By: Darrick Brown, Banker, Consultant and Facilitator.
When I first began my career as Banker, I found myself in consumer credit department making car loans, home equity loans and lines and debt consolidation loans which were very popular in the 80’s and 90’s. The 5 C’s of credit was one our key methods to determine the credit worthiness of a prospective borrower. It helped us to gauge whether or not the client was a good credit risk or not.
Years later, I was selected by my bank to join a Business Banking “Fastrack” training” program. I learned to read financial statements, business and personal tax returns, spread them, interpret them for cash-flow analysis and more. I also became exposed to many financial formulas related the cashflow of the businesses applying for loans. To my surprise, even in commercial lending the “5 C’s of credit” became more prevalent as Commercial Lenders would use as a tool to obtain “Public View” of the client and their business financial history. Because a number of commercial loans may require a “Personal Guarantee (Guarantor) the principal(s) qualification can and will be fed into credit sifter machine only to see what remains in the Credit Bowl. So… let’s take a closer look!
The 5 C’s of Credit
1) CAPACITY: How do you intend to pay?
2) CAPITAL: How much have in personally invested?
3) COLLATERAL: Can you pledge an asset?
4) CONDITIONS: Purpose of the loan?
5) CHARACTER: Are you trustworthy to pay the loan back? Does your history “Reflect” it? Let’s say FICO score.
Now, let’s dig a little deeper…
A business’s ability to repay the loan form its monthly cash flow which what every lender looks for. The borrower must show documented proof can repay the loan with additional resources (cushion) for the unexpected. Capacity is usually measured with a key formula known as DSC or Debt Service Coverage. It is generally measured by taking Net Income +Depreciation+ Interest Expense and dividing it by the Debt Service. Most banks like to see the ratio around 1.255 or higher. The higher the number the better as it indicates that the borrower can afford to make the monthly loan payment.
The borrower’s net worth is defined by its capital. However, for a business, this is the value of their investment or initial business funding, which includes outstanding shareholder loans and retained earnings (keep in mind the business formation could have impact). A positive net worth provides the lender with assurance that the borrower will have sufficient additional assets in which to repay the loan in the event of a change in business capacity. Also referred to Skin in the game from a cash injection typically with acquisition/purchases of a business and or equipment.
This consist of the borrowers personal and business assets own and are willing to pledge as security to back the loan. If Character and Capacity is strong their usually less a need for strong collateral. However in most cases lenders will require a 1:1 collateral coverage position to back their loan in the event the borrower(s) default. Collateral or business asset for a business include; business real estate, accounts receivables, inventory, equipment, home and or investment properties.
What is conditions? Conditions remains high on the lenders mind more from a subjective perspective than objective. This for example could be the review of the local, national and even global economy. Questions that may come up are; is the business in a growth mode, recession and what impact can affect the business relative to industry?
Specifically, change in raw material prices, rising or decreasing rates such as our current challenge in the countries oil and gas industry. Some banks will not lend to business where their concentration leans heavily in the oil & gas markets or how about the Marijuana base businesses.
This is one of the most important factors to most lenders especially when considering an approval for Bank- par pricing (aka traditional lending). It speaks directly to the borrowers “Integrity” and willingness to repay their loan. This is achieved by pulling the borrowers D&B or Paydex score for their business and their personal FICO Score” via one of the 3 credit agencies. The Credit Bureau reports the borrowers information provided by lenders that have extended credit. The lender’s will review the FICO (Fair Isaac Corporation) score generally a numeric value between 300 and 850 noting the higher the better.
Many borrowers avoid applying for credit because they were not aware of the 5 C’s of credit and how it can help to grow, sustain and some case make or break a business. The 5 C’s remain the “CORE” or should I say the main core of every bank’s loan decision. Yes different financial institutions may place different emphasis on any one of these factors, however they always assess each to help them to make their decision to fund or not to fund a prospective borrower.