern cannot explain a delay, a declined payment or a sudden request for documents by referring to it. The right answer to the client is a true one that says nothing: the bank is reviewing the account, and the banker will come back to them.

WORKED INThe In-Tray — a one-minute file on itThe In-Tray — a one-minute file on itThe In-Tray — a one-minute file on it

What does suitability mean when a bank sells a product?

Suitability is the duty to offer a customer a product that fits their needs, circumstances and understanding, rather than the one that pays the bank most or clears a target. For a business borrower it is the difference between a fixed rate explained with its break cost and a fixed rate sold because the quarter is short; for a hedging product it is whether the customer can carry the downside if the market moves the other way. It is tested over the life of the product, not only at the sale — a product that fitted when it was sold and no longer does is a conversation the bank owes.

WORKED INThe In-Tray — a one-minute file on itThe In-Tray — a one-minute file on itThe In-Tray — a one-minute file on it

What is beneficial ownership, and why must a bank know it?

The beneficial owners of a business are the people who ultimately own or control it, however many companies and trusts stand between them and the account. A bank must identify them before it takes a client on, and keep the record current, because layers of entities can be legitimate and are also how ownership is hidden — from lenders, tax authorities and sanctions screening. The chain is traced to its end; a structure whose last link cannot be named is a reason to stop.

WORKED INThe In-Tray — a one-minute file on it