Introduction
Money is the basic purpose of doing any business or entering into any market whether it is financial, manufacturing or any other. In order to earn money and earn revenues, investments and costs are involved that is needed to initialize and run the operations of the investment purpose or simply business. Cost is incurred whenever any individual or party involves in any type of business and therefore, an amount of money is required that should be adequate to the needs of the business. Not every individual may have enough resources of money or willingness to put up all funds of his or her own money in an investment that may flourish in the future involving some risks and uncertainties.
Usually initial investments or investments for the big projects require the companies to go towards the borrowing of money from banks. It is evident that businesses require capital in addition to man, material and land for running it, as the basic requirements. Since, capital is not unlimited with any individual nor anybody is willing to put its all capital into total stake. This lets the companies and businesses to borrow money from banks and financial institutions. It is important for the businesses to seek appropriate source of funding in order to minimize the risk of financial fallacy while on the other hand, financial institutions take care of the worthiness of the companies and organizations in order to evaluate how much loan and on what terms should be lent in order to minimize the risk of their investment loss that may result due to the bad performance of the borrowing organization.
Although businesses require financing and based on the economic factor of their business, not every financial institute allows lending or financing to every company or organization. Banks have certain rules, policies and guidelines to be followed in order to ensure the basic essence of financing other businesses while maintaining or growing the profitability of the bank. There are parameters against which banks evaluate and analyze the situation of an individual in order to see whether that individual or company is able to pay back the amount of money it has borrowed (that is Principal Amount) along with the payment of required interest that is essential for the bank to maintain its profitability in financing business while covering the risk of loss if the company or organization fails to pay the principal amount back to the bank. Therefore, banks form their procedures and policies in order to ascertain that no substantial financial loss is incurred by the bank while financing the business or organization willing to borrow money from the bank (Ruzgar and Ruzgar).
Thus, it is important for both the parties that are lending intuitions (banks) and the borrowing individuals (company, organization, individual) to place such terms and conditions following specified policies and procedures so as to minimize the risk of financial loss in any of the cases. This report therefore, highlights the process and procedure that banks follow in order to sanction loans to the businesses, what criteria they observe, how do they decide the interest on which loan should be lent, how do they evaluate the financial position of the business and how do they maintain the profitability in the lending system.
Issues of Securities
Firms and businesses require capital to start, expand or continue its basic process that emerges the need of financing. There may be a number of reasons as mentioned above including funds for particular project, wages or bills, for specific transactions, to solve any financial crisis or in general to finance the business on an ongoing concern basis.
Debt and equity financing are the common forms of financing the business and firms. However, companies may have diff erent approaches and priorities in order to set the equity and de3bt ratios in their total financing cost that is capital structure of the firm. Since, debt is usually available at less interest rates, thus companies that want to initiate with lower risk or that need to increase heavy amount of financing while investing any big projects at a lower rate of financing (i.e. interest rate or sometimes called hurdle rate). Debts can be acquired in different forms; however securities are one of them in order to acquire loans from the financing institutions or banks. Securities are the form of business loans that are issued by the financing institutions to the companies despite, the fact it may be between any two parties that hold legal permission to issue the securities. It refers to the cash financing against the agreement between the two parties called “Securities Lending Agreement” where the lender agrees to sanction an amount of money or financing as specified in the agreement on the terms and interests that are the part of written agreement and constitutes a legal binding. Premium and fee of the agreement are the benefits for the lender while the financing at an agreed interest rate on time when the business requires financing or capital is the advantage to the borrower.
