CHAPTER 17 LENDING TO BUSINESS FIRMS AND PRICING BUSINESS LOANSGoal of This Chapter: The purpose of this chapter is to explore how bankers can respond to a business customer seeking a lo
Trang 1CHAPTER 17 LENDING TO BUSINESS FIRMS AND PRICING BUSINESS LOANS
Goal of This Chapter: The purpose of this chapter is to explore how bankers can respond to a business customer seeking a loan and to reveal the factors they must consider in evaluating a business loan request In addition, we explore the different methods used today to price business loans and to evaluate the strengths and weaknesses of these pricing methods for achieving a financial institution’s goals
Key Topics in This Chapter
• 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
Chapter Outline
I Introduction
II Brief History of Business Lending
III Types of Business Loans
A Short-Term Business Loans
B Long-Term Business Loans
IV Short-Term Loans to Business Firms
A Self-Liquidating Inventory Loans
B Working Capital Loans
C Interim Construction Financing
D Security Dealer Financing
E Retailer and Equipment Financing
F Asset-Based Financing
G Syndicated Loans (SNCs)
V Long-Term Loans to Business Firms
A Term Business Loans
B Revolving Credit Financing
C Long-Term Project Loans
D Loans to Support the Acquisition of Other Business Firms—Leveraged Buyouts
VI Analyzing Business Loan Applications
A Most Common Sources of Loan Repayment
B Analysis of a Business Borrower's Financial Statements
1 Important Balance Sheet Composition Ratios
a Percentage Composition of Assets
b Percentage Composition of Total
Liabilities and Net Worth
Trang 22 Important Income Statement Composition Ratios
a Percentage Composition of Total IncomeVII Financial Ratio Analysis of a Customer's Financial Statements
A The Business Customer's Control over Expenses
B Operating Efficiency: Measure of a Business Firm's Performance Effectiveness
C Marketability of the Customer's Product or Service
D Coverage Ratios: Measuring the Adequacy of Earnings
E Liquidity Indicators for Business Customers
F Profitability Indicators
G The Financial Leverage Factor as a Barometer of a Business Firm's Capital
StructureVIII Comparing a Business Customer’s Performance to the Performance of Its Industry
A Contingent Liabilities
1 Types of Contingent Liabilities
2 Environmental Liabilities
3 Underfunded Pension Liabilities
IX Preparing Statements of Cash Flows from Business Financial Statements
A Statement of Cash Flows
B Pro Forma Statements of Cash Flows and Balance Sheets
C The Loan Officer's Responsibility to the Lending Institution and the Customer
X Pricing Business Loans
A The Cost-Plus Loan Pricing Method
B The Price Leadership Model
C Below-Prime Market Pricing
D Customer Profitability Analysis (CPA)
1 An Example of Annualized Customer Profitability Analysis
a Problem
b Interpretation
2 Earnings Credit for Customer Deposits
3 The Future of Customer Profitability Analysis
XI Summary of the Chapter
Concept Checks17-1 What special problems does business lending present to the management of a business lending institution?
While business loans are usually considered among the safest types of lending (their default rate, for example, is usually well below default rates on most other types of loans), these loans
average much larger in dollar volume than other loans and, therefore, can subject an institution toexcessive risk of loss and, if a substantial number of loans fail, can lead to failure Moreover, business loans are usually much more complex financial deals than most other kinds of loans, requiring larger numbers of personnel with special skills and knowledge These additional resources required an increase in the magnitude of potential losses unless the business loan portfolio is managed with great care and skill
Trang 317-2 What are the essential differences among working capital loans, open credit lines, based loans, term loans, revolving credit lines, interim financing, project loans, and acquisition loans?
