1. Lending to Business Firms and Pricing Business Loans

2. 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.

3. 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)

4. 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

5. 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.

6. Long Term Business Loans
Term Loans
Revolving Credit Lines
Project Loans
Loans to support acquisitions of
other business firms

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. Profitability Measures
Before Tax Net Income/Total Assets
After Tax Net Income/Total Assets
Before Tax Net Income/Net Worth
After Tax Net Income/Net Worth

16. Leverage or Capital Structure
Measures
 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

17. Problem 17-3
From the data given in the following table , please
construct as many of the financial ratios discussed in
this chapter as you can and then indicate the
dimension of a business firm’s performance each ratio
represents.

18. Problem 17-3 (continued)
Assets Annual Revenue and Expense Items
Cash account $ 50
Accounts receivable 155 Net sales $ 650
Inventories 128 Cost of goods sold 485
Fixed assets 286 Wages and salaries 58
Miscellaneous assets 96
715 Interest expense 28
Overhead expenses 29
Liabilities and Equity
Depreciation expenses 12
Short-term debt: Selling, administrative,
Accounts payable 108 and other expenses 28
Notes payable 107*
Long-term debt (bonds) 325* Before-tax net income 10
Miscellaneous liabilities 15 Taxes owed 3
Equity capital 160 After-tax net income 7
715

19. Problem 17-3 (continued)
485
Inventory urnoverRatio
T 3.79
128
155
AverageCollect ionP eriod 85.85 days
650/360
38
Int erestCoverage 1.36
28

20. 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

21. Problem 17-3 (continued)
T otalLiabilitie 555
s
Debt Ratio 77.62%
T otalAssets 715
T otalLiabilitie 555
s
Debt toEquity Ratio 346.88%
Equity 160
333
Current Ratio 1.549x
215
333- 128
Acid - T est 0.95x
215

22. Types of Contingent Liabilities
Guarantees or warrantees behind
products
Litigation or pending lawsuits
Unfunded pension liabilities
Taxes owed but unpaid
Limiting regulations

23. 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

24. Component of Sources and Uses
of Funds Statement – Statement of Cash
Flows
Cash flows from operations
Cash flows from investing
activities
Cash flows from financing
activities

25. 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

26. Traditional (Direct) Operating
Cash Flows
Net Sales Revenue from Operations
– Cost of Goods Sold
– Selling, General and Administrative
– Taxes Paid in Cash + Non Cash Expenses

27. Indirect Operating Cash Flows
Net 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

28. Methods Used to Price Business Loans
Cost-Plus Loan Pricing Method
Price Leadership Model
Below Prime Market Pricing
(Markup Model)
Customer Profitability Analysis

29. Cost-Plus Loan Pricing
Marginal
Cost of Estimated
Nonfund Bank's
Loan Raising Margin to
Bank Desired
Interest = Loanable + + Compensate +
Operating Profit
Rate Funds to Bank for
Costs Margin
Lend to Default Risk
Borrower

30. 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 3.50 percent and
borrowed $4 million in the Federal funds market from other
banks at today’s prevailing interest rate of 3.25 percent.
Credit investigation and recordkeeping costs are estimated
at $25,000 and 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. Using
cost-plus loan pricing, what loan rate should the bank
charge?

31. Problem 17-7 (continued)
The weighted average cost of bank funds in this case would
be:
$ 6,000,000 * .0350 = $210,000
$ 4,000,000 * .0325 = $130,000
Total Interest Cost = $340,000
Average 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 + Profit
Margin = 3.40% + 0.25% + 1.00% + 0.25% = 4.90%.

32. Price Leadership Model
Default
Risk Term Risk
Loan
Base or Premium Premium for
Interest = + +
Prime Rate for Non- Longer
Rate
Prime Term Credit
Borrowers

33. 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.

34. 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.

35. Problem 17-8
Many loans to corporations are quoted today at small risk
premiums and profit margins over the London Interbank
Offered Rate (LIBOR). Englewood Bank has a $25 million
loan request for working capital to fund accounts receivable
and inventory from one of its largest customers, APEX
Exports. The bank offers its customer a floating-rate loan for
90 days with an interest rate equal to LIBOR on 30-day
Eurodeposits (currently trading at 4.0%) plus a one quarter
percentage point markup over LIBOR.
APEX, however, wants the loan rate set at 1.014 LIBOR.

