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Chapter SeventeenLending 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.

Key TopicsTypes 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 LoansSelf-Liquidating Inventory LoansWorking Capital LoansInterim Construction LoansSecurity Dealer FinancingRetailer and Equipment Financing

Asset-Based FinancingSyndicated Loans

Syndicated LoansA 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.

Long Term Business LoansTerm LoansRevolving Credit LinesProject LoansLoans to support acquisitions of other business firms

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

Analyzing Business Loan ApplicationsCommon size ratios of customer over time

Financial ratio analysis of customer’s financial statements

Current and pro forma sources and uses of funds statement

Financial Ratio AnalysisControl over expensesOperating efficiencyMarketability of product or serviceCoverage ratios: measuring adequacy of

earningsLiquidity indicators for business

customersProfitability indicatorsThe financial leverage factor as a

barometer of a business firm’s capital structure

Expense Control MeasuresCost of Goods Sold/Net SalesSelling, Administrative and Other Expenses/Net Sales

Depreciation Expenses/Net SalesInterest Expenses on Borrowed Funds/Net SalesTaxes/Net Sales

Operating EfficiencyAnnual Costs of Goods Sold/Average Inventory

Net Sales/Net Fixed AssetsNet Sales/Total AssetsAvg collection period = A/R/(credit sales)/360

Marketability of Product or ServiceGross Profit Margin:(Net Sales – Cost of Goods Sold)

Net Sales

Net Profit Margin:Net Income After Taxes

Net Sales

Coverage Measures Interest Coverage:

Coverage of Interest and Principal Payments:

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

Liquidity MeasuresCurrent Assets/Current Liabilities:

Acid Test Ratio:

Working Capital:

Net Liquid Assets:

Current Assets Current Liabilities

Current Assets – Inventory Current Liabilities

Current Assets – Inventory (raw) –Current Liabilities

Current Assets – Current Liabilities

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

Leverage or Capital Structure Measures Leverage Ratios:

Capitalization Ratio:

Debt to Sales Ratio:

Total Liabilities Total Assets

Long Term Debt (LTD) Total LTD + Net Worth

Total Liabilities Net Sales

Total Liabilities Net Worth

Problem 17-3From 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.

Problem 17-3 (continued)AssetsCash account $ 50Accounts receivable 155Inventories 128Fixed assets 286Miscellaneous assets 96

715Liabilities and EquityShort-term debt: Accounts payable 108 Notes payable 107*Long-term debt (bonds) 325*Miscellaneous liabilities 15Equity capital 160

715

Annual Revenue and Expense Items

Net sales$ 650Cost of goods sold 485Wages and salaries 58Interest expense28Overhead expenses 29Depreciation expenses 12Selling, administrative, and other expenses 28Before-tax net income 10Taxes owed 3After-tax net income 7

Problem 17-3 (continued)

36.128

38CoverageInterest

days 85.58650/360

155 Period Collection Average

79.3128

485 RatioTurnover Inventory

Problem 17-3 (continued)

%375.4160

7

Equity

NIROE

469.4160

715

Equity

Assets Total MultiplierEquity

909.715

650

Assets Total

SalesTurnoverAsset Total

%08.1650

7

Sales

NIMarginProfit Net

Problem 17-3 (continued)

x

x

95.0215

128-333Test-Acid

549.1215

333RatioCurrent

%88.346160

555

Equity

sLiabilitie TotalRatioEquity Debt to

%62.77715

555

Assets Total

sLiabilitie TotalRatioDebt

Types of Contingent LiabilitiesGuarantees or warrantees behind products

Litigation 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 Uses of Funds Statement – Statement of Cash FlowsCash flows from operations

Cash flows from investing activities

Cash flows from financing activities

Sources and Uses of FundsIncrease in Assets = Use of FundsDecrease 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) Operating Cash FlowsNet Sales Revenue from Operations

– Cost of Goods Sold – Selling, General and Administrative – Taxes Paid in Cash + Non Cash Expenses

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

Methods Used to Price Business LoansCost-Plus Loan Pricing Method

Price Leadership Model

Below Prime Market Pricing (Markup Model)

Customer Profitability Analysis

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

Cost-Plus Loan Pricing

Problem 17-7In 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?

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%.

Loan Interest

Rate=

Base or Prime Rate

+

Default Risk

Premium for Non-

Prime Borrowers

+

Term Risk Premium for

Longer Term Credit

Price Leadership Model

Prime RateMajor 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.

LIBORThe London Interbank Offer Rate. The rate offered on short-term Eurodollar deposits with maturities ranging from a few days to a few months.

Problem 17-8Many 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.

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.

Loan Interest

Rate=

Interest Cost of Borrowing in the Money

Market

+Markup for Risk

and Profit

Below-Prime Market Pricing

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.

Customer Profitability Analysis (CPA)Take the whole customer

relationship into accountEstimate 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

Problem 17-6As 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.

Problem 17-6 (continued)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 Costs1,300 (Maintenance) Fees 4,500 Loan Processing Costs 12,400Wire 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 monthsAverage deposit balance: $2,125,000

Customer profitability analysis:

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.

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?

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.

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

ŸRatio analysis ŸCommon-size statementsŸSources and uses of funds

Importance of loan pricing Loan pricing methods

ŸCost-Plus ŸCap ratesŸPrice leadership ŸCustomer profitability analysisŸMarkup model

Prime rate LIBOR

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

ProblemWhat 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