Lending to Business Firms and Pricing

Business Loans

Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-2

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

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-3

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

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-4

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

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-5

Types of Business Loans

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-6

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
▫ 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

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-7

Short-Term Loans to Business Firms

(continued)
• 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

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-8

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
• 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

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-9

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
• Syndicated Loans (SNCs)
▫ A loan package extended to a corporation by a group of
lenders

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-10

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
• Revolving Credit Financing
▫ Allows a customer to borrow up to a prespecified limit, repay
all or a portion of the borrowing, and reborrow 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

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-11

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
▫ 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

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-12

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

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 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

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-14

Analyzing Business Loan Applications

(continued)
• Analysis of a Business Borrower’s Financial Statements

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-15

Analyzing Business Loan Applications

(continued)
• Analysis of a Business Borrower’s Financial Statements

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-16

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
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-17

Financial Ratio Analysis of a Customer’s

Financial Statements (continued)
• 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
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-18

Financial Ratio Analysis of a Customer’s

Financial Statements (continued)
• 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
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-19

Financial Ratio Analysis of a Customer’s

Financial Statements (continued)
• Operating Efficiency: Measure of a Business Firm’s
Performance Effectiveness

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-20

Financial Ratio Analysis of a Customer’s

Financial Statements (continued)
• 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

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-21

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)

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-22

Financial Ratio Analysis of a Customer’s

Financial Statements (continued)
• 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

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-23

Financial Ratio Analysis of a Customer’s

Financial Statements (continued)
• 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

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-24

Financial Ratio Analysis of a Customer’s

Financial Statements (continued)
• 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

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-25

Financial Ratio Analysis of a Customer’s

Financial Statements (continued)
• 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

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-26

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

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-27

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
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-28

Comparing a Business Customer’s Performance

to the Performance of Its Industry (continued)
• 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

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-29

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

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-30

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

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-31

Preparing Statements of Cash Flows from

Business Financial Statements (continued)

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-32

Preparing Statements of Cash Flows from

Business Financial Statements (continued)

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-33

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

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-34

Pricing Business Loans (continued)

• The Price Leadership Model

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-35

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

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-36

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

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-37

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

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-38

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
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-39

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

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
 17-40

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?

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.