Chapter 17

Lending to Business Firms and Pricing

Business Loans
Group 10
 17.6
Analyzing Business Loan Applications
Common sources of repayment for business loans

The business Business assets A strong balance Guarantees given

borrower’s profits pledged as sheet with ample by the business,
or cash flow. collateral behind amounts of such as drawing
the loan. marketable assets on the owners’
and net worth. personal property
to backstop a
loan.
Analysis of a Business Borrower’s Financial Statements

Important Balance Sheet Composition Ratios

Percentage Composition of Assets Percentage Composition of Total Liabilities and Net Worth

Accounts payable/Total liabilities and net worth (= total assets)

Cash/Total assets
Notes payable/Total liabilities and net worth
Marketable securities/Total assets
Taxes payable/Total liabilities and net worth
Accounts receivable/Total assets
Total current liabilities/Total liabilities and net worth
Inventories/Total assets
Long-term debt obligations/Total liabilities and net worth
Fixed assets, net of depreciation/Total assets
Other liabilities/Total liabilities and net worth
Other (miscellaneous) assets/Total assets
Net worth/Total liabilities and net worth
Analysis of a Business Borrower’s Financial Statements
Important Income Statement Composition Ratios
Percentage Composition of Total Income (gross revenues or sales)

Cost of sales/Sales
Gross profit/Sales
Labor costs (wages, salaries, and fringe benefits)/Sales
Selling, administrative, and other expenses/Sales
Depreciation expenses/Sales
Other operating expenses/Sales
Net operating profit/Sales
Interest expense on borrowed funds/Sales
Net income before taxes/Sales
Income taxes/Sales
Net income after taxes/Sales
 Example

Black Gold’s net income after taxes and net income as a percentage of total net
sales has been negative in two of the last four years. Its sales revenues have been
essentially flat over the past four years, while the cost of goods sold, both in dollar
terms and relative to net sales, has risen significantly over the past four years.
Moreover, if this loan is to be secured by accounts receivable and inventory, the
loan officer clearly has reason to be concerned, because the dollar amount and
percentage of total assets of both of these balance sheet items have risen sharply.
And the firm’s short-term (current) liabilities have risen as well.
 17.7
Financial Ratio Analysis of a Customer’s
Financial Statements
 A borrowing customer’s

Ability to control expenses

Operating efficiency in using resources to generate sales

Marketability of product line

Financial Coverage that earnings provide over financing cost
Ratios
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

claim in the future
 Control Over Expenses

 How carefully the business firm controls its expenses

 How well the business firm protects and grows its earnings
 Wages and Salaries/Net Sales

Overhead Expenses/Net Sales

Depreciation Expenses/Net Sales

Expense
Control Interest Expense on Borrowed Funds/Net Sales

Ratios Cost of Goods Sold/Net Sales

Selling, Administrative and Other Expenses/Net Sales

Taxes/Net Sales
 Expense Control Ratios for Black Gold Inc.

Most 1 Year 2 Years 3 Years

Recent Year Ago Ago Ago
Cost of Goods Sold/Net Sales 56.3% 53.5% 53.6% 45.2%
Selling, Administrative and Other Expenses/Net Sales 28.1% 30.0% 28.6% 35.5%
Depreciation Expenses/Net Sales 9.4% 10.0% 10.7% 6.5%
Interest Expense on Borrowed Funds/Net Sales 6.3% 3.3% 7.1% 6.5%
Taxes/Net Sales 0.3% 1.0% 0.4% 0.6%
 Operating Efficiency

 How effectively are assets being utilized to generate sales

 How efficiently are sales converted into cash

 Inventory Turnover ratio= Annual cost of goods sold/Average inventory

Total Asset Turnover ratio= Net sales/Total assets

Operating
Fixed Asset Turnover ratio= Net sales/Net fixed assets
Efficiency
Ratios Accounts Receivables Turnover ratio= Net sales/Accounts & notes receivables

Average collection period= Accounts Receivables/(Annual credit sales/360)

Operating Efficiency Ratios for Black Gold Inc.