asset-a Working capital loans are short-run credits to fund the current assets of a business, such
as accounts receivable, inventories, or to replenish cash Usually a working capital loan is
designed to cover seasonal peaks in a business customer’s production levels
Normally, working capital loans are secured by accounts receivable or by pledges of inventory and carry a floating interest rate on the amounts actually borrowed against the approved credit line
b Open credit lines include a credit agreement allowing a business to borrow up to a
specified maximum amount of credit at any time until the point in time when the credit line expires
c Asset-based loans are secured on the basis of the shorter-term assets of a firm that are expected to roll over into cash in the future Generally, the amount and timing of the credit is based directly upon the value, condition, and maturity of certain assets held by a business firm (such as accounts receivable or inventory) and those assets are usually pledged as collateral behind the loan
d Term loans are business credit that have an original maturity of more than one year and are normally used to fund the purchase of new plant and equipment or to provide for a permanentincrease in working capital Term loans usually look to the flow of future earnings of a business firm to amortize and retire the credit Term loans normally are secured by fixed assets (e.g., plant
or equipment) owned by the borrower and may carry either a fixed or a floating interest rate
e Revolving credit lines are lines of credit that promise the business borrower access to anyamount of borrowed funds up to a specified maximum amount; moreover, the customer may borrow, repay, and borrow again any number of times until the credit line reaches its maturity date It is one of the most flexible of all business loans, and is often granted without specific collateral and may be short-term or cover a period as long as five years
f Interim construction financing involves bank funding to start construction or to complete construction of a business project in the form of a short-term loan; once the project is completed, long-term funding will normally pay off and replace the interim financing
g Project loans are basically given to support the startup of a new business project, such as the construction of an offshore drilling platform or the installation of a new warehouse or
assembly line; often such loans are secured by the property or equipment that are part of the new project
Trang 4h Acquisition loans are made to finance mergers and acquisitions of businesses Among themost noteworthy of these acquisition credits are leveraged buyouts of firms by small groups of investors.
17-3 What aspects of a business firm's financial statements do loan officers and credit analysts examine carefully?
Analysis of the financial statements of a business borrower typically begins when the lender’s credit analysis department analyses how key figures on the borrower’s financial statement have changed (usually during the last three, four, or five years.) The percentage-composition ratios reflected in such financial statements, control for differences in size of firm, permitting the loan officer to compare a particular business customer with other firms and with the industry as a whole With the help of these ratios, the loan officers and credit analysts examine the following aspects of a business firm's financial statements:
a Control over expenses: A business firm’s management keeps a check on its quality by analyzing how carefully it controls its expenses and how well its earnings are likely to be
protected and grow
Key financial ratios to monitor a firm’s expense control program include, cost of goods sold/net sales; selling, administrative and other expenses/net sales; wages and salaries/net sales; interest expenses on borrowed funds/net sales; overhead expenses/net sales; depreciation expenses/net sales, and taxes/net sales
b Operating efficiency: It is also important to look at how effectively are assets being utilized to generate sales and how efficiently are sales converted into cash
The important ratios here are, net sales/total assets, annual cost of goods sold/average inventory levels, net sales/net fixed assets, and net sales/accounts and notes receivable
c Marketability of a product or service: A financial lender can often assess public
acceptance of what the business customer has to sell by analyzing such factors as the growth rate
of sales revenues, changes in the business customer’s share of the available market, and the grossprofit margin (GPM) These key factors can be found by computing the following ratios:
To measure the gross profit margin the manager has to divide the difference of net sales and cost
of goods sold with the net sales Also, the net profit margin can be found by dividing net income after taxes to net sales
d Coverage Ratio: The coverage ratio measures the adequacy of earnings to know whether the borrower will be able to pay back the loan
Important measures here include interest coverage which can be computed by dividing the income before interest and taxes by total interest payments, coverage of interest and principal payments can be found by dividing earnings before interest and taxes by the sum of annual interest payments and principal repayments adjusted for the tax effect Also, the coverage of all
Trang 5fixed payments can be found by dividing income before interest, taxes and lease payments by thesum of interest payments and lease payments.
