ACCOUNT OFFICER’S BASIC TRAINING Cash Flow Review Techniques

2 Objectives At the end of this session, Account Officers will be able to – 1.Review the Cash Flow and test the accuracy and consistency of data using the five Cash Flow Review Technique tools. 2.Make the adjustments to Cash Flow computations, if needed, to ensure that information contained in the report is accurate and consistent with industry and business standards.

3  Most information on the business is based on “memory” rather than actual financial records  High possibility of biased information from the loan applicant - overstated income and understated expenses.

4 The income and expense data supplied by the client can be checked for consistency by reviewing: (1) Price mark-up or Profit margin (2) Average Inventory (3) Total Monthly Income from Business and Other Sources (4) Total Monthly Household Expenses (5) Net Monthly Income

Price Mark-up/Gross Profit Margin Analysis

6 Price Mark-up/Gross Profit Margin Price mark-up or gross profit margin is computed using the formula: Sales - 1 x 100 Cost of Purchases

7 Price Mark-up/Gross Profit Margin  The computed price mark-up or profit margin should not exceed the maximum standard rate set by the MFU for each type of enterprise For example: % price mark-up for sari-sari stores, -25% for other retail shops, -50% for carenderias and food processing activities

8 Price Mark-up/Gross Profit Margin  If the computed mark-up exceeds the standard rate, the reported sales or income should be adjusted by using any acceptable rate and applying this on the cost of purchases.  Between using the reported sales or income and the cost of merchandise purchases, the latter would be easier to verify.

9 Example: If a sari-sari store owner claims that his weekly sales is P20,000 and his weekly purchases is P15,000, his average price mark-up will be: (P20,000 / P15,000) – 1 x 100 = 33.3% If the normal price mark-up for sari-sari stores in the area is only within the range of 10-20%, the reported sales is too high. Adjust sales by assuming that the average mark-up, say, is only 15%. A more realistic weekly sales level, therefore, can be computed, as follows: P15,000 x 1.15 = P17,250

10 Estimating the Average Price Mark-Up The average price mark-up can also be estimated by comparing the buying and selling prices of, at least, the five (5) fastest selling items in the shop, through the formula: Total Sales - 1 x 100 Total Purchases Where: Total Sales = Selling price x Quantity of each item Total Purchases= Buying price x Quantity of each item

11 Example: Average Current Buying Selling Total TotalPrice stock Price Price Sales PurchasesMark-Up Item A 100 units ,000 10,000 Item B 50 units ,650 1,500 Item C 70 units ,610 1,400 Item D 30 units ,800 1,500 Item E 60 units , ______ Total 18,140 15,300 ? 18, x 100 = 18.6% 15,300

12 Exercise: Question: Is there anything wrong with these data? Type of Business:Sari-sari store Daily sales: 1,500 Weekly Purchases: 9,000 Analysis: Weekly equivalent of daily sales = 1,500 x 7 days = 10,500 Weekly Purchases = 9,000 Price mark-up = (10,500/9,000) - 1 x 100 = ( ) x 100 = 16.7% Conclusion: This price mark-up is acceptable

13 Exercise: Analysis: Question: Is there anything wrong with these data? Type of Business:Sari-sari store Daily sales: 1,500 Weekly Purchases: 9,000 Merchandise Inventory (AO’s estimate): 1,000 Merchandise Inventory: 1,000 Daily Sales:1,500 Derived Cost of Purchase: (1,500/1.15) = 1,304 which means that the ending inventory cannot support even one day of sales Conclusion: Data on sales & purchases are doubtful

14 What to do -- Check sales receipts or records, if any; or Check receipts or records of purchases, if any; or Verify level of regular purchases with client’s suppliers; or Estimate a more realistic level of sales and purchases based on the client’s average inventory level

Average Inventory Analysis

16 Average Inventory Average inventory, is the total value of stocks usually maintained by the business. Small retail shops usually maintain an inventory equal to 2-4 weeks of regular daily or weekly sales.

17 Average Inventory  The AO should compare the reported average inventory with the total value of the stocks of the shop when he/she visits the business during the CI/BI.  If the discrepancy between the total value of the observed inventory and that of the reported inventory is large, the AO should verify reason for discrepancy from the client.  If the client cannot provide adequate explanation for the discrepancy, the AO should use whichever amount is lower to represent the applicant’ average business inventory.

18 Average Inventory For trading-related activities, such as retail shops, the ending inventory should be compared with the average inventory. The ending inventory should always be equal to, or greater than, the average inventory. If the ending inventory is lower than the average inventory, the COST OF SALES should be adjusted downwards using the difference between the average inventory and the ending inventory.

