Commercial Banking Management

BAF 421

HO# (6)
Chapter Seventeen
Lending to Business Firms and Pricing
Business Loans
THIS HANDOUT COVERS:
CLO#7: Comment on various types of business loans (short-term &
long –term).
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 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
• 1)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)
• 2) 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)
• 3) Interim Construction Financing
▫ Secured short-term loan used to support the construction
of homes, apartments, office buildings, shopping centers,
and other permanent structures

• 4) 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)
• 5) 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.

• 6) Asset-Based Financing
▫ Credit secured by the shorter-term assets of a firm that are
expected to roll over into cash in the future

• 7) 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
• 1) 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

• 2) Revolving Credit Financing (open credit lines)

▫ Allows a customer to borrow up to a pre-specified limit, repay all or
a portion of the borrowing, and re-borrow 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)
• 3) 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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 Long-Term Loans to Business Firms
(continued)
• 4)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 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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 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 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 Ratio Analysis of a Customer’s Financial
Statements (continued)
• 1) 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)
• 2)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)
• 3) 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)
• 4) 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)
• 5) 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)
• 6) 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)
• 7) 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)
• 8) 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
• 1) The Cost-Plus Loan Pricing Method: requires the bank to
add the cost of raising adequate funds to lend, the lender’s non-funds
operating costs, compensation for the degree of default risk inherent in a
loan request, and the desired profit margin.

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 Pricing Business Loans (continued)
• 2) The Price Leadership Model: 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 short-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.
 

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 Pricing Business Loans (continued)
• 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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 Pricing Business Loans (continued)

• 3) Below-Prime Market Pricing: prices a loan on

the basis of cost of borrowing in the money
market plus a small profit margin.

▫ Banks announced that some large corporate loans

covering only a few days or weeks would be made at
low money market interest rates

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 Pricing Business Loans (continued)
• 4) 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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 Pricing Business Loans (continued)
• 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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 Pricing Business Loans (continued)
• 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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