Chapter SeventeenLending to Business Firms and Pricing Business LoansCopyright 2013 The Mcra!"#i$$ Companies% &nc' Permission re(uired )or reproduction or disp$ay'McGraw-Hill/IrwinBank Management and Financial Services, 7/e 2008!e McGraw-Hill "#m$anies, Inc%, &ll 'ig!ts 'eserved%*ey TopicsTypes o) Business Loans+ Short Term and Long Term,na$y-ing Business Loan .e(uestsCo$$atera$ and Contingent Lia/i$itiesSources and 0ses o) Business FundsPricing Business LoansCustomer Pro)ita/i$ity ,na$ysis17-2Copyright 2013 The Mcra!"#i$$ Companies% &nc' Permission re(uired )or reproduction or disp$ay'McGraw-Hill/IrwinBank Management and Financial Services, 7/e 2008!e McGraw-Hill "#m$anies, Inc%, &ll 'ig!ts 'eserved%&ntroductionSecuring $arge amounts o) credit that many /usinesses re(uire can /e a cha$$enging tas1Business $oans are o)ten ca$$ed commercia$ and industria$ 2C3&4 $oans C3& $oans ran1 among the most important assets /an1s and their c$osest competitors ho$dFor 0'S' insured commercia$ /an1s% c$ose to one")i)th o) their $oan port)o$io is c$assi)ied as /usiness or C3& $oans This percentage o) the tota$ $oan port)o$io does not inc$ude many commercia$ rea$ estate $oans and $oans to other )inancia$ institutions17-3Copyright 2013 The Mcra!"#i$$ Companies% &nc' Permission re(uired )or reproduction or disp$ay'McGraw-Hill/IrwinBank Management and Financial Services, 7/e 2008!e McGraw-Hill "#m$anies, Inc%, &ll 'ig!ts 'eserved%Brie) #istory o) Business LendingCommercia$ and industria$ $oans represented the ear$iest )orm o) $ending that /an1s carried outLoans e5tended to ship o!ners% mining operators% goods manu)acturers% and property o!ners dominated /an1ers6 $oan port)o$ios )or centuries&n the $ate 17th and ear$y 20th centuries ne! competitors% particu$ar$y )inance companies% $i)e and property8casua$ty insurance )irms% and some thri)t institutions% entered the /usiness $ending )ie$dThis p$aced do!n!ard pressure on the pro)it margins o) many /usiness $enders17-4Copyright 2013 The Mcra!"#i$$ Companies% &nc' Permission re(uired )or reproduction or disp$ay'McGraw-Hill/IrwinBank Management and Financial Services, 7/e 2008!e McGraw-Hill "#m$anies, Inc%, &ll 'ig!ts 'eserved%Types o) Business Loans17-5Copyright 2013 The Mcra!"#i$$ Companies% &nc' Permission re(uired )or reproduction or disp$ay'McGraw-Hill/IrwinBank Management and Financial Services, 7/e 2008!e McGraw-Hill "#m$anies, Inc%, &ll 'ig!ts 'eserved%Short"Term Loans to Business FirmsSe$)"Li(uidating &nventory Loans These $oans usua$$y !ere used to )inance the purchase o) inventory 9 ra! materia$s or )inished goods to se$$ Such $oans ta1e advantage o) the norma$ cash cyc$e inside a /usiness )irm There appears to /e $ess o) a need )or traditiona$ inventory )inancing :ue to the deve$opment o) ;ust in time 25penses, /arometer o) the (ua$ity o) a )irm6s management is ho! it contro$s its e5penses and ho! !e$$ its earnings are $i1e$y to /e protected and gro!Se$ected )inancia$ ratios to monitor a )irm6s e5pense contro$+ =ages and sa$aries8?et sa$es @verhead e5penses8?et sa$es :epreciation e5penses8?et sa$es &nterest e5pense on /orro!ed )unds8?et sa$es Cost o) goods so$d8?et sa$es Se$$ing% administrative% and other e5penses8?et sa$es Ta5es8?et sa$es17-17Copyright 2013 The Mcra!"