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Commercial Lending Basics

Commercial Lending Fundamentals
Part One of four parts -
Nature of Business Enterprise and Borrowing Purpose


Lending money is a process by which the lender provides temporary use of funds to a borrower. The expectation is that the borrower will be able return the funds, with interest, to the lender in the normal course of business operations. Loans should be repaid from the borrower's resources without any reduction in the scope of the borrower's normal operations.

Since loans are expected to be repaid from the borrower's resources, the primary focus of analysis must be on the means of repayment of the loan. Repayment analysis involves not only the ability to repay, but also the specific sources from which repayment can be made and the timing of repayment. When lending to business enterprises this analysis may be relatively simple or quite complex depending upon the nature of the business operations involved and the purpose for which the funds are borrowed.

NATURE OF BUSINESS ENTERPRISE

Essentially, any business enterprise is an organization of people and resources put together for an economic purpose. The organization may range from a simple proprietorship serving a single market to a complex series of interrelated corporations serving multiple markets through the world. The primary purpose of any business enterprise is to produce a profit for the owners. The foundation upon which any business rests is the stream of revenue that it can obtain.

Revenue comes from sale of products or services. In order for revenue to be realized there must be a market. Profits will depend upon the price the market is willing to pay relative to the costs of the product or service being provided. Costs include not only direct and operating expenses, but also the costs involved in utilizing the assets necessary to conduct the business. For any particular product or service being provided to a given market, certain types of assets are required.

Manufacturing firms must have production equipment and facilities. By definition, a manufacturer makes a product for sale. The operating cycle for manufacturers (Exhibit 1) starts with cash or trade credit, which is used to finance the purchase of raw materials. Using these raw materials, finished goods inventory is manufactured and then sold to create accounts receivable. When the accounts receivable are collected, cash in generated, which is used to purchase raw materials, repay debt and begin the cycle again.

In general, manufacturing companies are capital intensive. That is, they require a large amount of debt and equity to carry out their operation. For practically every manufacturer, accounts receivable, inventory and fixed assets are the principal assets, each falling in the range of approximately 20-40 percent of the total.

Key to evaluating a manufacturer involves investigation of all factors, which could impact the operating cycle. In the case of manufacturing, this involves efficiency, control of waste and care of property plant and equipment. Inventory should be current, useable and within proper parameters for manufacturing needs. Sales should be stable or in the case of cyclical business, the nature of the cycle should be understood. Any concentration in receivables should be understood and justified and a system should be in place to control receivable turnover.


Wholesaler/Distributor firms need inventory and usually carry receivables resulting from credit sales. In essence, wholesalers are inventory managers who operate as middlemen for manufacturers and the final distributor of the product, the retailer. The operating cycle of a wholesaler (Exhibit 1) begins with the use of cash to purchase inventory from manufacturers. When the inventory is sold, accounts receivable are created, which, upon payment, are converted to cash, thus completing the cycle. A notable characteristic of the operating cycle of wholesalers is the large amount of inventory that is purchased and sold. With this high rate of inventory turnover, the profit as a percentage of sales is usually low.

As with manufacturers, the loan officer should be on the lookout for anything that may impede the flow of the operating cycle, including, concentration of receivables, and the life and seasonality of inventory.

Retailers buy finished products through wholesalers or directly from the manufacturer and then sell those products to consumers. As with wholesalers, the amount of capital required to finance a retail operation is a function of sales volume and type of industry. A company with high sales volume usually holds a significant amount of inventory and may have many outlets -both of which require capital. The operating cycle of a retailer (Exhibit 2) begins with the use of cash to purchase a finished product. This inventory is the sold, usually directly to the public. For this reason, many sales are in the form of cash (including bank cards), rather than accounts receivable. The cash is used to purchase more inventory and repay debt, beginning another cycle.

One key in evaluating a retailer is to look at inventory turnover. Retailers, particularly those that deal with large amounts of low-ticket items, must be able to move large amounts of inventory. Low consumer demand and other factors can disrupt the operating cycle. Unlike manufacturers, wholesaler, or retailers, companies in the service industry do not sell a tangible product. Their product is service, which can come in the form of financial consultation, legal advice or medical treatment. Banking also falls under the service industry classification, and as for other industries of its kind, success depends, to a large extent, on the quality of service being offered. The operating cycle of a service company is different from that of a manufacturers, wholesalers, and retailers in that no inventory is involved. Cash is used in the performance of a service, which generates accounts receivable. When the accounts receivable are paid, cash is generated to begin the cycle again.

