Chapter Seventeen

Lending to Business Firms and Pricing

Business Loans

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
 Key Topics
1. Introduction
2. Types of Business Loans: Short Term and Long
Term
3. Pricing Business Loans and Customer Profitability
Analysis
4. Analyzing Business Loan Requests
5. Collateral and Contingent Liabilities
6. Preparing Statements of Cash Flows

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1. Introduction
• 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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1. 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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 Key Topics
1. Introduction
2. Types of Business Loans: Short Term and Long
Term
3. Pricing Business Loans and Customer Profitability
Analysis
4. Analyzing Business Loan Requests
5. Collateral and Contingent Liabilities
6. Preparing Statements of Cash Flows

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 2. Types of Business Loans

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 2. 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
▫ Such loans take advantage of the normal cash cycle inside a
business firm
▫ The need arises on a regular basis and the cycle completes itself
within one year
▫ Loan is self-liquidating if repayment is derived from sales of the
finished goods
▫ Borrow cash- Buy raw materials-produce goods- sell goods- receive
money- pay back the loan
▫ 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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 2. Short-Term Loans to Business Firms
(continued)
• Working Capital Loans
▫ Short-run credit that lasts from a few days to one year
▫ Usually designed to cover seasonal peaks in business customer
production levels
▫ To fund the current assets of a business such as A/R and
Inventories.
▫ 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
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 2. Short-Term Loans to Business Firms
(continued)
• Interim Construction Financing
▫ Secured short-term loan used to support the
construction of homes, apartments, office buildings,
shopping centers, and other permanent structures
▫ Interim: financing for a limited time until permanent
financing is arranged

• 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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 2. Short-Term Loans to Business Firms
(continued)
• 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
• Asset-Based Financing
▫ Credit secured by the shorter-term assets of a firm that are
expected to roll over into cash in the future, typically
inventory and receivables (ex: factoring)
• Syndicated Loans (SNCs)
▫ A loan package extended to a corporation by a group of
lenders
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 2. 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
▫ The loan is paid in monthly or quarterly installments
▫ They are secured by the asset

• Revolving Credit Financing

▫ 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 (set interest rate) and
confirmed credit line (no pre set interest rate, used rather as a
guarantee to back up a loan obtained elsewhere)
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 2. Long-Term Loans to Business Firms
(continued)
• Long-Term Project Loans
▫ Credit to finance the construction of fixed assets
▫ Most risky of all business loans
▫ It could be granted on a recourse basis, with sponsoring
companies
▫ 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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 2. Long-Term Loans to Business Firms
(continued)
• 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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 Key Topics
1. Introduction
2. Types of Business Loans: Short Term and Long
Term
3. Pricing Business Loans and Customer Profitability
Analysis
4. Analyzing Business Loan Requests
5. Collateral and Contingent Liabilities
6. Preparing Statements of Cash Flows

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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

▫ But low enough to attract customers and be competitive

▫ With intense competition, lender is a price taker, and not a

price setter.

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 3. Pricing Business Loans (continued)

1. The Cost-Plus Loan Pricing Method

• Limitations:
• Neglects bank competition: more competition will lead to a
thinner margin
• Assumes that lending institution accurately knows its costs
(very difficult to allocate operating costs among
products/services offered in case of multi-products)

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 3. Pricing Business Loans (continued)
1. The Cost-Plus Loan Pricing Method

Example:
• Loan size: $5 million
• Marginal cost of loanable funds: 5%
• Operating costs to analyse and monitor loan : 2%
• Default risk: 2%
• Profit margin: 1%
• Loan interest rate = 5 + 2+ 2+ 1 = 10%

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 3. Pricing Business Loans (continued)
2. The Price Leadership Model