#i$$ Companies% &nc' Permission re(uired )or reproduction or disp$ay'McGraw-Hill/IrwinBank Management and Financial Services, 7/e 2008!e McGraw-Hill "#m$anies, Inc%, &ll 'ig!ts 'eserved%Financia$ .atio ,na$ysis o) a Customer6s Financia$ Statements 2continued4@perating >))iciency+ Measure o) a Business Firm6s Per)ormance >))ectiveness&t is a$so use)u$ to $oo1 at a /usiness customer6s operating e))iciency #o! e))ective$y are assets /eing uti$i-ed to generate sa$es and ho! e))icient$y are sa$es converted into cashF &mportant )inancia$ ratios here inc$ude+ ,nnua$ cost o) goods so$d8,verage inventory 2or inventory turnover ratio4 ?et sa$es8?et )i5ed assets ?et sa$es8Tota$ assets ?et sa$es8,ccounts and notes receiva/$e17-18Copyright 2013 The Mcra!"#i$$ Companies% &nc' Permission re(uired )or reproduction or disp$ay'McGraw-Hill/IrwinBank Management and Financial Services, 7/e 2008!e McGraw-Hill "#m$anies, Inc%, &ll 'ig!ts 'eserved%Financia$ .atio ,na$ysis o) a Customer6s Financia$ Statements 2continued4@perating >))iciency+ Measure o) a Business Firm6s Per)ormance >))ectiveness17-19Copyright 2013 The Mcra!"#i$$ Companies% &nc' Permission re(uired )or reproduction or disp$ay'McGraw-Hill/IrwinBank Management and Financial Services, 7/e 2008!e McGraw-Hill "#m$anies, Inc%, &ll 'ig!ts 'eserved%Financia$ .atio ,na$ysis o) a Customer6s Financia$ Statements 2continued4Mar1eta/i$ity o) the Customer6s Product or Service&n order to generate ade(uate cash )$o! to repay a $oan% the /usiness customer must /e a/$e to mar1et goods% services% or s1i$$s success)u$$yThe gross pro)it margin 2PM4% de)ined as17-20Copyright 2013 The Mcra!"#i$$ Companies% &nc' Permission re(uired )or reproduction or disp$ay'McGraw-Hill/IrwinBank Management and Financial Services, 7/e 2008!e McGraw-Hill "#m$anies, Inc%, &ll 'ig!ts 'eserved%Financia$ .atio ,na$ysis o) a Customer6s Financia$ Statements 2continued4Mar1eta/i$ity o) the Customer6s Product or Service, c$ose$y re$ated and some!hat more re)ined ratio is the net pro)it margin 2?PM417-21Copyright 2013 The Mcra!"#i$$ Companies% &nc' Permission re(uired )or reproduction or disp$ay'McGraw-Hill/IrwinBank Management and Financial Services, 7/e 2008!e McGraw-Hill "#m$anies, Inc%, &ll 'ig!ts 'eserved%Financia$ .atio ,na$ysis o) a Customer6s Financia$ Statements 2continued4Coverage .atios+ Measuring the ,de(uacy o) >arningsCoverage re)ers to the protection a))orded creditors /ased on the amount o) a /usiness customer6s earningsThe /est"1no!n coverage ratios inc$ude17-22Copyright 2013 The Mcra!"#i$$ Companies% &nc' Permission re(uired )or reproduction or disp$ay'McGraw-Hill/IrwinBank Management and Financial Services, 7/e 2008!e McGraw-Hill "#m$anies, Inc%, &ll 'ig!ts 'eserved%Financia$ .atio ,na$ysis o) a Customer6s Financia$ Statements 2continued4Li(uidity &ndicators )or Business CustomersThe /orro!er6s $i(uidity position re)$ects his or her a/i$ity to raise cash in time$y )ashion at reasona/$e cost% inc$uding the a/i$ity to meet $oan payments !hen they come due17-23Copyright 2013 The Mcra!"