Analysis of the creditworthiness

Leasing practice

Step 5 Analysis of the creditworthiness

This step is done by the lessor.

Although the leasing transaction is „dressed“ in an asset form, it realy is a form of a credit transaction. As each credit operation suggests, the future creditor – the lessor, executes an analysis of the creditworthiness of the potential debtor – the lessee.

The fears of the lessor

During the preparation of each leasing transaction the lessor has several fears:

  • That the lessee will not WANT to pay one or several future leasing obligations;
  • That the lessee will not be ABLE to pay one or several future leasing obligations;
  • And if one of the above does occur and the lessor repossesses the leasing asset and tries to resell it on the secondary market, that this will not happen in a timely manner or at the required price.

In order to evade such disadvantageus transactions, the lessor turns to an analysis of the creditworthiness of her potential lessee. The creditworthiness (unlike that of bank financing) is usually closely linked with the specifics of the leasing deal offered and the leasing asset.

Information for the credit analysis

In order to make the creditworthiness analysis the lessor uses three kinds of information:

  • Information provided by the future lessee – identification, accounting data or income data or the asset offer;
  • Public information such as information from the Trade Register for information on corporate development or the NOI for invormation on individuals, and so on;
  • Specialized information such as the Central Credit Register at the BNB for information related to the past credit performance of the lessee, economic analysis for the development of specific industries, etc;
  • Information about the leasing transaction, such as tenor, initial instalment, purchase price, residual value, etc. This information usually is gathered from the „Leasing application“, which is filled out by the lessee;
  • Information about the leasing asset, such as type (new or used), make, model, value, VAT, vendor, guaranty, and so on.

Information from these different sources is collected and analyzed in order to overcome the lessor’s concerns as described above.

Analysis of creditworthiness

The creditworthiness analysis itself is a process that differs between different leasing companies as well as  for different leasing exposures.

In the case of more standard leasing transactions (eg. car leasing), the so-called “scoring model” may be used, where, in pre-determined form or software, specific data is input from the collected information. The scoring form then generates a resulting suggestion for approval or denial of the leasing transaction.

It is normal that the credit analysis for larger exposures (exceeding 100,000) or for more specific leasing assets / industrial equipment / be deeper, longer and require some specific documents / specifications, descriptions, manuals, etc. ./.

The purpose of the creditworthiness analysis is to determine that:

  • the lessee is expected to settle in due course any of his obligation /usually a review of the previous credit history from the CCR/;
  • the lessee will not be hindered in the servicing of his obligations (to determine this the income data of the lessee, the industry in which he is employed and the ownership he / she has are used);
  • if, due to one or both of the above circumstances, the lessee fails to execute his obligation during the tenor of the lease deal, the lessor will reposses the collateral /the leasing asset/ and be able to sell it on the secondary market quickly and at a price enough to cover the remaining receivables under the lease.

A frequent cause for complains from the lessee is the duration of their creditworthiness analysis. In defence of the lessors, it should be noted that any timeframe begins to run after the complete set of required documents is gathered /which sometimes takes some time/. Otherwise, the lessor simply does not have the capability for analysis. As regards reasonable terms, a relatively standard asset and a relatively standard exposure (different for the different companies) may be expected to take 5-7 days for performing the credit analysis.

The positive opinion from the borrower’s creditworthiness analysis leads to a proposal from the lessor to execute the leasing transaction. A negative opinion leads to the lessor’s refusal to enter into the proposed transaction. … and, as in life, there is a middle position – the aid of “measures to enhance creditworthiness”.

Measures for creditworthiness enhancement

OK – it is clear that not all potential lessees have simultaneously:

  • A flawless credit reputation without what so ever delinquencies on all former credit obligations;
  • Stable and ever increasing incoming cash flow, dwarfing the sought lease financing;
  • Perspective business or occupation.

Even only the latter depends heavily on the market situation, and the “impeccable credit reputation” depends on it. The fact is that during the years of financial crisis and the subsequent stagnation, a large number of companies and individuals have fallen into some form of financial difficulties, which violates their “impeccable reputation”. It is also a fact that “cash inflows”, whether from salary, from sales of goods and services or from another engagement, also flucte over time.

