Lending to Business Firms and Pricing Business Loans
The purpose of this chapter is to explore howbankers can respond to a business customerseeking a loan and to reveal the factors they mustconsider in evaluating a business loan request. Inaddition, we explore the different methods usedtoday to price business loans and to evaluate thestrengths and weaknesses of these pricing methodsfor achieving a financial institution’s goals.
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 (CPA)
Short Term Business Loans Self-Liquidating Inventory Loans Working Capital Loans Interim Construction Loans Security Dealer Financing Retailer and Equipment Financing Asset-Based Financing Syndicated Loans
Syndicated LoansA loan or line of credit extendedto a business firm by a group oflenders in order to reduce therisk exposure to any one lendinginstitution.
Long Term Business LoansTerm LoansRevolving Credit LinesProject LoansLoans to support acquisitions of other business firms
Sources of Repayment for Business LoansThe borrower’s profits or cash flowsBusiness assets pledged as collateralStrong balance sheet with ample marketable assets and net worthGuarantees given by businesses
Analyzing Business Loan ApplicationsCommon size ratios of customer over timeFinancial ratio analysis of customer’s financial statementsCurrent and pro forma sources and uses of funds statement
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
Expense Control Measures Cost of Goods Sold/Net Sales Selling, Administrative and Other Expenses/Net Sales Depreciation Expenses/Net Sales Interest Expenses on Borrowed Funds/Net Sales Taxes/Net Sales
Operating Efficiency Annual Costs of Goods Sold/Average Inventory Net Sales/Net Fixed Assets Net Sales/Total Assets Avg collection period = A/R/(credit sales)/360
Marketability of Product or Service Gross Profit Margin: (Net Sales – Cost of Goods Sold) Net Sales Net Profit Margin: Net Income After Taxes Net Sales
Coverage Measures Interest Coverage: Income Before Interest and Taxes Interest Payments Coverage of Interest and Principal Payments: Income Before Interest and Taxes (Interest Pay. + Princ. Pay/(1-Marg.Tax)) Income Before Interest, Taxes and Lease Payments Interest Payments + Lease Payments
Liquidity Measures Current Assets/Current Liabilities: Current Assets Current Liabilities Acid Test Ratio: Current Assets – Inventory Current Liabilities Working Capital: Current Assets – Current Liabilities Net Liquid Assets: Current Assets – Inventory (raw) –Current Liabilities
Profitability MeasuresBefore Tax Net Income/Total AssetsAfter Tax Net Income/Total AssetsBefore Tax Net Income/Net WorthAfter Tax Net Income/Net Worth
Leverage or Capital StructureMeasures Leverage Ratios: Total Liabilities Total Liabilities Total Assets Net Worth Capitalization Ratio: Long Term Debt (LTD) Total LTD + Net Worth Debt to Sales Ratio: Total Liabilities Net Sales
Problem 17-3From the data given in the following table , pleaseconstruct as many of the financial ratios discussed inthis chapter as you can and then indicate thedimension of a business firm’s performance each ratiorepresents.
