Chapter Seventeen Lending to Business Firms and Pricing Business Loans Copyright © 2013 The...

Chapter Seventeen

Lending to Business Firms and Pricing Business Loans

Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

McGraw-Hill/IrwinBank Management and Financial Services, 7/e

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

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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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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Short-Term Loans to Business Firms (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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Short-Term Loans to Business Firms (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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Short-Term Loans to Business Firms (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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Long-Term Loans to Business Firms (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 involved2. The project may be delayed by weather or shortage of

materials3. Laws and regulations in the region where the project lies

may change4. Interest rates may change

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Long-Term Loans to Business Firms (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 borrower’s profits or cash flow2.Business assets pledged as collateral behind the loan3.A strong balance sheet with ample amounts of marketable

assets and net worth4.Guarantees given by the business, such as drawing on the

owners’ personal property to backstop a loan

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Analyzing Business Loan Applications (continued)• Analysis of a Business Borrower’s Financial Statements

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Analyzing Business Loan Applications (continued)• Analysis of a Business Borrower’s Financial Statements

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Financial Ratio Analysis of a Customer’s 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 expenses2. Operating efficiency in using resources to generate sales3. Marketability of product line4. Coverage that earnings provide over financing cost5. Liquidity position, indicating the availability of ready cash6. Track record of profitability7. 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 Ratio Analysis of a Customer’s Financial Statements (continued)• The Business Customer’s Control over Expenses▫A barometer of the quality of a firm’s 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 firm’s 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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Financial Ratio Analysis of a Customer’s Financial Statements (continued)• Operating Efficiency: Measure of a Business Firm’s

Performance Effectiveness▫ It is also useful to look at a business customer’s 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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Financial Ratio Analysis of a Customer’s Financial Statements (continued)•Operating Efficiency: Measure of a Business Firm’s

Performance Effectiveness

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Financial Ratio Analysis of a Customer’s Financial Statements (continued)•Marketability of the Customer’s 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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Financial Ratio Analysis of a Customer’s Financial Statements (continued)•Marketability of the Customer’s Product or Service

▫A closely related and somewhat more refined ratio is the

net profit margin (NPM)

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Financial Ratio Analysis of a Customer’s Financial Statements (continued)•Coverage Ratios: Measuring the Adequacy of

Earnings

▫Coverage refers to the protection afforded creditors based

on the amount of a business customer’s earnings

▫The best-known coverage ratios include

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Financial Ratio Analysis of a Customer’s Financial Statements (continued)•Liquidity Indicators for Business Customers

▫The borrower’s 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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Financial Ratio Analysis of a Customer’s Financial Statements (continued)• 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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Financial Ratio Analysis of a Customer’s Financial Statements (continued)•The Financial Leverage Factor as a Barometer of a

Business Firm’s 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

business’s credit standing and use of financial leverage include

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Comparing a Business Customer’s Performance to the Performance of Its Industry• It is standard practice to compare each business

customer’s performance to the performance of the customer’s entire industry

▫Dun & Bradstreet Industry Norms and Key Business

Ratios

▫RMA Annual Statement Studies

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Comparing a Business Customer’s Performance to the Performance of Its Industry (continued)• Contingent Liabilities▫ Usually not shown on customer balance sheets are other

potential claims against the borrower:1. Guarantees and warranties behind the business firm’s products

2. Litigation or pending lawsuits against the firm

3. Unfunded pension liabilities

4. Taxes owed but unpaid

5. Limiting regulations

▫ These contingent liabilities can turn into actual claims against the firm’s 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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Comparing a Business Customer’s Performance to the Performance of Its Industry (continued)•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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Comparing a Business Customer’s Performance to the Performance of Its Industry (continued)•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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Preparing Statements of Cash Flows from Business Financial Statements (continued)

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Preparing Statements of Cash Flows from 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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• Customer Profitability Analysis (CPA)

▫ 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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• Customer Profitability Analysis (CPA) ▫ 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 customer’s deposit account

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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 firm’s 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 Seventeen Lending to Business Firms and Pricing Business Loans Copyright © 2013 The...

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