BNFN 404 CREDIT ANALYSIS AND LENDING

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BNFN 404CREDIT ANALYSIS AND LENDING

• WEEK 4
• ROSE,HUDGINS (2005), CHP. 16
• LENDING TO BUSINESS FIRMS
• AND PRICING BUSINESS LOANS

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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
• Syndicated 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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• 5. 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.
• 6. 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.
• 7. Syndicated Loans
• A type of large corporate loan or loan package
  extended to a corporation by a group of banks and
  other institutional lenders.

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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. Pro Forma Statements of Cash Flows and Balance
  Sheets

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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 16.1).
• 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 Liabilities
• 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 Statements Of Cash Flows 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 Statement of Cash Flows.
• Such a statement can provide vital information on
  how the business firms cash balance (Inflows /
  Outflows) 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 the Statement of Cash Flows

• .The Statement of Cash Flows explains how cash
  receipts and payments are generated by operating
  activities, investing activities and financing
  activities.
• .The second section describes the inflows and
  outflows associated with investing activities
  (all purchases and sales of securities and long
  term assets)
• .The final section reports financing
  activities.
• Cash inflows include short and long-term
  funds by lenders and owners
• Cash outflows include repayment of
  borrowed funds, dividends to owners.

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Cash Inflows and Cash Outflows

• CASH INFLOWS
• Decrease in Assets
• Increase in Liabilities
• Increase in Net Worth
• CASH OUTFLOWS
• Increase in Assets
• Decrease in Liabilities
• Decrease in Net Worth

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Pricing Business Loans

• Most difficult task in lending is deciding how to
  price a loan. Lender wants to charge a high
  interest rate to make more profit and compensate
  for the risk involved.
• The loan interest rate must be low to accommodate
  the business customer then the customer can
  successfully repay the loan and do not transfer
  to another lender.
• Lender has many competitors in financial market.
  It is not easy to keep the price of the loan
  (interest rate) at a reasonable level.
• There is intensive competition, the lender is
  price taker not a price setter.

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Cost-Plus Loan pricing Method

• Management must consider the cost of raising
  loanable funds and the operating costs of running
  the business.
• Marginal
  Estimated
• Loan cost of raising Nonfunds
  margin to Desired
• Interest loanable funds operating
  compensate profit
• rate to lend to
  costs for default margin
• the borrower
  risk

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The Price Leadership Model

• In 1930s major commercial banks established a
  uniform base lending fee known as the prime rate
  or the base or reference rate.
• Most popular base is LIBOR London Interbank
  Offered Rate (on short-term Eurodollar deposits).
• Actual loan interest rate charged to customer
  would be determined by the formula
• Loan Base or prime
• Interest rate ( includes
  Default- risk Term-risk
• rate desired profit
  premium premium
• margin)

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• Libor based LIBOR Default-risk Term-Risk
  Profit margin
• Loan rate
  premium premium
• If no risk and short-term loan then LIBOR Profit
  Margin
• Customer Profitability Analysis
• When pricing each loan request, the lender will
  consider whole picture of customer.
• Revenue from
  loans Expenses from
• Net before-tax and other services
  _ providing loans
• Rate of return provided to customer
  to customer
• To lender __________________________
  _____________
• Net amount of
  loanable funds supplied to customer