e Profitability indicators: The ideal standard of performance in a market-oriented economy
is how much net income remains for the owners of a business firm after all expenses are charged against revenue
Key barometers of such financial success include the following ratios
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)
f Liquidity indicators: It reflects the borrower’s liquidity position so as to raise cash
regularly and at a reasonable cost The lender mainly looks at the borrower’s ability to meet the loan payments when they come due
Important ratio measures here usually include the current ratio (current assets/divided by current liabilities), acid-test ratio [(current assets – inventory)/ divided by current liabilities)], net liquid assets (current assets – inventory − current liabilities), and net working capital (current assets − current liabilities)
g Leverage indicators: The term financial leverage refers to use of debt expecting that the borrower can generate earnings that exceed the cost of debt, thereby increasing potential returns
to a business firm’s owners
Ratios indicating trends in this dimension of business performance usually include the leverage ratio (total liabilities/total assets), capitalization ratio (long-term debt/total long-term liabilities and net worth), and the debt-to-sales ratio (total liabilities/net sales)
One problem with employing ratio measures of business performance is that they only reflect symptoms of a possible problem but usually don't tell us the nature of the problem or its causes Management must look much more deeply into the reasons behind any apparent trend in a ratio Moreover, any time the value of a ratio changes that change could be due to a shift in the
numerator of the ratio, in the denominator, or both
17-4 What aspect of a business firm's operations is reflected in its ratio of cost of goods sold tonet sales? In its ratio of net sales to total assets? In its GPM ratio? In its ratio of income before interest and taxes to total interest payments? In its acid-test ratio? In its ratio of before-tax net income to net worth? In its ratio of total liabilities to net sales? What are the principal limitations
of these ratios?
The ratio of cost of goods sold to net sales is a widely used indicator of a business firm's expensecontrols The ratio of net sales to total assets reflects the operating efficiency indicating the efficiency with which the assets are being utilized to generate sales The gross profit margin (GPM) measure reflects the marketability of the customer's products or services A firm's ratio of
Trang 6income before interest expense and taxes to total interest payments indicates how effectively a business is covering its interest expenses through the generation of before-tax income The acid-test ratio provides a rough measure of a firm's liquidity position The ratio of before-tax income tonet worth represents a measure of profitability of the business Finally, the ratio of liabilities to net sales is an indicator of management's use of financial leverage.
These ratios are affected by changes in the numerator or the denominator or both; a financial or credit analyst would want to know the source of any change in a ratio's value These ratios only measure problem symptoms; you must dig deeper to find the cause
17-5 What are contingent liabilities, and why might they be important in deciding whether to approve or disapprove a business loan request?
Contingent liabilities are usually not shown on customer balance sheets These liabilities can be
in various forms such as pending or possible future obligations like lawsuits against a business firm, and warranties or guarantees the firm has given to others regarding the quality, safety, or performance of its product or service Other forms of contingent liabilities that business firms arelikely to incur are unfunded pension liabilities the firm will owe toward its employees in the future, taxes owed but unpaid, or limiting regulations Another example is a credit guarantee in which the firm may have pledged its assets or credit to back up the borrowings of another
business, such as a subsidiary Environmental damage caused by a business borrower has also recently become a great cause of concern of contingent liability for many banks This is because
a bank foreclosing on business property for nonpayment of a loan could become liable for cleanup costs, especially if the bank becomes significantly involved with a customer's business
or treats foreclosed property as an investment rather than a repossessed asset that is quickly liquidated to recover the unpaid balance on a loan
Loan officers must be aware of all contingent liabilities because any or all of them could become due and payable claims against the business borrower, weakening the firm's ability to repay its loan to the bank Hence, it becomes important for the loan officer to ask the customer about pending or potential claims against the firm and then follow up with his or her own investigation,checking government records, public notices, and newspapers
17-6 What is cash-flow analysis, and what can it tell us about a business borrower’s financial condition and prospects?
