Master of Banking and Finance (Day 1st Batch)

Bank Management (Chapter 17)

Lending to Business Firms and Pricing Business Loans

Presented by Group 1
1. Aye Hnin Maw (Roll No-4)
2. Ei Ei Myat (Roll No-8)
3. Lei Yin Htwe (Roll No-37)
4. Lwin Mie Mie Htay (Roll No-38)
5. May Phyu Sin (Roll No-40)
6. Naw Tin Moe Moe Swe (Roll No-53)
7. Phoo Pwint Mon (Roll No-55)
8. Zayar Lynn (Roll No-85)
9. Zin Zin Wint Phyu Oo (Roll No-90)
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

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Business Loans and Brief History of Business Lending

Business loans are known as Commercial and industrial

Loans (C&L). It was represented the earliest form of
lending that banks carried out
 Loans extended to ship owners, mining operators, goods
manufacturers, and property owners dominated bankers’
loan portfolios for centuries

In the late 19th and early 20th centuries new

competitors, particularly finance companies, life and
property/casualty insurance firms, and some thrift
institutions, entered the business lending field
 This placed downward pressure on the profit margins of
many business lenders

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Types of Business Loans

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Short-Term Loans to Business Firms

Self-Liquidating Inventory Loans

 These loans usually were used to finance the purchase of
inventory – raw materials or finished goods to sell
 Such loans take advantage of the normal cash cycle inside
a business firm
 There appears to be less of a need for traditional inventory
financing
▫ Due to the development of just in time (JIT) and supply chain
management techniques

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Short-Term Loans to Business Firms (continued)
Working Capital Loans
 Short-run credit that lasts from a few days to one year
 Most often used to fund the purchase of inventories
 Frequently it is designed to cover seasonal peaks in the
business customer's production levels and credit needs
 Secured by accounts receivable or by pledges of inventory
 Carry a floating interest rate
 A commitment fee is charged on the unused portion of the
credit line and sometimes on the entire amount of funds made
available
 Compensating deposit balances may be required from the
customer
 Recently compensating deposit balances as a part of a
business-loan arrangement has been on the decline
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Short-Term Loans to Business Firms (continued)
Interim Construction Financing
 Secured short-term loan used to support the
construction of homes, apartments, office buildings,
shopping centers, and other permanent structures

Security Dealer Financing

 Dealers in securities need short-term financing to
purchase new securities and carry their existing
portfolios of securities until they are sold to customers
or reach maturity
 Banks and security firms lend directly to business and
individuals buying stocks, bonds, options, and other
financial instruments.

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Short-Term Loans to Business Firms (continued)
 Retailer and Equipment Financing
 Lenders support installment purchases of automobiles,
home appliances, and other durable goods by financing the
receivables that dealers selling these goods take on when
they write installment contracts to cover customer
purchases
 Asset-Based Financing
 Credit secured by the shorter-term assets of a firm that are
expected to roll over into cash in the future
 Syndicated Loans (SNCs)
 A loan package extended to a corporation by a group of
lenders
 Many SNCs are traded in the secondary (resale) market

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Long-Term Loans to Business Firms
 Term Business Loans
 Designed to fund longer-term business investments, such as
the purchase of equipment or the construction of physical
facilities, covering a period longer than one year
 Normally loans are secured by fixed assets (plant or
equipment)
 Revolving Credit Financing
 Allows a customer to borrow up to a prespecified limit, repay
all or a portion of the borrowing, and reborrow as necessary
 One of the most flexible of all business unsecured loans
 May be short-term or long-term
 Lenders normally charge a loan commitment fee
 Two types: formal loan commitment and confirmed credit
line

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Long-Term Loans to Business Firms (continued)

 Long-Term Project Loans

 Credit to finance the construction of fixed assets

 Most risky of all business loans
 Some of the risks of project loans:
1. Large amounts of funds are usually involved
2. The project may be delayed by weather or shortage of
materials
3. Laws and regulations in the region where the project lies
may change
4. Interest rates may change

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Long-Term Loans to Business Firms (continued)

 Loans to Support the Acquisition of Other Business

Firms – Leveraged Buyouts

 The 1980s and 1990s ushered in an explosion of loans to

finance mergers and acquisitions
 Leveraged buyouts (LBOs) usually involve acquiring a
controlling interest in another firm with the use of a
great deal of debt (leverage) to finance the transaction

