Chapter 17 – Lending to Business

Firms and Pricing Business Loans

1
 Learning Outcomes

• Analyzing Business Loan Applications.

• Financial Ratio Analysis of a Customer’s Financial Statements.
• Comparing a Business Customer’s Performance to the Performance of its
Industry.
• Contingent Liabilities
• The Loan Officer’s Responsibility to the Lending Institution and the
Customer.
• Pricing Business Loans:
– The Cost-Plus Loan Pricing Method.
– The Price Leadership Model.
– Customer Profitability Analysis.

2
Analyzing Business Loan Applications

• In many business loan situations the lender’s margin for error is narrow.
Often business loans are of such large denomination that the lending
institution itself may be at risk if the loan goes bad.

• Most loan officers like to build several layers of protection around a

business loan agreement to ensure return of loan principal and interest
earnings by the end of the loan agreement.

• This requires finding two or three sources of funds the business borrower
could draw upon to repay the loan. They most common sources of
repayment for business loans are:

Strong Personal
Business
Business balance guarantees
assets
borrower’s sheet with by
pledged as
profits liquid business
collateral
assets owners
3
Analyzing Business Loan Applications
(Cont.)
Example (1)
Black Gold is asking for a $5 million working capital line of credit tied to a
borrowing base of assets, in the guise of accounts receivables and
inventory, in anticipation of a sharp rise in oil and gas prices.

Black Gold currently owes $3.9 million to another bank with whom it has
had a relationship for several years, but now the company has expressed
unhappiness with its current banking relationship and wants to establish
new relationship.

One of the a loan officer’s tasks is to find out as much as possible about
a business customer’s current lender relationships and why they are or
are not working out?

4
 Financial Ratio Analysis of a
Customer’s Financial Statements
• By careful selection of items from a borrower’s balance sheets and income
statements, the loan officer can shed light on such critical areas in business
lending as a borrowing customer’s:

1 5 Liquidity position, indicating

Ability to control expenses the availability of ready
cash
2 6
Operating efficiency in using
Track record of profitability
resources to generate sales

3 7
Marketability of product Financial leverage (or debt
lines relative to equity capital)

4 8 Contingent liabilities that

Coverage that earnings
may give rise to substantial
provide over financial cost
claims in future 5
 Financial Ratio Analysis of a Customer’s
Financial Statements (Cont.)
The Business Customer’s Control over Expenses
• A barometer of the quality of a business firm’s management is how carefully
it controls its expenses and how well its earnings – the primary source of
cash to repay a loan in most cases – are likely to be protected and grow.

• Expense-Control Ratios for Black Gold, Inc.

6
 Financial Ratio Analysis of a Customer’s
Financial Statements (Cont.)
Operating Efficiency: Measure of a Business Firm’s Performance
Effectiveness
• How effectively are assets being utilized to generate sales and how
efficiently are sales converted into cash?

• Efficiency Ratios for Black Gold, Inc.

7
 Financial Ratio Analysis of a Customer’s
Financial Statements (Cont.)
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 successfully.

• Gross and Net Profit Margins for Black Gold, Inc.

   

8
 Financial Ratio Analysis of a Customer’s
Financial Statements (Cont.)
Coverage Ratios: Measuring the Adequacy of Earnings
• Coverage refers to the protection afforded creditors based on the amount of
a business earning’s earnings.
• Coverage ratios for Black Gold, Inc.

9
 Financial Ratio Analysis of a Customer’s
Financial Statements (Cont.)
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. The concept of working capital is
important because it provides a measure of a firm’s ability to meet its short-
term debt obligation form current assets.
• Changes in liquidity at Black Gold, Inc.

10
 Financial Ratio Analysis of a Customer’s
Financial Statements (Cont.)
Profitability Indicators
• The ultimate standard of performance in a market-oriented economy is how
much net income remains for the owners of a business firm after all
expenses are charged against revenues.

• Profitability trends at Black Gold, Inc.

11
 Financial Ratio Analysis of a Customer’s
Financial Statements (Cont.)
The Financial Leverage Factor as a Barometer of a Business Firm’s
Capital Structure
• An lender is concerned about how much debt a borrower has taken on in
addition to the loan being sought. The term financial leverage refers to use
of debt in the hope the borrower can generate earnings that exceed the cost
of debt, thereby increasing potential returns to a business firm’s owners.

• Leverage Trends at Black Gold, Inc.

12
 Comparing a Business Customer’s
Performance to the Performance of its Industry

• It is standard practice among loan officers to compare each business

customer’s performance to the performance of the customer’s entire
industry.

Black Gold’s performance places it

below industry standards in terms of
several of key performance ratios
examined earlier.

The loan officer would want to

discuss with Black Gold’s
management the reasons for the
firm’s lagging performance and how
the management proposes to raise
Black Gold’s ranking within its own
industry.

13
 Contingent Liabilities
• Types of Contingent Liabilities
• Usually not shown on customer balance sheets are other potential claims
against the borrower that loan officers must be aware of:

Taxes owed but

unpaid
Unfunded
pension liabilities
the firm will likely
Litigation or owe its
pending lawsuits employees in the
against the firm
Guarantees and future
warranties
behind the
business firm’s
products

14
The Loan Officer’s Responsibility to the
Lending Institution and the Customer

Conclusion
The forgoing numbers of Black Gold would
make us think that the loan officer should say
no way.

However, a loan officer must look beyond the

immediate facts to the broader, longer-term
aspects of a customer relationship.