Example: 3 year, medium-sized business customer, if the

prime rate=8%, default risk = 2% , term risk = 2% ,=>
the loan rate is = 8 + 2 + 2 = 12%
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 3. Pricing Business Loans (continued)
• In the U.S., the prevailing prime rate is considered to be the
most common base rate.
• Prime rate is the lowest interest rate charged to their most
credit worthy/ most secure customers for short term working
capital loans offering zero default risk and zero term risk.
• The advent of inflation has lead to floating prime rate.
• Two different floating prime rate formulas were developed
▫ Prime-plus method: Prime + 2%
▫ Times-prime method: Prime x 1.2
Although these two formulas may lead to the same initial loan
rate, they can lead to very different loan rates when prime rate
changes.
• Times- prime method causes the rate to rise faster than prime-
plus method when rates increase
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 3. Pricing Business Loans (continued)
• Prime rate as a base for business loans was challenged by
LIBOR

• London Interbank Offered Rate (LIBOR): rate offered on

short term Eurodollar deposits with maturities ranging from
few days to few months

▫ 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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 3. Pricing Business Loans (continued)
• Cap Rate Model

▫ Bank Offers a Floating Rate Loan With an Agreed-upon

Upper Limit on the Loan Contract Regardless of the Course
of Future Interest Rates.
▫ Example: Assume that a borrowing customer is offered a
prime-plus-2 floating rate loan with a cap of 5 percentage
points above the initial loan rate.
▫ This means that if the loan were made when the prime was 10%,
the initial loan rate would be 10% + 2 % = 12% .
▫ But the rate could rise no higher than 17%

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 3. Pricing Business Loans (continued)
3. 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 plus a small margin
▫ It uses base rate below the prime rate plus very small margin
to cover risk exposure and profit margin
▫ Loan interest rate= Interest cost of borrowing in the money
market + markup for risk and profit
▫ Federal funds rate on domestic loans plus a small margin
▫ Applied to credit extended to best customers

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 3. Pricing Business Loans (continued)
4. Cost-Benefit-Loan

▫ The bank should charge enough for a loan to fully

compensate it for all the costs and risks involved.
▫ This system has three steps:
▫ Estimate the total revenue the loan will generate under a
variety of loan interest rates and other fees
▫ Estimate the net amount of loanable funds
▫ Estimate the before-tax yield from the loan by dividing the
estimated loan revenue by the net amount of loanable funds
the borrower will actually use.

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 3. Pricing Business Loans (continued)
4. Cost-Benefit-Loan

▫ Example: Suppose a customer requests a $5 million line

of credit, but actually uses only 4$ million at a contract
loan rate of 20%. The customer is asked to pay a
commitment fee of 1% of the unused portion of the
credit line. Moreover, the bank insists that the customer
maintains a deposit (compensating balance) equal to
20% of the amount of the credit line actually used and
5% of any unused portion of the line. Deposit reserve
requirements imposed by the central bank are assumed
to be 10% .
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 3. Pricing Business Loans (continued)
4. Cost-Benefit-Loan
▫ Estimated loan revenue:
$4,000,000 x 0.20 + 1,000,000 x 0.01 = $810,000
▫ Estimated bank funds used by the borrower:
$4,000,000 – ($4,000,000 x 0.20 + $1,000,000 x0.05)
(Compensating balance requirement)
+ 0.10($4,000,000 x 0.20 +$1,000,000 x 0.05)
(Deposit reserve requirement)
= $3,235,000
▫ Estimated (before tax) yield to the bank from the loan =
$810,000 / $3,235,000 =25.0%

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 3. Pricing Business Loans (continued)
5. Customer Profitability Analysis (CPA)
▫ New loan pricing technique that assumes that the lender should
take the whole customer relationship into account when pricing a
loan
▫ Focuses on net rate of return from entire customer relationship

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 3. Pricing Business Loans (continued)
5. Customer Profitability Analysis (CPA)
• Estimate total revenues : Loan interest income, fees income
from service (commitment fees, data processing charges,
safekeeping, letter of credit), investment income from
customers deposit balance held at the bank
• Estimate total expenses: Wages and salaries of a bank
staff, interest accrued on deposits, credit investigation
costs, loan processing cost, record keeping costs
• Estimate net loanable funds
▫ The amounts of credit used by customer minus average
collected deposits or compensating balance (adjusted for
legal minimum reserve requirement)
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 3. Pricing Business Loans (continued)
5. 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 loan might be denied or lender may
seek to raise the loan rate or increase the prices of other services.
▫ The greater the perceived risk of the loan, the higher the net rate of
return the lender should require
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 3. Pricing Business Loans (continued)
5. Customer Profitability Analysis (CPA)- Example

(216,000 – 125,000)/1,230,000 =
7.4%

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 3. 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 in earning assets adjusted for legal reserve and
float.