19 Adjusting SALES StepsFormula 1 Cost of Sales Reported Sales (1 + Normal Price Mark-up ) 2 Adjusted Cost of Sales Cost of Sales Plus : Ending Inventory minus Minus : Average Inventory 3 Adjusted SALES Adjusted Cost of Sales Multiply by : (1 + Normal Price Mark-up)

20 Example Type of Business:Sari-sari store Daily Sales:P 1,500 Total Weekly Purchases:P 9,000 Merchandise Inventory (AO’s estimate):P 1,000 Average Inventory (Client’s estimate):P 5,000 Analysis Step 1: COST OF SALES = P1,500 x 7days ( ) = 8,997 Step 2: ADJUSTED COST= 8,997 + (1, ,000) OF SALES 4,997 This means that the cost of sales of P9,000 should be reduced to P4,997.

21 Step 3: Adjusted Sales = Adjusted Cost of Sales x (1 + Normal price mark-up) Adjusted Sales = 4,997 x ( ) = 4,997 x = 5,831 This means that the reported sales of P1,500 per day or P10,500 per week should be reduced to only P5,831 per week, or P833 per day.

22 These adjustments are necessary in order to make the average inventory consistent with the average sales and purchases of the business, as shown in the table below.

23 NOTE : Do the average inventory analysis only if the total value of the inventory is substantially lower than the total cost of purchases reported by the client. However, if the difference between the observed inventory and the cost of purchases is not large, the price mark-up or gross profit margin analysis would suffice.

Analysis of Total Monthly Business and Household Income

25 Total Monthly Income from Business and Other Sources ItemDailyWeeklySemi- Monthly MonthlyMONTHLY TOTALS Net Income from Business: Total Business Income Business Expenses: Total Business Expense NET BUSINESS INCOME Total Other Household Income TOTAL BUSINESS & HOUSEHOLD INCOME Analyze data here

26 Total Monthly Income from Business and Other Sources  This income represents the regular monthly income of the household before household expenses.  It is, thus, comparable to the monthly salaries received by the AOs (or other employees), in the sense that both are incomes before household expenses.

27 Total Monthly Income from Business and Other Sources  The AO can verify whether the estimated total monthly household income of the applicant, as shown in the cash flow, is consistent with the living condition of the applicant and his family when he/she visit the borrower’s house during the CI/BI.  The AO may compare the applicant’s house and living condition with that of his own, or those of other persons whom he/she knows belong to the same income bracket as that of the applicant.

28 Total Monthly Income from Business and Other Sources NOTE : If the estimated total monthly business & household income is not consistent with the living condition of the household, the AO must revise the cash flow. Loan applicants tend to overstate their incomes.

29 Example Total Monthly Income from Business & Other Household Sources:P25,000 Analysis Compare the P25,000 total monthly income (before HH expenses) with the following items: No. of HH members4 Household appliancesNone House construction materialsTemporary Conclusion: The income data is doubtful. A household with only 4 HH members and receiving a monthly “salary” of P25,000 normally would be owning at least some small HH assets, or is residing in a house made of more durable materials. AO should further verify the discrepancy between the reported HH income & the observed living condition of the HH.

Analysis of the Total Monthly Household Expenses

31 Total Monthly Household Expenses ItemDailyWeeklySemi- Monthly MonthlyMONTHLY TOTALS Other Household Income Remittances Total Other Household Income Total Business & Household Income Household Expenses Food Education & School Allowance Utilities (Light & Water) Sub-Total Miscellaneous (10%) Total Household Expenses Analyze data here

32 Total Monthly Household Expenses  The total monthly household expense should be compared with the size of the household and the ages of household members.  The AO should be familiar with the major expenditure items of households in his/her area of assignment and the most common level of expenditures for each item.  For greater conservatism, add at least 10% to the total household expenses as miscellaneous expenses.

33 Example Total Monthly Household Expenses:P2,000 Analysis Compare the P2,000 total monthly expenses with the following items: Type of client’s businessSari-sari store No. of HH members5 Ages of HH members (children)1 HS, 1 college, 1 grade school Community where client is residingUrban Conclusion: The expense data appear too small for the household described above. AO should gather more information on the applicant’s HH expenditures and adjust these, if necessary.

Analysis of Net Monthly Household Income

35 Net Monthly Household Income Compute for this data using the Monthly Totals column in the Cash Flow Formula: Total Other Household Income less : Total Household Expense equals :NET HOUSEHOLD INCOME

36 Net Monthly Household Income  The Net Monthly Household Income also represents the monthly savings of the household or the size of its investment funds.  This amount should be checked against the relevant items in the applicant’s balance sheet -- i.e. savings deposit, cash on hand, real properties, other household assets, and other investments.