Companies acquire bank loans or issue debt securities in order to finance their purpose on the timely basis. There may be company preferences with regard to either issue debt securities in the market or apply for the bank loan. However, rates and interests may differ in each of the case that companies evaluate to finance with. Debt securities are actually the financial instruments that the companies issue requiring the Companies issue debt securities that are the source of financing the business through debt. The borrower actually needs to pay the interest on the security that has been bought by the lender or bank and need to repay the principal amount on the maturity of the security. The security can then be traded amongst the investors. Companies and businesses try to acquire more debt minimizing the interest that is needed to pay to the stakeholders of the business in an overall term referred to as cost of financing the capital structure of the company. Since, debt interest rates are usually lower than the equity mark up rate thus it is preferred by the businesses that they acquire financing through debt or debt securities. However, banks are not willing to pay heavy amounts of debts to the companies for financing regardless of the company’s size, credit worthiness and other parameters that can highlight the financial status of the company. This is to ensure that the business or firms do not collapse financially and fail to pay back the amount that they have borrowed to the banks at committed interest rate.
Small & Big Businesses and Availability of Securities
Firms differ in their sizes in terms of finance and value of the firm. There may be different standards and benchmarks on which the size of the firm is determined. Different industries have different level of investments and costs that determine the size of the business and strength of the company to support its financing activities in a profitable manner. Not all banks give loans to all companies. Also, different amount of interests are associated with different firm sizes and their financial health in the business.
Debt securities are eventually attractive to small as well as big investors and thus they are widely used in every size of the business. The fact that the securities have more potential to approach investors supports the timely need of financing to the firms and businesses, while at the same time investors have the attraction that one who needs it can pay a more attractive interest or premium on the loan in comparison to the bank interests. Also, securities are transferable instruments and thus listed in the stock exchange in most of the cases. This lets it to be traded in international capital market and gives wider exposure to the investors and borrowers.
International availability and tradability of the securities give it strength and potential to be invested in as an investor does not necessarily have to wait for the maturity of the security and payment of his or her invested amount along with the time to date premium. If an investor wants to get his invested amount back before the maturity of the security occurs, he simply has to trade the debt security in the market and expose it to other investors. Investors that are willing to invest at that time would buy and continue with the remaining period of maturity. This gives securities strong advantage to be used and traded in small and big businesses as well as high level of availability in the market. The willing lenders to buy the security with remaining maturity get their premium and have their share of profit out of that security investment.
Types of Securities Considered
Different companies and business consider different types of securities in order to acquire the financing for their business. It depends upon the situation and ability of the firm to get an amount on specified terms laid by the bank or lender. Different features of different security forms attract different investors so that they are willing to finance a purpose laid down by the company or business while observing a good profitability in security investments.
There are different types of securities that are considered while issuing them for the financing of the firm or business. This includes,
- Bonds: (This includes Eurobonds as well as high yield / junk bonds). Such types of bonds have a maturity of around one year or more usually.
- Medium Term Notes. Debt securities concerned to average term note planners as well as more often than not comprise a maturity of three.
- Commercial Paper: Usually the commercial papers are for one year period or less.
The reason why different securities are considered is the need of the business and the ease of repayment. As evident from the description of the types of securities, they mainly depend upon the time for which they require maturity of repayment. Covenants in the debt securities are quite more flexible than the terms and conditions involved in the bank loans or syndicated loans, while the interest rates and repayment options in the securities debt system are more flexible and can be customized to the need of the borrower and willingness of the lender as opposed to the conventional bank loan system. However, one disadvantage that is tied with the trading and financing through securities is that securities are usually more vulnerable and less secure in terms of payments compared to the bank loans. This is due to the fact that the debt securities require the borrower to disclose less information about him or her and thus the lender is not available with the credit worthiness or any such detailed information about the borrower. (Methods of raising debt finance: a quick guide.
Loan approval and Small Monetary Quantities
Bank loans are taken by the companies in order to finance their capital structure as well as the investments they require for several purposes as already mentioned in this report like expansion, new project or supporting some financial distress of the company. There may be several forms of financing for the businesses as options that may best suit for the firm in particular situation.
Companies may get loans from a single bank or financing institute that lends loan in order to earn on its premium and interest margin. There may be situations where companies may prefer getting a loan from a single source or single bank called a bilateral loan (that is loan agreement between two parties) whereas there may be situations where companies prefer getting a loan from multiple sources or a group of banks usually called syndicated loan. Syndicated loans can be customized to match the repayment ease of the borrower subject to the agreement of the lender (banks). It may be on an instalment basis, tenure basis or on revolving terms.
