CHAPTER SIXTEEN Lending 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.

Short Term Business Loans Self-Liquidating Inventory Loans Working Capital Loans Interim Construction Loans Security Dealer Financing Retailer Financing Asset-Based Financing

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

Long Term Business Loans Term Loans Revolving Credit Lines Project Loans Loans 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 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

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

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

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)

Marketability of Product or Service (Net Sales – Cost of Goods Sold)/Net Sales Net Income After Taxes/Net Sales

Income Before Interest and Taxes Interest Payments 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

Liquidity Current Assets Current Liabilities Current Assets – Inventory Current Liabilities Current Assets – Inventory (raw) –Current Liabilities Current Assets – Current Liabilities

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

Leverage Total Liabilities Total Assets Long Term Debt (LTD) Total LTD + Net Worth Total Liabilities Net Sales

Types of Contingent Liabilities Guarantees or Warrantees Behind Products Litigation or Pending Lawsuits Unfunded Pension Liabilities Taxes Owed But Unpaid Limiting 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 Changes in Cash Account Changes in Accounts Receivables Changes in Inventory Changes in Fixed Assets Changes in Accounts Payable Changes in Other Current Liabilities Changes in Long Term Debt Changes in Net Worth

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

Methods Used to Price Business Loans Cost-Plus Pricing Models Price Leadership Pricing Models Below Prime Market Pricing (Markup Model) Loans Bearing Maximum Interest Rates Customer Profitability Analysis

Cost-Plus Loan Pricing

Price Leadership Model

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

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

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) 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