Assignment 1

Topic: Short term and long term loans to business &

analyzing business loan applications

Submitted to: Sir Rizwan

Submitted by: ali

(accounting and finance) 7th

UNIVESITY OF GUJRAT

Short Term and Long Term Loans to

Business Firms:
 Products for business borrowers

Non funded
Funded facilities
facilities

Short term
Long term facilities
facilities

Over Demand Export Import Letter

Discounting Guarantees
Draft finance finance finance of credit

1. Short Term Financing Products to Business Borrowers

 Running finance/overdraft
 Demand finance
 Discounting
  Export finance
 import finance

I. Running Finance/Overdraft:

An overdraft generally known as RF in Pakistan is a type of lending which offers a high

degree of flexibility. For a bank, the overdraft is a staple product by means of which of
customer may overdraw their current account balance, that is, draw out more from the
account than the total amount of money standing in the account. The customer is
permitted to overdraw the account up to an agreed limit. When an account is overdrawn,
the customer is borrowing and owes the bank money. An overdraft is normally shown on
the customer’s bank statement by the abbreviation DR after the balance on the account.
Overdraft are only available on current accounts, the accounts through which business
pass their income and expenditure. Although overdrafts are repayable to the bank on
demand, they are normally agreed subject to annual review. Interest/mark-up on an
overdraft is only charged on the day-to-day balance outstanding on the account. The
overdraft is a convenient way of borrowing to cover a business’s short term requirements.
The overdraft provides finance to cover a business’s working capital needs.

II. Demand Finance:

Demand finance generally in Pakistan is similar to running finance in many aspects

except that the tenor of the demand finance is fixed. For example, a business may have a
requirement for short-term financing for PKR 500,000 for 2 months. The interest rate for
the loan will be booked on the date of the booking of the loan for the period of the loan.
The loan must be paid at the expiration of the term.

III. Export Finance:

Export finance is similar to demand finance. In Pakistan, the State Export of Pakistan to
incentivize exporters has in place special financing schemes whereby exporters can
access pre-shipment financing facilities as well as post-shipment financing facilities.
These facilities are available through the State Bank funded schemes via the banks or
through banks own sources. The facilities available at present are:

Pre-shipment Financing-Part 1 (Founding bank’s own source)

Pre-shipment Financing-Part 2 (Funded through SBP refinance scheme).
IV. Import Finance:

Import finance is generally available in terms of import loans or financing against trust
receipts. Under this facility, the Bank provides the documents of title of goods imported
under L/C to the customer to enable the customer to obtain goods prior to payment and to
sell them to generate funds to pay-off the bank. The goods represented thereby and the
sale proceeds thereof in trust for the bank. Since this is a fund-based facility as opposed
to a non-funded facility as the case of LCs, due care and diligence needs to be exercised
when extending this facility.
It further classified into following:

a) Finance against trust receipt:

FATRs are related to import transactions. The bank may allow specific customers FATR facility
against collection documents as per the terms set out from time to time.

 FATRs in respect of L/C documents:

Under this facility the Bank delivers the documents of the tittle to goods imported under L/C, to
the customers, this enables the customers to get the goods prior to payment. The customer
undertakes to hold the documents in lieu of a Trust Receipt.
b) Finance against imported Merchandise (FIM):
This facility is allowed against the commodities imported from other countries s usually through letter of
credit. At times the importer does not have enough money to pay for the imported merchandise. He
therefore requests the bank to pay the dues to the exporter against the security of imported merchandise.
This facility is usually allowed against imported goods but occasionally such financing may be allowed
against locally manufactured good covered under L/Cs or received for collection.

2. Long-Term Financing products to business borrowers

Term loans are usually granted over a period of years to assist business customers in buying
assets such as plant and equipment, and buildings. A term loan spreads the cost of the assist over
its expected life. A term loan is a loan for a fixed amount, for an agreed period, and on specific
terms and conditions. Normally such loans are for terms of between three and seven years,
although they can range up to twenty years. Longer periods depend on the nature of the proposal,
Terms loans are generally used for longer terms asset purchases as these are not suitable for
financing under an overdraft facility, which should be used for working capital purposes. The
terms and conditions under which they were granted includes interest and other costs. The terms
and conditions of the loan are set out in a loan agreement which includes:

 Tenor: the term over which the loan is to be repaid

 Repayment Schedule: the intervals at which the principal and interest are due for
payment.
 Pricing: the mark-up rate that will be charged.
 Collateral: the security to the granted.