Loan approvals require exhaustive background check up of the borrower in order to determine whether he is able to pay back the amount that is required by him from the lender or not. The extent of this investigation about the credit worthiness of a potential borrower depends upon the amount of loan required by the potential borrower. More the amount is at risk, the more exhaustive and in-depth information about the borrower would be required to the bank to sanction any amount and approvals.
Businesses need different amount of loans at different times and thus lender tailors the loan structure as per the borrower’s requirements while observing and caring for its own profitability and margin of interest. Due to this many forms of loans are present to match the borrower’s requirements and needs for that time. This includes,
- Overdraft: In this type of loan, the amount of loan that is borrowed has to be repaid to the lender when the lender demands for it,
- Term Loan: In this type of loan system, the loan is repaid to the lender after a specific period of time that is agreed and a part of loan agreement between the parties.
- Revolving Facility: In such types of loans, the relation between the borrower and the lender is usually in long terms and the borrower can actually re-borrow the amount that it has repaid already to the lender.
Loan approvals require the assessment of required quantity of money against the portfolio of that individual as well as the bank’s policy to sanction the loan amount. Usually banks seek overall profitability while investing in loans and securities for financing any firm in an overall perspective. However, risks associated with the amount of money that can occur due to the financial failure of the firm or the credit non-worthiness of the firm may occur. It also includes premiums and cushion in order to cover different variations in the value of money including exchange rate variations, inflation premium and others.
Excessive Paperwork
Loan approvals require the assessment of required quantity of money against the portfolio of that individual. Thus, a lot of paper work is involved in order to determine, valuate and prove the opposition of a firm or business as per the requirement of the lending authority against the securities or loans.
Interests Acquired
Various companies and businesses involve in different types of transactions against different forms of the loans. Therefore, banks demand different levels of interests against different quantities and nature of the business in which companies and firms are involved. Banks seek their profitability while covering the risk of investment that they make through allowing a loan amount to the businesses at the time they require it, this interest is determined by the bank by laying down different premiums and risk cushions that may occur or will occur during the course of the repayment of the principal amount of the loan. The principal amount of the loan is referred to the main financing amount that the company or business has acquired from the bank or financial institution while the interest determines the overall profitability to the bank or simply the cost of financing that amount to the business incorporating required profit and risk premiums by the bank. Banks and financial institutions always observe that the interest rates they offer are competitive to the market rates and they cover all the aspects of the risks involved with the transaction of loans. They own the responsibility of evaluating and examining the companies before approving an amount to the businesses. Also, the location and references are sought in order to determine the ease of recovery of the appropriate interest along with the principal amount of the loan (Patel).
The way of evaluating companies
Companies are evaluated on different parameters as not all information is available to the financing institutions about every business organization. Size of the firm, credit worthiness, its past history, the nature of the business it is involved in and many other parameters are looked into in order to evaluate the companies. Banks need to gather much data or inquire from the company management about the company’s profile so that they may determine the situation of the firm to pay back the principal amount as well as the required cost of financing to the bank (Ruzgar and Ruzgar).