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 3. Pricing Business Loans (continued)
• Customer Profitability Analysis (CPA)

▫ Earnings Credit for Customer Deposits

▫ Suppose a customer posts a deposit balance of $1,125,000 for this

month. Float from uncollected funds accounts for $125,000. The legal
reserve is 10%

▫ Net investable funds= $1,125,000-$125,000-(0.1x1,000,000)= $900,000

▫ Given a T-bill rate of 6.6%, then earning credit= 6.6%x900,000x1/12=

$4,950

▫ Thus, revenue from investing the customers’ deposits in earning assets

is recorded as $4,950
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 3. Fixed versus Floating rates
• Floating rate loans:
• Reduce net interest losses from rising interest rates

• Because banks generally operate with rate sensitive

liabilities, floating rate loans normally reduce bank’s
interest rate risk

• Borrowers prefer fixed rate loans to avoid interest rate

risk, while banks prefer floating rate loans
• Floating rates are initially set below fixed rates for borrowers
• A bank may establish an interest rate cap on floating-rate loans
to limit the possible increase in periodic payments

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Problem 17.1
From the descriptions below please identify what type of
business loan is involved.
1. A temporary credit supports construction of homes,
apartments, office buildings, and other permanent structures.
Interim construction financing
2. A loan is made to an automobile dealer to support the
shipment of new cars.
Retailer and equipment financing
3. Credit extended on the basis of a business’s accounts
receivable.
Asset-based financing

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Problem 17.1
From the descriptions below please identify what type of
business loan is involved.
4. The term of an inventory loan is being set to match the
length of time needed to generate cash to repay the loan.
Self-liquidating inventory loan
5. Credit extended up to one year to purchase raw materials
and cover a seasonal need for cash.
Working capital loan
6. A securities dealer requires credit to add new government
bonds to his securities portfolio.
Security dealer financing
7. Credit granted for more than a year to support purchases of
plant and equipment.
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Problem 17.1
From the descriptions below please identify what type of
business loan is involved.

8. A group of investors wishes to take over a firm using mainly

debt financing.
Acquisition loan or leveraged buyout
9. A business firm receives a three-year line of credit against
which it can borrow, repay, and borrow again if necessary
during the loan’s term.
Revolving credit financing
10. Credit extended to support the construction of a toll road.
Long-term project loan
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Problem
Suppose a bank estimates that the marginal cost of raising
loanable funds to make a $10 million loan to one of its
corporate customers is 4 percent, its non-funds operating
costs to evaluate and offer this loan are 0.5 percent, the
default-risk premium on the loan is 0.375 percent, a term-
risk premium of 0.625 percent is to be added, and the desired
profit margin is 0.25 percent. What loan rate should be
quoted to this borrower? How much interest will the
borrower pay in 6 month assuming semi-annual payments
(taking place on day 182) and 365 days?
4% + 0.5% + 0.375% + 0.625% + 0.25% = 5.75%
6 month interest = 10 million x 0.0575 x 182/365 = $286,712
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 Problem 17.5
Blue Jay Corporation is a new business client for First Commerce National Bank and has
asked for a one-year, $10 million loan at an annual interest rate of 6 percent. The company
plans to keep a 2.75 percent, $3 million CD with the bank for the loan’s duration. The loan
officer in charge of the case recommends at least a 4 percent annual before-tax rate of
return over all costs. Using customer profitability analysis (CPA), the loan committee hopes
to estimate the following revenues and expenses which it will project using the amount of
the loan requested as a base for the calculations:

Estimated Revenues Estimated Expenses

Interest income from loan? Interest to be paid on customer’s $3 million deposit?
Loan commitment fee (0.75%)? Expected cost of additional funds needed to support
the loan (4%)?
Cash management fees (3%)? (on an Labor costs and other operating expenses associated
annual average of $15 million) with monitoring the customer’s loan (2%)?
Cost of processing the loan (1.5%)?

