Lahore School of Economics

Lending to Business Firms

and Pricing Business Loans

Dr. Ayesha Afzal

Assistant Professor

Spring 2020 Dr. Ayesha Afzal

Lahore School of Economics 17-2

Short Term Business Loans

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

Spring 2020 Dr. Ayesha Afzal

Lahore School of Economics 17-3

Long Term Business Loans

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

• Question: What are the essential differences between

various short- and long-term business loans?

Spring 2020 Dr. Ayesha Afzal

Lahore School of Economics 17-4

Sources of Repayment for Business

Loans

• The Borrower’s Profits or Cash Flows

• Business Assets Pledged as Collateral
• Strong Balance Sheet With Ample
Marketable Assets and Net Worth
• Guarantees Given By Businesses

Spring 2020 Dr. Ayesha Afzal

Lahore School of Economics 17-5

Analyzing Business Loan

Applications

• Common Size Ratios of Customer Over

Time
• Financial Ratio Analysis of Customer’s
Financial Statements
• Current and Pro Forma Sources and
Uses of Funds Statement

Spring 2020 Dr. Ayesha Afzal

Lahore School of Economics 17-6

Financial Ratio Analysis

• Control Over Expenses
• Operating Efficiency
• Marketability of Product or Service
• Coverage Ratios: Measuring Adequacy
of Earnings
• Liquidity Indicators for Business
Customers
• Profitability Indicators

Spring 2020 Dr. Ayesha Afzal

Lahore School of Economics 17-7

Expense Control Measures

• Cost of Goods Sold/Net Sales

• Selling, Administrative and Other
Expenses/Net Sales
• Depreciation Expenses/Net Sales
• Interest Expenses on Borrowed Funds
/Net Sales
• Taxes/Net Sales

Spring 2020 Dr. Ayesha Afzal

Lahore School of Economics 17-8

Operating Efficiency

• Annual Costs of Goods Sold/Average

Inventory
• Average Receivables Collection Period
• Net Sales/Net Fixed Assets
• Net Sales/Total Assets
• Net Sales/Accounts Receivables

Spring 2020 Dr. Ayesha Afzal

Lahore School of Economics 17-9

Marketability of Product or Service

• Gross Profit Margin=(Net Sales-

CGS)/Net Sales
• Net Profit Margin=Net Income After
Taxes/Net Sales

Spring 2020 Dr. Ayesha Afzal

Lahore School of Economics 17-10

Coverage Measures

• Interest Coverage
• Coverage of Interest and Principal
Payments

Spring 2020 Dr. Ayesha Afzal

Lahore School of Economics 17-11

Liquidity Measures

• Current Assets/Current Liabilities

• Acid Test Ratio
• Working Capital
• Net Liquid Assets

Spring 2020 Dr. Ayesha Afzal

Lahore School of Economics 17-12

Profitability Measures

• Before Tax Net Income/Total Assets

• After Tax Net Income/Total Assets
• Before Tax Net Income/Net Worth
• After Tax Net Income/Net Worth

Spring 2020 Dr. Ayesha Afzal

Lahore School of Economics 17-13

Leverage or Capital Structure

Measures

• Leverage Ratio
• Total Liabilities/Net Worth
• Capitalization Ratio
• Debt to Sales Ratio

Spring 2020 Dr. Ayesha Afzal

Lahore School of Economics 17-14

Types of Contingent Liabilities

• Guarantees or Warrantees Behind
Products
• Litigation or Pending Lawsuits
• Unfunded Pension Liabilities
• Taxes Owed But Unpaid
• Limiting Regulations

Spring 2020 Dr. Ayesha Afzal

Lahore School of Economics 17-15

Comprehensive Environmental
Response, Compensation and
Liability Act

This Law Makes Current and Past

Owners of Contaminated Property,
Current and Past Owners and Prior
Operators of Businesses Located on
Contaminated Property and Those Who
Transport Hazardous Substances
Potentially Liable
Spring 2020 Dr. Ayesha Afzal
Lahore School of Economics 17-16

Component of Sources and Uses of Funds

Statement

• Cash Flows from Operations

• Cash Flows from Investing Activities
• Cash Flows from Financing Activities

Spring 2020 Dr. Ayesha Afzal

Lahore School of Economics 17-17

Traditional (Direct) Operating Cash

Flows

Net Sales Revenue – Cost of Goods Sold

– Selling, General and Administrative –
Taxes Paid in Cash + Non Cash
Expenses

Spring 2020 Dr. Ayesha Afzal

Lahore School of Economics 17-18

Indirect Operating Cash Flows

Net Income + Non Cash Expenses +

Losses from the Sale of Assets – Gains
from the Sale of Assets – Increases in
Assets Associated with Operations +
Increases in Current Liabilities
Associated with Operations –
Decreases in Current Liabilities
Associated with Operations +
Decreases in Current Assets
Associated with Operations
Spring 2020 Dr. Ayesha Afzal
Lahore School of Economics 17-19

Methods Used to Price Business

Loans
• Cost-Plus Loan Pricing Method
• Price Leadership Model
• Below Prime Market Pricing
• Customer Profitability Analysis

Spring 2020 Dr. Ayesha Afzal

Lahore School of Economics 17-20

Cost-Plus Loan Pricing

Marginal
Cost of Estimated
Nonfund Bank's
Loan Raising Margin to
Bank Desired
Interest = Loanable + + Compensate +
Operating Profit
Rate Funds to Bank for
Costs Margin
Lend to Default Risk
Borrower

Spring 2020 Dr. Ayesha Afzal

Lahore School of Economics 17-21

Price Leadership Model

Default
Risk Term Risk
Loan
Base or Premium Premium for
Interest = + +
Prime Rate for Non- Longer
Rate
Prime Term Credit
Borrowers

Spring 2020 Dr. Ayesha Afzal

Lahore School of Economics 17-22

Prime Rate

Major Banks Established a Base

Lending Fee During the Great
Depression. At that Time It Was the
Lowest Interest Rate Charged Their
Most Credit Worthy Customers for
Short-Term Working Capital Loans

Spring 2020 Dr. Ayesha Afzal

Lahore School of Economics 17-23

LIBOR

The London Interbank Offer Rate. The

Rate Offered on Short-Term Eurodollar
Deposits With Maturities Ranging From
a Few Days to a Few Months

Spring 2020 Dr. Ayesha Afzal

Lahore School of Economics 17-24

Below-Prime Market Pricing

Interest Cost
Loan Markup
of Borrowing
Interest = + for Risk
in the Money
Rate and Profit
Market

Spring 2020 Dr. Ayesha Afzal

Lahore School of Economics 17-25

Customer Profitability Analysis (CPA)

• Estimate Total Revenues From Loans

and Other Services
• Estimate Total Expenses From
Providing Net Loanable Funds
• Estimate Net Loanable Funds
• Estimate Before Tax Rate of Return By
Dividing Revenues Less Expenses By
Net Loanable Funds

Spring 2020 Dr. Ayesha Afzal

Lahore School of Economics 17-26

Questions
• What aspects of a business firm’s financial
statements do loan officers and credit analysts
examine carefully?
• What methods are used to price business loans?
• Suppose a bank estimates that the marginal cost of
raising loanable funds to make a $10m loan to one
of its corporate customers is 4%, its nonfunds
operating costs to evaluate and offer this loan are
0.5%, the default-risk premium on the loan is
0.375%, a term-risk premium of 0.625% is to be
added, and the desired profit margin is 0.25%. What
loan rate should be quoted this borrower? How
much interest will this borrower pay in a year?
Spring 2020 Dr. Ayesha Afzal