Credit worthiness refers to the trust and integrity of an individual or a company that would pay back the amount it has borrowed. This does not mean that a company that wants to pay back the loan has good credit worthiness, rather a company who is willing and has the capability as well to pay back the interest amount as well as the principal amount. Banks also seek support from different institutions that are actually involved in determining the status and credit worthiness of the businesses and firms to support the financing institutions to evaluate companies against a premium they charge for the information. Lenders are interested in analysis of different trends, ratios and financial statements through financial experts, as not every figure written on financial books or statements can return a true picture of the financial evaluation of the firms and businesses. Trends and ratios are analyzed and the rationale to any appreciable changes is drilled down in order to be certain about the accuracy of the data relevant. Companies are also analyzed on the basis of Alsman Z-Score analysis that was developed in 1968 by Edward Alsman. This is used to predict the financial distress and bankruptcy of a business through defining the probability against different ratios
Ratios and Formulas. Source: (Financial Analysis)
Similarly, rough set approach and logistic regression are used in order to examine whether the companies or potential borrowers under consideration will be able to refund the payment or not as there is always a risk associated with the non-payment of the loan amount to the lender. Since, issuers related to the debt securities often need to be the established companies to whom other firms or financial institutions trust as far as the credit worthiness is concerned. Financial institutions or investors definitely prefer to invest with the established companies as they have the ability and a good past record of paying back loans at good margins as a result of their healthy operations making good profits for them. Therefore, investors always prefer to go with the firms having good credit history as well as reputation in the financial market. Therefore, usually if the borrower is not a big firm or has not shown a good past record in the debt security trading then, they need to go towards the loan side of the financing their needs and business (Ruzgar and Ruzgar).
Availability of Credit History & Guarantee Taker
No loans are sanctioned by the banks and financing companies without exhaustively analyzing the situation of the company or business to whom they are lending money. They always keep a close eye of the financial situation of the company before allowing it to acquire a loan amount, especially when the loan amount required by the business or firm is very high. However, such information about any company is not readily available and may not be public so that the banks can easily access them to evaluate the situation of the company.
Credit histories are usually inventoried by specialized financial institutions that they sell in the market to the investors. As the investors require updated information about the past history of the potential borrowers whereas the borrowers are also looking for the investors interested in the lending of money, rather it is a bank or a company or an individual. Thus, companies like PACRA, Moody’s, Dun and Bradstreet rate the potential borrowers in the market for their credit worthiness based upon their financial position and their past history. Credit scorecards are developed based on the analysis and assessment of specialized companies that look into the trends and figures of the financial statements and position of the company to predict the business profitability and credit worthiness in the future. Such information is available to the interested investors on some buying cost that reveals healthy information about the borrower’s credit worthiness. This in turn helps them to evaluate different companies and firms in the financial market that are looking for loans or financing. However, it is important that the information on which a firm or financing institution is deciding should be up to date and should be from the authentic source like PACRA as mentioned above because with the passage of time, no one may guarantee that what developments have taken place and which companies have failed to maintain their credit worthiness. This may be a result of financial losses to the company, inefficient operations, strategic directional changes or the change of higher management. Similarly, guarantee takers of the bank loans on behalf of the business or firms may charge some premium to take guarantee. However, they are too interested in the overall risk portfolio of the investment. This allows them to have close eyes on the business activities and profitability of the business in order to ascertain that the guarantee would not cost them ultimately (Patel).
Is the Business Asset Generating
Banks are interested in knowing whether the businesses or firms are able to pay back the amount of the loan. This lets them to inquire about the financial position and healthiness of the companies, financial health is not determined usually by the case in hand by the company, rather the fact that how quickly and profitably the company is able to generate profits from its deployed assets. Different parameters are used to determine and compare the position of the different companies with respect to the investment they have made to employ their assets. Banks look forward if the assets of the companies are actually relevant to the business in which the firm is involved or they have been employed without any planning and strategy. They are concerned while sanctioning heavy amounts of loan to determine of the firm would be able in the long run or in specified period to generate cash or profit from their assets in a rightful way so that the loan amount along with its cost of financing is paid back to them. Companies themselves are also concerned about the fact that whether the amount they are seeking as loan will be utilized in such a manner that would not result its default and hence bankruptcy, throwing them out of the business. Ratios are also often used in order to analyse whether the company is employing right assets that are generating profits for it or it is unable to engage its assets in a profit generating manner.
If the business assets are not generating cash or the cash flow statements of the company show that there are changes in the asset base of the company with no or minor change in the profit margins, then it is worthy enough to query that what assets and for what purpose were they employed or made redundant. Since investors and banks are interested in the financial health of the companies that directly relates to the fact that how well the business is performing thus it is important for the investors and banks as well to inquire whether the business is well enough to generate profits from its assets or is it just a temporary show off of the cash in their financial books.
