17-3

Key topics
 A banker is a fellow who lends his 1. Types of business loans: short-term and long-
LENDING TO BUSINESS FIRMS umbrella when the sun is shining and term
AND PRICING BUSINESS wants it back the minute it begins to
2. Analyzing business loan requests
LOANS rain.
(Mark Twain) 3. Collateral and contingent liabilities

4. Sources and uses of business funds

Chapter 2 - Why?
5. Pricing business loans
- How does it affect the borrowers?
6. Customer profitability analysis (CPA)
- How is the case of Vietnam banks now?

1 2 3

17-4 17-5 17-6

Self-liquidating inventory loans:

Short term business loans
1. Self-liquidating inventory loans:
 used to finance the purchase of inventory, taking
the advantage of cash cycle in a business firm
 Demand for traditional inventory loans is on the
decline due to the development of the JIT (just in
time) and supply chain management techniques
Short term business loans
Cash cycle…
2. Working capital loans: closest to self-liquidating loans
1. Cash is spent to acquire inventory
 Bank can set up a credit line (max funding need) in a
2. Goods are produced or shelved and listed for certain short period (a few months)
 Loans can be renewed provided that the borrower pay off
sale
all significant portion of the loan before the renewal
3. Sales are made (often on credit)  Loans are secured by account receivables, pledges of
inventory
4. The cash received is used to repay the self-  Borrower has to pay floating interest rate on disbursed
liquidating loan amount & a commitment fee is charged on unused credit
line.
 Compensating deposit balances may be required.

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17-7 17-8 17-9

Short term business loans Short term business loans Short term business loans

3. Interim construction loans: support the construction
of homes, apartments, office buildings, etc.
 Fund supplied to hire workers, lease construction
equipments, purchase building materials & develop land
4. Security dealer financing:
 short-term (overnight to few days) financing new
securities purchase backed by the dealers’ holdings of
government securities as collateral
 Can be extended to investment banking firm in
5. Retailer and Equipment financing:
 Banks finance receivables that dealers selling
automobiles, home appliances, furniture, business
equipment,… take on they write installment contracts to
cover customer purchase

 The loan is paid off with a longer-term mortgage loan
issued by another lender
 “Mini-permanent loan” providing fund for the construction
and early operation of a project in 5-7 years
underwriting new securities issued by the government or
firms
 Can be lent directly to businesses and individuals in
buying stocks, bonds, options, etc.
 Margin requirements are enforced (≤ 50% of acquired
securities)
 Contracts are purchased by lenders at an interest rate
varying with the borrower risk, collateral quality and loan
terms
 “Floor planning”: lender finances the dealer’s goods
purchase from manufacturer and be paid as goods are
sold

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 17-10 17-11 17-12

Short term business loans Short term business loans Long-term business loans
5. Asset-based financing: 6. Syndicated loans (SNCs): 1. Term loans
 Credit secured by the shorter-term assets of a firm that  Loans package extended to a corporation by a lender 2. Revolving credit lines
are expected to roll over into cash in the future group 3. Project loans
 Lender commits funds against a specific % of book value 4. Loans to support acquisitions of other business
 Lender aims to reduce risk of large loans and earn fee
of outstanding receivables or inventory firms
income (facility fee to open credit line or commitment fee
 The borrower retains title to the asset pledged in most
to keep credit available)
cases
 Factoring: lender takes on responsibility of collecting  Many SNC loans are traded in the secondary (resale)
receivables. Due to higher risk → higher discount rate market carrying interest rate based on LIBOR on
and loan accounts for a smaller fraction of receivable Eurodollar deposits (1-4% above LIBOR)
book value

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17-13 17-14 17-15

Term loans:
Term loans attention should be paid to…. Revolving credit lines
Term loans are designed to fund long-term 1. Qualification of the borrower’s management  Allowing the customer to borrow up to pre-specified
business investment (equipment or construction) 2. Quality of accounting & auditing system limit, repay all or a portion of the borrowing and re-
3. The borrower’s continuous filling in periodical financial borrow as necessary until the credit line matures
1. A lump-sum loan is approved
statements  Being one of the most flexible business loan,
2. Payment is made by amortization monthly/quarterly
4. The lender’s priority in claiming the borrower’s pledged granted without specific collateral and maybe short-
3. Repayment source is from business earnings
assets term or cover a period as long as 5 years
4. Payment is scheduled based on firm’s cashflow cycle
5. Adequate insurance coverage  Useful when firms are uncertain about timing of
5. Collateralization is made by fixed assets owned
6. The borrower’s risk exposure to technology risk future cash flow and borrowing need magnitude
either by the borrower or the guanrantee
7. Length of time before the project can generate positive  Help even out fluctuations in business cycle
6. Interest rate is either fixed or floated and higher than
cash flow
short-term rate due to higher risk  Loan commitment fee is charged on unused portion
8. Trend in market demand of credit line or entire credit amount available
7. “Bullet loan”: interest is paid periodically and no
principal is made till maturity date 9. Strength of borrower’s net worth posistion