The statement of cash flows shows how cash receipts and disbursements are generated by
operating, investing, and financing activities of a business firm Such a cash flow statement indicates the changes in a business firm's assets and liabilities as well as its flow of net profit andnoncash expenses (such as depreciation) over a specific time period It shows where the firm raised its operating capital during the time period under examination and how it spent or used those funds in acquiring assets or paying down liabilities It also examines all purchases and sales of securities and long-term assets, such as plant and equipment in the form of investing activity The financing activities section of the firm will include cash flows from short- and long-term funds provided by lenders and owners, while cash outflows will include the repayment of borrowed funds, dividends to owners, and the repurchasing of outstanding stock
Trang 7From the perspective of a loan officer, the cash flow statement indicates whether the firm is relying heavily upon borrowed funds or on sales of assets These are two less desirable funding sources from the point of view of lending money to a business firm as these sources of cash inflow suggest the company may be exhausting its liquidity and capacity to borrow, casting doubts regarding its ability to repay future borrowings Loan officers usually prefer to focus uponthe generation of sufficient cash flows to repay most of its debt and remain viable in the long run.17-7 What is a pro forma statement of cash flows, and what is its purpose?
A pro forma statement of cash flows is useful not only to look at historical data in a statement of cash flows, but also to estimate the business borrower’s future cash flows and financial conditionand its ability to repay the loan
17-8 Should a loan officer ever say “no” to a business firm requesting a loan? Please explain when and where
A loan request may not appear of having reasonable prospects for being repaid in the future The loan officer can come to this conclusion after noticing the borrowing company’s recent record of sales revenue, expenses, cash flow, and net earnings Loan officers will inevitably be confronted with such loan requests that will have to be flatly rejected, particularly in those cases where the borrower has falsified information or has a credit history of continually "walking away" from debt obligations
In such cases, the loan officer should be as polite as possible, suggesting to the customer what needs to be changed or improved for the future to permit the customer to be seriously considered for a loan The officer can offer to provide noncredit services, such as cash management services,advice on a proposed merger, or assistance with a new security offering the customer may be planning Another possible option is a counteroffer on the proposed loan that is small enough andsecured well enough to adequately protect the lender Also, the loan rate can be shaped in such a way that it further protects and compensates the lender for any risks incurred
17-9 What methods are used to price business loans?
The following methods are in use today to price business loans:
a Cost-plus loan pricing
b Price leadership pricing model
c Below-prime market pricing
d Customer profitability analysis (CPA)
Cost-plus-profit pricing requires the bank to add the cost of raising adequate funds to lend, the lender’s nonfunds operating costs, compensation for the degree of default risk inherent in a loan request, and the desired profit margin
Trang 8The price-leadership model, on the other hand, bases the loan rate upon a uniform national or international rate (such as prime or LIBOR) posted by major commercial banks The prime rate
is usually considered to be the lowest rate charged to the most creditworthy customers on term loans The actual loan rate charged to any particular customer is determined by adding the default-risk premium and the term-risk premium as a markup over the prime rate Lending institutions can expand or contract their loan portfolios simply by contracting or expanding their loan-rate markups
short-The below-prime market pricing prices a loan on the basis of cost of borrowing in the money market plus a small profit margin Customer profitability analysis looks at all the revenues and costs involved in serving a customer and then the bank is required to calculate the net rate of return from some large corporates covering a loan for only a few days or weeks
17-10 Suppose a bank estimates that the marginal cost of raising loanable funds to make a $10 million loan to one of its corporate customers is 4 percent, its nonfunds operating costs to
evaluate and offer this loan are 0.5 percent, the default-risk premium on the loan is 0.375
percent, a term-risk premium of 0.625 percent is to be added, and the desired profit margin is 0.25 percent What loan rate should be quoted to this borrower? How much interest will the borrower pay in a year?
According to the cost-plus loan pricing model:
Loan interest rate =
Marginal cost of raising loanable funds to lend to the borrower +
Nonfunds operating costs + Estimated margin to compensate for default risk +
Desired profit margin
Loan interest rate = 4 percent + 0.50 percent + 0.375 percent + 0.25 percent = 5.125 percent
Based on a $10 million loan to be raised, the customer will pay interest of: $10,000,000 × 5.125 percent = $512,500
17-11 What are the principal strengths and weaknesses of the different loan-pricing methods in use today?