Problem 17-3 (continued)Assets Annual Revenue and Expense ItemsCash account $ 50Accounts receivable 155 Net sales $ 650Inventories 128 Cost of goods sold 485Fixed assets 286 Wages and salaries 58Miscellaneous assets 96 715 Interest expense 28 Overhead expenses 29Liabilities and Equity Depreciation expenses 12Short-term debt: Selling, administrative, Accounts payable 108 and other expenses 28 Notes payable 107*Long-term debt (bonds) 325* Before-tax net income 10Miscellaneous liabilities 15 Taxes owed 3Equity capital 160 After-tax net income 7 715
Problem 17-3 (continued) 485Inventory urnoverRatio T 3.79 128 155AverageCollect ionP eriod 85.85 days 650/360 38Int erestCoverage 1.36 28
Problem 17-3 (continued) NI 7 Net P rofitMargin 1.08% Sales 650 Sales 650 T otalAsset T urnover .909 T otalAssets 715 T otalAssets 715 Equity Multiplier 4.469 Equity 160 NI 7 ROE 4.375% Equity 160
Problem 17-3 (continued) T otalLiabilitie 555 sDebt Ratio 77.62% T otalAssets 715 T otalLiabilitie 555 sDebt toEquity Ratio 346.88% Equity 160 333Current Ratio 1.549x 215 333- 128Acid - T est 0.95x 215
Types of Contingent LiabilitiesGuarantees or warrantees behind productsLitigation or pending lawsuitsUnfunded pension liabilitiesTaxes owed but unpaidLimiting regulations
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
Component of Sources and Usesof Funds Statement – Statement of CashFlowsCash flows from operationsCash flows from investing activitiesCash flows from financing activities
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
Traditional (Direct) OperatingCash FlowsNet Sales Revenue from Operations – Cost of Goods Sold – Selling, General and Administrative – Taxes Paid in Cash + Non Cash Expenses
Indirect Operating Cash FlowsNet Income + Non Cash Expenses + Losses from the Sale of Assets – Gains from the Sale of Assets – Increases in Assets Associated with Operations + Increases in Current Liabilities Associated with Operations – Decreases in Current Liabilities Associated with Operations + Decreases in Current Assets Associated with Operations
Methods Used to Price Business LoansCost-Plus Loan Pricing MethodPrice Leadership ModelBelow Prime Market Pricing (Markup Model)Customer Profitability Analysis
Cost-Plus Loan Pricing Marginal Cost of Estimated Nonfund Banks Loan Raising Margin to Bank DesiredInterest = Loanable + + Compensate + Operating Profit Rate Funds to Bank for Costs Margin Lend to Default Risk Borrower
Problem 17-7In order to help fund a loan request of $10 million for oneyear from one of its best customers, Lone Star Bank soldnegotiable CDs to its business customers in the amount of $6 million at a promised annual yield of 3.50 percent andborrowed $4 million in the Federal funds market from otherbanks at today’s prevailing interest rate of 3.25 percent.Credit investigation and recordkeeping costs are estimatedat $25,000 and the Credit Analysis Division recommends aminimal 1 percent risk premium on this loan and a minimalprofit margin of one-fourth of a percentage point. Usingcost-plus loan pricing, what loan rate should the bankcharge?
Problem 17-7 (continued)The weighted average cost of bank funds in this case wouldbe: $ 6,000,000 * .0350 = $210,000 $ 4,000,000 * .0325 = $130,000 Total Interest Cost = $340,000Average interest costs = $ 340,000 /$10,000,000 = 3.40%Operating costs = $25,000/$10,000,000 = 0.25%Risk premium = 1.00%Profit margin = 0.25%The loan rate on a cost-plus basis would be:Interest Cost + Non-interest Cost + Risk Premium + ProfitMargin = 3.40% + 0.25% + 1.00% + 0.25% = 4.90%.
Price Leadership Model Default Risk Term Risk Loan Base or Premium Premium forInterest = + + Prime Rate for Non- Longer Rate Prime Term Credit Borrowers
Prime RateMajor banks established a baselending fee during the greatdepression. At that time it was thelowest interest rate charged theirmost credit worthy customers forshort-term working capital loans.
LIBORThe London Interbank OfferRate. The rate offered on short-term Eurodollar deposits withmaturities ranging from a fewdays to a few months.
Problem 17-8Many loans to corporations are quoted today at small riskpremiums and profit margins over the London InterbankOffered Rate (LIBOR). Englewood Bank has a $25 millionloan request for working capital to fund accounts receivableand inventory from one of its largest customers, APEXExports. The bank offers its customer a floating-rate loan for90 days with an interest rate equal to LIBOR on 30-dayEurodeposits (currently trading at 4.0%) plus a one quarterpercentage point markup over LIBOR.APEX, however, wants the loan rate set at 1.014 LIBOR.
Problem 17-8 (continued)If the bank agrees to this loan rate request what interest ratewill attach to the loan if it is made today?Customers requested rate:APEX preferred rate = 1.014 x 4.0% = 4.056%How does this compare with the loan rate the bank wanted tocharge?Bank’s preferred rate = 4.0% + 0.25% = 4.25%What does this customer’s request reveal about theborrowing firm’s interest rate forecast for the next 90 days?Loan rates tend to move up and down faster with thecustomers loan-rate formula than with the banks LIBOR-plus formula. This customer appears to believe interest rateswill soon decline, pulling its loan rate lower.