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17-16 17-17 17-18

Project loans Project loans (cont.) Loans to support firm acquisitions

 The most risky of all business loans to finance fixed
asset construction designed to generate revenue in
future (oil refineries, power plants, harbor facilities…)
 Risks are large and numerous, due to
 Large funding is involved
 Project maybe delayed caused by weather or material
shortage
 Laws and regulations in the project location are
negatively changed
 Interest rate change adversely affects the ability to pay
 Loans are granted to several companies jointly
sponsoring the project and/or the project is co-
financed by several lenders for risk sharing
 Project loan may be granted on  Loans to finance mergers/acquisitions of businesses
 Recourse basis: lender can recover funds from the  Most noted: LBOs (leveraged buyouts)
sponsoring companies if the project fails to repay as
 Firm purchased is financed heavily by debt in the
planned
belief that revenues can be raised higher than debt
 Non-recourse basis: no sponsor guarantees, project
costs
stands or falls on its own merit → higher loan rate and
 Frequently optimistic assumptions have turned to be
more sponsor’s capital contribution due to higher risk
wrong and loans have turned delinquent

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Quick quiz
1. How business loans are classified in Vietnam?
2. What are the essential differences between
various short- and long-term business loans?
3. What special problems does business lending
present to the management of a business
lending institution?
19
Problems of business loans
Though business loans are usually considered among
the safest types (low default rate), these loans:
 average much larger in dollar volume than other
loans → excessive risk of loss and, if a substantial
number of loans fail, can lead to failure
 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. → increase the magnitude of potential
losses unless the business loan portfolio is managed
with great care & skill.
22
17-25
Analyzing business loan applications
 Common size ratios of customer over time
 Financial ratio analysis of customer’s financial
statements
 Current and pro forma sources and uses of
funds statement
25
Differences between short- & long-term
Loan types (Circular 39/2016/TT-NHNN) business loans
1- Term loan or closed-end credit (Cho vay từng lần): short-
&long-term
Long - term vs short-term loans:
2- Syndicated loan (Cho vay hợp vốn): short- &long-term
3- Seasonal loan (Cho vay lưu vụ): short-term  large volume
4- Revolving credit line or Lines of credit (Cho vay theo hạn  long term
mức tín dụng): short-term
 high default risk
5- Stand-by credit line loan (Cho vay hạn mức tín dụng dự
phòng): short-term
6- Overdraft loan (Cho vay theo hạn mức thấu chi): short-
term
7- Revolving loan (Cho vay quay vòng): short-term
8 - Rollover loan (Cho vay tuần hoàn): short-term
9 - Combinations of different types mentioned above
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17-23 17-24
Analyzing business loan application Sources of repayment for business loans
 The lender’s margin for error is narrow, due to:
 The borrower’s profits or cash flows
 Large loan denomination
 Yield spread reduction because of competition for best  Business assets pledged as collateral
customers  Strong balance sheet with ample marketable
→ requiring special care by
assets and net worth
 Asking more repayment sources from borrowers
 Guarantees given by businesses
 Analyzing the borrower’s financial statements
 Pricing the loan correctly to cover costs & be
competitive.
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17-27
Case study - Financial ratio analysis Financial ratio analysis
 Control over expenses
 Analyzing the Black Gold financial statements:  Operating efficiency
Tables 17.1  17.9 (p. 561 p. 576)  Marketability of product or service
 Coverage ratios: measuring adequacy of
earnings
 Preparing the cash flow – Pro Forma?  Liquidity indicators for business customers
 Profitability indicators
 The financial leverage factor as a barometer of
a business firm’s capital structure
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 17-28 17-29 17-30

Expense control measures Operating efficiency Marketability of product or service

