Every day millions of people and businesses around the world approach their bank or financial institution requesting loans or other banking facilities to expand their businesses, buy a home, a car, take a family vacation, or simply to refinance existing loans. While no two customers share the same financial profile and needs, some loan applications are approved while others are rejected.
Furthermore, interest rates and other terms and conditions vary a great deal between borrowers. Hence, the most common question asked to a banker:
“What information are you looking for from me or my business if I need to borrow money?”
Simply stated: Bankers need to establish the willingness and ability of the borrower to make the interest and principal payments on time. Additionally, the borrower has to comply with all the Terms and Conditions attached to the loan. In order to establish the ‘willingness and ability’ criteria, most banks require their credit officers to utilise some variations of the 5Cs of credit when making credit decisions.
The 5Cs of credit contains the pertinent elements a banker has to understand and verify about your business before making the credit decision. The 5Cs is an abbreviation for Capacity, Character, Collateral, Capital, and Conditions.
This article will help you understand the bank’s perspectives and will, hopefully, better prepare you to handle their questions and concerns.
Capacity (or Cash Flow):
The banker has to be certain that the borrower, individual or business, can generate enough cash flow to repay each installment when due. In order to acquire this information the banker will look at the historic and prospective cash flows of the company and compare the figures to the projected debt service requirements. In addition, the banker will analyse the financial statements and will use certain ratios such as Free Cash Flow (FCF) and Debt Service Coverage Ratios (DSCR). The banker appreciates a comfortable margin of error in the company’s cash flow. A typical minimum level of DSCR is 1.25 times indicating that the company is expected to generate at least $1.25 for each dollar of debt they have.
This is considered a secondary source for loan repayment. Thus, if the borrower fails to generate adequate amounts of cash flow to make the loan repayments on time, the bank will have the legal right to liquidate the collateral and use the proceeds to settle the loan. The banker accepts only certain types of assets as collateral such as land, buildings, accounts receivables, and inventories because these assets are liquid in nature and their value can be reasonably estimated. Bankers usually demand a cushion of comfort in case the value of the collateral declines.
Arguably this is the most important of the 5Cs. This factor determines the willingness of the borrower to repay the loan as required. Bankers like to deal with customers of the highest moral standards who act in good faith and are dependable. Although this is an intangible trait, bankers need to satisfy themselves by checking credit history, education, communicating with his vendors and customers. This feature is most important in difficult financial times at which time the character issue becomes very crucial.
The banker is interested in the capital structure for two main reasons; first, if the company becomes unprofitable the banker may not feel comfortable funding these losses but rather will be pleased to know that the capital is there as a cushion. Secondly, well capitalised companies show the level of commitment of the owners and their confidence in its management, business line, and future. The banker should also keep the ratio of debt to equity at reasonable rates.
Bankers will not extend facilities to any company if its viability is threatened by some unmitigated risk that is not sufficiently addressed. Basically, the banker will look at the competitive position of your company vis-a-vis other companies in the same industry, the nature of your customer relationships, supply of raw materials, risks, political instability etc. These macro-economic factors are very important for the banker to analyse and understand how you plan to mitigate them.
To summarise, the 5Cs of credit form the basis of any banker’s analysis when considering your request for a loan. If properly conducted, it helps manage the credit risk and keeps it at an acceptable level. Nobody can ensure 100% success in credit decisions. However, careful study of the borrower will reduce the likelihood of being exposed to bad customers. Hopefully this article will help you to be better prepared to obtain the loan you need for your business to grow and thrive.