I. Letter of Credit
A letter of credit is generally established by the bank of the behalf of customer.it guaranteeing
the seller’s bank that the bank makes the payment to the seller on the time if seller perform as per
term and condition of letter of credit. Letter of credit may be revocable or irrevocable.
Irrevocable letter of credit cannot change by both seller or buyer but revocable letter of credit
change without the consent of beneficiary. Dealing in letter of credit bank does not lend funds to
business or customers directly but may have to pay if customer is unable to pay. L/C are
contingent liabilities for bank.
Two types of Letter of Credit:
 Sight letter of credit
 Usance letter of credit

a. Sight letter of credit:

In sight payment is due to the seller at the time of receipt of goods by the buyer. Sight L/C
requires the importer bank to pay as soon as it receives the clean documents from exporter.
Document of title of goods released only against payment either by cash or debit by customer
current account. L/C generally is not opened for a period in excess of 180 days without approval
from competent authorities.

b. Usance letter of credit

Usance is that in which payment is due after certain pre agreed number of days by the buyers.
The seller in this instance provide credit to the buyer. It is same as sight but usance draft payable
after specified period of times. Normal usance period for this facility is 90 days but maximum
days for this facility is 180 with approval of competent authority.

II. Guarantees OR Stand-by Letter of Credit

Business customers sometime requires the bank to issue letter of guarantee on their behalf.it is
regarding to the delivery of goods and services by customers to the party. The bank in this
instance does not lend fund directly but may have to pay if customer not perform this obligation.
Guarantees fall into many categories, each of which have its own characteristics.

a. Shipping Guarantee:
Guarantees of this nature are required to enable the customers to release goods before arrival of
documents of title which the render the bank liable to shipping company to whom the guarantee
has been issued. Shipping company is in return liable to true owner of goods if the goods are
released wrongfully. Such guarantees should issue to importers with credit line.

b. Bid bond
A bid bond is guarantees compensation to the bond owner if the bidder fails to begin a project. A
bid bond often uses for construction jobs or other projects with similar bid base section. The
function of bid bond is to provide a guarantee to project owner that the bidder will complete the
project if selected. The existence of bid bond gives the owner assurance that the bidder has the
financial means to accept the job for the price quoted in the bid.

c. Advance Payment Guarantee:

A contract in which the issuer undertakes to be responsible for the fulfillment of contractual
obligation owed by one person to another if the first person default. Civil engineering contract
those awarded by local government, sometime provide for an advance payment to be made to
contractor for purpose such as mobilizing site, plant and equipment, in order to obtain this
payment contractor, require to produce an Advance Payment Guarantee.

d. Financial Guarantee:
It is general description of various guarantees whose main characteristics is an undertaking to
meet any claim from beneficiary up to a fix sum on simple demand. This guarantees often use
when credit worthiness of concerned customer is undoubted such guarantees are issued against
full cash margin.
Analyzing Business Loan Applications

Bank policy is the frame work through which loan applications are considered. The steps of loan
analysis can vary but generally follow specific instructions. Specific qualifier the bank measure
is below:

 Company ability to provide all required documentation

 Debt level below the percentage of total average annual income
 Debt level below the percentage of company asset value
 Potential and probability of loan to facilitate profitability
 Credibility with lenders and credit agencies
 Banking history and asset held within the bank
 Proven company compliance with government tax code
 Compliance with loan terms and agreement

Bank look at 5Cs of lending before approving loan:

 Capacity
 Character
 Collateral
 Capital
 Condition

I. Capacity
The lender wants to know that your business is able to repay the loan. The business should have
sufficient cash flow to support its business expenses and debts comfortably while also providing
principals’ salaries sufficient to support personal expenses and debts. Examining the payment
history of current loans and expenses is an indicator of the borrower’s reliability to make loan
payments.
 II. Character:
Lenders need to know the borrower and guarantors are honest and have integrity. Additionally,
the lender needs to be confident the applicant has the background, education, industry knowledge
and experience required to successfully operate the business. Lending institutions may require a
certain amount of management and/or ownership experience. They will also ask about your
licensing and whether or not you have a criminal record. As history is the best predictor of the
future, a lender will examine the personal credit of all borrowers and guarantors involved in the
loan, sound business and personal credits are a must. Check both reports before calling our
lender; if there are any delinquencies, be prepared to explain. The lender may be able to make
exceptions for low credit scores.