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Analyzing Business Loan Applications

 Need to find at least 2 or 3 sources of fund for

repayment of the loan

 The most common sources of repayment for business

loans are:

1. The business borrower’s profits or cash flow

2. Business assets pledged as collateral behind the loan
3. A strong balance sheet with ample amounts of
marketable assets and net worth
4. Guarantees given by the business, such as drawing on
the owners’ personal property to backstop a loan
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Analyzing Business Loan Applications (continued)

 Analysis of a Business Borrower’s Financial Statements

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Analyzing Business Loan Applications (continued)
 Analysis of a Business Borrower’s Financial Statements

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Financial Ratio Analysis of a Customer’s
Financial Statements
 Information from balance sheets and income statements is
typically supplemented by financial ratio analysis
 Critical areas of potential borrowers loan officers consider:
 Ability to control expenses
 Operating efficiency in using resources to generate sales
 Marketability of product line
 Coverage that earnings provide over financing cost
 Liquidity position, indicating the availability of ready cash
 Track record of profitability
 Financial leverage (or debt relative to equity capital)
 Contingent liabilities that may give rise to substantial
claims in the future
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Financial Ratio Analysis of a Customer’s
Financial Statements (continued)
 The Business Customer’s Control over Expenses
 A barometer of the quality of a firm’s management is how it
controls its expenses and how well its earnings are likely to be
protected and grow
 Selected financial ratios to monitor a firm’s expense control:
• 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

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Financial Ratio Analysis of a Customer’s
Financial Statements (continued)
 Operating Efficiency: Measure of a Business Firm’s
Performance Effectiveness
 It is also useful to look at a business customer’s operating
efficiency
• How effectively are assets being utilized to generate sales and
how efficiently are sales converted into cash?
 Important financial ratios here include:
• Inventory turnover ratio - annual cost of goods sold/Average inventory
• Turn over of fixed assets ratio- Net sales/Net fixed assets
• Turn over of total assets ratio- Net sales/Total assets
• Net sales/Accounts and notes receivable
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Financial Ratio Analysis of a Customer’s
Financial Statements (continued)

 Operating Efficiency: Measure of a Business Firm’s

Performance Effectiveness

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Financial Ratio Analysis of a Customer’s
Financial Statements (continued)

 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, or skills successfully
 The gross profit margin (GPM), defined as

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Financial Ratio Analysis of a Customer’s
Financial Statements (continued)

 Marketability of the Customer’s Product or Service

 A closely related and somewhat more refined ratio is the

net profit margin (NPM)

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Financial Ratio Analysis of a Customer’s
Financial Statements (continued)
 Coverage Ratios: Measuring the Adequacy of Earnings
 Coverage refers to the protection afforded creditors
based on the amount of a business customer’s earnings
 The best-known coverage ratios include

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Financial Ratio Analysis of a Customer’s
Financial Statements (continued)
 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

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Financial Ratio Analysis of a Customer’s
Financial Statements (continued)
 Profitability Indicators
 How much net income remains for the owners of a
business firm after all expenses (except dividends) are
charged against revenue?
 Popular bottom line indicators include
• Before-tax net income / total assets, net worth, or total sales
• After-tax net income / total assets (or ROA)
• After-tax net income / net worth (or ROE)
• After-tax net income / total sales (or ROS) or profit margin

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Financial Ratio Analysis of a Customer’s
Financial Statements (continued)
 The Financial Leverage Factor as a Barometer of a
Business Firm’s Capital Structure
 Any lender is concerned about how much debt a
borrower has taken on in addition to the loan being
sought
 Key financial ratios used to analyze any borrowing
business’s credit standing and use of financial leverage
include

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Comparing a Business Customer’s Performance
to the Performance of Its Industry

 It is standard practice to compare each business

customer’s performance to the performance of the
customer’s entire industry
 Dun & Bradstreet Industry Norms and Key Business
Ratios
 RMA Annual Statement Studies