3 Years
Most Recent Year 1 Year Ago 2 Years Ago Ago

Inventory Turnover ratio 3.46 times 3.56 times 4.41 times 6.09 times

Average collection period 93.4 days 88.8 days 79.7 days 47.6 days

Fixed Asset Turnover ratio 3.44 times 2.73 times 2.07 times 1.79 times

Total Asset Turnover ratio 1.14 times 1.03 times 0.93 times 0.97 times
 Sales Growth Rate

Changes in Market Share

Marketability
Ratios
GPM (Gross profit margin)= (Net Sales – Cost of Goods Sold)/Net Sales

NPM (Net profit margin)= Net Income After Taxes/Net Sales

 Marketability Ratios for Black Gold Inc.

3 Years
Most Recent Year 1 Year Ago 2 Years Ago Ago

GPM 43.8% 46.7% 46.4% 54.8%

NPM -0.3% 2.3% -3.6% 5.8%

   Interest Coverage ratio=

Coverage   Coverage of Interest and Principal Payments

Ratios =

  Coverage of All Fixed Payments

=
 Coverage Ratios for Black Gold Inc.

Most 2 Years 3 Years

Recent 1 Year Ago Ago Ago
Year

Interest Coverage 1.0 times 2.0 times 1.0 times 2.0 times

Coverage of Interest & Principal payments 0.29 times 0.80 times 0.65 times 1.01 times
   Current ratio=

  Acid-test ratio=
Liquidity
Ratios
Net Liquid Assets= Current assets – Inventory – Current Liabilities

Net Working Capital= Current Assets – Current Liabilities

 Liquidity Ratios for Black Gold Inc.

3 Years
Most Recent Year 1 Year Ago 2 Years Ago Ago

Current ratio 2.83 times 2.92 times 3.00 times 1.91 times

Acid test ratio 1.85 times 1.98 times 2.17 times 1.40 times

Working capital $9.7 million $9.2 million $8.2 million $4.1 million

Net liquid assets $4.5 million $4.7 million $4.8 million $1.8 million
  Before   tax   net   income
total   assets ,  net   worth ,  or   total   sales  

Profitability   ROA =

Indicators
  ROE =

  ROS or Profit Margin =

 Profitability Trends at Black Gold, Inc.

Most Recent Year 1 Year Ago 2 Years Ago 3 Years Ago

Before-tax net income / total

assets 0.0% 3.4% 0.0% 6.3%

After-tax net income / total assets -0.4 2.4 -0.3 5.6

Before-tax net income / net 0.0 9.4 0.0 20.0

worth

After-tax net income / net worth -1.0 6.6 -1.0 18.0

   Leverage ratio=

Financial
Leverage   Capitalization ratio=
Factor
  Debt-to-sales ratio =
 Profitability Trends at Black Gold, Inc.

Most Recent Year 1 Year Ago 2 Years Ago 3 Years Ago

Leverage ratio 62.50% 63.40% 67.00% 68.80%

Total liabilities/ net worth 1.67 times 1.74 times 2.03 times 2.20 times

Capitalization ratio 53.70% 55.50% 55.80% 53.30%

Debt-to-sales ratio 54.70% 61.30% 71.80% 71.00%

 17.8
Comparing with Industry Performance
 Comparing with Industry Performance

It is standard practice among loan officers to compare each business customer’s performance
to the performance of the customer’s entire industry

In Bangladesh, individual banks have to manage their own

database for industry performance.
Typically a Relationship Manager is responsible for the assessing.
 Comparing with Industry Performance

