Finance Company Evaluation Tests
Using 'Heartland' as an example I have been through five bank-imposed hurdles that any finance company, that will give you your invested capital back, must jump through. However, I know that numbers make some readers glaze over. So I think it is worthwhile trying to explain the reasoning behind imposing each of these 'hurdle tests' in a 'number free' way.
H1/ 'Interest Cover Ratio' In order to pay out interest to debenture holders, a finance company must have someone feeding cash into the other end of the 'debenture paying machine'. That cash must be sufficient to cover all debenture interest, with a margin for safety.
H2/ 'Liquidity Buffer Ratio' Real cash is required to pay debenture interest. " I have earned the money but I will pay it to you later" is not an acceptable business practice. Matching payments with incoming money can only be achieved when there is some kind of connection between the term over which the money is used and the term the money is lent.
H3/ 'Gearing ratio' Underlying every finance company is a building, some staff and a few computers. 'The office' must be in sound financial shape itself to provide a firm foundation to the lending capital business that is built on top of it.
H4/ 'Single Customer Group Exposure' If a disproportionate amount of business is done with a single customer, however good that customer seems, the potential exists for the whole finance group to collapse because of an unexpected glitch in one customer arm.
H5/ 'Minimum Equity Contribution' Why don't you and I don't go out and start a finance company tomorrow? Because a certain buffer of shareholder funds to cover unexpected bad debts and to help massage any small mismatch between borrowers and lenders expectation in the timing of loans.
Once you understand the importance of these five hurdles you can see how unhelpful the information generally published in share tables on finance companies is. PE ratio? Yield? Asset backing? Profit trends? As an potential investor in the finance industry I won't be considering those statistics any more. Because whatever their value, unless the finance company under consideration can pass the five hurdle test then I don't think it can survive at all in the medium term.
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