III. Collateral:
A lender will consider the value of the business’ assets and he personal assets of the guarantors
as a secondary source of repayment. Collateral is an important consideration, but its significance
varies depending on the type of loan. A lender will be able to explain the types of collateral
needed for your loan.

IV. Capital:
Your lender will ask what personal investment you plan to make in the business. Not only does
injecting capital decrease the chance of default, but contributing personal assets also indicates
that you are willing to take a personal risk for the sake of your business; it shows that you have
skin in the game.

V. Condition:
The lender will need to understand the condition of the business, the industry, and the economy,
which is why it is important to work with a lender who understands the WCB industry. The
lender will want to know if the current condition of the business will continue, improve or
deteriorate. Furthermore, the lender will want to know how the loan proceeds will be used-
working capital, renovations, additional equipment etc.

Credit Analysis Ratios Used by Banks

Credit analysis ratios are tools that assist the credit analysis process. These ratios help analysts
and investors determine whether individuals or corporations are capable of fulfilling financial
obligations.

1. Profitability Ratios:
As the profitability ratios measure the ability of the company to generate profit relative to
revenue, balance sheet assets, and shareholders’ equity. They also help lenders determine the
growth rate of corporations and their ability to pay back loans.
 Gross profit margin
 EBIT margin
 Operating profit margin
 Return on assets
 Return on equity

I. Gross profit margin:

The Gross Profit (GP) of a business is the accounting result obtained after deducting the cost of
goods sold and sales returns/allowances from total sales revenue. GP is located on the income
statement (sometimes referred to as the statement of profit and loss) produced by a company and
is used in determining a company’s gross margin.
II. EBIT Ratio:
EBIT margin is a profitability ratio that measures how much in earnings a company is generating
before interest, taxes, depreciation, and amortization, as a percentage of revenue.
III. Operating Profit Margin:
Operating Profit Margin is a profitability or performance ratio that reflects the percentage of
profit a company produces from its operations, prior to subtracting taxes and interest charges. It
is calculated by dividing the operating profit by total revenue and expressing as a percentage.
IV. Return on Asset:
Return on Assets (ROA) is that measures the profitability of a business in relation to its total
assets. This ratio indicates how well a company is performing by comparing the profit it’s
generating to the capital it’s invested in assets. The higher the return, the more productive and
efficient management is in utilizing economic resources.
V. Return on Equity:
Return on Equity (ROE) is the measure of a company’s annual return (net income) divided by
the value of its total shareholders’ equity, expressed as a percentage.

2. Liquidity Ratios
Liquidity ratios indicate the ability of companies to convert assets into cash. In terms of credit
analysis, the ratios show a borrower’s ability to pay off current debt. Higher liquidity ratios
suggest a company is more liquid and can, therefore, more easily pay off outstanding debts.

Liquidity ratios include:

 Current ratio
 Quick ratio
 Cash ratio
 Working capital

I. Current Ratio:
The current ratio, also known as the working capital ratio, measures the capability of a business
to meet its short-term obligations that are due within a year. The ratio considers the weight of
total current assets versus total current liabilities.
II. Quick Ratio:
The Quick Ratio, also known as the Acid-test or Liquidity ratio, measures the ability of a
business to pay its short-term liabilities by having assets that are readily convertible into cash.
These assets are, namely, cash, marketable securities, and accounts receivable. These assets are
known as “quick” assets since they can quickly be converted into cash.
III. Cash Ratio:
The cash ratio sometimes referred to as the cash asset ratio is that indicates a company’s capacity
to pay off short-term debt obligations with its cash and cash equivalents.
IV. Working Capital:
Working capital tells us the short-term liquid assets remaining after short-term liabilities have
been paid off. It is a measure of a company’s short-term liquidity and is important for performing
financial analysis.