 Cost of goods sold/Net sales  Annual costs of goods sold/Average inventory

 Selling, administrative and other expenses/Net  Average receivables collection period  Gross profit margin=(Net sales-CGS)/Net sales

sales  Net sales/Net fixed assets

 Net profit margin=Net income after taxes/Net
 Depreciation expenses/Net sales  Net sales/Total assets
sales
 Interest expenses on borrowed funds /Net sales  Net sales/Accounts receivables

 Taxes/Net sales

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17-31 17-32 17-33

Coverage measures Profitability measures

Liquidity measures

 Current assets/Current liabilities  Before tax net income/Total assets

 Interest coverage
 Acid test ratio
 After tax net income/Total assets
 Coverage of interest and principal payments  Working capital
 Before tax net income/Net worth
 Net liquid assets
 After tax net income/Net worth

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17-34 17-35 17-36

Comprehensive environmental response,

Leverage or capital structure measures Types of contingent liabilities compensation and liability act

 Guarantees or warrantees behind products This law makes current and past owners of
 Leverage ratio
contaminated property, current and past owners
 Litigation or pending lawsuits
 Total liabilities/Net worth and prior operators of businesses located on
 Unfunded pension liabilities contaminated property and those who transport
 Capitalization ratio
hazardous substances potentially liable.
 Taxes owed but unpaid
 Debt to sales ratio
 Limiting regulations

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 17-37 17-38 17-39

Component of sources and uses of funds Indirect operating cash flows

statement
Traditional (direct) operating cash flows
Net income
+ Non cash expenses
 Cash flows from operations Net sales revenue – Cost of goods sold – Selling, + Losses from the sale of assets
– Gains from the sale of assets
 Cash flows from investing activities general and administrative – Taxes paid in cash – Increases in assets associated with operations
+ Increases in current liabilities associated with
 Cash flows from financing activities + Non cash expenses operations
– Decreases in current liabilities associated with
operations
+ Decreases in current assets associated with
operations

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17-41 17-42

Ethics in banking Methods used to price business loans Cost-plus loan pricing

 Earning deception by borrowing  Cost-plus loan pricing method

businesses: what should loan officers do?
Marginal
 Price leadership model Cost of Estimated
Nonfund Bank's
Loan Raising Margin to
Bank Desired
 Below prime market pricing Interest = Loanable + + Compensate +
Operating Profit
Rate Funds to Bank for
Costs Margin
Lend to Default Risk
 Customer profitability analysis Borrower

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17-43 17-44 17-45

Price leadership model Prime rate LIBOR: London Interbank Offer Rate

Major banks established a base lending fee

The rate offered on short-term Eurodollar
Default
during the great depression. At that time it was
Risk Term Risk
Loan
Base or Premium Premium for deposits with maturities ranging from a few
Interest = + + the lowest interest rate charged their most
Prime Rate for Non- Longer
Rate
Prime Term Credit days to a few months.
credit worthy customers for short-term working
Borrowers
capital loans.

