5 C's of Credit

What does a lender look for when evaluating a loan request?  While each lending situation is unique, many lenders utilize some variation of evaluating the five Cs of credit:  character, capacity, capital, collateral, and conditions.

  1. Character is the moral obligation that a borrower feels to repay the loan. Since there is not a accurate quantifiable measure to judge character, the lender will decide subjectively whether or not you are sufficiently trustworthy to repay the loan. The lender will investigate your past payment experience, review a credit bureau report, and consider your educational background and experience in business. The quality of your references and the background and experience of your employees will also be considered.  Character and capacity (covered next) are the most important of the 5 Cs.
  2. Capacity refers to the company’s ability to generate sufficient cash flow from operations to meet the loan payments.  Since this represents the primary source of repayment for a loan, the prospective lender will want to know exactly how you intend to repay the loan. The lender will consider the cash flow from the business, the timing of the repayment, and the probability of successful repayment of the loan.

    We generally calculate cash flow by adding the depreciation and amortization expense back to earnings before interest and taxes (EBIT - also called net operating income). This sum is called EBITDA, for Earnings Before Interest, Taxes, Depreciation, and Amortization.  Since depreciation and amortization are not cash expenses, they should be added back to EBIT to determine the cash flow available for things such as loan payments, capital spending, and taxes.

    Next the cash flow will be compared to the company’s current obligations (debt service). Debt service is simply the anticipated principal and interest payments on all debt.  Generally, an electronic spreadsheet is used to model the cash flows (by assuming various levels for Sales) to determine the risk of not being able to meet the principal and interest payments.

  3. Capital is the money you personally have invested in the business and is an indication of how much you will lose should the business fail.  Lenders expect you to contribute your own assets and to undertake personal financial risk before asking them to commit any funding.  If you have a significant personal investment in the business, you are more likely to do everything in your power to make the business successful.

    Lenders will generally consider the company's debt-to-equity ratio to understand how much money the lender is being asked to lend (debt) in relation to how much the owners) have invested (equity).

  4. Collateral or third-party guarantees are additional forms of security you can provide the lender. If the business' cash flows are not adequate to repay the loan, the bank wants to know there is a second source of repayment. Equipment, buildings, accounts receivable, and inventory may be seized and sold by the bank if the company defaults on the debt.  The loan agreement should carefully identify any items that serve as collateral.  Business owners may be asked to place personal assets (home, stocks, bonds, etc.) in addition to the business assets as collateral for a loan. In some cases, the lender may ask for a third-party guarantee where someone else signs a guarantee document promising to repay the loan if you can't.

    A lender will normally want the term of the loan to match the useful life of the asset used as collateral.  If equipment with a five-year expected life is used as collateral, then the term of the loan will generally be five years or less.

  5. Conditions refer to national and local economic conditions.  How sensitive is the company's sales to the overall economy?  If the country enters a recession soon, will the company's sales fall dramatically or can they be expected to be relatively unaffected (like a grocery store chain, for example).  Companies with stable sales that are not tied closely to the overall economy are generally looked upon more favorably by lenders.