Chapter 17 (Lending To Business Firms and Pricing Business Loans)

Chapter Seventeen
Lending to Business Firms and Pricing

Business Loans
Copyright 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
17-2
Key Topics
Types of Business Loans: Short Term and Long
Term
Analyzing Business Loan Requests
Collateral and Contingent Liabilities
Sources and Uses of Business Funds
Pricing Business Loans
Customer Profitability Analysis
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Bank Management and Financial
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17-3
Introduction
Securing large amounts of credit that many businesses
require can be a challenging task
Business loans are often called commercial and
industrial (C&I) loans
C&I loans rank among the most important assets banks and
their closest competitors hold
For U.S. insured commercial banks, close to one-fifth of

their loan portfolio is classified as business or C&I loans
This percentage of the total loan portfolio does not include
many commercial real estate loans and loans to other
financial institutions
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Brief History of Business Lending

Commercial and industrial loans represented the earliest
form of lending that banks carried out
Loans extended to ship owners, mining operators, goods
manufacturers, and property owners dominated bankers
loan portfolios for centuries
In the late 19th and early 20th centuries new

competitors, particularly finance companies, life and
property/casualty insurance firms, and some thrift
institutions, entered the business lending field
This placed downward pressure on the profit margins of
many business lenders
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Types of Business Loans
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Short-Term Loans to Business Firms

Self-Liquidating Inventory Loans
These loans usually were used to finance the purchase of
inventory raw materials or finished goods to sell
Such loans take advantage of the normal cash cycle inside
a business firm
There appears to be less of a need for traditional inventory
financing
Due to the development of just in time (JIT) and supply chain
management techniques
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(continued)
Working Capital Loans
Short-run credit that lasts from a few days to one year
Secured by accounts receivable or by pledges of inventory
Carry a floating interest rate
A commitment fee is charged on the unused portion of the
credit line and sometimes on the entire amount of funds
made available
Compensating deposit balances may be required from the
customer
Recently compensating deposit balances as a part of a
business-loan arrangement has been on the decline
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(continued)
Interim Construction Financing
Secured short-term loan used to support the
construction of homes, apartments, office buildings,
shopping centers, and other permanent structures
Security Dealer Financing
Dealers in securities need short-term financing to
purchase new securities and carry their existing
portfolios of securities until they are sold to customers
or reach maturity
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(continued)
Retailer and Equipment Financing
Lenders support installment purchases of automobiles, home
appliances, and other durable goods by financing the
receivables that dealers selling these goods take on when they
write installment contracts to cover customer purchases
Asset-Based Financing
Credit secured by the shorter-term assets of a firm that are
expected to roll over into cash in the future
Syndicated Loans (SNCs)
A loan package extended to a corporation by a group of
lenders
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Long-Term Loans to Business Firms

Term Business Loans
Designed to fund longer-term business investments, such as the
purchase of equipment or the construction of physical facilities,
covering a period longer than one year
Revolving Credit Financing

Allows a customer to borrow up to a prespecified limit, repay all
or a portion of the borrowing, and reborrow as necessary
One of the most flexible of all business unsecured loans
May be short-term or long-term
Lenders normally charge a loan commitment fee
Two types: formal loan commitment and confirmed credit line
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(continued)
Long-Term Project Loans

Credit to finance the construction of fixed assets
Most risky of all business loans
Some of the risks of project loans:
1. Large amounts of funds are usually involved
2. The project may be delayed by weather or shortage of
materials
3. Laws and regulations in the region where the project lies
may change
4. Interest rates may change
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(continued)
Loans to Support the Acquisition of Other Business
Firms Leveraged Buyouts
The 1980s and 1990s ushered in an explosion of loans to
finance mergers and acquisitions
Leveraged buyouts (LBOs) usually involve acquiring a
controlling interest in another firm with the use of a great
deal of debt (leverage) to finance the transaction
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Analyzing Business Loan Applications

Often business loans are of such large denomination that
the lending institution itself may be at risk if the loan
goes bad
The most common sources of repayment for business
loans are:
1.The business borrowers profits or cash flow
2.Business assets pledged as collateral behind the loan
3.A strong balance sheet with ample amounts of marketable
assets and net worth
4.Guarantees given by the business, such as drawing on the
owners personal property to backstop a loan
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(continued)
Analysis of a Business Borrowers Financial Statements
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(continued)
Analysis of a Business Borrowers Financial Statements
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Financial Ratio Analysis of a Customers