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 17-46
Below-prime market pricing
Interest Cost
Loan Markup
of Borrowing
Interest = + for Risk
in the Money
Rate and Profit
Market
46
Answers
1. What special problems does business lending present to
the management of a business lending institution?
Though business loans are usually considered among the
safest types of lending (low default rate), these loans:
 average much larger in dollar volume than other loans
→ excessive risk of loss and, if a substantial number of
loans fail, can lead to failure
 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.
→ increase the magnitude of potential losses unless the
business loan portfolio is managed with great care & skill.
49
Answers
2. 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?
d. Term Loans -- Business loans that have an original
maturity of more than one year and normally are used to
fund the purchase of new plant and equipment or to
provide for a permanent increase in working capital. Term
loans usually look to the flow of future earnings of a
business firm to amortize and retire the credit.
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17-47
Customer profitability analysis (CPA)
 Estimate total revenues from loans and other
services
 Estimate total expenses from providing net
loanable funds
 Estimate net loanable funds
 Estimate before tax rate of return by dividing
revenues less expenses by net loanable funds
47
Answers
2. 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?
a. Working Capital Loans -- Loans to fund the current
assets of a business, such as accounts receivable,
inventories, or to replenish cash.
b. Open Credit Lines -- 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.
50
Answers
2. 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?
e. Revolving Credit Lines -- Lines of credit that promise the
business borrower access to any amount of borrowed
funds up to a specified maximum amount; the customer
may borrow, repay, and borrow again any number of times
until the credit line reaches its maturity date.
f. Interim Financing -- 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.
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Questions & Problems
1. What special problems does business lending present to
the management of a business lending institution?
2. 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?
3. What are contingent liabilities, and why might they be
important in deciding whether to approve or disapprove a
business loan request?
4. What are the principal strengths and weaknesses of the
different loan-pricing methods in use today?
5. Problem 3, 4, 6 and 7 (page 586-8)
48
Answers
2. 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?
c. Asset-based Loans -- Credit secured by the shorter-term
assets of a firm that are expected to roll over into cash in
the future. Credit whose amount and timing is based
directly upon the value, condition, and maturity of certain
assets held by a business firm (such as accounts
receivable or inventory) with those assets usually being
pledged as collateral behind the loan.
51
Answers
2. 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?
g. Project Loans -- Credit to support the start up 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.
h. Acquisition Loans--Loans to finance mergers and
acquisitions of businesses. Among the most noteworthy of
these acquisition credits are leveraged buyouts of firms by
small groups of investors.
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 Answers
3. What are contingent liabilities, and why might they be
important in deciding whether to approve or disapprove a
business loan request?
Contingent liabilities include:
 Pending or possible future obligations as 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.
 A credit guaranty 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
also has recently become of great concern as a contingent
liability for many banks
Answers
3. What are contingent liabilities, and why might they be
important in deciding whether to approve or disapprove a
business loan request?
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.
Answers
4. What are the principal strengths and weaknesses of the
different loan-pricing methods in use today?
a. Cost plus pricing is the simplest loan pricing model.
However, it assumes that a lending institution can
accurately know what its costs are and often they don’t.
b. Price leadership overcomes the problems of accurately
predicting what the costs of a loan will be to a lending
institution. However, it is still difficult to assign risk
premiums to loans. In addition, using something like the
prime rate as the base rate has been challenged by LIBOR
and other market based rates.

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Answers Answers Answers

4. What are the principal strengths and weaknesses of the 5. Problem 3 (page 586)
different loan-pricing methods in use today? Expense Control Ratios
Wages and salaries / Net Sales
Overhead expenses / Net Sales
c. Below prime market pricing uses LIBOR as the base rate Depreciation expenses / Net Sales
5. Problem 3 (page 586)
Operating Efficiency Measures Profitability Measures Liquidity Indicators
Inventory turnover ratio
Before-tax net income / Total assets Current ratio
Net sales / Total assets
Net sales / Fixed assets
After-tax net income / Total assets Acid-test ratio

and includes only a small profit margin as part of the loan Interest expense / Net Sales Net sales / Accounts receivable
Before-tax net income / Net worth Net liquid assets
or equity capital
price. This works well for short term loans for large, well Cost of goods sold / Net Sales Average collection period
known corporations but is not generally used for small and Taxes / Net Sales After-tax net income / Net worth or Net working capital
equity capital
medium sized companies or longer term loans Selling, administrative & other
d. Customer profitability analysis is similar to cost plus expenses / Net Sales Before-tax net income / Net Sales Leverage Ratios

pricing but differs in that it considers the whole customer After-tax net income / Net Sales Total liabilities / Total assets
relationship into account when pricing a loan. Customer Coverage Ratios Marketability Indicators
Long-term debt / Long-term
Interest coverage GPM
profitability analysis has become increasingly sophisticated liabilities
Coverage of principal and interest NPM
as computer models have been designed to help with the payments Total liabilities / Net Sales
analysis.

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Answers Answers Answers

5. Problem 4 (page 586)
The Sources and Uses of Funds Statement for Grape
Corporation would appear as follows:
Cash Flows from Operations
Net income
+ Depreciation
- increase in acc/rec
- increase in inventory
- increase in other assets
+ increase in accounts payable
- decrease in taxes payable
Net cash flow from operations
5. Problem 4 (page 586) 5. Problem 4 (page 586)
There are several areas of possible concern for a bank
Cash Flows from Investment Activities
loan officer viewing Grape's projected figures. First, the
Acquisition of fixed assets (300)
firm is relying heavily upon increasing debt of all kinds to
Net cash flow from investment activities (300)
210 finance its growth in assets. The increase in notes payable
of $197 million indicates growing reliance on bank debt
Cash Flows from Financing Activities supplemented by sizable increases in supplier-provided
100
Increase in notes payable 197 credit (accounts payable) and long-term debt obligations
(192) (most likely, bonds) with no change in funds provided by
Increase in long term debt 59
(79) issuing stock. The bank could experience a serious
Dividends paid (50)
(21) weakening in the strength of its claim against the firm as
Net Cash Flows from Financing Activities 206
99 other creditors post a more substantial claim against
(111) Grape’s assets.
6 Increase (Decrease) in Cash -88

