Credit Process: Lending products
Let’s review the list of products available in financial markets to meet the lending needs of a business. An understanding of customer needs and how those needs are met is important before we get into now credit analysis works.
Commercial Banks, Institutional Investors, private and public lenders offer a number of products to potential borrowers. Some of these are discussed below:
Line of Credit
Under this form of borrowing, a bank agrees to lend up to the credit limit that has been allocated. The customer can borrow repeatedly (and can revolve the credit), provided the credit limit is not exceeded. For example, In the Willy Whale case above, the credit line is for $18,000,000. The firm borrows $12,000,000 and then borrows an additional $4,000,000. The total outstanding balance on the line is now $16,000,000. The remaining balance on the line is $2,000,000. For Willy Whale to borrow an amount greater than $2,000,000, a portion of the existing balance would need to be paid down to keep the total balance under $18,000,000. Bottom line is that Willy can keep on borrowing and repaying amounts on the credit line as long as the line is active and the outstanding balance stays below $18,000,000.
Businesses have short-term cash flow crunches where they need to borrow amounts for short periods to meet operational cash flows. This situation is quite common for firms with extended operating cycles (manufacturing, distribution or collection) & seasonal sales. It is also true for companies experiencing cash flows problems (short term as well as long term).
Although a line of credit can be extended for as long as 60 months, the bank has no legal obligation to lend (i.e. there is no commitment). A lender can cancel a Line of Credit at any time and demand payment of all outstanding amounts. Working Capital loans and Transaction loans are also Lines of Credit that are taken for a specific purpose; the former to finance routine day-to-day operations and the latter to carry out transactions of a specific nature, such as a purchase, expansion or capital investment
This is a formal line of credit used by large organizations. The bank agrees to lend up to a committed amount during a certain period (the revolving period), generally not exceeding 5 years. If the client borrows under a revolver and then repays the principal, it can borrow again, as long as the total amount outstanding does not exceed the commitment.
The client is under no obligation to borrow (in fact, many revolvers are never used). Revolving credit is very similar to a regular line of credit, as discussed above. Unlike a line of credit, however, the bank has legal obligation to honor a revolving credit agreement and it receives a commitment fee.
In the U.S., most investment grade companies have revolvers in place, but do not borrow under them. This is because they can borrow cheaper funds from public markets using other lending / credit products. Revolving credit is used as a backup in case the firm is unable to obtain funds from public markets. Non-investment grade companies in the U.S. generally borrow under revolvers for seasonal and/or cyclical cash needs.
Banks allow advances against the security of bills or notes, purchased from their approved customers within sanctioned limits. In effect, the notes are held as a security for the advance. The bank, in addition to rights against parties to the notes, can also exercise a claim over the goods covered by the document.
A term loan is an agreement or contract where the lender provides the borrower with a fixed sum of money upfront, and the borrower agrees to make a series of interest and principal payments on specific dates. Terms loans are usually taken on by firms to finance fixed assets that require large outlays of capital. The maturity for term loans typically runs from 3 to 10 years.
The interest rate on a term loan can be fixed or floating. Term loans are usually private placements of debt rather than public offerings i.e. they are not offered to all investors or trade in open markets. They often go by other names: Mortgages if property or real estate is used as collateral; Bridge loans if the maturity period is very short. The common theme among these loans is that unlike revolvers and credit lines, once an amount has been borrowed, the entire principal (sometimes a %) has to be repaid before the facility can be reused again.
Term loans are most often used by non-investment grade borrowers for long-term financing, and by companies involved in mergers and acquisitions activity.
Most commercial banks lend money to consumers for the purchase of assets like cars, houses and other consumer goods. Credit cards can also be considered as a type of consumer loan. In the case of direct consumer loans, the bank provides a certain amount upfront for the purchase of the asset and the borrower makes repayments in periodic installments.
This represents credit granted by suppliers of goods, etc. in the form of account or notes payable. Trade credit is a valuable source of financing because it has no explicit costs and as long as a business continues its operations, the credit keeps rotating.
Bonds are like term loans, except that a borrower agrees to make payments of interest and principal on specific dates to the holder of the bond. A bond issue is generally advertised publicly by large corporations (borrower) and is usually sold to many different investors (lenders). When a firm has decided that it needs to borrow, it can issue a bond.
The bond can be sold in different denominations and can be bought by many people. Buyers of the bond (lenders) get a commitment to receive interest and principal payments. The issuer of the bond gets the proceeds less commission. Institutions as well as individual investors may purchase bonds. Some of the current bond offerings include
- High-yield bonds are issued by organizations that do not qualify for “investment-grade” ratings by the leading credit rating agencies. Those issuers with a high risk of default are rated below investment grade. Hence, they must pay a higher interest rate to attract investors to buy their bonds and to compensate them for the risks associated with investing in their organization. Also referred to as Junk Bonds, the general idea is that these securities yield enough returns to more than offset the risk.
- Debentures are unsecured bonds. Debenture holders are general creditors whose claims are protected by assets that are not pledged elsewhere. Companies that have a strong credit standing in the market usually issue debentures; these firms do not need to secure their loans with assets.
- Mortgage bonds are issued by organizations that pledge real estate assets as security on the bond.
- Convertible bonds are bonds that are convertible into common shares of the issuers on certain dates or occurrence of certain events.