Chapter 17 – Lending to Business Firms and Pricing Business Loans
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CHAPTER 17
LENDING TO BUSINESS FIRMS AND PRICING BUSINESS LOANS
Goal of This Chapter: 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 Topics in This Chapter
• 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
Chapter Outline
I. Introduction
II. Brief History of Business Lending
III. Types of Business Loans
A. Short-Term Business Loans
B. Long-Term Business Loans
IV. Short-Term Loans to Business Firms
A. Self-Liquidating Inventory Loans
B. Working Capital Loans
C. Interim Construction Financing
D. Security Dealer Financing
E. Retailer and Equipment Financing
F. Asset-Based Financing
G. Syndicated Loans (SNCs)
V. Long-Term Loans to Business Firms
A. Term Business Loans
B. Revolving Credit Financing
C. Long-Term Project Loans
D. Loans to Support the Acquisition of Other Business Firms—Leveraged Buyouts
VI. Analyzing Business Loan Applications
A. Most Common Sources of Loan Repayment
B. Analysis of a Business Borrower’s Financial Statements
1. Important Balance Sheet Composition Ratios
a. Percentage Composition of Assets
b. Percentage Composition of Total
Liabilities and Net Worth
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2. Important Income Statement Composition Ratios
a. Percentage Composition of Total Income
VII Financial Ratio Analysis of a Customer’s Financial Statements
A. The Business Customer’s Control over Expenses
B. Operating Efficiency: Measure of a Business Firm’s Performance Effectiveness
C. Marketability of the Customer’s Product or Service
D. Coverage Ratios: Measuring the Adequacy of Earnings
E. Liquidity Indicators for Business Customers
F. Profitability Indicators
G. The Financial Leverage Factor as a Barometer of a Business Firm’s Capital
Structure
VIII Comparing a Business Customer’s Performance to the Performance of Its Industry
A. Contingent Liabilities
1. Types of Contingent Liabilities
2. Environmental Liabilities
3. Underfunded Pension Liabilities
IX. Preparing Statements of Cash Flows from Business Financial Statements
A. Statement of Cash Flows
B. Pro Forma Statements of Cash Flows and Balance Sheets
C. The Loan Officer’s Responsibility to the Lending Institution and the Customer
X. Pricing Business Loans
A. The Cost-Plus Loan Pricing Method
B. The Price Leadership Model
C. Below-Prime Market Pricing
D. Customer Profitability Analysis (CPA)
1. An Example of Annualized Customer Profitability Analysis
a. Problem
b. Interpretation
2. Earnings Credit for Customer Deposits
3. The Future of Customer Profitability Analysis
XI. Summary of the Chapter
Concept Checks
17-1. What special problems does business lending present to the management of a business
lending institution?
While business loans are usually considered among the safest types of lending (their default rate,
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17-2. What are the essential differences among working capital loans, open credit lines, asset-
based loans, term loans, revolving credit lines, interim financing, project loans, and acquisition
loans?
a. Working capital loans are short-run credits to fund the current assets of a business, such
as accounts receivable, inventories, or to replenish cash. Usually a working capital loan is
designed to cover seasonal peaks in a business customer’s production levels.
are normally used to fund the purchase of new plant and equipment or to provide for a permanent
increase in working capital. Term loans usually look to the flow of future earnings of a business
firm to amortize and retire the credit. Term loans normally are secured by fixed assets (e.g., plant
or equipment) owned by the borrower and may carry either a fixed or a floating interest rate.
e. Revolving credit lines are lines of credit that promise the business borrower access to any
project.
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17-3. What aspects of a business firm’s financial statements do loan officers and credit analysts
examine carefully?
Analysis of the financial statements of a business borrower typically begins when the lender’s
credit analysis department analyses how key figures on the borrower’s financial statement have
changed (usually during the last three, four, or five years.) The percentage-composition ratios
sales, and taxes/net sales.
b. Operating efficiency: It is also important to look at how effectively are assets being
utilized to generate sales and how efficiently are sales converted into cash.
The important ratios here are, net sales/total assets, annual cost of goods sold/average inventory
levels, net sales/net fixed assets, and net sales/accounts and notes receivable.