36. Problem 17-8 (continued)
If the bank agrees to this loan rate request what interest rate
will attach to the loan if it is made today?
Customer's requested rate:
APEX preferred rate = 1.014 x 4.0% = 4.056%
How does this compare with the loan rate the bank wanted to
charge?
Bank’s preferred rate = 4.0% + 0.25% = 4.25%
What does this customer’s request reveal about the
borrowing firm’s interest rate forecast for the next 90 days?
Loan rates tend to move up and down faster with the
customer's loan-rate formula than with the bank's LIBOR-
plus formula. This customer appears to believe interest rates
will soon decline, pulling its loan rate lower.

37. Below-Prime Market Pricing
Interest Cost
Loan Markup
of Borrowing
Interest = + for Risk
in the Money
Rate and Profit
Market

38. 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.

39. 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

40. Problem 17-6
As a loan officer Sun Flower National Bank, you have been
responsible for the bank’s relationship with USF
Corporation, a major producer of remote control devices for
activating television setsDVDs, and other audio video
equipment. USF has just filed a request for renewal of its
$10 million line of credit, which will cover approximately nine
months. USF also regularly uses several other services sold
by the bank. Applying Customer Profitability Analysis (CPA)
and using the most recent year as a guide, you estimate that
the expected revenues from this commercial loan customer
and the expected costs of serving this customer will consist
of the following. The bank’s credit analysts estimated the
customer will keep an average deposit balance of
$2,125,000 for the year in which the line is active.

41. Problem 17-6 (continued)
Customer profitability analysis:
Expected Revenues Expected Costs
Interest Revenue $ 400,000* Deposit Interest (5.0%) $ 106,250
Commitment Fees 100,000 Cost of Other Funds 180,000
Deposit Service Wire Transfer Costs 1,300
(Maintenance) Fees 4,500 Loan Processing Costs 12,400
Wire Transfer Fees 3,500 Record keeping Expenses 4,500
Agency Fees 4,500 Account Activity Cost 5,000
Total Expected Rev $512,500 Total Expected Costs $ 277,575
*Interest revenue on $ 10 million line of credit at 4% for 12 months
Average deposit balance: $2,125,000

42. Problem 17-6 (continued)
What is the expected net rate of return from this proposed
loan renewal if the customer actually draws down the full
amount of the requested line?
Net Revenue = $512,500 - $277,575 = $234,925
Net Funds Loaned = $10,000,000 - $2,125,000
= $7,875,000
Expected Net Rate of Return = $234,925/ $7,875,000
= .0298 or 2.98%
What decision should the bank make under the foregoing
assumptions?
Since the 2.98% is positive, the bank should make the loan.

43. Problem 17-6 (continued)
If you decide to turn down this request, under what
assumptions regarding revenues, expenses, and customer-
maintained deposit balances would you make this loan?

44. Problem 17-6 (continued)
An initial reaction might be to increase loan revenues by raising the
interest rate on the loan or increasing the loan commitment fee.
Depending on the customer's relationship with the bank and with other
banks, this may prove to be extremely difficult. Initially, it was assumed
that the customer would draw down the entire line of credit, that
is, borrow the full $10,000,000. If the customer were to borrow less
than the full amount, the cost of funds raised to support this loan could
be reduced, increasing the net revenue from the loan. Relative to
expenses, it would be more likely that some adjustment in the
expenses associated with the relationship would be more appropriate.
For example, a careful examination of the relationship activities could
allow for a revision of estimated costs incurred by the bank to manage
the various aspects of the relationship. As far as the customer-
maintained balances are concerned, there could be an opportunity to
revise these estimates upward, making the net funds loaned smaller
and the expected net rate of return greater.

45. 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?

46. 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

47. Problem
Wren Corporation has requested a $5 million term
loan with an annual interest rate of 5%, a $2
million revolving line of credit with a 4.5% interest
rate (anticipated usage is 50% of the line). The
Company 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

48. Problem
What is the interest income on the revolving
line of credit?
= $1,000,000 * 0.045 = $45,000
What is the interest income on deposits?
= $500,000 * 0.02 = $10,000
If the bank has labor costs of 2.5%, what is
the cost to the bank for the credit facilities?
= ($5,000,000 + $2,000,000) * 0.025 =
$175,000