Cost plus pricing is the simplest loan pricing model as it considers the cost of raising loanable funds and the operating costs of running the lending institution However, the model assumes that a lending institution can accurately judge the costs which often don’t turn out to be accurate
Price leadership overcomes the problems of accurately predicting what the costs of a loan will befor a lending institution as major commercial banks establish a uniform base lending fee, the prime rate, Moreover, LIBOR, which is being switched over from prime rates, offer a common pricing standard for all banks, both foreign and domestic, and give customers a common basis for comparing the terms on loans offered by different lenders However, it is still difficult to
Trang 9assign risk premiums to loans as it would differ among borrowers based on the risk that they carry.
Below prime market pricing uses LIBOR as the base rate and includes only a small profit margin
as part of the loan price This has been proposed only for short term loans for large, well known corporations but is not generally used for small and medium sized companies or longer term loans
Customer profitability analysis is similar to cost plus pricing It however differs from the same technique as in that it considers the whole customer relationship into account when pricing a loanCustomer profitability analysis has become increasingly sophisticated as computer models have been designed to help with the analysis Often the borrowing company itself, its subsidiary firms,major stockholders, and top management are all consolidated into one profitability analysis statement so that the lender receives a comprehensive picture of the total customer relationship Automated CPA systems permit lenders to plug in alternative loan and deposit pricing schedules
to see which pricing schedule works best for both customer and lending institution CPA can also
be used to identify the most profitable types of customers and loans and the most successful loan officers
17-12 What is customer profitability analysis? What are its advantages for the borrowing
customer and the lender?
Customer profitability analysis is a loan pricing method that takes into account the lender’s entirerelationship (all revenues and expenses associated with a particular customer) with the customer when pricing the loan It is based on the difference between revenues from loans and other services provided and expenses from providing loans and other services to the customer is taken over net loanable funds Net loanable funds are those funds used in excess of the customer’s deposits If the calculated net rate of return from a customer’s relationship is positive the loan is made and if it is not, the rate is raised or the loan is not made
As CPA takes the entire relationship of the borrowing company itself, its subsidiary firms, major stockholders, and top management into account, it gives a better picture of which customer relationships are profitable to the lender
Problems and Projects17-1 From the descriptions below please identify what type of business loan is involved.
a A temporary credit supports construction of homes, apartments, office buildings, and
other permanent structures
b A loan is made to an automobile dealer to support the shipment of new cars
c Credit extended on the basis of a business’s accounts receivable
d The term of an inventory loan is being set to match the length of time needed to generate
cash to repay the loan
e Credit extended up to one year to purchase raw materials and cover a seasonal need for
cash
Trang 10f A securities dealer requires credit to add new government bonds to his securities
portfolio
g Credit granted for more than a year to support purchases of plant and equipment
h A group of investors wishes to take over a firm using mainly debt financing
i A business firm receives a three-year line of credit against which it can borrow, repay,
and borrow again if necessary during the loan’s term
j Credit extended to support the construction of a toll road
Based upon the descriptions given in the text the type of business loan being discussed is:
a Interim construction financing
b Retailer and equipment financing
c Asset-based financing
d Self-liquidating inventory loan
e Working capital loan
f Security dealer financing
g Term business loan
h Acquisition loan or leveraged buyout
i Revolving credit financing
j Long-term project loan
17-2 As a new credit trainee for Evergreen National Bank, you have been asked to evaluate thefinancial position of Hamilton Steel Castings, which has asked for renewal of and an increase in its six-month credit line Hamilton now requests a $7 million credit line, and you must draft yourfirst credit opinion for a senior credit analyst Unfortunately, Hamilton just changed
management, and its financial report for the last six months was not only late but also garbled
As best as you can tell, its sales, assets, operating expenses, and liabilities for the six-month period just concluded display the following patterns: