BNFN 404 CREDIT ANALYSIS AND LENDING

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BNFN 404CREDIT ANALYSIS AND LENDING

• WEEK 11 12
• ROSE (1999), CHP. 17
• LENDING TO BUSINESS FIRMS

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TYPES OF BUSINESS LOANS

• Business loans are commercial and industrial
  loans (CI). We can classify the business loans
  as
• Short-term business loans
• Long-term business loans

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Short Term Business Loans

• Self-Liquidating Inventory Loans
• Working Capital Loans
• Interim Construction Loans
• Security Dealer Financing
• Retailer Financing
• Asset-Based Loans

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Long-Term Business Loans

• Term Loans
• Revolving Credit Lines
• Project Loans
• Loans to Support Acquisitions of Other Business
  Firms

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Short-Term Loans to Business Firms

• Self-Liquidating Inventory Loans
• These loans usually are used to finance the
  purchase of inventory raw materials or finished
  goods to sell. Such loans take advantage of the
  normal cash cycle in a business firm. It takes
  about 60-90 days to borrow the cash and pay it
  back.
• BUY RAW MATERIALS
• PRODUCE
• CASH GOODS
• SALE GOODS

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• 2. Working Capital Loans
• Provide business with short-run credit, lasting
  from a few days to about one year. The working
  capital loan is designed to cover seasonal peaks
  in the business customers production levels and
  credit needs (eg. clothing industry).
• 3. Interim Construction Financing
• A popular form of secured short-term lending for
  most commercial banks is the interim construction
  loan, used to support the construction of homes,
  apartments, office buildings, shopping centers,
  and other permanent structures.
• 4. Security Dealer Financing
• Dealers in government and private 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.

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• 4. Retailer Financing
• Banks support consumer installment purchases of
  automobiles, home appliances, furniture, and
  other durable goods by financing the receivables
  that dealers selling these goods take on when
  they write installment contracts to cover
  customer purchases.
• 5. Asset-Based Financing
• In asset-based loans, credit secured by the
  shorter-term assets of a firm that are expected
  to roll over into cash in the future. The key
  business assets used for the majority of these
  loans are accounts receivable and inventories of
  raw materials or finished goods. For example,
  bank may be willing to loan an amount equal to 70
  of a firms current accounts receivable, or 40
  of the business customers current inventory of
  goods.

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Long-Term Loans to Business Firms

• Term Business Loans
• Term loans are designed to fund long and
  medium-term business investments, such as the
  purchase of equipment or the construction of
  physical facilities, covering a period longer
  than one year. The loan is paid in monthly or
  quarterly installments. Term loans are secured by
  fixed assets (eg. plant or equipment) owned by
  the borrower and may carry either a fixed or a
  floating interest rate.
• 2. Revolving Credit Financing
• Revolving credit line allows a business customer
  to borrow up to a prespecified limit, repay all
  or a portion of the borrowing, and reborrow as
  necessary until the credit line matures. One form
  of business revolving credit is the use of credit
  cards.

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• Long-Term Project Loan
• The most risky of all business loans are project
  loans credit to finance the construction of
  fixed assets designed to generate a flow of
  revenue in future periods.Eg oil refineries,
  pipelines, mines, power plants, bridges, and
  harbor facilities.
• The risks involved in project finance 1) loans
  are very large, 2) project may be delayed 3) laws
  and regulations may change in a way that
  adversely affects the completion or cost of the
  project, 4) interest rates may change.
• Project loans may be granted on a recourse basis,
  in which the lender can recover funds from the
  sponsoring companies if the project does not pay
  out as planned.

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• 4. Loans to Support Acquisitions of Other
  Business Firms
• In the 1980s loans to finance mergers and
  acquisitions of businesses expanded rapidly. One
  of the most important acquisition credit is LBOs
  - leverage buyouts of firms by small groups of
  investors, often led by managers inside the firm.
  In the 1990s, LBO slowed down. In LBOs, a high
  credit risk is involved because of the high debt
  ratio. If interest rates rise, or if the sales of
  these business do not perform as predicted, due
  to an economic recession, these businesses may
  not service their debt, and can go bankrupt.

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Sources of Repayment For Business Loans

• The Borrowers Profits or Cash Flows
• Business Assets Pledged as Collateral
• Strong Balance Sheet With Ample Marketable Assets
  and Net Worth
• Guarantees Given By Business

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Analyzing Business Loan Applications

• 1. Common Size Ratios of Customer Over Time
• 2. Financial Ratio Analysis of Customers
  Financial Statements
• 3. Current and Pro Forma Sources and Uses of
  Funds Statement

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1. Common-Size Ratios of Customer

• Common-size ratios are given in percentages such
  as percentages of total assets (in the case of
  the balance sheet) and percentages of total sales
  (in the case of the income statement). Eg.
  inventories/total assets, cost of sales/sales,
  gross profits/sales, etc. (See Table 17.1).
• These percentage-composition ratios control for
  differences in size of firm, permitting the loan
  officer to compare a particular business customer
  with other firms and with the industry as a
  whole.

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2. Financial Ratio Analysis

• Information from balance sheets and income
  statements allow us to do a financial ratio
  analysis. The financial ratio analysis gives us
  information about a business in the following
  areas
• Control Over Expenses
• Operating Efficiency
• Marketability of Product or Service
• Coverage
• Liquidity
• Profitability
• Leverage

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• Control Over Expenses
• A borrowing customers ability to control its
  expenses is an important indicator of its
  management quality and its earnings prospects for
  the future. These ratios are
• 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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2. Operating Efficiency

• Operating efficiency shows how effectively are
  assets being utilized to generate sales and cash
  flow for the firm and how efficiently are sales
  converted into cash? Important financial ratios
  here are
• Annual cost of goods sold/average inventory
• Net sales / Total assets
• Net sales/ Net fixed assets
• Net sales/ Accounts and notes receivable
• Average collection period Accounts receivable/
• Annual credit sales /360

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3. Marketability of Product or Service

• A business has to be able to market its products
  or services successfully in order to generate
  adequate cash flows to repay a loan. In this
  respect we analyze the growth rate of sales
  revenues, changes in the business customers
  share of the available market, and the gross
  profit margin (GPM).
• Net sales-Cost of goods sold
• GPM
• Net sales
• Net income after taxes
• NPM
• Net sales

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• The Gross Profit Margin (GPM) measures both
  market conditions , that is, demand for the
  business customers product or service and how
  competitive a marketplace the customer faces
  and the strength of the business customer in its
  own market, as indicated by how much the market
  price of the firms product or service exceeds
  the customers unit cost of production and
  delivery.
• The Net Profit Margin (NPM) , on the other hand,
  indicates how much of the business customers
  profit from each dollar of sales survives after
  all expenses (including taxes) are deducted,
  reflecting both the effectiveness of the firms
  expense-control policies and the competitiveness
  of its pricing policies.

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4. Coverage Ratios Measuring the Adequacy of
Earnings

• Coverage refers to the protection afforded
  creditors of a firm based on the amount of the
  firms earnings. The best known coverage ratios
  include the following
• Income before interest and taxes
• Interest coverage
• Interest payments
• Coverage of all Income before interest, taxes,
  and lease payments
• fixed assets
• Interest payments Lease payments
• Income before interest and taxes
• Coverage of interest
• and Principle payments Interest payments
  Principal Repayments/
• 1-Firms marginal tax rate

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5. Liquidity Indicators for Business Customers

• The borrowers 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.
• An individual, business firm, or government is
  considered liquid if it can convert assets into
  cash or borrow immediately spendable funds
  precisely when cash is needed. Liquidity
  therefore is a short-run concept in which time
  plays a key role. For that reason, most measures
  of liquidity focus on the amount of current
  assets and current liabilities.

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• Current assets
• Current ratio
• Current liabilities
• Current assets - inventory
• Acid-test ratio
• Current liabilities
• Net liquid assets Current - Inventories of
  raw - Current
• assets materials or goods
  Liabilities
• Net working capital Current assets current
  liabilities

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6. Profitability Indicators

• Most loan officers look at both pretax net income
  and after-tax net income to measure the overall
  financial success or failure of a prospective
  borrower relative to comparable firms in the same
  industry.
• Before-tax net income
• total assets, net worth, or total sales
• After-tax net income
• total assets, net worth, or total sales

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7. Financial Leverage

• Any lender of funds is concerned about how much
  debt a borrower has taken on in addition to the
  loan being applied for. The financial leverage
  refers to the use of debt in the hope that the
  borrower can generate earnings that exceed the
  cost of debt, thereby increasing the potential
  return to a business firms owners
  (stockholders). Key financial ratios are
• Total Liabilities
• Leverage Ratio
• Total assets
• Long-term debt
• Capitalization Ratio
• Total long term liabilities and net worth
• Total liabilities
• Debt-to-sales ratio
• Net sales

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• The greater the amount of indebtedness a
  borrower has already taken on , other factors
  held equal, the less well secured is any
  particular lenders position.
• High Leverage Ratio
• The higher the leverage ratio becomes, the less
  likely it is that additional loans will be
  granted to a customer until he or she pays down
  some of the outstanding indebtedness. Moreover,
  if a loan is granted to a highly leverage
  borrower, it is likely to carry a higher interest
  rate plus a requirement that more collateral be
  pledged.
• Capitalization Ratio
• The capitalization ratio focuses upon the
  business customers use of permanent financing,
  essentially comparing the degree to which the
  firm is supported by long-term creditors as
  opposed to its owners equity capital (net worth).

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• Debt-to-Sales Ratio
• Business debt can also be linked to business
  sales, because those sales ultimately provide the
  funds needed to retire the debt. If a firms
  liabilities increase relative to its sales,
  management will have to compensate for the
  heavier debt burden by either finding
  less-expensive sources of credit or lowering
  expenses.
• Contingent Liabilities
• Contingent liabilities are usually not shown on
  customer balance sheets, but they are potential
  claims against the borrower that the loan officer
  must be aware of.

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• Types of Contingent Liabilites
• Guaranties and warranties behind the business
  firms products
• Litigation or pending lawsuits against the firm
• Unfunded pension liabilities the firm will likely
  owe to its employees in the future
• Taxes owed but unpaid
• Limiting regulations
• Environmental Liabilities A new contingent
  liability that has increasingly captured
  bankers concern is the issue of possible lender
  liability for environmental damage.

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Preparing Sources and Uses of Funds Statements
From Business Financial statements

• Besides balance sheets and income statements,
  bank loan officers frequently like to see a third
  accounting statement from a business borrower-
  the Sources and Uses of Funds Statement.
• Such a statement can provide vital information on
  how the business firms financial position is
  changing over time, telling the loan officer how
  the firm is financing itself and allocating the
  funds it raises.
• This kind of statement usually has the following
  components

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Components of Sources and Usesof Funds Statement

• Changes in Assets Changes in Liabilities

• Changes in Accounts Payables
• Changes in Other Current Liabilities
• Changes in Long Term Debt
• Changes in Net Worth

• Changes in Cash Account
• Changes in Accounts Receivables
• Changes in Inventory
• Changes in Fixed Assets

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Sources and Uses of Funds

• SOURCE OF FUNDS
• Decrease in Assets
• Increase in Liabilities
• Increase in Net Worth
• USE OF FUNDS
• Increase in Assets
• Decrease in Liabilities
• Decrease in Net Worth

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Table 17.9
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Pro Forma Sources and Uses statements and
Balance Sheets

• It is very important to estimate the business
  borrowers future sources and uses of funds and
  its statement of financial condition. The bank
  often has the customer prepare pro forma
  statement and then credit analysts within the
  bank will prepare their own version of these
  forecast for comparison purposes.

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Table 17.10