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Comparing a Business Customer’s Performance
to the Performance of Its Industry (continued)
 Contingent Liabilities
 Usually not shown on customer balance sheets are other
potential claims against the borrower:
• Guarantees and warranties behind the business firm’s products
• Litigation or pending lawsuits against the firm
• Unfunded pension liabilities
• Taxes owed but unpaid
• Limiting regulations
 These contingent liabilities can turn into actual claims against
the firm’s assets and earnings at a future date
 Loan officer must ask the customer about pending or
potential claims against the firm
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Comparing a Business Customer’s Performance
to the Performance of Its Industry (continued)

 Contingent Liabilities
 Environmental Liabilities
• The Comprehensive Environmental Response,
Compensation, and Liability Act (CERCLA) and its Super
Fund Amendments
• Make current and past owners of contaminated property or of
businesses located on contaminated property and those who
dispose of or transport hazardous substances potentially liable
for any cleanup costs associated with environmental damage

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Comparing a Business Customer’s Performance
to the Performance of Its Industry (continued)
 Contingent Liabilities (continued)

 Underfunded Pension Liabilities

 Under Financial Accounting Standards Board (FASB),
borrowing customers may be compelled to record employee
pension plan surpluses and deficits on their balance sheets
 If projected pension-plan liabilities exceed expected funds
sources, the result may be an increase in liabilities

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Preparing Statements of Cash Flows from
Business Financial Statements
 The Statement of Cash Flows illustrates how cash receipts
and disbursements are generated by operating, investing,
and financing activities

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Preparing Statements of Cash Flows from
Business Financial Statements (continued)

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Preparing Statements of Cash Flows from
Business Financial Statements (continued)

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Pricing Business Loans
 One of the most difficult tasks in lending is deciding how
to price a loan
 Lender wants to charge a high enough interest rate to
ensure each loan will be profitable and compensate the
lending institution for the risks involved

 The Cost-Plus Loan Pricing Method

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Pricing Business Loans (continued)
 The Price Leadership Model

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Pricing Business Loans (continued)
 In the U.S., the prevailing prime rate is considered to be
the most common base rate
 Two different floating prime rate formulas were soon
developed by leading money center banks
 Prime-plus method
 Times-prime method
 London Interbank Offered Rate (LIBOR)
 Leading commercial lenders have switched to LIBOR-
based loan pricing due to the growing use of
Eurocurrencies as a source of loanable funds
 LIBOR-based loan rate = LIBOR + Default-risk premium + Profit margin

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Pricing Business Loans (continued)
 Below-Prime Market Pricing

 Banks announced that some large corporate loans

covering only a few days or weeks would be made at low
money market interest rates
 Federal funds rate on domestic loans plus a small margin

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Pricing Business Loans (continued)

 Customer Profitability Analysis (CPA)

 New loan pricing technique that is similar to the cost-plus

loan pricing technique
 Assumes that the lender should take the whole customer
relationship into account when pricing a loan

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Pricing Business Loans (continued)
 Customer Profitability Analysis (CPA)

 If the net rate of return is positive, the proposed loan is

acceptable because all expenses have been met
 If the net rate of return is negative, the proposed loan and
other services provided to the customer are not correctly
priced as far as the lender is concerned
 The greater the perceived risk of the loan, the higher the net
rate of return the lender should require

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Pricing Business Loans (continued)

• Customer Profitability Analysis (CPA)

▫ Earnings Credit for Customer Deposits
▫ In calculating how much in revenues a customer generates for a
lending institution, many lenders give the customer credit for any
earnings received from investing the balance in the customer’s
deposit account

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Summary
 Business loans are often divided into short term (under one
year) and long term (more than a year to Maturity).
 Sometimes more meaningful classification divides these credits
into working capital loans and term loans including seasonal
open credit dealer financing asset-based loans, revolving credit,
project loans .
 Among the more important credit evaluation techniques used
today are
 Composition analysis of borrower financial statements
(including the use of common-size balance sheets and income
statements);
 Financial ratio analysis (including ratio measures of expense
control, efficiency, coverage, profitability, liquidity, and
leverage);
 Actual and pro forma statements of cash flows.

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Summary
 Several different methods for pricing business loans have
appeared over the years, including cost-plus loan pricing, price
leadership loan pricing, below-prime loan pricing, and customer
profitability analysis.

 Many business loans today are priced directly off money market
interest rates (such as LIBOR or the prevailing Federal funds
rate) with narrow profit margins reflecting intense competition.

 There is a growing trend toward pricing business credit based

on the total relationship between lender and borrower.

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Thanks for your kind attention

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