Operating Expenses
A company’s operating expenses determine the level of profitability it generates from its routine activities or the basic operation of the business. It is possible that the company is making high profits and showing good income through their income statements and other financial statements. However, it is very important for the investors and the banks to know whether this income is coming from the routine or basic operation of the business or any temporary hype has been created. If there is a lot of cash inflow showing up in the company’s financial statements without any progressive improvement in the operating activities and yield, then it might be possible that the cash flow has been resulted due to sale of any assets that were important for thus business. In that case investors will not be really willing to invest. Also, there are chances that the cash inflows are actually resulting from the further financial assistance acquired by the company that would temporarily show up in the company’s financial statements, but in the long-term they have nothing to do with the firm’s financial health or profitability then again lenders would be reluctant to sanction big amount of loans to these companies. On the other hand, if the company is showing up low. However, consistent profitability of the firm that actually is driven by the operating activities of the business, then lenders would be willing to invest and give that company loans as they would regard the consistency or improvement in their performance through their core operating activities.
Analysis of Overall Profitability from Loans Given to Small& Big Businesses
Companies are evaluated on different parameters as not all information is available to the financing institutions. However, lenders seek to give loans to the firms and companies that can pay them back good profits and interests. The premium usually consists of
- Profit margin
- Default premium
- Exchange premium
- Inflation premium
- Any other specific risk premium
Profitability of loans given to small businesses is usually low however, the default risk premium associated with such companies is evidently high that makes up the total margin of interest higher. Whereas the loans that are given to big companies usually bare little premiums associated with default or other risk factors that ease up the profit margin for the lender or investor up to a better level. Similarly, loans transactions in the currency that is strong enough in the international trading would bare less currency exchange risk giving a good room for the investor to make up high higher profit margin in the overall interest rate.
Loans in Saudi Banks
Saudi Arab is an Islamic state and thus observes Islamic laws in order to sanction, lend or borrow the loan amounts along with its interest payments or premium. Saudi Arab works mostly on Islamic Banking that does not allow interest to be traded and considers the Sharia laws for the transactions and investments rather are it loans or borrowings.
Saudi Arabian monetary Agency (SAMA) looks after these matters and enforces the laws that are approved and in accordance with the Islamic laws (The Saudi Network). Although local as well as foreign banks are present in Saudi Arab, however for lending purposes and to avoid the non-Islamic interest based banking to be practised, specialized lending institutions of the government are present like the Saudi Industrial Development Fund (SIDF), The Saudi Credit Bank, The Public Investment Fund (PIF), The Real Estate Development Fund (REDF), etc (Albalawi).
Role of Islamic Law
Islamic laws are never seen in isolation as it is believed that they are close to the social nature of the business and trades and is able to evaluate good profits for the business and the society overall. Thus, in banking as well, Islamic laws play important role in determining the way in which such transactions that require lending or borrowing of money are involved. Since, Islamic banking is one the fastest emerging fields in the banking sector; it has spread all around the world impacting not only Islamic countries, but also the countries that rely on the rules and procedures of banking in alignment to Islamic laws. Since Islamic banking prohibits interest unlike conventional banking thus it works under the Sharia Laws that is considered usury (Riba) by majority of Islamic scholars. Thus, it is rather Profit Loss Sharing (PLS) banking and not just interest profits given to the investor regardless of the financial health and performance of the business in which one has invested.