In analyzing the operating cycle of a service business (Exhibit 2), the loan officer should focus on accounts receivable. A concentration of accounts receivable or a large number of uncollected receivables may indicate a potential disruption of the operating cycle and, therefore, a risk to the lender. Because nothing tangible is produced, most service companies have few physical assets and, thus, low capital requirements.


Management is the essential ingredient that pulls the various elements of a business together and provides control, direction, and planning. Management decides the market to be served and the product or service to be provided. Management is also responsible for obtaining funding for the assets required by the firm. While ownership will provide some funding, external sources of funding will increase returns to the owners through leverage and provide greater flexibility for variations in asset requirements. Management also must react to changes in market conditions and maintain the appropriate resources to produce satisfactory returns from operations under changing conditions. An important element in the nature of any business is the environment in which it operates. The environment includes not only the direct market that is being served but also the social and regulatory climate. The market consists of existing and potential customers as well as any direct and indirect competition encountered. The social climate is the degree of public acceptance of the product or service. In the United States many industries are subject to varying degrees of governmental regulation. In addition there are many general regulations applicable across a wide spectrum of business activities. All these components of the environment have varying impacts on the manner in which a specific firm operates.

Revenues for most business enterprises result from utilization of assets. Consequently, one comprehensive approach to gaining understanding of the nature of a particular business is to examine the balance sheet. By definition, the balance sheet must balance - assets must equal liabilities plus equity (A=L+E). Assets show the resources being utilized while liabilities and equity represent the means by which the assets have been funded. Each asset should have a role in operations relating to producing revenue. Certain revenue producing resources such as personnel expertise may not appear on the balance sheet. This does not diminish their importance. An examination of the balance sheet, coupled with a review of the success factors necessary for a particular enterprise should highlight the importance of this type of off-balance sheet resource.

The nature of the specific business will generally have a strong influence on the financial structure and financing needs. With an understanding of the nature of the business the lender can turn to the specific borrowing purposes represented by a given loan application.

BORROWING PURPOSE

The starting point for evaluating any business loan request is identification of the purpose of the loan. Historically, commercial bank lending has involved making loans to business enterprises for purposes, which in and of themselves generate funds for repayment of the loan. A merchant borrows in the fall for inventory for the Christmas season and repays from the proceeds of holiday season sales. A farmer borrows in the spring for feed, fertilizer and operating costs and repays the loan in the fall from proceeds of the sale of the harvested crop. A manufacturer borrows to purchase productive equipment and repays the loan over several years with cash flow from sales produced by operating the equipment. In each of these instances the source of repayment of the loan is directly linked to the purpose for which the loan was made.

There are only three primary reasons for which business enterprises borrow money.
- To acquire assets
- Temporary trading assets
- Permanent trading assets
- Permanent Operating assets
- Speculative assets

- To replace existing liabilities
- Refinance
- Restructure

- To replace equity
- Fund losses
- Replace owner/investor

Asset Acquisition
Acquisition of assets to support growing sales is one of the most common business borrowing purposes. As sales rise, trading assets (receivables and inventory) rise. If sales growth is seasonal, or temporary, these assets will return to normal levels in a relatively short time, almost automatically producing cash to repay borrowed funds. The classic, self-liquidating loans are relatively easy to evaluate and safe. Verification of the seasonality or temporary nature of the sales increase, certainty that the product or service is acceptable and can be absorbed by the market, and satisfaction with management's capability and the general financial health of the firm provides ample support for this type of loan.

However, if the sales growth is not temporary or seasonal, the asset needs will continue indefinitely and reduction in trading asset levels is not available as a primary source of loan repayment. This type of loan is more difficult to evaluate. In this situation the real purpose of the loan is to provide permanent working capital. Consequently, the loan must be repaid from future cash flow from earnings produced by the increased sales volume, which produced the asset need.

Frequently sales growth will create need for additional capacity. Such growth may come either from increased demand from existing markets or expansion into new markets. Operating assets such as machinery, equipment, vehicles, buildings or land may be needed. Sometimes new operating assets are required to reduce costs, either to enhance profit margins or to remain competitive. Cash flow from the increased volume or improved profit margins provides the means of repayment, usually over several years. Repayment of these loans should be accomplished well within the useful life of the asset acquired.

Sometimes additional assets may be required by legal or regulatory mandate. These assets may not always contribute to increased volume or reduced costs by may be necessary to continue operations in a socially acceptable manner. Such items as air or water pollution control equipment or safety devices on machinery are examples of this type of expenditure. Loans for such purposes must be repaid from existing cash flow since there is no specific source of repayment created by the asset being financed.

