L 14: Lending to Business Firms and Pricing of Business Loans

Contact hours 27 & 28 , Content ref 6.2 (Chapter 17 of R&H)

BITS Pilani AprilFINZG

4, 2020
513
Pilani|Dubai|Goa|Hyderabad

WORK INTEGRATED LEARNING PROGRAMMES

Introduction, Types of Lending to Business

Introduction
• A large portion of the FIs’ lending is to business firms
• We will study many types of business loans, process of their evaluation, pricing of these loans etc.
Types of Lending to Business
• Fund based (‘FB’) lending:
 Most common form of lending, it is granted as a loan with an actual outflow of funds to borrower by lender
 Bank earns interest income in FB lending
 Examples: overdraft, bill finance, term loan etc.
• Non-fund based (‘NFB’) lending:
 No immediate outflow of funds for a bank while entering into an agreement with a counterparty on behalf of the
bank’s customer
 Bank earns a FEE INCOME in NFB lending, NOT interest income
 However, the NFB lending may crystallise into fund based advances for the bank if bank’s customer defaults on its
obligation with the counterparty
 Examples: letters of credit, bank guarantees (or ‘SLC’)

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Fund Based Lending, Short Term Loans

•Fund based lending can be classified based on the loans’ tenure: Short term loan & Long term loan Working Capital
Cycle
Short term loans: maturity < one year, mostly to finance the WORKING CAPITAL*
Cash purchase of raw material (or the trading goods) Goods are produced (or kept ready for trading) Goods are sold to customer (may be on
credit)

Cash (Payment) received from customer Generate the accounts receivables (if sold on credit)
•Fund Based Lending: can also be unsecured (to the creditworthy borrowers)
*Working Capital
The capital of a business which is used in
•Working Capital Loans
its day-to-day operations
Short-term credit that lasts from a few days to one year, generally renewable
Secured usually by way of 1st charge by way of hypothecation of inventory and/or the accounts receivables,
#Usually arranged by a ‘managing
AND 2 charge on the fixed assets (land, building, machinery etc)
nd
bank’ involving international txns,
A commitment fee (L-13) may be charged on the undrawn portion of the credit line different currencies etc.
Generally, self liquidating based on the working capital cycle, could be 2~6 months’ duration.
The managing bank earns FEE income
•Short-Term Loans to Business Firms:
Retailer Financing:
To support the dealers of automobiles, home appliances etc. Banks check stocks periodically to avoid ‘diversion’ of funds
•Syndicated Loans (SNCs):
A large loan package# extended to a borrower by a group of lenders
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Short Term Loans, Revolving Credit Financing

Revolving credit financing

• A line of credit allowing a customer to borrow up to a prespecified limit
• Customer is allowed to use the funds as & when needed
i.e. repay all, or a part of, the borrowing and to reborrow as and when required
• The most flexible type of loans
• Banks may monitor the purpose of borrowings to avoid ‘diversion of funds’ by the borrowers
• Helpful when borrower is uncertain of sales, expenses, cashflows etc.
• Borrowers may be charged a commitment fee
• Revolving lines of credit may be availed by individuals or business organisations
• Most common form of lending: Working capital loans (‘cash credit’ advances), Credit card loans
• Transfer liquidity risk from borrower to the lender

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Long-Term Loans to Business Firms: Amortising Loans vs Bullet Loans

• Designed to finance the ‘fixed assets’ (e.g. buildings, machinery etc.) having life of > one year
• Also, to finance a project e.g. for expansion, modernisation, diversification activities etc.
• More risky (because of project delays, interest rate risks, higher credit risk because of longer duration) than ST loans
• May have a moratorium period#
• Repayment period: over the life of the project (such loans are called ‘amortising loans’ or ‘instalment loans’)
 Generally 3~5 years for short term projects, could be even 20 years esp. for the infrastructure projects
 Repayment: periodically e.g. quarterly or half-yearly
 Periodic repayments expose the banks to ‘reinvestment risk’ i.e. a probability that the banks may be unable to
reinvest these cash flows at a rate comparable to that of the current term loans
 Bullet loans: one lump sum repayment, at the end of maturity period of the loans, hence no reinvestment risk
 Pros & Cons of the ‘amortising loans (vs ‘bullet loans’) from lenders’ perspective
 Periodic repayments reduce the effective ‘duration’ of the loans thereby reduce the banks’ risk exposure and hence
need a lower capital backing
 Repayments could be deployed in new assets
 However, the ‘amortising loans’ expose the banks to the ‘reinvestment risk’
#
Period during the loan term when a borrower is not required to make any repayment. It is a waiting period before repayments begin

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Loans to Support the Leveraged Buyouts (LBOs),
Analysing Business Loan Applications

• LBOs usually involve acquiring a controlling interest in a firm, funding primarily by huge debt (or ‘leverage’)
• Analysing Business Loan Applications
 Lender may be at risk in case any large denomination business loan goes bad
 Competition for best loans can squeeze the spreads
 Small reward (because of low spreads) to risk ratio for most loans
 Hence, analyse the sources of repayments carefully
 Common sources of repayment for business loans are:
1. Borrowers’ profits or cash flows
⇒ Lenders should carefully analyse borrower’s financial statements & business plans
2. Assets pledged as collateral
3. Guarantees obtained e.g. the personal guarantees or corporate guarantees
4. Strong balance sheet with ample amounts of marketable assets and net worth