Black Gold is a member of the crude oil and natural gas extraction industry

Generally, Black Gold’s performance places it below industry standards

 Contingent Liabilities

Types of Contingent Liabilities

1. Guarantees and warranties behind the business firm’s products.

2. Litigation or pending lawsuits against the firm.
3. Environmental Liabilities
3. Unfunded pension liabilities the firm will likely owe its employees in
the future.
4. Taxes owed but unpaid.
5. Limiting regulations
 17.9
Statements of Cash Flows
 Net Cash Flow from Operations
 Normal flow of production, inventories, and sales
 Reconciliation of Net Income: Depreciation
 Adjust for changes in Assets and Liabilities: A/R, A/P, Tax Payable

Net Cash Flow from Investment Activities

Cash Flow  Purchase and Sale of Assets
By origin  Gains and Losses while trading assets

Net Cash Flow from Financing Activities

 Short and Long-term funds collected
 Repayment of borrowed funds
 Payment of dividends
 Repurchasing outstanding stock
 Cash Flow Statement of Black Gold Inc.

Cash inflow Cash outflow

  Accounts receivables
Getting short-term borrowings
  Inventories
Postponing replacement of equipment
 Repayment of liabilities
(fully depreciated)
 Purchase of equipment
 Pro Forma Statements

Performance prediction

 Customer: More optimistic and less objective

 Loan officer: Simulation analysis

 Loan Officer’s Responsibility

Consequences of denying a loan Building a customer relationship

 Deposit account  Counteroffer with limits
 Stakeholders of the company  Non-credit services
 Related firms or industries  Serve in the future
 17.10
Pricing Business Loans
 Marginal cost of raising loanable funds to lend to
the borrower

+
Non-fund operating costs
Cost-Plus 

Cost to analyze, grant and monitor the loan
Wages and salaries of loan personnel
Loan Pricing  Cost of materials and physical facilities involved in the process

Method +
Estimated margin to compensate for default risk

+
Desired profit margin
 Example

Suppose, for a loan request made to a bank,

Cost of borrowing the fund through selling negotiable CDs 5%

Non-funds operating cost 2%

Compensation charged for default risk 2%

Desired profit margin 1%

⸫ Loan interest rate 10%

 Drawbacks
Of
The cost plus loan pricing method
 Assumption that a lending
institution accurately knows what its costs are.
Drawbacks
Assumption that a lender can price a loan with little
regard for the competition
posed by other lenders
The price leadership model
 The price leadership model

Loan Interest rate = Base or prime rate + Default-risk premium paid by

nonprime-rated borrowers + Term-risk premium paid by borrowers
seeking long-term credit
 example

Consisting of a prime (or

base) rate of 6 percent plus 2 percent for default risk and another 2 percent for term risk, how
much should the annual rate of a medium-sized business asking for a three-year loan to purchase new
equipment be assessed?
 Solution

Loan Interest rate = 6% + 2% + 2% =10%

 LIBOR —the London Interbank Offered Rate

short-term Eurocurrency deposits

spreading internationalization of the financial system

common pricing standard for all banks, both foreign and domestic,

common basis for comparing the terms on loans

 LIBOR —the London Interbank Offered Rate

LIBOR-based loan rate = LIBOR + Default-risk premium + Profit margin

 example

leading international
banks in London were quoting a three-month average LIBOR on Eurodollar deposits of
about 5.30 percent. Assuming the default risk premium to be charged at 0.125% and profit margin would be
0.125%
a large corporation borrowing short-term money for 90 days might be quoted an interest rate on a multimillion
dollar loan of what percent?
 solution

LIBOR-based loan rate = LIBOR + Default-risk premium + Profit margin

= 5.30% + 0.125% + 0.125%
=5.55%
 Customer Profitability Analysis (CPA)

  Net before-tax rate of return to the lender from the whole customer relationship

=
 Example

Revenues expected is $216 000, Costs expected $125 000, Net amount of loanable funds supplied is
$1,230,000, then what would the net rate of return from the entire lender–customer relationship be? Is the
proposed loan acceptable?
 solution

  Net before-tax rate of return to the lender from the whole customer relationship

= 0 074 or 7.4%
Thank you