Should this loan be approved

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 Estimated revenues:
Interest income from loan $10,000,000 × 6.00% $600,000
=
Loan commitment fee $10,000,000 × 0.75% $75,000
=
Cash management fee $15,000,000 × 3.00% $450,000
=
Total revenues $1,125,000

Estimated expenses:
Interest on deposit $3,000,000 × 2.75% = $82,500
Expected cost of additional funds $10,000,000 × 4.00% $400,000
=
Labor costs and other operating costs $10,000,000 × 2.00% $200,000
=
Costs of processing the loan $10,000,000 × 1.50% $150,000
=
Total expenses $832,500

Net amount of the bank’s reserves expected to be

drawn
Average amount of credit committed to customer $10,000,000
Less: Average customer deposit balances $3,000,000
Net amount of loanable reserves supplied to $7,000,000
customer

Before-tax rate of return over costs from the entire lender-customer relationship 
Revenues expected - Costs expected
Net amount of all loanable funds supplied customer
$1,125,000 -$832,500
McGraw-Hill/Irwin = = 4.18 percent.
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 Problem 17.7
In order to help fund a loan request of $10 million for one year
from one of its best customers, Lone Star Bank sold negotiable
CDs to its business customers in the amount of $6 million at a
promised annual yield of 2.75 percent and borrowed $4 million
in the Federal funds market from other banks at today’s
prevailing interest rate of 2.80 percent.
Credit investigation and recordkeeping costs to process this
loan application were an estimated $25,000. The Credit
Analysis Division recommends a minimal 1 percent risk
premium on this loan and a minimal profit margin of one-
fourth of a percentage point. The bank prefers using cost-plus
loan pricing in these cases. What loan rate should it charge?
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Problem 17.7
Lone Star Bank has sold negotiable CDs in the amount of $6 million at a yield of 2.75 percent
and purchased $4 million in Federal funds at a rate of 2.80 percent. The weighted average cost
of bank funds in this case would be:

We can find the interest cost of funding a $10 million loan as follows:

Sale of negotiable CDs cost $165,000 ($6,000,000 × 2.75 percent) to the bank. Whereas, the
funds borrowed from Federal funds cost $112,000 ($4,000,000 × 2.80 percent).

Hence, the total interest cost of $277,000 is to be borne by the bank. On a $10 million loan,
average annual interest cost is 2.77 percent ($277,000 ÷ $10,000,000).

The bank incurs a noninterest cost 0.25 percent ($25,000 ÷ $10,000,000) to process this loan
application. The bank considers a risk premium one percent and a 0.25 percent minimal profit
margin.

Based on the cost-plus loan pricing model:

Loan interest rate =
Marginal cost of raising loanable funds to lend to the borrower +
Nonfunds operating costs + Estimated margin to compensate for default risk +
Desired profit margin

McGraw-Hill/Irwin Loan interest rate = 2.77 percent + 0.25 percent + 1 percent + 0.25 percent = 4.27 percent
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 Problem 17.8
Many loans are quoted at small risk premiums and profit
margins over LIBOR. Englewood Bank has a $25 million loan
request for working capital from one of its largest customers.
The bank offers APEX a floating-rate loan for 90 days with an
interest rate equal to LIBOR on 30-day Eurodeposits (currently
trading at a rate of 4 percent) plus a one-quarter percentage
point markup over LIBOR. APEX, wants the loan at a rate of
1.014 times LIBOR.
- If the bank agrees to this loan request, what interest rate will
attach to the loan if it is made today?
- How does this compare with the loan rate the bank wanted to
charge?
- What does this customer’s request reveal about the interest
rate forecast for the next 90 days?
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Problem 17.8
At today’s prevailing LIBOR rate the customer's
requested loan-rate formula would generate a loan
interest rate of 1.014 × 4.0 percent = 4.056 percent.
However, the bank wanted to charge a rate of 4.0
percent + 0.25 percent = 4.25 percent.