Profitability
No loan or financing is viable until there are some profits or premiums are involved. The cause of the business in financing is profit and thus it must be acquired in whatever way it is realized to be fair and rightful. Since in Islamic banking there is prohibition of interest, thus profit margins are not consistent and known before the transaction. In Islamic countries, like Saudi Arab, usually interpretations of Sharia law are not always consistent, thus each bank takes its own position to determine whether a particular transaction type is compliant or not. Basic Sharia principles applied in banking are prohibitions on (i) riba (interest), (ii) gharrar (excessive speculation) and (iii) jahl (ignorance of material terms). Therefore, the profitability in the Islamic banking system associated with the loans and funding are governed by the investment perspective or a trade perspective where the lender actually involves with the stakes of the business itself rather being an individual with no concern with the primary activity of the borrower
Recommendations
Although the current system of loan in Saudi Arab is quite in alignment with the Islamic laws and preserve some profitability for the financing institutes as a benefit for the lender, however there may be some improvements in the current system of loans. There is a need of coherence to be produced between the Islamic laws and the conventional banking system in the Saudi Arab as well as other Islamic countries. Since, there is individual interpretation and not very authenticated standard practices have been demonstrated in following Islamic banking laws, thus there is a need of proper standards to be developed in accordance with Islamic laws to be practised by all banks following Sharia laws (De La Campa).
Regression Analysis, Ratios and Data
Different ratios, data and analysis are used in the determination and evaluation of the firms for their credit worthiness and value to pay back the loan amount as per their agreement with the bank. Ratios including quick test ratio, current ratio, asset turnover ratio, return on assets and other such financial ratios depict the financial position of the company. Investors are interested to know the direction of the company heading towards so that they may actually visualize their profits towards realization. If a company is not making good progress with its assets or it has less utilization and profit generation with the assets they employ, then their asset turnover ratio would depict the situation. Similarly, if a company is already under heavy debts and liabilities that are merely enough for the company to pay back from its current employed capital or assets then the quick or acid test ratio can be used. Liquidity ratios, profitability ratios, leverage ratios and working capital analysis are looked into to determine the financial position of the company.
Companies are analyzed for their financial health and strength through not only the point in time ratio analysis but also through regression analysis observing the trend in the profit making and its core business success through a series of period. This helps the financing institutions and banks to determine the direction of the business itself whether it is going upwards, downwards or is it infant (Ruzgar and Ruzgar).
Along with different ratios, horizontal and vertical analyses of the financial statements of the companies as well as regression analysis are used in order to forecast the company’s position to pay back the lent amount or the ability to pay back if it is applying for further borrowing in the market. A firm’s financial data is very much useful to analyze the situation of the company whether it is able to take further loans or at what capital structure does it run presently. The capital structure of the firm determines that what mode of financing it prefers and how much is the size of it. Generally, stocks (equities) and debt financing constitute the total capital structure of a company that offset each other’s interest or mark up to make a cumulative and optimal financing cost for the company. If a company is heavily relying on debt financing while it is unable to generate good profits then the lenders and investors would hesitate to invest as their investment may not be fruitful enough in the future, while on the other hand of the company is relying heavily on equity then it worth knowing that why is company seeking debts now or is it a policy change or is it a small amount that is not going to change appreciably the current capital structure of the firm (Patel).
Conclusion
Companies require capital and financing to run and fulfil their financing needs from time to time for different proposes. Debt financing is a form of financing that supports the company to invest in any purpose at the expense of financing cost or premium. Securities are issued as a form of debt in order to acquire the loans or financing when required by the firms against an agreed securities trading terms. Different types of securities are issued to fulfil different requirements of the financing on different terms as per the suitability of payment and viability for both the parties. There are different parameters and methods through which banks evaluate the financial position of the companies and determine whether to approve or reject the required loan amount to the borrower. Also, they determine the cost that should be associated with the financing through loan in order to cover the premiums and risks along with the profitability of lending the money. The amount of money that can be approved for a specific lender is also determined by the bank in order to keep a safe position and avoid a huge amount loss in case the company or firm bankrupts or goes in to loss or in any way becomes unable to pay back the principal amount as well as the interest amount associated with the financing the company.
Since, there should be certain parameters and factors on which the banks decide whether to approve and how much to approve the loan for the specific company or business so that there is ideally no risk or practically minimum risk of failing of the investment.
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