#i$$ Companies% &nc' Permission re(uired )or reproduction or disp$ay'McGraw-Hill/IrwinBank Management and Financial Services, 7/e 2008!e McGraw-Hill "#m$anies, Inc%, &ll 'ig!ts 'eserved%Financia$ .atio ,na$ysis o) a Customer6s Financia$ Statements 2continued4Pro)ita/i$ity &ndicators#o! much net income remains )or the o!ners o) a /usiness )irm a)ter a$$ e5penses 2e5cept dividends4 are charged against revenueFPopu$ar /ottom $ine indicators inc$ude Be)ore"ta5 net income 8 tota$ assets% net !orth% or tota$ sa$es,)ter"ta5 net income 8 tota$ assets 2or .@,4,)ter"ta5 net income 8 net !orth 2or .@>4 ,)ter"ta5 net income 8 tota$ sa$es 2or .@S4 or pro)it margin17-24Copyright 2013 The Mcra!"#i$$ Companies% &nc' Permission re(uired )or reproduction or disp$ay'McGraw-Hill/IrwinBank Management and Financial Services, 7/e 2008!e McGraw-Hill "#m$anies, Inc%, &ll 'ig!ts 'eserved%Financia$ .atio ,na$ysis o) a Customer6s Financia$ Statements 2continued4The Financia$ Leverage Factor as a Barometer o) a Business Firm6s Capita$ Structure,ny $ender is concerned a/out ho! much de/t a /orro!er has ta1en on in addition to the $oan /eing sought*ey )inancia$ ratios used to ana$y-e any /orro!ing /usiness6s credit standing and use o) )inancia$ $everage inc$ude17-25Copyright 2013 The Mcra!"#i$$ Companies% &nc' Permission re(uired )or reproduction or disp$ay'McGraw-Hill/IrwinBank Management and Financial Services, 7/e 2008!e McGraw-Hill "#m$anies, Inc%, &ll 'ig!ts 'eserved%Comparing a Business Customer6s Per)ormance to the Per)ormance o) &ts &ndustry&t is standard practice to compare each /usiness customer6s per)ormance to the per)ormance o) the customer6s entire industry:un 3 Bradstreet &ndustry ?orms and *ey Business .atios.M, ,nnua$ Statement Studies17-26Copyright 2013 The Mcra!"#i$$ Companies% &nc' Permission re(uired )or reproduction or disp$ay'McGraw-Hill/IrwinBank Management and Financial Services, 7/e 2008!e McGraw-Hill "#m$anies, Inc%, &ll 'ig!ts 'eserved%Comparing a Business Customer6s Per)ormance to the Per)ormance o) &ts &ndustry 2continued4Contingent Lia/i$ities 0sua$$y not sho!n on customer /a$ance sheets are other potentia$ c$aims against the /orro!er+1' uarantees and !arranties /ehind the /usiness )irm6s products2' Litigation or pending $a!suits against the )irm3' 0n)unded pension $ia/i$itiesA' Ta5es o!ed /ut unpaidC' Limiting regu$ationsThese contingent $ia/i$ities can turn into actua$ c$aims against the )irm6s assets and earnings at a )uture dateLoan o))icer must as1 the customer a/out pending or potentia$ c$aims against the )irm17-27Copyright 2013 The Mcra!"#i$$ Companies% &nc' Permission re(uired )or reproduction or disp$ay'McGraw-Hill/IrwinBank Management and Financial Services, 7/e 2008!e McGraw-Hill "#m$anies, Inc%, &ll 'ig!ts 'eserved%Comparing a Business Customer6s Per)ormance to the Per)ormance o) &ts &ndustry 2continued4Contingent Lia/i$ities>nvironmenta$ Lia/i$itiesThe Comprehensive >nvironmenta$ .esponse% Compensation% and Lia/i$ity ,ct 2C>.CL,4 and its Super Fund ,mendments Ma1e current and past o!ners o) contaminated property or o) /usinesses $ocated on contaminated property and those !ho dispose o) or transport ha-ardous su/stances potentia$$y $ia/$e )or any c$eanup costs associated !ith environmenta$ damage17-28Copyright 2013 The Mcra!"