Loan rates tend to move up and down faster with the

customer's loan-rate formula than with the bank's
formula.

This customer appears to believe interest rates will

decline in a period of 90 days and hence pulls the loan
rate lower.
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Problem 17.10
Eagle Corporation has posted an average deposit balance
this past month of $325,000. Float included in this one-month
average balance has been estimated at $50,000. Required
legal reserves are 3 percent of net collected funds. What is
the amount of net investable (usable) funds available to the
bank holding the deposit?
Suppose Eagle’s bank agrees to give the firm credit for an
annual interest return of 2.25 percent on the net investable
funds the company provides the bank. Measured in total
dollars, how much of an earnings credit from the bank will
Eagle earn?

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Problem 17.10

Net investable funds = $325,000 – $50,000 – (3 percent × $275,000) = $266,750.

Earnings credit = 2.25 percent × 1/12 × $266,750= $500.16.

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Problem
A bank has a listed prime rate of 8%. They have estimated
the marginal cost of raising funds is 10%, their default risk
premium on a loan is 2% and they want a profit margin of
1%. They have also estimated that the term risk premium
is 2%. Federal funds rate is 5%, and it is estimated that
2% are needed to analyze and monitor the loan
- What is the interest rate this bank will charge if they use
the cost plus pricing model?
- What is the interest rate under price leadership model?
- What is the interest rate under below prime market
pricing?
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 Key Topics
1. Introduction
2. Types of Business Loans: Short Term and Long
Term
3. Pricing Business Loans and Customer Profitability
Analysis
4. Analyzing Business Loan Requests
5. Collateral and Contingent Liabilities
6. Preparing Statements of Cash Flows

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4. Analyzing Business Loan Applications
Fundamental Credit Issues

• There are two types of errors in judgment when evaluating

loan requests:

• The first is extending credit to a customer who will ultimately

default.
• The second is denying a loan to a customer who would ultimately
repay the debt.

• Bankers tend to focus on eliminating the first type of error but

turning down goods loans is also unprofitable.

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4. Analyzing Business Loan Applications
Important Questions Regarding Loan Requests:

• What is the character of the borrower, the nature of the loan

request and quality of information provided?

• What will the loan proceeds be used for?

• How much does the customer need to borrow?

• What is the primary source of repayment, and when will the

loan be repaid?

• What is the secondary source of repayment; that is, what

collateral, guarantees, or other cash inflows are available?
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4. Analyzing Business Loan Applications
Character of the Borrower, the Loan Request and Quality of
Data Provided

• Most important issue in assessing credit risk is determining

borrower’s commitment and ability to repay debts according to
the loan agreement

• Negative signals include borrower who:

• consistently overdraws accounts
• makes significant changes in business structure
• appears to be consistently short of cash
• has personal habits that have changed for the worse

• A firm with goals incompatible with stockholders, employees

and customers - is also a negative signal
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4. Analyzing Business Loan Applications
Character of the Borrower, the Loan Request and Quality of
Data Provided
• Audited financial statements preferred in determining the
quality of the data. Even with audited data, manipulation can
occur. Analysts should review:

• Accounting choices requiring estimates and judgments

• Periods in which a change in accounting principle, method or key

assumption has been made

• Extraordinary expenditures and nonrecurring transactions

• Income and expense recognition that doesn’t closely track cash

flow

• Nonoperating income, gains and

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4. Analyzing Business Loan Applications
Use of Loan Proceeds

• Loan proceeds should be used for legitimate business

operating purposes, including:
▫ seasonal and permanent working capital needs, the purchase of
depreciable assets, physical plant expansion, acquisition of
other firms, and extraordinary operating expenses

• Speculative asset purchases and debt substitutions should be

avoided

• Use of loan proceeds can either enhance the borrower’s ability

to repay or make it riskier
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 4. Analyzing Business Loan Applications
How Much Does the Borrower Need? The Loan Amount

