Chapter Nine

Lending to Business Firms and Pricing

Business Loans
 17-2

17.1 Types of Business Loans

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Short-Term Loans to Business Firms

• Self-Liquidating Inventory Loans
▫ These loans usually were used to finance the purchase of inventory – raw
materials or finished goods to sell

▫ A short-term credit that is repaid with money generated by the assets it is

used to purchase.

▫ The repayment schedule and maturity of a self-liquidating loan are timed to

coincide with when the assets are expected to produce income.
For Example: A retail business might use this loan to purchase extra
inventory in anticipation of the holiday shopping season.

▫ 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 (Conti..)

• Working Capital Loans
▫ Short-run credit that lasts from a few days to one year, helps businesses to cover the day-to-
day costs or seasonal demands

▫ Secured by accounts receivable or by pledges of inventory

▫ Carry a floating interest rate

▫ Frequently, it is designed to cover seasonal peaks business clients’ production level and credit
needs.

▫ Example: A clothing manufacturer may forecast a huge demand upon the winter season. A
home appliances company may predict increased demand of fan, air-conditioner, air-cooler
upon the summer season.

▫ 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
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 17-5

Short-Term Loans to Business Firms (conti…)

• Interim Construction/Bridge Financing
▫ Secured short-term loan used to support the construction of homes,
apartments, office buildings, shopping centers, and other permanent
structures.
▫ For example: A housing company may need a short-term loan to
payoff wages for labors, equipment for construction before it raises
long-term fund from the HBFC.

• Security-Dealer/Brokerage House 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.
▫ It is usually extended by the broker/dealer to its clients for buying stock,
bonds and other instruments with Margin credit.

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 17-6

Short-Term Loans to Business Firms (Conti..)

• Retailer and Equipment Financing/Dealer 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. A well-known example of dealer financing is auto dealers
that offer car purchase financing. EMI, Equal Monthly Installment, facility can be availed to any
electronic or home appliances products from Walton, Sony, Samsung, Rangs, Whirlpool, and Sharp.

▫ Dealer financing is a type of loan that is originated by a retailer to its customers and then sold to a 
bank. The bank purchases these loans at a discount and then collects principle and interest
payments from the borrower.

▫ By offering loans at the dealership, an auto retailer may be able to secure the sale of a vehicle more
readily than waiting for potential buyers to arrange financing on their own. The dealer will forward
the customer’s information to the financial institutions they have finance arrangements with.

▫ Dealer financing can reduce the time and effort it takes to do so. Auto dealers often market these
loans to customers who might not otherwise qualify for financing because of a poor credit rating or
other factors. The interest rates may be higher for such loans or other tradeoffs may be incurred.

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 Short-Term Loans to Business Firms (Conti..)
• Asset-Based Financing
▫ Credit secured by the shorter-term assets of a firm that are expected to
roll over into cash in the future. Key assets used for many of these loans
are accounts receivable and inventories.
▫ The lender commits fund against a specific % of book value of the
outstanding accounts receivables (AR). In most of the cases, these
loans, collateralised by ARs or Inventory, the borrower retains title to
the assets pledged.
▫ For example: A bank may be willing to grant a credit up to 70% of the
outstanding ARs, and 40% of current inventory level. The most
common example of this arrangement is factoring. We’ll have a close
look on discounting vs. factoring.

• Syndicated Loans (SNCs)/Consortium Financing

▫ A big loan package extended to a corporation by a group of lenders to
facilitate a big project which won’t be possible for a single bank to
finance. Now-a-days, major industrial loans are extended on the
Syndicated /Consortium loan basis.
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 Factoring Vs. Discounting
Credit Control:
• With Factoring, the provider takes the role  of  managing the sales ledger, credit control and
chasing customers for settlement of their invoices.
• With Invoice Discounting, your business retains control of its own sales ledger and chases
payment in the usual way.
Confidentiality:
• With Factoring, the customer settles their invoice directly with the Factoring company; so
customers are more likely to be aware of your Factoring arrangement.
• With Invoice Discounting, your customers still pay you directly; there is no need for them to
know that a third party is involved.
Risk & Costs:
• Without credit control, the lender has less control over whether your customers will pay on
time (or pay at all), which means they’re taking on more risk by advancing you cash based
on these invoices. Thus, factoring is slightly more expensive than invoice discounting
• For this reason, discounting is traditionally used by bigger companies with higher turnover
and creditworthy customers, whereas invoice factoring is commonly used by smaller firms.
Flexibility:
• With invoice discounting, the lender will usually require you to finance your entire debtor
book (i.e. all of your current outstanding invoices).
• There’s also a form of invoice finance called selective invoice finance or ‘spot factoring’,
which allows you to choose single invoices, specific clients, or specific projects to fund only
applicable in Factoring.
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 17-9

Long-Term Loans to Business Firms

• 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.
▫ Term loans usually look to the future flow of earnings of a business to amortize or
retire loan. The schedule of installments is structured in compliance with borrower’s
normal cycle of cash inflows and outflows.

▫ For example, there might be ‘Blind Spots’ built into the repayment schedule, so that no
payment is required during the borrowers remain short of cash or need high-cash
outflows to support business.

▫ Term loans are normally secured by fixed assets of borrowers and carry fixed or
floating interest rate.

▫ The probability of default or adverse changes is higher due to the longer course of time
and inflation risk and thus price of loan is also higher. Therefore, credit officers put
special attention while sanctioning term loans to business houses.
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 Long-Term Loans to Business Firms (Conti…)

• Revolving Credit Financing

▫ Allows a customer to borrow up to a pre-specified limit, repay all
or a portion of the borrowing, and reborrow as necessary
▫ One of the most flexible of all business unsecured loans
▫ Usually, short-term in nature and can be renewed
▫ Lenders normally charge a ‘loan commitment fee’ for committing
a certain amount of fund for the borrower throughout the
promised periods.
▫ Two types:
▫ Formal loan commitment:
▫ Confirmed credit line: It’s more like a guarantee to back up a loan
obtained elsewhere. It is only given to top-notch firms and priced at
much lower than the formal loan commitment.
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 17-11

Long-Term Loans to Business Firms (Conti..)

• Long-Term Project Loans
▫ Credit to finance the construction of fixed assets. Examples are,
investment for oil refineries or power plants.

▫ Most risky of all business loans, may be of recourse basis, in which

the lender can recover funds from the sponsoring firms if the projects
do not pay out as planned. Whereas, non-recourse means that lender
cannot claim the parent firms asset/ sponsor’s personal asset upon
default.

▫ 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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 17-12

Long-Term Loans to Business Firms (Conti..)

• 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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 17-13

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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 17-14

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
• 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
• 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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Ratio Analysis of a Customer’s F. Statements

• Operating Efficiency: Measure of a Business Firm’s
Performance Effectiveness

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Financial Ratio Analysis of a Customer’s

Financial Statements
• 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

• 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
• 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
• 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
• 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
• 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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17.3 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.

• The Cost-Plus Loan Pricing Method

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Pricing Business Loans (continued)

• The Price Leadership Model

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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: 4+1.2= 5.2
▫ Times-prime method: 4 *1.2 = 4.8 Borrower prefers when
predicting the fall of interest rates.
• 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)

• Below-Prime Market Pricing
▫ Banks announced that some large corporate loans
covering only a few days or weeks would be made at low
money market interest rates
▫ Federal funds rate on domestic loans plus a small margin

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Pricing Business Loans (continued)

• 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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