The lending of a sum of the money by a lender to a
borrower to be repaid with a certain amount of interest.
(Dictionary of Banking and Finance)
Formal agreement between a bank and borrower to
provide a fixed amount of credit for a specified period.
(Timothy W Koch)
Banks provide credit to the clients and earn interest from
If banks have excess loanable funds, they may invest in
money market or capital market instruments and earn
dividend, interest or bonus share.
Loan is debt transactions whereas investment is mostly
The income source for loan is only interest and penal
interest, and dividends, bonus share, right share, capital
appropriation gains are the source of income for
investment. But in case of debenture investment interest
is the only source.
Risk in loan is higher than risk in investment. Except prime
customers most of the loans face default risk. On the other hand, in
investment risk depends on the types of instruments.
In case of loan, successful termination depends on the willingness
of the borrower; whereas for investment terminated at the
willingness of the bank/shareholder or holder of the debentures.
Most of the loans are of smaller volumes except industrial loans, and
most of the volume of investment is larger.
Amount of loan
Mode of loan
Nature of disbursement
Process of disbursement
Periodicity of bank loan
Repayment of loan
1. Internal source
2. External source
Variable rate: The rate of interest changes basing on the minimum
rate from time to time depending on the demand for and supply of
Fixed rate: The loan is written at fixed interest rate which is
negotiated at origination. The rate remains fixed until maturity.
Caps and floors: For loans extended at variable rates, limits are
placed on the extent to which the rate may vary. A cap is the upper
limit and a floor is the lower limit.
Prime times: If the maturity of the loan is increased or decreased,
the rate will also be increased or decreased in a multiple.
Prime rate: Usually, relatively low rate offered to the highly honored
clients for track record.
Rate for general customers: The rate is applied for general
borrowers. This rate is usually higher than the prime rate.
Compensating balances: Deposit balances that a lender
may require to be maintained throughout the period of the
loan. Balances are typically required to be maintained of
average rather than at a strict minimum.
Fees, charges: After sanctioning credit but before
disbursing the amount to the borrower, a charge is taken
for this interim period.
Short-Term Business Loans
• Self-liquidating inventory loans
• Working capital loans
• Interim construction financing
• Asset-based loans (accounts receivable financing, factoring and inventory
• Syndicated loans
Long-Term Business Loans
• Term loans to support the purchase of equipment, rolling stock and structures
• Revolving credit financing
• Project loans
• Loans to support acquisitions of other business firms
Self-liquidating inventory loans: These loans usually were used to finance the
purchase of inventory-raw materials or finished goods to sell. In this case, the
term begins when cash is needed to purchase inventory and ends (perhaps in 60 to
90 days) when cash is available in the firm’s account to write the lender a check
for the balance of its loans.
Working capital loans: Short term credit that lasts from a few days to one year
helps businesses to cover the day to days costs or seasonal demands. Frequently
the working capital loan is designed to cover seasonal peaks in the business
customer’s production levels and credit needs.
Interim construction financing: These types of loans are used to support the
construction of homes, apartments, office buildings, shopping centers and other
permanent structures. Although the structures involved are permanent, the loans
themselves are temporary. They provide builders with funds to hire workers, rent
or lease construction equipment, purchase building materials and develop land.
Asset-based financing: Credit secured by the shorter term assets of a firm that are
expected to roll over into cash in the future. Key business assets used for many of
these loans are accounts receivable and inventories. The lender commits funds
against a specific percentage of the book value of outstanding credit accounts or
Syndicated Loans: A syndicated loan normally consists of a loan package extended
to a corporation by a group of lenders. These loans may be drawn by the borrowing
company with the funds used to support business operations or expansion or
undrawn serving as lines of credit to back a security issue and other venture.
These loans are extended by multiple banks where the overall credit involved
exceeds an individual lender’s lending or other limits.
Term loans : Are designed to fund longer-term business investments such as the
purchase of equipment or the construction of physical facilities covering a period
longer than one year. Usually the borrowing firm applies for a lump sum loan
based on the budgeted cost of its proposed project and then pledges to repay the
loan in a series of monthly or quarterly installments.
Revolving Credit Financing ▫ Allows a customer to borrow up to a prespecified
limit, repay all or a portion of the borrowing, and reborrow as necessary ▫ One of
the most flexible of all business unsecured loans ▫ May be short-term or long-term
▫ Lenders normally charge a loan commitment fee ▫ Two types: formal loan
commitment and confirmed credit line.
Long-Term Project Loans: Credit to finance the construction of fixed assets. Most
risky of all business loans
Some of the risks of project loans:
1. Large amounts of funds are usually involved
2. The project may be delayed by weather or shortage of materials
3. Laws and regulations in the region where the project lies may change
4. Interest rates may change
Often business loans are of such large denomination that the lending
institution itself may be at risk if the loan goes bad.