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 Answers Answers Answers
5. Problem 4 (page 586) 5. Problem 6 (page 587) 5. Problem 6 (page 587)
Grape is projecting a sizable increase in its retained The total of expected revenues and expected costs is:
earnings (undivided profits) which suggests that Expected Revenues Expected Costs Net revenue = $512,500 - $277,575 = $234,925
management is counting on a year of strong earnings. Net funds loaned = $10,000,000 - $2,125,000 = $7,875,000
Interest Revenue $400,000 Deposit Interest $
However, both accounts receivable and inventories (as 74,375
well as net fixed assets) are growing rapidly, perhaps Commitment Fees 100,000 Cost of Other Funds 180,000 Expected net rate of return
Raised
reflecting troubles in collecting from the firm's customers = $$234,925/ $7,875,000 = 0.0298 or 2.98%
and in marketing Grape's products and services. The Deposit Service 4,500 Wire Transfer Costs 1,300

bank's loan officer would want to explore with the company (Maintenance) Fees Loan Processing Costs 12,400
Because the estimated net rate of return is positive, the bank
Wire Transfer Fees 3,500 Record keeping 4,500
the bases for its projected jump in net income and why
Expenses should strongly consider approving the loan as requested
accounts receivable and inventories are expected to rise in Agency Fees 4,500 Account Activity Cost 5,000
such large amounts Total Expected $512,500 Total Expected Costs $ 277,575
because the bank can earn a premium over its costs.
Revenues

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Answers Answers Answers

5. Problem 6 (page 587)
If you decide to turn down this request, under what
assumptions regarding revenues, expenses, and
customer-maintained deposit balances would you make
this loan?
a. raise the interest rate on the loan
b. increase the loan commitment fee
→ Depending on the customer's relationship with the bank
and with other banks, this may prove to be extremely
difficult.
5. Problem 6 (page 587)
If you decide to turn down this request, under what
assumptions regarding revenues, expenses, and
customer-maintained deposit balances would you make
this loan?
c. Allow the borrower to borrow less than the full amount
($10mil), the cost of funds raised to support this loan
could be reduced → increase the loan net revenue
d. Make some adjustment in the expenses associated with
the relationship, (e.g. a careful examination of the
relationship activities could allow for a revision of
estimated costs incurred by the bank to manage the
various aspects of the relationship).
5. Problem 6 (page 587)
If you decide to turn down this request, under what
assumptions regarding revenues, expenses, and
customer-maintained deposit balances would you make
this loan?
e. Raise customer-maintained balances, making the net
funds loaned smaller and the expected net rate of return
greater.

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Answers Answers
5. Problem 7 (page 588) 5. Problem 7 (page 588)
On a $10 million loan this is an average annual interest cost of LENDING TO BUSINESS FIRMS
$277,000/$10,000,000 or 0.0277 which is 2.77%. There was
Lone Star Bank has sold negotiable CDs in the amount of $6
million at a yield of 2.75% and purchased $4 million in
also $25,000 in noninterest costs or 0.25% of the loan total of AND PRICING BUSINESS
$10 million. With a one percent risk premium and a 0.25%
federal funds at a rate of 2.80%. The weighted average minimal profit margin, the loan rate on a cost-plus basis would LOANS
cost of bank funds in this case would be: be:
Interest Cost + Non-interest Cost + Risk Premium + Profit Margin
$ 6,000,000 * .0275 = $165,000 = 2.77% + 0.25% + 1.00% + 0.25% = 4.27%.
$ 4,000,000 * .0280 = $112,000
Total Interest Cost = $277,000
To break even we take out the profit margin, thus the loan rate
would be: 4.27 -.25 = 4.02% Chapter 2
Interest Cost = Loan rate - Non-interest cost - Risk premium
Interest cost = 4.27 – 0.25 – 1.00 = 3.02%

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