Credit & Lending Exam 2

Chapter 5, 6, & 7

When developing the structure of a loan, which of the following are least critical to consider?

a. The cash flow and collateral available for repayment

b. The customer’s sensitivity to pricing and restrictive covenants

c. The need to meet a much lower rate offered by a competitor

d. The type of loan offered based on the loan purpose

c. The need to meet a much lower rate offered by a competitor

While the bank certainly would wish to retain a customer relationship, it should do so when the overall relationship generates satisfactory profitability for the bank. The keys to successful loan structuring addresses the customer’s goals (low rate and fees and ability to operate business effectively –without excessive restrictions), the availability of adequate sources of repayment (cash flow, collateral and, in some cases, third party support) and matching the loan type to the borrowing cause to assist in timely repayment ability.

Mom's Roses is a local florist with several locations in the county. You met the owner recently and she has asked to speak to you about a potential loan request. Which of the following would be the most typical type of loan this company would require?

a. A term loan to acquire capital assets.

b. A revolving credit to fund long-term sales growth

c. A mortgage loan to acquire one of the store locations

d. A seasonal line to fund inventory build-up

d. A seasonal line to fund inventory build-up

While all are potential borrowing needs, the most typical need based on the type of business would be a seasonal line to acquire inventory ahead of peak selling periods (Valentine’s Day, Mother’s Day, June weddings and graduations, Thanksgiving and Christmas holidays). A florist would have relatively modest fixed assets requirements other than perhaps fixtures, a delivery vehicle and some POS equipment and would likely not want to own their premises because of the fixed costs associated with real estate ownership. A revolving credit to fund longer-term growth might be required if the business plans to open more locations or acquire other florists, but these would be atypical needs

A bridge loan typically displays which of the following characteristics?

a . A term exceeding one year with a single repayment at maturity

b. Repayment from operating cash flow and secured by receivables

c. Repayment from the sale of equipment or real estate for example with a term of one year or less

d. Interest only payments with a clean-down period required

c. Repayment from the sale of equipment or real estate for example with a term of one year or less

A bridge loan is designed to bridge a short-term financing need (1 year or less typically) between two events. Loan repayment is tied to the completion of a specifically-identified event, such as an asset sale when sale proceeds are available to repay the bridge loan. Repayment from operating cash flow is NOT typically the source of repayment (unless operating cash flow is available over time to repay a failed bridge loan), clean-downs are not required (because cash flow isn’t available until the event occurs), nor are receivables the most typical collateral (which in many bridge loans would be real estate)

Tom’s Surfboards and Sundries sells a range of products at the Galveston shore, including sunscreen, beach toys, and beach apparel during the summer season. Which of the following types of financial information would be most relevant in determining both the amount and duration of a seasonal financing need for the company?

a. Three years of company tax returns

b. Audited statement and a six-month interim

c. Five-year annual projections

d. Monthly cash budget or interims

d. Monthly cash budget or interims

Through the monthly interims or cash budget a lender could see the timing and amount of build-up in inventory and the pattern of sales through the year, helping to identify both the amount of financing required and when financing needs could reasonably be repaid from seasonal sales. The tax returns and audited statements would show only the year-end balance sheet with total sales. At year-end the balance sheet would likely show the lowest point in the operating cycle (most cash, least inventory). The six-month interim might show some information about seasonal needs, but the duration of the need would be difficult to determine without multiple interims. The annual projections also would not show the seasonal financing requirement, but may indicate the need for term financing to fund growth.

When evaluating creditworthiness, all the following are reasons that banks and business owners focus attention on capital structure EXCEPT:

a. Appropriate capital structure insures the operating profitability of the business

b. Appropriate capital structure is necessary to implement the business strategy

c. Appropriate capital structure can help the business through economic downturns

d. Appropriate capital structure suggests the ability to meet obligations as they come due

a. Appropriate capital structure insures the operating profitability of the business

Capital structure itself cannot insure operating profitability –although it may certainly contribute to it by allowing the business to obtain financing resources to execute its business strategy. Appropriate capital structure means greater likelihood of surviving unexpected events or economic downturns and is indicative of timely repayment ability of both short and long-term obligations.