37  If the amount appears large compared with the amount the applicant intends to borrow, verify from the client the reason why he/she still intends to borrow.  If the applicant cannot provide an adequate explanation for the apparent discrepancy, the AO should review the cash flow and make the necessary adjustments in the applicant’s income and expense data.

38 Example Total Net Monthly HH Income: P10,000 Analysis Compare the P10,000 net monthly income with the following items: Savings/cash in bankNone Cash on handP500 Real propertiesNone Household appliancesP10,000 Business assetsP10,000 Total AssetsP40,000 Conclusion: The income data is doubtful. It is not clear where the P10,000 net monthly income or “savings” is kept or invested by the applicant. AO should further verify the applicant’s income and expense data.

39 Example Total Net Monthly HH Income: P3,000 Analysis Compare the P3,000 net monthly income with the following items: Savings/cash in bankNone Cash on handP500 Real propertiesP300,000 Household appliancesP100,000 Business assetsP10,000 Total AssetsP500,000 Total liabilitiesNone Conclusion: The income data is doubtful. Monthly net income is too small compared with the HH’s assets. This HH most likely had acquired all these assets from borrowings. AOs should further verify the liabilities of the HH.

Analysis of Monthly Household Income Structure

41 Monthly Household Income Structure This refers to the ratio of the NET BUSINESS INCOME to the TOTAL BUSINESS & HH INCOME The ratio is computed as follows: Net Business Income x 100 Total Business & HH Income

42 Net Income from Business should be at least 80% of the total household income. If Other Household Income is more than 20% of the Total Business & HH Income, the AO should gather proof of this income (e.g. pay slip of spouse’s salary). If Other HH Income is more than 50% of the Total Business & HH Income – that is, most of the HH income come from outside the client’s business, offer the client other loan products of the banks (e.g. salary loan)

43 Example Net Business Income10,000 Other HH Income (Spouse’s salary) 4,000 Total Business & HH Income14,000 Analysis Net Business Income71.4% Other HH Income (Spouse’s salary)29.6% Total Business & HH Income 100.0% Recommendation: AO should present proof of the spouse’s salary (pay slip)

44 Example Net Business Income 4,000 Other HH Income (Spouse’s salary)10,000 Total Business & HH Income14,000 Analysis Net Business Income29.6% Other HH Income (Spouse’s salary)71.4% Total Business & HH Income 100.0% Recommendation: Client’s spouse should be offered a salary loan instead.

Cash Flow Paradox

46 The Puzzle -- Even without any improvement in the client’s cash flow, and using the same loan term and Adjusted Repayment Capacity Rate (ARCR), a client can still be given a bigger loan amount by moving the repayment schedule from daily to weekly.

47 Example By just moving the amortization schedule from daily to weekly, the loan amount can be increased from P6,349 to P8,888 - or an increase of about 40%. How is this possible?

48 Solving the Puzzle -- In the daily loan amortization schedule, the loan amount is computed using 65 collection days. In the weekly loan amortization schedule, however, the loan amount is computed using 13 weeks, or 91 days. To avoid committing this error, the number of days to be used in computing the loan amount for loans paid either daily or weekly should be the same. If loans with daily payments are computed using 65 days, loans with weekly payments should also be computed using 5 collection days a week. In the daily loan amortization schedule, the loan amount is computed using 65 collection days. In the weekly loan amortization schedule, however, the loan amount is computed using 13 weeks, or 91 days. To avoid committing this error, the number of days to be used in computing the loan amount for loans paid either daily or weekly should be the same. If loans with daily payments are computed using 65 days, loans with weekly payments should also be computed using 5 collection days a week.

49 Example

50 SUMMARY -- The secret in analyzing the cash flow is in the MONTHLY TOTALS. Without the Monthly Totals, it is difficult to compare and analyze the various items in the cash flow. There are a lot of information in the CIBI report that can be used in validating the data reported in the cash flow. Do not limit cash flow analysis by looking only at the figures in the cash flow. Also, compare the cash flow figures with other sections of the CIBI report.

51 Individual Case Analysis You may have the participants prepare the Cash flow for Jenni’s Bakery and apply Cash Flow Review techniques to checking for validity/accuracy of the data.

52 Lending to Microenterprises without analyzing the cash flow … CHANCE … is like playing darts blind-folded. Determining how much loan the bank should give to a client is left to CHANCE.

Thank you!