We know that an analysis of business risk is the first step in the credit assessment process. But how should the analysis be structured?
There’s an argument that says an analyst should first analyse a business’s macro-environment and then its market environment before paying any attention to the micro-environment.
However, one of the major components of the micro-environment is the management team of the business so the counter-argument is that if the quality of the team is completely inadequate and presents a poor risk profile, there’s no point in wasting time analysing the external environments since the bank wouldn’t want to be exposed to a poorly managed business. Analysts taking that view would then analyse management quality first and only if that’s acceptable would they then turn to the external environments.
I don’t take sides in this argument. Each to his or her own. The main thing is that the business’s operations and structure are understood which means that all of these environments have to be analysed before turning to the financial performance and position of the business.
What should an analyst be looking for in an analysis of the management team?
- Credit history; do the managers of the business have clear credit records? If not, there is little likelihood that the bank will provide finance to the business. To be clear, this is not about the business’s credit history – it’s the personal credit histories of the management team that have to be tested here. The reason being that if people are not sufficiently disciplined to manage their own money effectively, they’re unlikely to manage the business’s finances any better.
- Personal characteristics; this has been covered in some detail in a previous post in which I made the point that many business problems and failures are caused by the personal attitudes of the managers/owners. We always want to see positive characteristics, e.g. commitment to the business, transparency, openness, hard working, not status driven or egotistical etc.
- Contractual capacity; the managers/owners who negotiate the finance with the bank must have contractual capacity otherwise the agreement is null and void and any finance provided by the bank may not be legally recoverable.
- Technical expertise; this is really relevant to smaller businesses but usually a particular type of business is started by a person because they have the necessary technical expertise, e.g. a trained baker might start a bakery business. However, if the manager does not have the required technical expertise it would be necessary for the bank to find out whether someone has been employed with that expertise. This may be a problem if that person leaves the business at a later date taking their critical skills with them.
- Management, finance and marketing skills; these are the main skills that managers of smaller businesses commonly lack. Again, people start businesses because they have the necessary technical expertise but they usually don’t have the skills and knowledge required to run a business. We would want to know that these skills can be obtained via employees or consultants. Under this heading we would also look at the experience of the management team in the industry and their track record of success or otherwise.
- Personal assets and liabilities; this tells us whether the managers/owners have assets outside the business and whether they could be used as a secondary source of repayment should the business fail for any reason. Of course, these assets can also be used as collateral, should it be required. The level of personal assets and liabilities also indicates the income that the managers/owners have been taking from the business and may reflect on their personal characteristics.
- Able succession plan; very often a business is run and managed by one person and the bank will be concerned to know what would happen to the business if that person were to become incapacitated or if he or she died suddenly. Not only should there be a succession plan in place but the person identified as the successor should be adequately trained in the key areas of the business so that he or she could continue the business at short notice. If this is not possible, one solution is to effect an insurance policy which can be used to settle any loans and advances from the bank should the owner die or become unable to operate the business.
In our e-book, Business Lending Essentials Part 1; Assessing Business Risks, we set out some background to this analysis and provide some tools and techniques to enable analysts to apply a logical approach to the assessment of a business. The ebook is free and can be downloaded from www.businessbankingcoach.com by clicking here.