Bill Miller started Miller Architectural Associates 35 years ago and has built a stable base of clients and a sound management team. He plans to retire in a year and his key managers want to purchase the business from him but have little equity to contribute. Given this situation, which of the following would be the most appropriate source of financing for the buyout?

a. A revolving credit

b. A term loan

c. A seller note

d. A bridge loan

c. A seller note (a loan provided by the seller to the buyer to finance part of a business purchase, where the buyer pays the remaining balance over time rather than upfront)

An architectural firm would have little in the way of hard assets to pledge as collateral and with little equity from the purchasers, this type of request poses a high degree of risk for a bank. A bridge loan would only make sense if the key mangers thought they could obtain permanent financing from another source, such as a private investor –or contemplated some form of equity injection. The most viable option would be for the seller to take back a note and agree to be paid for the business out of profits over time.

The covenants of a loan agreement should serve which of the following purposes?

A. They legally “perfect” the bank’s collateral position and list events of default and their remedies

B. They are designed to ensure timely repayment and keep the bank informed as to financial performance

C. They identify key risks in a borrower’s operating profile and restrict management’s ability to make daily operating decisions

D. They enable the bank to spot signs of deterioration and provide a means of communication with the borrower

D. They enable the bank to spot signs of deterioration and provide a means of communication with the borrower

Covenants cannot protect against payment default or otherwise insure loan repayment. They should not be designed to restrict management’s ability to effectively run the business, nor do they perfect a bank’s interest in collateral, which is done through other documentation. They should be used to help the bank detect signs of financial deterioration and keep the borrower in contact with the bank throughout the life of the loan.

Which of the following would be the primary objective of a negative covenant in a loan agreement?

A. To enable early detection of financial deterioration

B. To establish a means of communication with a borrower

C. To preserve cash flows for debt repayment

D. To provide assurance that a loan will be repaid

C. To preserve cash flows for debt repayment

Negative covenants generally seek to prohibit or limit activities that would potentially reduce/drain cash flow that would otherwise be used to repay principal and interest on the bank’s loan.

Harrell Properties, LLC develops and owns several fully-occupied commercial properties. Harrell Properties’ ownership includes the following: Harrell Development Corporation, a major regional developer with substantial financial resources (15%), Jared Harrell, largest shareholder of Harrell Development and a customer of your bank’s trust department (5%), and Harrell’s four children, all of whom are under the age of 22 (20% each). In setting the structure for a loan to Harrell Properties, which of the following support would provide the bank the most protection?

a. Maintenance agreements from each of the 20% owners of Harrell Properties.

b. A collection guaranty from Harrell Development Corporation

c. Comfort letters from each of the six owners of Harrell Properties

d. Payment guaranties from Harrell Development and Jared Harrell

d. Payment guaranties from Harrell Development and Jared Harrell

Payment guaranties from the two owners known to have substantial resources allow the bank to pursue both immediately in the event of a payment default. The collection guaranty would eventually allow access to the resources of Harrell Development (known to have substantial financial resources), but only after all other remedies for payment from the borrower have been exhausted. Maintenance agreements from the four children (20% owners) are of questionable value as there is no information about the ability of these owners to insure that minimum financial characteristics can be maintained –or what those minimum financial characteristics might be. As all are under 20 years old. It is possible that each has only limited financial resources to support the borrower financially. The comfort letters likewise offer very little protection as they are informal promises that fall substantially short of a legally enforceable guaranty.

Personal credit scores are relevant when considering a commercial loan to a business because:

a. They provide an indication of ability to pay rent

b. They are valid indicators as to business management ability

c. They are useful in determining the business loan amount that can be qualified

d. They provide information about loans guaranteed by the business owner

b. They are valid indicators as to business management ability

For closely held businesses, personal credit scores are indicative of how the business owner handles his or her personal financial affairs and is an indicator of the business owner’s management ability. The score will provide indications about the business owner’s ability to obtain various types of credit –such as consumer loans and personal lease arrangements, but these will not directly relate to commercial credit extension. The credit score will not take into account personal guaranties issued (but may be influenced by co-signed consumer obligations).

Which of the following companies report consumer credit information?

a)Experian and TRW

b)Fair-Isaac and Equifax

c)TransUnion and TRW

d)Equifax and Experian

d)Equifax and Experian

Fair-Isaac is the name of the developers of the first and now widely used credit-scoring model. TRW is the former name of Experian. The reporting bureaus are Experian, TransUnion and Equifax.

Which of the following actions are most likely to negatively impact an individual’s credit score?

a)Paying off the balance on a revolving card instead of making monthly payments

b)Underutilization of a home equity line of credit.

c)Closing out a well-established credit card account with good payment history.

d)Applying for a new auto loan every five years.

c)Closing out a well-established credit card account with good payment history

Closing established accounts that show a good payment history may have a detrimental effect on a credit score. Minimal usage on a home equity line and paying off credit card balances each month will generally improve the score. Applying for an auto loan every few years would not necessarily have a negative impact on the score unless the individual applied for several other credit extensions around the same time.