… or if all of the above circumstances are fulfilled, then not every lease transaction has:

  • A strongly liquid asset
  • A highly reputable vendor of the leasing asset
  • 50% initial installment
  • 12 tenor of the lease transaction

For an easy illustration we can state: each lessor would be happy to render leasing for a single new car to Lukoil Neftochim /one of the biggest companies in Bulgaria/.

It is important to note that the lessor consider the creditworthiness through the prism of the potential leasing transaction. A lessor may not have sufficient creditworthiness for a one transaction /say, for industrial equipment costing one million/, but to be fully creditworthy for another /say leasing of ten new cars/.

Although all lessors seek the above ideal lessee and leasing transaction, they fully realize the economic reality. A contradiction occurs – all a seeking the “ideal” but all realize that such opportunities are limited.

A way to overcome this contradiction is presented by the tools for increasing the creditworthiness.

We remind again, that the analysis of the creditworthiness is directly linked with the remaining components of the leasing transaction – the volume of financing, the leasing asset, the leasing tenor and the initial installment.

Here, too, the lessors should play the leading role, but also the active participation of the lessee is required. Measures to enhance creditworthiness imply finding additional collateral to the lease in addition to the leasing asset, due to lessor concerns or doubt in the lessee’s inability to meet future lease liabilities, which the lessor has deducted from his analysis of the creditworthiness.

It is important to note that the creditworthiness may be enhanced only of “slightly shaken” and not in the event of a complete lack of creditworthiness. A poor and unemployed person with a default on electricity bills will not be able to benefit from any measures to enhance his creditworthiness.

Here are a few of the commonly used measures to enhance the creditworthiness:

  • Correction of the leasing paramenters

As mentioned, the creditworthiness of the prospective lessee is analyzed not in the abstract but directly in relation to the desired lease. Accordingly, the easiest and most commonly used method for enhancing creditworthiness is modeling or adjusting some of the parameters of the leasing transaction.

The leasing transactions have a multitude of parameters, which helps for their calibration in regards of the result of the credit analysis of the lessee. Here are three examples as illustrations of this calibration for creditworthiness enhancement:

Example 1:

A potential lessee wants to acquire a leasing vehicle with a 5% initial installment, at the same time the credit analysis shows that the resulting leasing installment will be too high to be met and hence suggests vulnerability to default. Accordingly, the lessor proposes to increase the creditworthiness by increasing the initial installment to 20% for the same lessee and the same asset. Thus, the lessor’s asset risk is decreased, while reducing the amount of the monthly installment. If the lessee has the possibility of a similar higher initial lease installment, then the leasing transaction becomes possible.

Example 2:

A potential lessee wants to acquire specific industrial equipment for a lease term of 7 years, but the lessor is concerned about the prospects of the industry for such a long term and the lean liquidity of the leasing asset. A corresponding solution may be found when shortening the lease term to 4 years and / or increasing the initiall installment. The goal is by increasing the borrower’s creditworthiness under this transaction, to make it possible.

Example 3:

A potential lessee wants to acquire a second-hand vehicle of BGN 20,000 with an initial installment of 20% and a term of 24 months. The lessor, however, fears the inadequate secondary value of the used car, the lack of warranty and the uncertainty of the quality of the asset, as well as the length of its future operational life. Accordingly, the lessor offers financing for the same type of vehicle, but in a new state of BGN 60,000 with an initial installment of 5% and a lease term of 60 months, thus even improving the parameters of the originally sought transaction for the lessee and eliminating the reasons for his concerns.

The re-modeling of the parameters of the leasing transaction increases the creditworthiness of the lessee and provides an opportunity for its successful execution.

  • Guarantee of the leasing transaction

The guarantee is a commitment by a third party to cover all the obligations under the lease if the lessee is in difficulty. It is used in for “mildy” unacceptable creditworthiness or “mildy” unacceptable leasing asset.

For natural persons, a guarantor may be another individual whose financial reputation or financial capabilities are better than those of the lessee. It is also possible for this to be the employer of the future lessee.