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fixed payments can be found by dividing income before interest, taxes and lease payments by the
sum of interest payments and lease payments.
e. Profitability indicators: The ideal standard of performance in a market-oriented economy
is how much net income remains for the owners of a business firm after all expenses are charged
17-4. What aspect of a business firm’s operations is reflected in its ratio of cost of goods sold to
net sales? In its ratio of net sales to total assets? In its GPM ratio? In its ratio of income before
interest and taxes to total interest payments? In its acid-test ratio? In its ratio of before-tax net
income to net worth? In its ratio of total liabilities to net sales? What are the principal limitations
of these ratios?
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income before interest expense and taxes to total interest payments indicates how effectively a
business is covering its interest expenses through the generation of before-tax income. The acid-
17-5. What are contingent liabilities, and why might they be important in deciding whether to
approve or disapprove a business loan request?
Contingent liabilities are usually not shown on customer balance sheets. These liabilities can be
in various forms such as pending or possible future obligations like lawsuits against a business
firm, and warranties or guarantees the firm has given to others regarding the quality, safety, or
17-6. What is cash-flow analysis, and what can it tell us about a business borrower’s financial
condition and prospects?
The statement of cash flows shows how cash receipts and disbursements are generated by
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From the perspective of a loan officer, the cash flow statement indicates whether the firm is
long run.
17-7. What is a pro forma statement of cash flows, and what is its purpose?
17-8. Should a loan officer ever say “no” to a business firm requesting a loan? Please explain
when and where.
A loan request may not appear of having reasonable prospects for being repaid in the future. The
loan officer can come to this conclusion after noticing the borrowing company’s recent record of
17-9. What methods are used to price business loans?
The following methods are in use today to price business loans:
a. Cost-plus loan pricing
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The price-leadership model, on the other hand, bases the loan rate upon a uniform national or
international rate (such as prime or LIBOR) posted by major commercial banks. The prime rate
17-10. Suppose a bank estimates that the marginal cost of raising loanable funds to make a $10
0.25 percent. What loan rate should be quoted to this borrower? How much interest will the
borrower pay in a year?
According to the cost-plus loan pricing model:
Loan interest rate =
Marginal cost of raising loanable funds to lend to the borrower +
Nonfunds operating costs + Estimated margin to compensate for default risk +
Desired profit margin
Loan interest rate = 4 percent + 0.50 percent + 0.375 percent + 0.25 percent = 5.125 percent
Based on a $10 million loan to be raised, the customer will pay interest of: $10,000,000 × 5.125
percent = $512,500.
17-11. What are the principal strengths and weaknesses of the different loan-pricing methods in
use today?
Cost plus pricing is the simplest loan pricing model as it considers the cost of raising loanable
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assign risk premiums to loans as it would differ among borrowers based on the risk that they
carry.
Below prime market pricing uses LIBOR as the base rate and includes only a small profit margin
as part of the loan price. This has been proposed only for short term loans for large, well known
officers.
17-12. What is customer profitability analysis? What are its advantages for the borrowing
customer and the lender?
Customer profitability analysis is a loan pricing method that takes into account the lender’s entire
relationship (all revenues and expenses associated with a particular customer) with the customer
17-1. From the descriptions below please identify what type of business loan is involved.
a. A temporary credit supports construction of homes, apartments, office buildings, and
cash.
Chapter 17 – Lending to Business Firms and Pricing Business Loans
f. A securities dealer requires credit to add new government bonds to his securities
portfolio.
g. Credit granted for more than a year to support purchases of plant and equipment.
17-2. As a new credit trainee for Evergreen National Bank, you have been asked to evaluate the
financial position of Hamilton Steel Castings, which has asked for renewal of and an increase in
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because you will be asked for your opinion of this loan request (though you have been led to
believe the loan will be approved anyway, because Hamilton’s president serves on Evergreen’s
board of directors).
2) Industry outlook for the next six to eighteen months would also help in reinforcing Hamilton’s
ability to service the debt from the summer and fall cash flows.
4) Also, more information about other relationships that Hamilton has with Evergreen would
be.
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 what dimension of a business firm’s
performance each ratio represents.
Business Assets
Annual Revenue and Expense Items
Cash account
$60
Net sales
$600
Accounts receivable
155
Cost of goods sold
445
Inventories
128
Wages and salaries
52
Fixed assets
286
Interest expense
28
Miscellaneous assets
96
Overhead expenses
29