Rev. October 29, 1993
Note on Bank Loans
Bank loans are a versatile source of funding for businesses. For example, these loans can be structured either as short- or long-term, fixed or floating rate, demand or with a fixed maturity, and secured or unsecured. While each potential borrower's business is unique, reasons to borrow generally include the purchase of assets including new fixed assets or entire businesses, repayment of obligations, raising of temporary or permanent capital, and the meeting of unexpected needs. Loan repayment generally comes from one of four sources: operations, turnover or liquidation of assets, refinancing, or capital infusion. This note describes traditional bank lending products, the role of the lending officer, credit evaluation, and the structuring of credit facilities and loan agreements. Specialized loan and credit products are described in Appendix A.
Traditional Commercial Bank Lending Products
While increased competition has forced banks to develop innovative credit facilities and financing techniques, traditional products, which include short-term, long-term, and revolving loans, continue to be the mainstay of commercial banking. Short-Term Loans
Short-term loans, those with maturities of one year or less, comprise more than half of all commercial bank loans made. Seasonal lines of credit and special purpose loans are the most common short-term credit facilities. Their primary use is to finance working capital needs resulting from temporary build-ups of inventory and receivables. Reflecting their use, repayment of short-term loans typically comes from the routine conversion of current assets to cash. These loans may be either secured or unsecured. A seasonal line of credit is used by companies with seasonal sales cycles to finance periodic increases in current assets, such as inventory. The amount of credit made available is based on the borrower's estimated peak funding requirements. The borrower may draw on the seasonal line of credit as funds are required and repay the line as seasonal sales lead to liquidation of inventories. Interest accrues only on the amount of borrowings outstanding. A bank's commitments under lines of credit may exceed its ability to fund them all simultaneously, though simultaneous demand is unlikely to occur. So as not to have a legal obligation to lend its capital to a borrower in the rare
Research Associate Susan L. Roth prepared this note under the supervision of Professor Scott P. Mason and with the assistance of the Citicorp Institute for Global Finance as the basis for class discussion. Copyright © 1991 by the President and Fellows of Harvard College. To order copies, call (617) 495-6117 or write the Publishing Division, Harvard Business School, Boston, MA 02163. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School. 1
Note on Bank Loans
case that demand for funds does exceed supply, the bank may structure this facility with a provision that allows the bank to terminate the facility at its option or provide funding subject to availability. Businesses use special purpose loans to finance, on a temporary basis, increases in current assets resulting from unusual or unexpected circumstances. Funding is based on the borrower's estimated needs, with the bank agreeing to fund either all or up to some percentage of the full amount. The credit facility is most likely to require full payment of accrued interest and principal at maturity, i.e. a "bullet." The term for such a loan is usually fixed and is determined by approximating the time when repayment can be made. The bank's principal risk with a special purpose loan is default due to a change in the circumstances on which the repayment plan had...