• Borrowers often request a loan before they clearly understand

how much external financing is actually needed and how much
is available internally

• Borrowers often ask for too little and return later for more
funds.
▫ Lender should estimate how much a borrower needs now and
in the future

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 4. Analyzing Business Loan Applications
The Primary Source and Timing of Repayment

• Loans repaid from four basis sources of cash flows:

▫ Liquidation of assets, cash flow from normal operations, new debt,
and new equity issues

• Specific cash sources associated with types of loans:

▫ Short-term, seasonal working capital loans normally repaid from
receivables liquidation or inventory reduction
▫ Term loans typically repaid from cash flows from operations

• Primary source of repayment can also determine the risk of the

loan
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 4. Analyzing Business Loan Applications
Secondary Source of Repayment: Collateral

• Banks should select collateral that will retain its value over the
business cycle
▫ Receivables and inventory preferred due to liquidity
▫ Plant, equipment and real estate also potentially valuable

• Collateral must exhibit three features:

▫ Value should always exceed outstanding loan principal
▫ Lender should be able to easily take possession of the collateral and
have a ready market for its sale
▫ Lender must be able to clearly mark collateral as its own
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4. Analyzing Business Loan Applications
Secondary Source of Repayment: Collateral

• When physical collateral not readily available, banks often look

for personal guarantees
▫ Loan covenants and cosigners may also be required

• Liquidating collateral second best source:

▫ Significant transactions costs associated with foreclosure
▫ Bankruptcy laws allow borrowers to retain possession of the
collateral long after they have defaulted
▫ When bank takes possession of the collateral, it deprives the
borrower of the opportunity to salvage the company
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4. 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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4. Credit Analysis
• Four-part process
1. Overview of management and operations
1. Organizational and business structure of the borrower
2. Products and services offered
3. Management quality
4. Nature of loan request and quality of data
2. Common size ratios analysis
3. Financial ratios analysis of customers’ financial statements
4. Cash flow analysis- sources and uses of cash

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 4. Analyzing Business Loan Applications
(continued)
• Analysis of a Business Borrower’s Financial Statements

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 4. Analyzing Business Loan Applications
(continued)
• Analysis of a Business Borrower’s Financial Statements

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 4. 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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 4. 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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 4. 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 (Fixed asset utilization)
▫ Net sales/Total assets (Total Asset utilization)
▫ Net sales/Accounts and notes receivable (Account receivable
turnover)
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 4. Financial Ratio Analysis of a Customer’s
Financial Statements (continued)
2. Operating Efficiency: Measure of a Business Firm’s
Performance Effectiveness
 Average collection period (DSO)= Account receivable
/(Annual credit sales/360) or 360/Account receivable
turnover
 Day payable outstanding: A/P/Daily purchases where
purchase = COGC+ change in inventory
 Days inventory held
 Cash conversion cycle: collection period + days inventory
– days payable
 Efficiency ratio: Inventory/daily sales + Account
receivable/daily sales (convert raw materials into cash)

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 4. 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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 4. Financial Ratio Analysis of a Customer’s
Financial Statements (continued)
3. 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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 4. 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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 4. 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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 4. 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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 4. 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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 4. 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

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 Key Topics
1. Introduction
2. Types of Business Loans: Short Term and Long
Term
3. Pricing Business Loans and Customer Profitability
Analysis
4. Analyzing Business Loan Requests
5. Collateral and Contingent Liabilities
6. Preparing Statements of Cash Flows

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 5. 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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5. Contingent Liabilities (continued)

▫ 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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5. 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

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e 17-74
 Key Topics
1. Introduction
2. Types of Business Loans: Short Term and Long
Term
3. Pricing Business Loans and Customer Profitability
Analysis
4. Analyzing Business Loan Requests
5. Collateral and Contingent Liabilities
6. Preparing Statements of Cash Flows