Below-Prime Market Pricing Interest Cost Loan Markup of Borrowing Interest = + for Risk in the Money Rate and Profit Market
Cap Rate ModelBanks offer a floating rate loanwith an agreed upon upper limiton the loan contract regardless ofthe course of future interest rates.
Customer Profitability Analysis (CPA) Take the whole customer relationship into account Estimate total revenues from loans and other services Estimate total expenses from providing net loanable funds Estimate net loanable funds Estimate before tax rate of return by dividing revenues less expenses by net loanable funds
Problem 17-6As a loan officer Sun Flower National Bank, you have beenresponsible for the bank’s relationship with USFCorporation, a major producer of remote control devices foractivating television setsDVDs, and other audio videoequipment. USF has just filed a request for renewal of its$10 million line of credit, which will cover approximately ninemonths. USF also regularly uses several other services soldby the bank. Applying Customer Profitability Analysis (CPA)and using the most recent year as a guide, you estimate thatthe expected revenues from this commercial loan customerand the expected costs of serving this customer will consistof the following. The bank’s credit analysts estimated thecustomer will keep an average deposit balance of$2,125,000 for the year in which the line is active.
Problem 17-6 (continued)Customer profitability analysis:Expected Revenues Expected CostsInterest Revenue $ 400,000* Deposit Interest (5.0%) $ 106,250Commitment Fees 100,000 Cost of Other Funds 180,000Deposit Service Wire Transfer Costs 1,300(Maintenance) Fees 4,500 Loan Processing Costs 12,400Wire Transfer Fees 3,500 Record keeping Expenses 4,500Agency Fees 4,500 Account Activity Cost 5,000Total Expected Rev $512,500 Total Expected Costs $ 277,575*Interest revenue on $ 10 million line of credit at 4% for 12 monthsAverage deposit balance: $2,125,000
Problem 17-6 (continued)What is the expected net rate of return from this proposedloan renewal if the customer actually draws down the fullamount of the requested line?Net Revenue = $512,500 - $277,575 = $234,925Net Funds Loaned = $10,000,000 - $2,125,000 = $7,875,000Expected Net Rate of Return = $234,925/ $7,875,000 = .0298 or 2.98%What decision should the bank make under the foregoingassumptions?Since the 2.98% is positive, the bank should make the loan.
Problem 17-6 (continued)If you decide to turn down this request, under whatassumptions regarding revenues, expenses, and customer-maintained deposit balances would you make this loan?
Problem 17-6 (continued)An initial reaction might be to increase loan revenues by raising theinterest rate on the loan or increasing the loan commitment fee.Depending on the customers relationship with the bank and with otherbanks, this may prove to be extremely difficult. Initially, it was assumedthat the customer would draw down the entire line of credit, thatis, borrow the full $10,000,000. If the customer were to borrow lessthan the full amount, the cost of funds raised to support this loan couldbe reduced, increasing the net revenue from the loan. Relative toexpenses, it would be more likely that some adjustment in theexpenses associated with the relationship would be more appropriate.For example, a careful examination of the relationship activities couldallow for a revision of estimated costs incurred by the bank to managethe various aspects of the relationship. As far as the customer-maintained balances are concerned, there could be an opportunity torevise these estimates upward, making the net funds loaned smallerand the expected net rate of return greater.
Quick Quiz• 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?
Summary Types of bank loans Sources of repayment Contingent liabilities Analysis of the loan application Ratio analysis Common-size statements Sources and uses of funds Importance of loan pricing Loan pricing methods Cost-Plus Cap rates Price leadership Customer profitability analysis Markup model Prime rate LIBOR
ProblemWren Corporation has requested a $5 million termloan with an annual interest rate of 5%, a $2million revolving line of credit with a 4.5% interestrate (anticipated usage is 50% of the line). TheCompany has average bank deposit balance of$500,000 that will have a return of 2%.What is the interest income on the term loan?= $5,000,000 * .05 = $250,000
ProblemWhat is the interest income on the revolvingline of credit?= $1,000,000 * 0.045 = $45,000What is the interest income on deposits?= $500,000 * 0.02 = $10,000If the bank has labor costs of 2.5%, what isthe cost to the bank for the credit facilities?= ($5,000,000 + $2,000,000) * 0.025 =$175,000