COMMERCIAL LOAN

Loans from commercial banks are an important source of negotiated short-term financing. Bank loans may be secured by assets or may be unsecured. Such loans usually appear as notes payable on the balance sheet.

In granting loans, the bank must balance the benefit of the additional interest income generated against the cost of a default on the loan. To estimate the probability that a borrower will pay, banks gather information on their potential customers. The information will generally include a business plan and pro forma financial statements. Banks often use credit scoring models that predict future payment performance on the basis of financial and nonfinancial factors. Generally, financial institutions group these factors into the five Cs: capacity, capital, character, collateral, and conditions. Capacity refers to the borrower's ability to meet credit obligations out of the business's cash flow. Capital refers to the customer's financial reserves. In analyzing character, the bank attempts to evaluate the borrower's willingness to meet credit obligations. Collateral is an asset pledged by the borrower in case of default. Finally, the bank must also analyze the general economic conditions and the borrower's line of business.

LENDING AGREEMENTS

Bank credit is commonly available under three different arrangements: single loans, lines of credit, and revolving credit agreements. Single loans are usually arranged for specific financing needs. The interest rate charged on a single loan can be either a fixed rate over the term of the loan or a floating rate usually tied to the prime rate (although an increasing number of domestic loans are being tied to the London interbank offered rate, the rate that banks participating in the international debt market charge each other for short-term loans).

A line of credit is an agreement that permits the firm to borrow up to a predetermined credit limit at any time during the life of the agreement. A line of credit is usually negotiated for a one-year period, and the interest rate is usually stated in terms of the prime rate and varies as the prime rate changes during the year. A line of credit usually requires that the firm have no loans outstanding under the agreement for a portion of the year, known as the cleanup period. This type of lending agreement does not guarantee that the bank will lend the requested funds since the bank is not legally obligated to make loans if the firm's financial position has deteriorated. Some banks also require borrowers to maintain a compensating balance, although this practice is of diminishing importance.

Revolving credit agreements legally commit the bank to making loans up to the credit limit specified in the agreement. Revolving credit agreements are usually secured, and generally require the firm to pay a commitment fee on the unused portion of the funds.

INTEREST AND REPAYMENT PROVISIONS

Most commercial loans, especially those with maturities of greater than one year, are amortized loans. With an amortized loan, the borrower is required to make equal periodic payments. As a payment is made, the interest for the period is calculated based on the outstanding balance at the time of the payment. The remainder of the payment is then applied to the principal balance. Since the principal balance declines with each payment, the interest portion of the payment decreases and the principal portion of the payment increases over time. With a discounted loan, either the lender receives payment of all the interest at the time the loan is granted or the interest is deducted from the proceeds of the loan. Since the interest is effectively prepaid, the borrower must repay only the principal, usually in equal payments. In an add-on loan, the total interest for the loan is calculated and added to the principal. The sum of the principal and interest is then divided by the number of periods to calculate the constant periodic payment. The effective interest rate on discounted and add-on loans will differ significantly from the stated rate.

SECURED FINANCING

Accounts receivable are one of the most common forms of collateral for secured short-term borrowing. When accounts receivable are pledged, the firm retains title to them and continues to carry them on its balance sheet. The borrower sends copies of invoices to the lender who determines the percentage of the invoice that will be advanced depending on the creditworthiness of the receivable. The risk of nonpayment remains with the borrower. Factoring receivables involves the outright sale of the receivables to a financial institution, called a factor. When receivables are factored, title passes to the factor and they no longer appear on the balance sheet of the firm. Therefore, the factor assumes the risk of default. The borrowers' customers typically make their payments directly to the factor.

Inventory constitutes another common source of collateral for secured loans. Three basic arrangements exist with regard to possession of the collateral by the borrower or by a third party. A floating lien is a general claim on all the firm's inventory. These arrangements offer little security to the lender and are used for large-volume, small-value, high-turnover inventory held by the borrower. A trust receipt is another type of loan in which the inventory is held either in a public warehouse or by the borrower in a field warehouse. As the inventory is sold, the proceeds are forwarded to the lender along with notification of the goods sold. Trust receipts require specifically identifiable units of inventory, and are frequently used for automobiles and appliances. With a terminal warehouse plan, the inventory is held in a bonded warehouse operated by a public warehouse company. As the loan is paid off, the lender authorizes the warehouse to release the inventory.