18.3: Bank Financing Flashcards
What is a line of credit (LC)?
A basic financing tool provided by banks that establishes a loan with a specified limit to a firm based on its creditworthiness.
What is an operating or demand LC?
Lending facilities that are made available by the bank for the firm’s operating purposes and that generally cannot be used to back up a CP program; these demand loans can be canceled at any time.
What is the prime lending rate?
The interest rate banks use to calculate their other interest rates; it is also the standard cost of an operating line of credit.
What is a floating interest rate?
An interest rate that changes regularly.
What is a term or revolving LC?
A line of credit extended by a bank to a firm for a specific amount that automatically adjusts as payments are made or received.
What are the restrictions firms must meet to maintain access to the funds in an LC?
- A minimum current ratio of 1.4 or net working capital ratio of 0.25
- Net worth (shareholders’ equity) in excess of $250 million
- A minimum interest coverage ratio (times interest earned) of 1.75
- Maximum leverage ratio in excess of 2 and a debt ratio less than 0.75
What are covenants?
Promises or restrictions in a contract.
What are term loans?
Loans to finance longer-term requirements, such as equipment purchases; they have a fixed maturity and require repayment to be made on a fixed schedule.
How do term loans differ from lines of credit?
Term loans have a fixed maturity, require repayment to be made on a fixed schedule, and are meant to finance longer-term requirements such as equipment purchases.
How are term loans structured?
Term loans are usually structured for a term of at least three years and may go out to 10 years or longer.
Some involve “bullet” or “balloon” payments where only interest is paid until maturity, at which time the entire principal is due and payable.
What is the main advantage of term loans for borrowing companies?
Term loans are easy to arrange and all firms have banking relationships because they need chequing accounts to gain access to the payments system and need access to short-term financing and hedging contracts.
How are term loans often structured to fit with a firm’s other lines of credit?
Sometimes a revolver is structured to switch into a term loan at the end of its five-year life.
Briefly describe operating LCs, revolving LCs, and term loans.
- Operating LCs: Lending facilities for the firm’s operating purposes that can be canceled at any time.
- Revolving LCs: A line of credit extended by a bank to a firm for a specific amount that automatically adjusts as payments are made or received.
- Term loans: Loans for longer-term requirements with a fixed maturity and repayment schedule.
Why do banks typically impose debt covenants on their borrowing customers?
To ensure that the credit quality of the firm does not deteriorate, thus protecting the bank’s exposure to credit risk.
Why is it reasonable to assume that most firms will have a banking relationship?
Firms need chequing accounts to gain access to the payments system, need access to short-term financing, and need to arrange hedging contracts.