Changes in operating characteristics may produce changes in asset needs. A change from cash-only sales to granting credit will produce receivables that did not previously exist. Purchasing of inventory in larger lots may reduce costs but will probably increase inventory levels. Manufacturing of previously purchased components will increase both inventory and probably operating assets. Owning, rather than leasing real estate or other operating assets may increase asset levels. In each of these situations the utility of the asset and its contribution to future cash flow needs to be evaluated as a source of loan payment.

Occasionally a business firm may acquire assets not directly related to current operations. Sometimes this may be a desire to employ excess cash. At other times it may be in anticipation of some future need. This type of asset acquisition may not always be an appropriate use of financial resources. During periods of rapid inflation, acquisition of assets beyond normal requirements frequently produces abnormal profits. From the lender's point of view speculation is speculation. Debt incurred to acquire assets that do not currently produce cash flow places an additional burden on existing productive assets to provide funds for debt service.

Liability Replacement
Business firms commonly replace one liability with another in the normal course of business. Trade payables are constantly being paid and new debts incurred. Accruals turnover with the passage of time. Annual tax payments may be paid with borrowings under a bank line of credit with the loan being repaid as the tax accrual builds up during the following year. Bank borrowings may be used to keep payables within terms during most of the year with the bank line being cleared for an annual rest period by extending payment terms of trade payables for a month or two. It is also not uncommon for bank lines to be rested by rotating borrowings among two or more banks.

As interest rates were volatile in recent rears, there were frequent instances of existing loans being refinanced at lower interest rates. When rates are high many borrowers are unwilling to commit to loans for extended periods of time and prefer to borrow short. When rates come down, the short-term loans are refinanced into longer-term loans at more favorable rates. Many large corporations finance capital expenditures or other needs with short term bank loans and then refinance completed projects with privately placed or publicly offered long term bonds. Borrowers sometimes change banking relationships and refinance existing loans with a new bank.

In such refinancing transactions it is important to determine the original purpose of the borrowing and to evaluate performance of the original repayment source. Sometimes the refinancing is in reality a restructure resulting from changed conditions necessitating a new or revised repayment program.

Existing debt may be restructured to change its maturity or repayment schedule. Sometimes this results from having borrowed short term for a long-term purpose. In other instances, things may not have gone as expected and cash flow is not adequate to meet the original terms. In all such situations a comprehensive evaluation of repayment sources and timing is important to insure the soundness of the restructured loan.

Equity Replacement
Since by definition, the balance sheet must balance, any reduction in equity must be accompanied by either a reduction in assets or an increase in liabilities. Operating losses, or dividends greater than profits, reduce equity and may lead to requests for borrowing. If a firm is losing money, it is critical for both the borrower and the lender to understand the reasons for the losses. There needs to be a plan, in place, to return to profitability understood by both the borrower and lender. Losses usually result from excessive costs or inadequate sales. If excessive costs can be eliminated in a reasonable time the firm may be able to return to profitability and repay funds borrowed for the turnaround period. These loan require careful analysis and solid secondary sources of repayment, since failure of the turnaround plan usually leads to liquidation of the business.

Losses from inadequate sales volume usually fall into one of three categories - seasonal, cyclical or changing markets. Loans to fund seasonal losses are quite common in many industries and are as easy to evaluate as seasonal working capital loans. There is a historic operating pattern that can be reviewed and the return to profitability is usually predictable.

Cyclical operating losses resulting from economic recessions are more difficult to finance. All marginal firms do not survive economic downturns. Changes in consumption patterns or the entry of new competitors or products sometimes lead to declining sales. Losing operations in these situations may never return to profitability. Loans to fund their losses will be repaid, if at all, from ultimate liquidation of the business. In any request for a loan to fund operating losses, the key issue is to determine with reasonable certainty, when profitability will be restored.

Successful business enterprises tend to exist for periods of time spanning multiple generations. There is frequently a need to transfer ownership to the next generation. For publicly held firms this transfer takes place routinely through operation of the stock market. For more closely held family owned firms, bank financing may be needed to assist in the ownership transfer.

In other situations, partial owners may need to be bought out or new owners may want to acquire an existing operation. Bank loans for such purposes rely upon a history of profitable operations that can be projected forward under the new management to provide cash flow for repayment.

Whatever the disclosed purpose of a proposed loan may be, it is important for the lender to understand the real purpose of the loan. Through such understanding it can be determined what the primary source of repayment should be and the reliability of such repayment source.


Part Two - Source of Loan Repayment and Analytical Process
Part Three - Income Statement and Cash Flow
Part Four - Definitions, Formulas and Loan Check List


Ray Beaufait
beau1943@aol.com


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