Financial Statements
Information from balance sheets and income statements is
typically supplemented by financial ratio analysis
Critical areas of potential borrowers loan officers consider:
1. Ability to control expenses
2. Operating efficiency in using resources to generate sales
3. Marketability of product line
4. Coverage that earnings provide over financing cost
5. Liquidity position, indicating the availability of ready cash
6. Track record of profitability
7. Financial leverage (or debt relative to equity capital)
8. Contingent liabilities that may give rise to substantial claims in
the future
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Financial Statements (continued)
The Business Customers Control over Expenses
A barometer of the quality of a firms management is how it

controls its expenses and how well its earnings are likely to be
protected and grow
Selected financial ratios to monitor a firms expense control:
Wages and salaries/Net sales

Overhead expenses/Net sales
Depreciation expenses/Net sales
Interest expense on borrowed funds/Net sales
Cost of goods sold/Net sales
Selling, administrative, and other expenses/Net sales
Taxes/Net sales
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Operating Efficiency: Measure of a Business Firms
Performance Effectiveness
It is also useful to look at a business customers operating
efficiency
How effectively are assets being utilized to generate sales and
how efficiently are sales converted into cash?
Important financial ratios here include:
Annual cost of goods sold/Average inventory (or inventory
turnover ratio)
Net sales/Net fixed assets
Net sales/Total assets
Net sales/Accounts and notes receivable
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Operating Efficiency: Measure of a Business Firms
Performance Effectiveness
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Marketability of the Customers Product or Service
In order to generate adequate cash flow to repay a loan,
the business customer must be able to market goods,
services, or skills successfully
The gross profit margin (GPM), defined as
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Marketability of the Customers Product or Service
A closely related and somewhat more refined ratio is the
net profit margin (NPM)
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Coverage Ratios: Measuring the Adequacy of
Earnings
Coverage refers to the protection afforded creditors based
on the amount of a business customers earnings
The best-known coverage ratios include
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Liquidity Indicators for Business Customers
The borrowers liquidity position reflects his or her ability
to raise cash in timely fashion at reasonable cost, including
the ability to meet loan payments when they come due
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Profitability Indicators
How much net income remains for the owners of a
business firm after all expenses (except dividends) are
charged against revenue?
Popular bottom line indicators include
Before-tax net income / total assets, net worth, or total sales
After-tax net income / total assets (or ROA)
After-tax net income / net worth (or ROE)
After-tax net income / total sales (or ROS) or profit margin
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The Financial Leverage Factor as a Barometer of a
Business Firms Capital Structure
Any lender is concerned about how much debt a borrower
has taken on in addition to the loan being sought
Key financial ratios used to analyze any borrowing
businesss credit standing and use of financial leverage
include
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Comparing a Business Customers Performance

to the Performance of Its Industry
It is standard practice to compare each business
customers performance to the performance of the
customers entire industry
Dun & Bradstreet Industry Norms and Key Business
Ratios
RMA Annual Statement Studies
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to the Performance of Its Industry (continued)
Contingent Liabilities
Usually not shown on customer balance sheets are other
potential claims against the borrower:
1.
2.
3.
4.
5.
Guarantees and warranties behind the business firms products

Litigation or pending lawsuits against the firm
Unfunded pension liabilities
Taxes owed but unpaid
Limiting regulations
These contingent liabilities can turn into actual claims against

the firms assets and earnings at a future date
Loan officer must ask the customer about pending or potential
claims against the firm
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Contingent Liabilities
Environmental Liabilities
The Comprehensive Environmental Response,
Compensation, and Liability Act (CERCLA) and its Super
Fund Amendments
Make current and past owners of contaminated property or of
businesses located on contaminated property and those who
dispose of or transport hazardous substances potentially liable
for any cleanup costs associated with environmental damage
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Contingent Liabilities (continued)
Underfunded Pension Liabilities
Under Financial Accounting Standards Board (FASB),
borrowing customers may be compelled to record employee
pension plan surpluses and deficits on their balance sheets
If projected pension-plan liabilities exceed expected funds
sources, the result may be an increase in liabilities
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Preparing Statements of Cash Flows from

Business Financial Statements
The Statement of Cash Flows illustrates how cash
receipts and disbursements are generated by
operating, investing, and financing activities
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Business Financial Statements (continued)
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Business Financial Statements (continued)
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Pricing Business Loans

One of the most difficult tasks in lending is deciding
how to price a loan
Lender wants to charge a high enough interest rate to ensure
each loan will be profitable and compensate the lending
institution for the risks involved
The Cost-Plus Loan Pricing Method
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Pricing Business Loans (continued)