Denial of this loan request will almost

certainly lose this customer’s business
(including deposits placed with the lender)
and probably lose the personal accounts of
Black Gold’s stockholders and employees.

Other firms in the same or related industries

may also be discouraged from applying to
this lender for coverage of their credit needs.
15
 The Loan Officer’s Responsibility to the
Lending Institution and the Customer (Cont.)

Proposed plan
Many experienced loan officers
argue that a better long-run loan
policy is to find some way to help
a business customer under terms
the lender feels adequately
protect its funds and reputation.

Helping the customer may mean,

instead, offering to provide
noncredit services, such as cash
management services, advice on
a proposed merger or assistance
with a new security offering the
customer may be planning.

16
 The Loan Officer’s Responsibility to the
Lending Institution and the Customer (Cont.)
Alternative Proposed Plan

The lender will extend a $1.5 million line of credit for six months.
- If all payment on this credit are satisfactorily made and there is no
Decision further deterioration in the customer’s financial position, the lender will
renew the credit line on a quarterly basis.
1 - Any drawings against the line will be secured by a lien against all
fixed assets of the firm, 70% of all accounts receivable that are current,
and 40% of the value of all inventories held.
2 - The lender will be granted a first lien against any new fixed assets.
Collaterals 3 - The customer must keep a deposit with the lender equal to 20% of
the amount of any actual drawings against the line and 5% of the
amount of any unused portion of the line.
1 - The customer must file monthly reports on the status of sales,
expenses, net income, accounts receivable, and inventory and to file
quarterly audited financial statements.
Covenants 2 - Any changes in the management, sales of plant and equipment,
merger agreement or liquidation must be approved by the lender.
3 - The customer will maintain the current levels of leverage and
liquidity ratios and any significant changes in the firm’s financial
position must be reported to the lender immediately.
17
 The Loan Officer’s Responsibility to the
Lending Institution and the Customer (Cont.)
Black Gold Reaction to the Alternative Proposed Plan
• Black Gold may well decline this agreement, particularly because:

(a) It gives the customer much less money than

requested ($1.5 m instead of $5m)

(b) The loan funds are offered for a shorter term

than requested (6 months instead of 1 year)

(c) The agreement places many restrictions on

the freedom of Black Gold’s management.

18
 Pricing Business Loans

• One of the most difficult tasks in lending is deciding how to price a loan.

• The lender wants to charge a high enough interest rate to ensure each loan
will be profitable and compensate the lending institution fully for the risks
involved.

• However, the loan rate must also be low enough to accommodate the
customer in such a way that he or she can repay the loan and not be driven
away to another lender.

• The more competition the lender faces for a customer’s loan business, the
more it will have to keep the price of that loan in line with interest rates on
similar competition, the lender is a price taker, not a price setter.

19
 Pricing Business Loans (Cont.)

Cost-Plus Loan The Price

Pricing Method Leadership

Loan Pricing
Methods

20
 Pricing Business Loans (Cont.)
The Cost-Plus Loan Pricing Method
• This method assumes the rate of interest charged on any loan include four
components:

The lender’s
operating costs
The cost to the
(including
lender of
salaries and
raising
materials used
adequate
in
funds to lend
administrating
a loan)

The desired
Compensation
profit margin
paid to the
that provides
lender for the
the
degree of
stockholders
default risk in a
with return on
loan request
their capital

21
 Pricing Business Loans (Cont.)
The Cost-Plus Loan Pricing Method (Cont.)

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

Example (2)
Suppose a lender has a loan request from one of its corporate customers
for $5 million. The lender must sell negotiable CDs in the money market at
an interest rate of 5% to fund this loan. Operating costs to analyze, grant,
and monitor this loan are estimated at 2% of the $5 million request. The
credit department may recommend adding another 2% of the amount
requested to compensate for default risk. Finally, the lender may desire a
1% profit margin over and above the financial, operating, and risk-related
costs of this loan. How much is the interest rate charged on this loan?
The loan may be offered to the borrower at an annual interest rate of 10%
(5% + 2% + 2% + 1%) 22
 Pricing Business Loans (Cont.)

• There are two drawbacks of the cost-plus loan pricing model:

It assumes that the lending institution

accurately knows what its costs are. *

It assumes that a lender can price a loan

with little regard for the competition posed
by other lenders. **
• These limitations led to a form of price leadership in the banking industry.

23
 Pricing Business Loans (Cont.)

The Price Leadership Model (Cont.)

• During the Great Depression of the 1930s, major commercial banks
established a uniform base lending fee, the prime rate, sometimes called
the base or reference rate.

Loan interest rate = Base or prime rate + Markup (Default-risk

premium + Term-risk premium paid by borrowers seeking long-
term credit)
Example (3)
a medium-sized business asked a lender a three-year loan to purchase
new equipment. If the prime (base) rate of 6%, and the credit department
recommended 2% of default risk and another 2% for term risk because of
the long term character of the loan requested. The interest rate charged
on this loan is?
The loan may be offered to the borrower at an annual interest rate of 10%
(6% + 2% + 2%) *
24
 Learning Outcomes

• Analyzing Business Loan Applications.

• Financial Ratio Analysis of a Customer’s Financial Statements.
• Comparing a Business Customer’s Performance to the Performance of its
Industry.
• Contingent Liabilities
• The Loan Officer’s Responsibility to the Lending Institution and the
Customer.
• Pricing Business Loans:
– The Cost-Plus Loan Pricing Method.
– The Price Leadership Model.
– Customer Profitability Analysis.

25