Where is a lender most likely to look for evidence of a fraud in financial statements received from a borrower in support of a loan request?

A. Understating the balance of receivables

B. Overstating payables owed to the trade

C. Including contingent sales in revenues

D. Accelerating recognition of expenses

C. Including contingent sales in revenues

In providing financial information to a lender the borrower’s motivation is to overstate assets and revenues and understate liabilities and expenses. A contingent sale still has a degree of uncertainty as to whether the sale is actually complete – and therefore should not be included in revenues until all contingencies have been satisfied.

Which business entity exposes an owner to potential liability for business obligations?

A. C corporation

B. S corporation

C. General partnership

D. Limited liability company

C. General partnership

Partners in a general partnership have joint and several liability for the obligations of the partnership. The other entities provide limited liability shields to their owners.

Which type of entity is potentially subject to a "built-in gains tax"?

a) C corporation

b) S corporation

c) General partnership

d) Limited liability company

b) S corporation

The built-in gains tax may apply to an S corporation that converted from a C corporation. Assets acquired while a C corporation, and subsequently sold within 7-10 years (depending on current tax law) for a profit, would be subject to this tax. Both general partnerships and LLCs are taxed at the ownership level only. C corporations are taxed directly on all earnings and shareholders are taxed again when the C corporation pays a dividend

Identify steps in the cash flow estimation process. In estimating cash flow from a business tax return, which of the following steps are taken?

a. Subtract depreciation and amortization

b. Add decreases in accounts receivable balances

c. Subtract increases in account payable balances

d. Add dividends and distributions paid

b. Add decreases in accounts receivable balances

When accounts receivable balances decrease it signifies that receipt of cash and are added to cash flow. Depreciation and amortization are non-cash charges that are added back to cash flow, not subtracted. Increases in accounts payable conserve/create cash flow and are added to cash flow, not subtracted. Dividends and distributions paid are cash outflows and therefore, subtracted to arrive at cash flow

When a corporate tax return indicates that it is a consolidated return, it signifies that:

A. There are intercompany loans and advances.

B. A list of subsidiaries is provided.

C. An additional controlled group tax is due.

D. There are parent guaranties of subsidiary debt.

B. A list of subsidiaries is provided.

A list of subsidiaries whose results are consolidated will appear on Form 851.

When reviewing a Form 4562(depreciation and amortization), what information will a lender learn about the business?

a)The amount of any capital gains tax payments.

b)The amount of proceeds received from used equipment sales.

c)The amount of proceeds from securities sales.

d)The amount of any fixed asset purchases

d)The amount of any fixed asset purchases

The Form 4562(Depreciation and Amortization) reports expenditures for fixed and intangible assets made during the current tax year. Capital gains tax would be included in the computation of federal tax owed for a C corporation, but owners would pay any capital gains taxes owed for S corporations, partnerships and LLCs. Proceeds from used equipment sales would appear on Form 4797(sales of business property) while proceeds from securities sales are reported on Schedule D

Tax law provides for a variety of deductions that can be used by businesses or their owners (if the business is taxed at the ownership level). Which of the following deductions would be available only to C corporations and not to S corporations, partnerships, LLCs and their owners?

A. Domestic production activities deduction

B. Net operating loss carryforwards

C. Dividends received deduction

D. Section 179 expense deduction

C. Dividends received deduction

Only a c corporation can take a deduction for some or all of the dividends received from another c corporation. The deduction is designed to avoid excessive taxation of dividends paid by one corporation to another. The other deductions are all available to all businesses and/ or their owners.

XYZ Partnership submitted a current tax return showing the following balance sheet entries. Based on the entries above, how much did the combined asset changes impact the partnership’s operating cash flow in the current year?

a) ($3,575)

b) ($1,745)

c) ($1,485)

d) ($1,140)

c) ($1,485)

Both receivables and other current assets increased, leading to a cash outflow of ($3,575). This outflow was offset in part by the $2,090 reduction in inventory. The net outflow was ($1,485).

Which type of entity is subject to an "accumulated earnings

tax"?

a. S-corp

b. C-corp

c. Sole proprietorship

d. Partnership

b. C Corp

What is Form 4797? and What will information will it provide the lender?

Sales of Business Property and it provides the amount of proceeds received from used equipment sales or other business property sales.