The most common sources of repayment for business loans are:
1. The business borrower’s profits or cash flow
2. Business assets pledged as collateral behind the loan
3. A strong balance sheet with ample amounts of marketable assets
and net worth
4. Guarantees given by the business, such as drawing on the owners’
personal property to backstop a loan
Information from balance sheets and income statements is typically supplemented
by financial ratio analysis
Critical areas of potential borrowers loan officers consider:
1. Ability to control expenses
2. Operating efficiency in using resources to generate sales
3. Marketability of product line
4. Coverage that earnings provide over financing cost
5. Liquidity position, indicating the availability of ready cash
6. Track record of profitability
7. Financial leverage (or debt relative to equity capital)
8. Contingent liabilities that may give rise to substantial claims in the future
A barometer of the quality of a firm’s management is how it controls
its expenses and how well its earnings are likely to be protected and
Selected financial ratios to monitor a firm’s expense control:
▫ 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
It is also useful to look at a business customer’s operating efficiency
▫ How effectively are assets being utilized to generate sales and how
efficiently are sales converted into cash?
• Important financial ratios here include:
▫ Annual cost of goods sold/Average inventory (or inventory
▫ Net sales/Net fixed assets
▫ Net sales/Total assets
▫ Net sales/Accounts and notes receivable
In order to generate adequate cash flow to repay a loan, the business
customer must be able to market goods, services, or skills
successfully. A lender can often assess public acceptance of what the
business customer has to sell by analyzing such factors as the
growth rate of sales revenues, changes in the customer’s share of the
▫ The gross profit margin (GPM), defined as
A closely related and somewhat more refined ratio is the net profit
Coverage refers to the protection afforded creditors based
on the amount of a business customer’s earnings.
The second of these coverage ratios adjusts for the fact that
repayments of loan principal are not tax deductible, while
interest and lease payments are generally tax deductible
The borrower’s 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.
The concept of working capital is important because it provides a
measure of a firm’s ability to meet its short-term debt obligations from its
holdings of current assets.
How much net income remains for the owners of a business firm
after all expenses (except dividends) are charged against revenue?
Most loan officers will 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
Popular bottom line indicators include
▫ Before-tax net income / total assets, net worth, or total sales
▫ After-tax net income / total assets (or ROA)
▫ After-tax net income / net worth (or ROE)
▫ After-tax net income / total sales (or ROS) or profit margin
Any lender is concerned about how much debt a borrower has taken
on in addition to the loan being sought. The term financial leverage
refers to use of debt in the hope the borrower can generate earnings
that exceed the cost of debt, thereby increasing potential returns to
a business firm’s owners. Key financial ratios used to analyze any
borrowing business’s credit standing and use of financial leverage
Comparing a Business Customer’s Performance to the
Performance of Its Industry.
Preparing Statements of Cash Flows from Business
One of the most difficult tasks in lending is deciding how to price a
Lender wants to charge a high enough interest rate to ensure each
loan will be profitable and compensate the lending institution for the
risks involved. However, the loan rate must also be low enough to
accommodate the business customer in such a way that he or she
can successfully repay the loan and not be driven away to another
lender or into the open market for credit.
The Cost-Plus Loan Pricing Method:
In pricing a business loan management must consider the cost of raising
loanable funds and the operating costs of running the lending institution.
The simplest loan pricing model assumes that the rate of interest charged
on any loan includes four components:
1. The cost to the lender of raising adequate funds to lend.
2. The lender’s nonfunds operating costs (including wages and salaries of
loan personnel and the cost of materials and physical facilities used in
granting and administrating a loan).
3. Necessary compensation paid to the lender for the degree of default risk
inherent in a loan request.
4. The desired profit margin on each loan that provides the lending
institution’s stockholders with an adequate return on their capital.
Major commercial banks established a uniform base lending fee, the
prime rate, sometimes called the base or reference rate. The prime
rate is usually considered to be the lowest rate charged the most
creditworthy customers on short-term loans.
Banks announced that some large corporate loans covering
only a few days or weeks would be made at low money
market interest rates.
The prime rate continues to be important as a pricing
method for smaller business loans, consumer credit, and
New loan pricing technique that is similar to the cost-plus loan
Assumes that the lender should take the whole customer
relationship into account when pricing a loan.
Revenues paid by a borrowing customer may include loan interest,
commitment fees, fees for cash management services and data
Expenses incurred on behalf of the customer may include wages and
salaries of the lender’s employees, credit investigation costs, interest
accrued on deposits, account reconciliation and processing costs and
fund’s acquisition costs.
Net loanable funds are the amount of credit used by the customer
minus his or her average collected deposits.
If the net rate of return is positive, the proposed loan is acceptable because all
expenses have been met
If the net rate of return is negative, the proposed loan and other services provided
to the customer are not correctly priced as far as the lender is concerned
The greater the perceived risk of the loan, the higher the net rate of return the
lender should require
Earnings Credit for Customer Deposits:
In calculating how much in revenues a customer generates for a lending institution,
many lenders give the customer credit for any earnings received from investing the
balance in the customer’s deposit account