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Analysis of Business Borrowers’ Financial Statements

• Banks calculate the financial ratios of the borrowers, and compare them:
 With the borrower’s own ratios in last 3~5 years to analyse adverse trends, if any
 With the ratios of other comparables i.e. other prominent players generally in the same industry
 
 

• Ratio Analysis of a borrower’s Financial Statements

 Information from balance sheets and P&L a/c is supplemented by ratio analysis
 Analyse the following critical areas:
Ability to control expenses, Operating efficiency in using resources to generate sales, Marketability of product line,
Coverage that earnings provide, Liquidity position, Track record of profitability, Contingent liabilities

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Ratio Analysis of Borrowers’ Financial Statements

1. Ability to Control the Expenses: a measure of the quality of a borrower’s management

 Shows how well the expenses are controlled or the earnings are protected
 Prominent financial ratios to monitor a firm’s expense control, i.e. the % to sales of:
o Wages and salaries, Overhead expenses, Depreciation, Interest cost, Cost of goods sold
o Selling, general & administrative (‘SGA’) expenses
2.Operating Efficiency: a measure of a borrower’s performance effectiveness
 How effectively are assets being utilised to generate sales and how efficiently are sales converted into cash
 Important financial ratios:
o Inventory turnover ratio (= Annual cost of goods sold/average inventory)
o Average collection period (= Accounts receivables x 365# /Annual credit sales)
o Turnover of fixed assets (= Net sales/Net fixed assets)
3. Marketability of the Product or Service: analyse the products’ market acceptance
o Prominent measures: Growth rate of sales, Market share, Gross profit margin (GPM)
 GPM = (Net sales-Cost of goods sold)/ Net sales

 # for collection period in days

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Ratio Analysis of Borrowers’ Financial Statements (contd)

4. Coverage Ratios: measure the adequacy of the borrower’s earnings

o Interest coverage = EBIT# /Interest payments EBIT: Earnings before interest & tax, also called PBIT
o Coverage of interest & principal or ‘Debt service coverage ratio’(‘DSCR’) = EBIT/(Interest + principal repayments)
5. Liquidity Indicators:
Indicate the borrowers’ liquidity position (and hence their ability to service the loans)
o Current ratio = Current assets/ Current liabilities
o Acid-test ratio = (Current assets- inventory)/ Current liabilities
o Net working capital = Current assets – Current liabilities (NOT A RATIO)
6. Profitability Indicators: these are the ultimate measures of performance
Indicate how much net profit remains for the owners of a business firm after paying all expenses
o PBT/(total assets, net worth, or total sales)
PBT : Profit before tax
o PAT / total assets (or ‘ROA’)
PAT : Profit after tax
o PAT / net worth (or ‘ROE’)
o PBT/ total sales (or ‘ROS’ or ‘profit margin’)

#
Specific formula used will vary from one lender to another. Usually, it could be among:EBIT or EBIDT or EBIDTA
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Ratio Analysis of Borrowers’ Financial Statements (contd),
Comparing a Business Customer’s Performance,
Contingent Liabilities
7. Financial Leverage ratios: (also called the debt- equity ratios):measure the business firm’s capital structure
o Financial leverage helps in boosting the EPS IF the borrower can generate the earnings more than the cost of debt
o Leverage means high risk and high rewards
 Debt-equity ratio = Total outside liabilities / Tangible net worth
(Tangible net worth = equity capital + reserves & surplus- intangible assets)
8. Valuation ratios: (done in L-13)
o Book value/share, Price/ earning ratio (‘P/E’ ratio)

• Comparing a Business Customer’s Performance

 Usually, financial performance of a borrower is compared with that of other players in the same industry

CONTINGENT LIABILITIES
• Shown, NOT in the balance sheet, but by way of ‘Notes to Accounts’ forming an integral part of the financial
statements
• A contingent liability is a potential liability that may occur depending on the outcome of an uncertain future event
Example: the guarantees or warranties given against the products (or services), the pending litigations etc.
• Contingent liabilities can turn into actual claims against FIs’ assets and earnings at a future date
 

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Cash Flow Statements

• Apart from the balance sheet and P&L accounts, the lenders also analyse the cash flow statements of the borrowers
• Analysis of cash flow statements helps to understand:
 Will the borrower’s cash flow be sufficient to sustain its operations AND service the capital
 Changes in cashflows over a period of time, effect on operations and debt servicing
• Cash flow statements are prepared according to the accounting regulations. They show:
 How cash receipts and disbursements are generated by: the Operating, Investing, and Financing activities
• Two methods to prepare the cash flow statements:
 Traditional method (Operating cash flow measure)
 Net profit from Operations + Non cash expenses = PAT + depreciation
 Cash flow by Origin
 Net cash flow from Operating activities (focusing upon the normal flow of production, inventories & sales)
+ Net cash flow from Investing activities (focusing upon the purchase and sales of assets)
+ Net cash flow from Financing activities (including the issuance of debt)