#i$$ Companies% &nc' Permission re(uired )or reproduction or disp$ay'McGraw-Hill/IrwinBank Management and Financial Services, 7/e 2008!e McGraw-Hill "#m$anies, Inc%, &ll 'ig!ts 'eserved%Comparing a Business Customer6s Per)ormance to the Per)ormance o) &ts &ndustry 2continued4Contingent Lia/i$ities 2continued40nder)unded Pension Lia/i$ities0nder Financia$ ,ccounting Standards Board 2F,SB4% /orro!ing customers may /e compe$$ed to record emp$oyee pension p$an surp$uses and de)icits on their /a$ance sheets &) pro;ected pension"p$an $ia/i$ities e5ceed e5pected )unds sources% the resu$t may /e an increase in $ia/i$ities17-29Copyright 2013 The Mcra!"#i$$ Companies% &nc' Permission re(uired )or reproduction or disp$ay'McGraw-Hill/IrwinBank Management and Financial Services, 7/e 2008!e McGraw-Hill "#m$anies, Inc%, &ll 'ig!ts 'eserved%Preparing Statements o) Cash F$o!s )rom Business Financia$ StatementsThe Statement o) Cash F$o!s i$$ustrates ho! cash receipts and dis/ursements are generated /y operating% investing% and )inancing activities17-30Copyright 2013 The Mcra!"#i$$ Companies% &nc' Permission re(uired )or reproduction or disp$ay'McGraw-Hill/IrwinBank Management and Financial Services, 7/e 2008!e McGraw-Hill "#m$anies, Inc%, &ll 'ig!ts 'eserved%Preparing Statements o) Cash F$o!s )rom Business Financia$ Statements 2continued417-31Copyright 2013 The Mcra!"#i$$ Companies% &nc' Permission re(uired )or reproduction or disp$ay'McGraw-Hill/IrwinBank Management and Financial Services, 7/e 2008!e McGraw-Hill "#m$anies, Inc%, &ll 'ig!ts 'eserved%Preparing Statements o) Cash F$o!s )rom Business Financia$ Statements 2continued417-32Copyright 2013 The Mcra!"#i$$ Companies% &nc' Permission re(uired )or reproduction or disp$ay'McGraw-Hill/IrwinBank Management and Financial Services, 7/e 2008!e McGraw-Hill "#m$anies, Inc%, &ll 'ig!ts 'eserved%Pricing Business Loans@ne o) the most di))icu$t tas1s in $ending is deciding ho! to price a $oanLender !ants to charge a high enough interest rate to ensure each $oan !i$$ /e pro)ita/$e and compensate the $ending institution )or the ris1s invo$vedThe Cost"P$us Loan Pricing Method17-33Copyright 2013 The Mcra!"#i$$ Companies% &nc' Permission re(uired )or reproduction or disp$ay'McGraw-Hill/IrwinBank Management and Financial Services, 7/e 2008!e McGraw-Hill "#m$anies, Inc%, &ll 'ig!ts 'eserved%Pricing Business Loans 2continued4The Price Leadership Mode$17-34Copyright 2013 The Mcra!"#i$$ Companies% &nc' Permission re(uired )or reproduction or disp$ay'McGraw-Hill/IrwinBank Management and Financial Services, 7/e 2008!e McGraw-Hill "#m$anies, Inc%, &ll 'ig!ts 'eserved%Pricing Business Loans 2continued4&n the 0'S'% the prevai$ing prime rate is considered to /e the most common /ase rateT!o di))erent )$oating prime rate )ormu$as !ere soon deve$oped /y $eading money center /an1s Prime"p$us methodTimes"prime methodLondon &nter/an1 @))ered .ate 2L&B@.4 Leading commercia$ $enders have s!itched to L&B@."