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Bank Management and Financial Services, 7/e 17-75
 6. Preparing Statements of Cash Flows from
Business Financial Statements
Statement of cash flows illustrates how cash receipts
and disbursements are generated.
It provides insights into how and why a firm’s cash
balance has changed and helps to answer:
1. Will the borrower be able to generate sufficient cash to
support its production and sales activities and still be
able to repay the lender?
2. Why is cash changing over time and what are the
implication of these changes for the lender

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 6. Preparing Statements of Cash Flows from
Business Financial Statements
Four sections:
▫ Cash flow from operations
▫ Cash flow from investing (Change in all long term assets)
▫ Cash flow from financing (Payment for debt and dividends,
change in long term liabilities, change in short term bank
debt, and any new stock issues)
▫ Change in cash

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 6. Preparing Statements of Cash Flows from
Business Financial Statements
2 approaches for operating cash flow:
• Direct: Net cash flow from operations + non cash charges
measured on a cash, not an accrual basis:

• Indirect:

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 6. Preparing Statements of Cash Flows from
Business Financial Statements
• Cash-Flow Statement Format
▫ Operations Section - income statement items and the change in current
assets and current liabilities (except bank debt).
▫ Investments Section - the change in all long-term assets.
▫ Financing Section - payments for debt and dividends, the change in all
long-term liabilities, the change in short-term bank debt, and any new
stock issues.
▫ Cash Section - the change in cash and marketable securities.

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McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
 6. Preparing Statements of Cash Flows from
Business Financial Statements
• Cash-Flow Statement Format
▫ Sources of cash:
 increase in any liability,
 decrease in any assets,
 revenue
 New issue of stock and addition to surplus
▫ Uses of cash:
 decrease in any liability
 increase in assets
 Cash Expenses
 Taxes
 Cash dividend
 Repayment/Buy back stock
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 6. Preparing Statements of Cash Flows from
Business Financial Statements (continued)

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 6. Preparing Statements of Cash Flows from
Business Financial Statements (continued)

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Problem 17.2
As a new credit trainee for Evergreen National Bank, you have been asked to evaluate the financial
position of Hamilton Steel Castings, which has asked for renewal of and an increase in its six-month
credit line. Hamilton now requests a $7 million credit line, and you must draft your first credit opinion
for a senior credit analyst. Unfortunately, Hamilton just changed management, and its financial report
for the last six months was not only late but also garbled. As best as you can tell, its sales, assets,
operating expenses, and liabilities for the six-month period just concluded display the following
patterns:

Millions of Dollars January February March April May June

Net sales
$48.1 $47.3 $45.2 $43.0 $43.9 $39.7
Cost of goods sold 27.8 28.1 27.4 26.9 27.3 26.6
Selling, administrative, and
other expenses
19.2 18.9 17.6 16.5 16.7 15.3
Depreciation 3.1 3.0 3.0 2.9 3.0 2.8
Interest cost on borrowed
funds 2.0 2.2 2.3 2.3 2.5 2.7
Expected tax obligation
1.3 1.0 0.7 0.9 0.7 0.4
Total assets 24.5 24.3 23.8 23.7 23.2 22.9
Current assets 6.4 6.1 5.5 5.4 5.0 4.8
Net fixed assets 17.2 17.4 17.5 17.6 18.0 18.0
Current liabilities
McGraw-Hill/Irwin 4.7 5.2 5.6 5.9 5.8 6.4
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Bank Management and Financial Services, 7/e 15.9 16.1 16.4 16.5 17.1 17.2 17-84
Problem 17.2
Hamilton has a 16-year relationship with the bank and has routinely received

and paid off a credit line of $4 million to $5 million. The department’s senior

analyst tells you to prepare because you will be asked for your opinion of this

loan request (though you have been led to believe the loan will be approved

anyway, because Hamilton’s president serves on Evergreen’s board of

directors). What will you recommend if asked? Is there any reason to question

the latest data supplied by this customer? If this loan request is granted, what

do you think the customer will do with the funds?