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Projected Financial Statements,
Pricing Business Loans

• Projected financial statements

 Useful to analyse the historical data. Also, important to see the future projections of the borrowers
 Prospective borrowers are advised to submit Financial Projections
 Analyse growth in sales, interest cost, profits, cash flow and ability to service the capital
 Borrower may present a ROSY picture
o However, the lenders need to critically analyse the forecasts to take lending decisions
• Pricing of Fund based Business Loans:
1.Front end fee (or management fee or processing fee), chargeable upfront @ ½ ~ 1% (flat) of the loan facility
2.Interest rates on the amount of loan drawn
3.Commitment fee on undrawn balances, normally @ ¼ ~ ½ % p.a.
4.Compensating deposit balances
 Compensating balance is a minimum balance that must be maintained in a bank account, used to offset the cost
incurred by a bank to set up a business loan. The compensating balance is not available for the borrower’s use
 The bank is free to loan the compensating balance to other borrowers and profit from differences between the
interest rates

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Pricing Business Loans (contd . . .)

Interest rates charged by the lenders:

• Interest rates should be:
 High enough to improve the lender’s profitability & to get compensation for the risks involved
 Low enough to enable the borrower to repay the loan, and not driven away to competition
• Globally, including in India, the interest rates have been deregulated
• Several methods of pricing the loans:
The ‘Cost-Plus’ Loan Pricing Method
 Interest rate ≥ Cost of raising funds+ Servicing cost (salaries, SGA etc.) + Risk premium + Profit margin
o Borrowers with different risk profiles will carry different risk premia and hence different loan pricing
Example: A bank wants to fund a corporate customer
 Bank needs to borrow CDs @ 7.5% p.a. (⇒ marginal cost for this loan is 7.5% p.a.)
 SGA costs @ 0.50% p.a.,
 Default risk premium (for the applicable risk category) @1.5% p.a.
 Profit margin (to service its capital) @1.0 % p.a.
⇒Loan pricing = 7.5 + 0.5+1.5+1.0 = 10.5% p.a.

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Fixed vs Floating Interest Rates, Problems with Cost Plus Pricing Method

Fixed vs Floating interest rates

• With a stable, upward sloping yield curve, banks can lend at Fixed interest rates
 i.e. lend at rates higher than their cost of borrowing for short term liabilities
• However, with volatile interest rates, banks’ borrowing rates will fluctuate
• Hence, banks may like to lend at floating rates. Effectively, transferring interest rate risk to borrowers
• Higher interest rates can mean higher interest costs for borrowers
 If unable to pay, this becomes a credit risk for the banks
• Many borrowers may prefer a fixed interest rate ⇒ an interest rate risk for banks
Problems with Cost Plus Pricing Method:
• This method:
 Assumes that the banks know their costs accurately
 Assumes that the banks can estimate probability of default and recovery rate for each borrower
 Ignores the competition effect: more competition, lower pricing
• Also lender-borrower relationship affects the size of loan, duration etc.
• These considerations gave way to the Price Leadership Model

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The Price Leadership Model

• Banks establish a Prime rate (also called Base Rate, or Reference Rate)
 Prime rate is the lowest rate charged from the most creditworthy customers on short term loans
• Pricing of the leading commercial lenders is LIBOR# based
 Because of the growing use of Eurocurrencies as sources of loanable funds:
• LIBOR is a common ‘floating’ prime rate
• LIBOR based interest rate on lending:
= LIBOR + Default-risk premium (for non prime borrowers)
+ Term risk premium (for long term loans) + Profit margin
Example:
A medium-sized business is requesting for a 3-year loan to finance some equipments
Prime rate: 7.5% p.a., default risk premium: 2.0% p.a., term risk premium:1.5% p.a.(because of longer term loan),
Profit margin: 1.0 % p.a.

⇒ The Loan pricing (interest rate)= 7.5+ 2.0+ 1.5+ 1.0 = 12.0% p.a.

#
London Inter Bank Offered Rate
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Customer Profitability Analysis (‘CPA’)

• CPA is a (relatively) new loan pricing technique that is similar to the ‘cost-plus pricing’ technique
• In CPA, the lenders consider the whole customer relationship i.e. all the revenues & costs associated with a
customer while pricing a loan
• Net Rate of Return to the lender from the whole customer relationship
= (Revenues1 from loans & other services provided to this customer − Expenses2 from providing loans & other
services)/ Net loanable funds3 used in excess of this customer’s deposits
1
Revenues: all interest & fee income (Front end fee, commitment fee, cash management services, data processing
charges) etc.
2
Expenses: all wages & salaries incurred on behalf of the customer, credit investigation costs, interest cost on
borrowings/ deposits, other administrative costs etc.
3
Net loanable funds: amount of credit used by the borrower less average collected deposits (adjusted for the legal
reserves)
 If the net rate of return is positive : the proposed loan may be acceptable because all expenses have been met
 If the net rate of return is negative : the proposed loan may be rejected or the pricing may be improved
 The greater the perceived risk of the loan, the higher the net rate of return the lender should require
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