/ased $oan pricing due to the gro!ing use o) >urocurrencies as a source o) $oana/$e )unds L&B@."/ased $oan rate G L&B@. H :e)au$t"ris1 premium H Pro)it margin17-35Copyright 2013 The Mcra!"#i$$ Companies% &nc' Permission re(uired )or reproduction or disp$ay'McGraw-Hill/IrwinBank Management and Financial Services, 7/e 2008!e McGraw-Hill "#m$anies, Inc%, &ll 'ig!ts 'eserved%Pricing Business Loans 2continued4Be$o!"Prime Mar1et PricingBan1s announced that some $arge corporate $oans covering on$y a )e! days or !ee1s !ou$d /e made at $o! money mar1et interest rates Federa$ )unds rate on domestic $oans p$us a sma$$ margin17-36Copyright 2013 The Mcra!"#i$$ Companies% &nc' Permission re(uired )or reproduction or disp$ay'McGraw-Hill/IrwinBank Management and Financial Services, 7/e 2008!e McGraw-Hill "#m$anies, Inc%, &ll 'ig!ts 'eserved%Pricing Business Loans 2continued4Customer Pro)ita/i$ity ,na$ysis 2CP,4?e! $oan pricing techni(ue that is simi$ar to the cost"p$us $oan pricing techni(ue ,ssumes that the $ender shou$d ta1e the !ho$e customer re$ationship into account !hen pricing a $oan17-37Copyright 2013 The Mcra!"#i$$ Companies% &nc' Permission re(uired )or reproduction or disp$ay'McGraw-Hill/IrwinBank Management and Financial Services, 7/e 2008!e McGraw-Hill "#m$anies, Inc%, &ll 'ig!ts 'eserved%Pricing Business Loans 2continued4Customer Pro)ita/i$ity ,na$ysis 2CP,4 &) the net rate o) return is positive% the proposed $oan is accepta/$e /ecause a$$ e5penses have /een met&) the net rate o) return is negative% the proposed $oan and other services provided to the customer are not correct$y priced as )ar as the $ender is concernedThe greater the perceived ris1 o) the $oan% the higher the net rate o) return the $ender shou$d re(uire17-38Copyright 2013 The Mcra!"#i$$ Companies% &nc' Permission re(uired )or reproduction or disp$ay'McGraw-Hill/IrwinBank Management and Financial Services, 7/e 2008!e McGraw-Hill "#m$anies, Inc%, &ll 'ig!ts 'eserved%Pricing Business Loans 2continued4Customer Pro)ita/i$ity ,na$ysis 2CP,4 >arnings Credit )or Customer :eposits &n ca$cu$ating ho! much in revenues a customer generates )or a $ending institution% many $enders give the customer credit )or any earnings received )rom investing the /a$ance in the customer6s deposit account 17-39Copyright 2013 The Mcra!"#i$$ Companies% &nc' Permission re(uired )or reproduction or disp$ay'McGraw-Hill/IrwinBank Management and Financial Services, 7/e 2008!e McGraw-Hill "#m$anies, Inc%, &ll 'ig!ts 'eserved%Iuic1 Iui-=hat are the essentia$ di))erences among !or1ing capita$ $oans% open credit $ines% asset"/ased $oans% term $oans% revo$ving credit $ines% interim )inancing% pro;ect $oans% and ac(uisition $oansF=hat aspects o) a /usiness )irm6s )inancia$ statements do $oan o))icers and credit ana$ysts e5amine care)u$$yF=hat methods are used to price /usiness $oansF=hat is customer pro)ita/i$ity ana$ysisF =hat are its advantages )or the /orro!ing customer and the $enderF17-40Copyright 2013 The Mcra!"#i$$ Companies% &nc' Permission re(uired )or reproduction or disp$ay'