CHAPTER SIXTEENLending To Business Firms And Pricing Business Loans

The purpose of this chapter is to explore how bankers can respond to a business customer seeking a loan and to reveal the factors they must consider in evaluating a business loan request. In addition, we explore the different methods used today to price business loans and to evaluate the strengths and weaknesses of these pricing methods for achieving a financial institution’s goals.

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Short Term Business Loans

Self-Liquidating Inventory Loans

Working Capital Loans

Interim Construction Loans

Security Dealer Financing

Retailer Financing

Asset-Based Financing

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Syndicated Loans

A Loan or Line of Credit Extended to a Business Firm By a Group of Lenders in Order to Reduce the Risk Exposure to Any One Lending Institution

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Long Term Business Loans

Term Loans

Revolving Credit Lines

Project Loans

Loans to Support Acquisitions of Other Business Firms

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Sources of Repayment for Business Loans

The Borrower’s Profits or Cash Flows

Business Assets Pledged as Collateral

Strong Balance Sheet With Ample Marketable Assets and Net Worth

Guarantees Given By Businesses

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Analyzing Business Loan Applications

Common Size Ratios of Customer Over Time

Financial Ratio Analysis of Customer’s Financial Statements

Current and Pro Forma Sources and Uses of Funds Statement

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Financial Ratio Analysis

Control Over Expenses

Operating Efficiency

Marketability of Product or Service

Coverage Ratios: Measuring Adequacy of Earnings

Liquidity Indicators for Business Customers

Profitability Indicators

The Financial Leverage Factor as a Barometer of a Business firm’s Capital Structure

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Control Over Expenses

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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Operating Efficiency

Costs of Goods Sold/Average Inventory

Net Sales/Total Assets

Net Sales/Fixed Assets

Net Sales/Accounts Receivables

Accounts Receivables/(Net Sales/360)

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Marketability of Product or Service

(Net Sales – Cost of Goods Sold)/Net Sales

Net Income After Taxes/Net Sales

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Coverage

Income Before Interest and Taxes Interest Payments

Income Before Interest and Taxes Interest Pay. + Princ. Pay/(1-Marg.Tax)

Income Before Interest, Taxes and Lease Payments Interest Payments + Lease Payments

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Liquidity

Current Assets Current Liabilities

Current Assets – Inventory Current Liabilities

Current Assets – Inventory (raw) –Current Liabilities

Current Assets – Current Liabilities

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Profitability

Before Tax Net Income/Total Assets

Before Tax Net Income/Net Worth

Before Tax Net Income/Total Sales

After Tax Net Income/Total Assets

After Tax Net Income/Net Worth

After Tax Net Income/Total Sales

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Leverage

Total Liabilities Total Assets

Long Term Debt (LTD) Total LTD + Net Worth

Total Liabilities Net Sales

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Types of Contingent Liabilities

Guarantees or Warrantees Behind Products

Litigation or Pending Lawsuits

Unfunded Pension Liabilities

Taxes Owed But Unpaid

Limiting Regulations

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Comprehensive Environmental Response, Compensation and Liability

Act

This Law Makes Current and Past Owners of Contaminated Property, Current and Past Owners and Prior Operators of Businesses Located on Contaminated Property and Those Who Transport Hazardous Substances Potentially Liable

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Component of Sources and Uses of Funds Statement

Changes in Cash Account

Changes in Accounts Receivables

Changes in Inventory

Changes in Fixed Assets

Changes in Accounts PayableChanges in Other Current LiabilitiesChanges in Long Term DebtChanges in Net Worth

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Sources and Uses of Funds

Increase in Assets = Use of Funds

Decrease in Assets = Source of Funds

Increase in Liabilities = Source of Funds

Decrease in Liabilities = Use of Funds

Increase in Equity = Source of Funds

Decrease in Equity = Use of Funds

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Methods Used to Price Business Loans

Cost-Plus Pricing ModelsPrice Leadership Pricing ModelsBelow Prime Market Pricing (Markup Model)Loans Bearing Maximum Interest RatesCustomer Profitability Analysis

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Cost-Plus Loan Pricing

Loan Interest

Rate=

Marginal Cost of Raising

Loanable Funds to Lend to

Borrower

+

Nonfund Bank

Operating Costs

+

Estimated Margin to

Compensate Bank for

Default Risk

+

Bank's Desired Profit

Margin

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Price Leadership Model

Loan Interest

Rate=

Base or Prime Rate

+

Default Risk

Premium for Non-

Prime Borrowers

+

Term Risk Premium for

Longer Term Credit

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Prime Rate

Major Banks Established a Base Lending Fee During the Great Depression. At that Time It Was the Lowest Interest Rate Charged Their Most Credit Worthy Customers for Short-Term Working Capital Loans

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LIBOR

The London Interbank Offer Rate. The Rate Offered on Short-Term Eurodollar Deposits With Maturities Ranging From a Few Days to a Few Months

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Below-Prime Market Pricing

Loan Interest

Rate=

Interest Cost of Borrowing in the Money

Market

+Markup for Risk

and Profit

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Cap Rate Model

Banks Offer a Floating Rate Loan With an Agreed Upon Upper Limit on the Loan Contract Regardless of the Course of Future Interest Rates

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Customer Profitability Analysis (CPA)

Estimate Total Revenues From Loans and Other ServicesEstimate Total Expenses From Providing Net Loanable FundsEstimate Net Loanable FundsEstimate Before Tax Rate of Return By Dividing Revenues Less Expenses By Net Loanable Funds