For legal entities, the most frequently used form of guarantee is by one or more of the owners of the capital of the corporate lessee. The form itself suggests the desire of lessors to “escape” from the legal form of a “Limited Liability Company”, especially if they are slightly overwhelmed by their financial analysis. For lessees, this could also be a parent /holding/ company or a partner company (for example, a large client of the lessee who will purchase the production produced with the leasing equipment).

As can be seen in both cases, the guarantee, in addition to the additional financial source, also provides preferential treatment in the event of a possible financial crunch and greater willingness for a timely repayment of the obligations by the lessee and full support from a reliable guarantor.

  • Mortgage of real estate

This form of credit enhancement implies the conclusion of an additional contract for martgage of a real estate, which is tied to the payments of the lease. The contract implies that if the lessee is overdue on some installment under the lease, the mortgage will become effective and the lessor will also be able to use the mortgaged property (other than the leasing asset) to satisfy his receivables.

This form of creditworthiness enhancement makes sense for larger exposures of the lease and / or for a higher risk asset and / or a more unacceptable construction of the lease (for example, a very long lease term with respect to the depreciation of the asset).

Although relatively rare, such enhancement of creditworthiness makes it possible to overcome some deficiencies of the borrower’s creditworthiness, thus allowing the conclusion of the lease.

  • Cross default clauses in several leasing contracts

It is normal for a lessee to use a lessor’s services for more than one transaction. This is the quest for most lessors. At the same time, with each subsequent transaction, the exposures /remaining receivables/ of the lessee are increased and if its creditworthiness was sufficient for the first transaction, it decreased progressively with the increase of the exposure.

A way to enhance the creditworthiness in such cases is to tie all leases to the same lessee. The formal way to do so is so is by the “Cross default” clause in all leasing contracts. This clause provides that arrears on one of the contracts will be considered as default on all lease contracts. In this way, the lessor increases his collateral, including the lease assets of earlier contracts, where most of their value has already been repaid.

  • Re-purchase agreement with the vendor

We know that one of the lessor’s fears is that when the lessee suspends payments on a lease contract and he reposes the leasing asset, he will not be able to re-sell it in a timely manner or at the required price. These concerns are particularly valid for the leasing of more specific equipment, the market for which is relatively limited. It is possible that even a lessee with impeccable reputation and a good cash flow does not have a good enough creditworthiness for the purchase of particularly specific equipment /we should recall that the leasing asset is the basic collateral for the leases under the leasing contract by the lessor/.

In such cases, the equipment vendor himself, who knows the leasing asset, has the opportunity to recycle it if necessary, and certainly has access to the corresponding market demand. Linking the supplier to the lease is done through a repurchase agreement that is mirrored by the payment of the leasing asset to the lessor.

For example, if the delivery price is 100 and the initial installment is 20, the redemption sought by the supplier on the first day after the purchase will be 80, this amount decreasing each month by the amount of each subsequent monthly installment. If the supplier is willing to do so, the repurchae contract can be used to enhance the borrower’s creditworthiness and for the leasing deal and be concluded. Needless to say, in such cases, the reputation and financial position of the supplier are also subject to analysis by the lessor.

  • Interest increase

Last but not least, is the measure to increase the creditworthiness by increasing the lease rate of interest. Many leasing companies have pre-determined interest rates for different customer groups, depending on their creditworthiness.

Here is one example for how this method works:

If for a given leasing asset (for example, a car) which costs 100 units, we assume that the interest for “excellent” client is 10% per year /we use not market, but easy to illustrate levels/, then the leasing transaction may be concluded with an “acceptable” /less than perfect/ customer at 20%. It is precisely this example that the “acceptable” lessee is exactly twice as likely to be arrears and complete loss of the leasing asset to arrise. Its creditworthiness is strengthened by the grouping of very similar lessees in one group, with the increased risk being covered by the increased interest rates. In our example, the interest of 5 lessees would cover a complete loss of the lease asset and lease receivables of the 6th one. This lessor will not profit, but its risk will be covered, and he would be inclined to conclude the deal, though not with an “ideal” client, but only with an “acceptable” one. It is important to note here the presence of a leasing asset and its relatively rare “total loss” combined with a complete lack of insurance coverage. The leased asset, combined with increased interest rates, can overcome some of the lessor’s concerns and make the lease possible.

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