The Price Leadership Model
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In the U.S., the prevailing prime rate is considered to be
the most common base rate
Two different floating prime rate formulas were soon
developed by leading money center banks
Prime-plus method
Times-prime method
London Interbank Offered Rate (LIBOR)
Leading commercial lenders have switched to LIBOR-based
loan pricing due to the growing use of Eurocurrencies as a
source of loanable funds
LIBOR-based loan rate = LIBOR + Default-risk premium +
Profit margin
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Below-Prime Market Pricing
Banks announced that some large corporate loans
covering only a few days or weeks would be made at low
money market interest rates
Federal funds rate on domestic loans plus a small margin
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Customer Profitability Analysis (CPA)
New loan pricing technique that is similar to the cost-plus loan
pricing technique
Assumes that the lender should take the whole customer
relationship into account when pricing a loan
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If the net rate of return is positive, the proposed loan is

acceptable because all expenses have been met
If the net rate of return is negative, the proposed loan and other
services provided to the customer are not correctly priced as far
as the lender is concerned
The greater the perceived risk of the loan, the higher the net
rate of return the lender should require
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Earnings Credit for Customer Deposits
In calculating how much in revenues a customer generates for a
lending institution, many lenders give the customer credit for any
earnings received from investing the balance in the customers
deposit account
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17-40
Quick Quiz
What are the essential differences among working
capital loans, open credit lines, asset-based loans, term
loans, revolving credit lines, interim financing, project
loans, and acquisition loans?
What aspects of a business firms financial statements
do loan officers and credit analysts examine carefully?
What methods are used to price business loans?
What is customer profitability analysis? What are its
advantages for the borrowing customer and the
lender?
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Chapter 17 (Lending To Business Firms and Pricing Business Loans)

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Chapter 17 (Lending To Business Firms and Pricing Business Loans)

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Chapter Seventeen

Lending to Business Firms and Pricing

2008 The McGraw-Hill Companies, Inc., All Rights

For U.S. insured commercial banks, close to one-fifth of

2008 The McGraw-Hill Companies, Inc., All Rights

Brief History of Business Lending

In the late 19th and early 20th centuries new

2008 The McGraw-Hill Companies, Inc., All Rights

Types of Business Loans

2008 The McGraw-Hill Companies, Inc., All Rights

Short-Term Loans to Business Firms

2008 The McGraw-Hill Companies, Inc., All Rights

Short-Term Loans to Business Firms

2008 The McGraw-Hill Companies, Inc., All Rights

Short-Term Loans to Business Firms

2008 The McGraw-Hill Companies, Inc., All Rights

Short-Term Loans to Business Firms

2008 The McGraw-Hill Companies, Inc., All Rights

Long-Term Loans to Business Firms

Revolving Credit Financing

2008 The McGraw-Hill Companies, Inc., All Rights

Long-Term Loans to Business Firms

Long-Term Project Loans

2008 The McGraw-Hill Companies, Inc., All Rights

Long-Term Loans to Business Firms

2008 The McGraw-Hill Companies, Inc., All Rights

Analyzing Business Loan Applications

2008 The McGraw-Hill Companies, Inc., All Rights

Analyzing Business Loan Applications

2008 The McGraw-Hill Companies, Inc., All Rights

Analyzing Business Loan Applications

2008 The McGraw-Hill Companies, Inc., All Rights

Financial Ratio Analysis of a Customers

2008 The McGraw-Hill Companies, Inc., All Rights

Financial Ratio Analysis of a Customers

A barometer of the quality of a firms management is how it

Wages and salaries/Net sales

2008 The McGraw-Hill Companies, Inc., All Rights

Financial Ratio Analysis of a Customers

2008 The McGraw-Hill Companies, Inc., All Rights

Financial Ratio Analysis of a Customers

2008 The McGraw-Hill Companies, Inc., All Rights

Financial Ratio Analysis of a Customers

2008 The McGraw-Hill Companies, Inc., All Rights

Financial Ratio Analysis of a Customers

2008 The McGraw-Hill Companies, Inc., All Rights

Financial Ratio Analysis of a Customers

2008 The McGraw-Hill Companies, Inc., All Rights

Financial Ratio Analysis of a Customers

2008 The McGraw-Hill Companies, Inc., All Rights

Financial Ratio Analysis of a Customers

2008 The McGraw-Hill Companies, Inc., All Rights

Financial Ratio Analysis of a Customers

2008 The McGraw-Hill Companies, Inc., All Rights

Comparing a Business Customers Performance

2008 The McGraw-Hill Companies, Inc., All Rights

Comparing a Business Customers Performance

Guarantees and warranties behind the business firms products

These contingent liabilities can turn into actual claims against

2008 The McGraw-Hill Companies, Inc., All Rights

Comparing a Business Customers Performance

2008 The McGraw-Hill Companies, Inc., All Rights

Comparing a Business Customers Performance