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Problem 17.2
The figures given in the case as well as the supporting background
information suggest several developing problems. Hamilton has had a recent
shakeup in its senior management, which usually leads to loss in control of
the firm until the new management gains sufficient experience.
Among the obvious problems are decline in sales (from $48.1 million to
$39.7 million) in the past six months. Hamilton's cost of goods sold dropped
but by less than the decline in sales, thereby squeezing the firm's margin and
net income.
We can also note that the firm, probably faced with declining cash flows, has
been forced to rely more heavily on borrowings which will mean that the
bank's position will be less secure. Current assets have also declined while
current liabilities are on the rise, thus reducing the firm's net liquidity
position. The bank's relationship with Hamilton needs to be reviewed carefully
with an eye to gaining additional collateral or reducing the bank's total credit
commitment to the firm.

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Problem 17.2
Additional information that would be desirable and helpful, if not essential,
should include:

1) Past financial statements for the last two or three years, preferably on a
monthly basis. This could help us verify seasonality and improvement.

2) Industry outlook for the next six to eighteen months would also help in
reinforcing Hamilton's ability to service the debt from the summer and fall
cash flows.

3) Additionally, information about the company's suppliers, other creditors,

customers, and competitors would be helpful.

4) Also, more information about other relationships that Hamilton has with
Evergreen would certainly be helpful.

In summary, the more information we have, the better our analysis and
subsequent decisions will be.
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Problem 17.4
Construct a pro forma Statement of Cash Flows for the current year using the consecutive
balance sheets and some additional needed information. The forecast net income for the
current year is $210 million with $50 million being paid out in dividends. The depreciation
expense for the year will be $100 million and planned expansions will require the
acquisition of $300 million in fixed assets at the end of the current year. As you examine
the pro forma Statement of Cash Flows, do you detect any changes that might be of concern
either to the lender’s credit analyst, loan officer, or both?
Grape Corporation
(all amounts in millions of dollars
Assets Assets Projected Liabilities and Liabilities and
Equity Equity Projected
Cash $ 532 $ 600Accounts payable $ 970 $1,069
Accounts 1,018 1,210Notes payable 2,733 2,930
receivable
Inventories 894 973Taxes payable 327 216
Net fixed assets 2,740 2,940Long-term debt 872 1,072
obligations
Other assets 66 87Common stock 85 85
Undivided profits 263 473
Total assets $5,250 $5,810 Total liabilities and $5,250 $5,810
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Problem 17.4
The Sources and Uses of Funds Statement for Grape Corporation would appear as
follows:
There are several areas of possible concern for a
Cash Flows from Operations bank loan officer viewing Grape's projected
Net income $210 figures. First, the firm is relying heavily upon
increasing debt of all kinds to finance its growth in
Add: depreciation $100 assets. The increase in notes payable of $197
Less: million indicates a growing reliance on bank debt
supplemented by sizable increases in supplier-
increase in accounts receivable ($192) provided credit (accounts payable) and long-term
increase in inventories ($79) debt obligations (most likely, bonds) with no
increase in other assets ($21) change in funds provided by issuing stock. The
bank could experience a serious weakening in the
Add: increase in accounts payable $99 strength of its claim against the firm as other
Less: decrease in tax payable ($111) creditors post a more substantial claim against
assets.
Net cash flow from operations $6 Grape is projecting a sizable increase in its
Cash Flows from Investment Activities retained earnings (undivided profits) which
Acquisition of fixed assets ($300)
suggests that management is counting on a year
of strong earnings. However, both accounts
Net cash flow from investment activities ($300) receivable
Cash Flows from Financing Activities and inventories (as well as net fixed assets) are
growing rapidly, perhaps reflecting troubles in
Increase in notes payable $197 collecting from the firm's customers and in
Increase in long-term debt $200 marketing products and services. The bank's loan
officer would want to explore with the company the
Less: dividends paid ($50) bases for its projected jump in net income and
Net Cash Flows from Financing Activities
McGraw-Hill/Irwin $347 why accounts receivable and inventories are
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Increase (Decrease)
Bank Management in Cash
and Financial Services, 7/e $53 expected to rise in such large amounts. 17-89