Loan Evaluation
Loan Evaluation Assignment
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Loan Evaluation
As a practitioner-researcher, you will apply knowledge to real-life situations. In the following scenario, assume you are a loan officer for a bank and the owner of a small business approaches you regarding a loan. Consider the following questions as you formulate your decision:
• What financial ratios would you examine and why?
• Is there other information, in addition to the ratios, you would want to obtain from the business owner before making your decision on the loan?
• How would your answer change if it were a larger company seeking the loan?
Resources;
• Articles
• Graham, J., Harvey, C., & Rajgopal, S. (2006). Value destruction and financial reporting decisions. Financial Analysts Journal, 62(6), 27–39. Retrieved from Business Source Premier database.
Senior corporate executives make decisions as to which performance measurements to use in their financial reporting. As these reports affect the company’s stock market performance, the authors of this article explore the widespread practice and impact of executives opting to use factors which may make the company appear successful, while in actuality, they may cause the destruction of value.
• O’Connor, J., Priem, R., Coombs, J., & Gilley, K. (2006). Do CEO stock options prevent or promote fraudulent financial reporting? Academy of Management Journal, 49(3), 483–500. Retrieved from Business Source Premier database.
Large stock options for CEOs are a hotly debated subject. In this journal article, the authors explore whether these stock options encourage or discourage accurate financial reporting of a company’s profits. They conclude that certain other factors, when combined with large stock options, are more likely to result in fraudulent misrepresentation.
• Haskins, M. (2002). Instant insight. Strategic Finance, 84(3), 42–47. Retrieved from Business Source Premier database.
This article describes how Delta Factor reference tables may be used to turn finance ratio analysis into an accurate planning tool.
• Skogsvik, S. (2008). Financial statement information, the prediction of book return on owners- equity and market efficiency: The Swedish case. Journal of Business Finance & Accounting, 35(7/8), 795–817. Retrieved from Business Source Premier database.
This author discusses a financial model that uses financial statement information and a prediction formula to determine changes in medium-term book return on equity.
• Readings
• Course Text
Corporate Finance
• Chapter 3, “Financial Statement Analysis and Financial Models”
This chapter discusses methods for analyzing financial statements such as balance sheets, ratio analysis, and liquidity measures. These calculations are then used to develop long-term financial planning models.
• Chapter 4, “Discounted Cash Flow Valuation”
The concepts of present value, future value, and interest rate returns are introduced in this chapter along with details on multi-period situations, compounding periods, and perpetuates. Explanations are then given on how to make the calculations and then most effectively use the results.
SAMPLE ANSWER
Loan Evaluation
When a small business approaches a bank for a loan, its business plan is a very important component of what will finally influence the loan officer to approve the loan. While it may seem like the loans officer makes decision based on arbitrary standards, loan application will begin by interrogating the business plan to determine the different ratios.
Ratios are important since they give a peek into the business operation without having to visit the business in person (O’Connor, Priem, Coombs, & Gilley, 2006). The loan officer will want to understand how the business controls its expenses. This will be derived from the cost of goods sold/net sales; selling, administrative and other expenses/net sales; wages and salaries/net sales; interest expenses on borrowed funds/net sales; overhead expenses/net sales; depreciation expenses/net sales and taxes/net sales.
Of importance to the loans officer is the efficiency with which a business operates. This will be derived from the net sales/total assets, annual cost of goods sold divided by average inventory levels, net sales/net fixed assets and net sales/accounts and notes receivable (Skogsvik, 2008). Given a business will trade in a product, service or skill, it will be important to determine its marketability. This will be verified by the gross profit margin, or net sales less cost of goods sold to net sales, and the net profit margin, or net income after taxes to net sales.
The loans officer will also be interested in understanding how loan and interest will be covered by specific business aspects. This will include interest coverage (such as income before interest and taxes divided by total interest payments), coverage of interest and principal payments (such as earnings before interest and taxes divided by annual interest payments plus principal payments adjusted for the tax effect), and the coverage of all fixed payments (such as income before interest, taxes and lease payments divided by interest payments plus lease payments) (Graham, Harvey, & Rajgopal, 2006). Every business operates to be profitable.
The loans officer will develop profitability ratios like before-tax net income divided by total assets, net worth, or sales, and after-tax net income divided by total assets (or ROA), net worth (or ROE), or total sales (or ROS) or profit margin (Moyer, McGuigan, & Kretlow, 2009). Of importance to a business is the ability to meet expenses as they are incurred. The loans officer will determine the liquidity of the business through the current ratio (current assets divided by current liabilities), and the acid-test ratio (current assets less inventories divided by current liabilities).
Finally, the loans officer will seek to determine how the business is leveraged. This will be known through the use of the leverage ratio (total liabilities/total assets or net worth), the capitalization ratio (of long-term debt divided by total long-term liabilities and net worth), and the debt-to-sales ratio (of total liabilities divided by net sales).
Ratios will not tell the whole story as they only reflect the symptoms of a possible predicament as opposed to exposing the root cause and nature of the problem. The loans officer will, thus, make a more informed decision if they should investigate the reasons behind the trend exhibited by the ratios (Charantimath, 2006). After all, when a ratio changes, it could be as a result of a shift in the numerator or the denominator or both. A loans officer will also seek additional information that will capture the experience of the owner, the potential value of prospective customers and other non-balance sheet items (Haskins, 2002).
For a large company seeking a loan, a loans officer will seek the credit history of the organization. This will be given by the credit reference bureau. The company will also have to provide collateral and any options available. The choice of collateral used to secure a loan will affect the bank’s acceptable loan-to-value ratio.
References
Charantimath, P. M (2006). Entrepreneurship Development and Small Business Enterprise, Dorling Kindersley, New Delhi
Graham, J., Harvey, C., & Rajgopal, S. (2006). Value destruction and financial reporting decisions. Financial Analysts Journal, Vol. 62, No. 6, pp, 27–39.
Haskins, M. (2002). Instant insight. Strategic Finance, Vol. 84, No. 3, pp. 42–47.
Moyer, R. C., McGuigan, J & Kretlow, W (2009). Contemporary Financial Management, 11th Ed, South-Western Cengage Learning, Mason OH.
O’Connor, J., Priem, R., Coombs, J., & Gilley, K. (2006). Do CEO stock options prevent or promote fraudulent financial reporting? Academy of Management Journal, Vol. 49, No. 3, pp. 483–500.
Skogsvik, S. (2008). Financial statement information, the prediction of book return on owners- equity and market efficiency: The Swedish case. Journal of Business Finance & Accounting, Vol. 35, No. 7 and 8, pp. 795–817.
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