Five C’s of Credit (5 C’s of Banking)
The “5 C’s of credit” or “5C’s of banking” are a common reference to the major elements of a banker’s analysis when considering a request for a loan. Namely, these are Cash Flow, Collateral, Capital, Character and Conditions. This article will provide an in-depth description of each of the 5 C’s of credit or banking to help you understand what your banker needs to understand about your business in order to approve your loan. By the end of this article, you will have insight as to where your banker is coming from, and therefore better prepare you to handle their questions and concerns.
Cash Flow Importance
Cash Flow After Tax is the first “C” of the 5 C’s of Credit (5 C’s of Banking). Your banker needs to be certain that your business generates enough cash flow to repay the loan that you are requesting. In order to determine this the banker will be looking at your company’s historical and projected cash flow and compare that to the company’s projected debt service requirements. There are a variety of credit analysis metrics used by bankers to evaluate this, but a commonly used methodology is the “Debt Service Coverage Ratio” generally defined as follows:
Typically the bank will look at the company’s historical ability to service the debt. This means the banker will compare the company’s past 3 years free cash flow to projected debt service, as well as the past twelve months to the extent your company is well into its fiscal year. While projected cash flow is important as well, the banker will generally want to see that the company’s historical cash flow is sufficient to support the requested debt. Usually projected cash flow figures are higher than historical figures due to expected growth at the company, however your banker will view the projected cash flows with skepticism as they will generally entail some level of execution risk. To the extent that the historical cash flow is insufficient and the banker must rely on your projections, you must be prepared to defend your future cash flow projections with information that would give your banker visibility to future performance, such as backlog information.
The banker will also want to see a comfortable margin of error in the company’s cash flow. A typical minimum level of Debt Service Coverage is 1.2 times. This means that the company is expected to generate at least $1.20 of free cash flow for each dollar of debt service. This margin of error is important since the banker wants to be comfortable that if there is a blip in the company’s performance that the company will still be able to meet its obligations.
Importance of Collateral
In most cases, the bank wants the loan amount to be exceeded by the amount of the company’s collateral. The reason the bank is interested in collateral is as a secondary source of repayment of the loan. If the company is unable to generate sufficient cash flow to repay the loan at some point in the future, the bank wants to be comfortable that it will be able to recover its loan by liquidating the collateral and using the proceeds to pay off the loan.
How does the banker assess your company’s available collateral? It is common place for borrowers to think that the bank will lend a dollar for every asset that their company owns. This is not the case.
First, the banker is interested in only certain asset classes as collateral – specifically accounts receivable, inventory, equipment and real estate – since in a liquidation scenario, these asset classes can be collected or sold to generate funds to repay the loan. Other asset classes such as goodwill, prepaid amounts, investments, etc. will not be considered by the banker as collateral since in a liquidation scenario, they would not fetch any meaningful amounts. In the case of accounts receivable, the debtor (your company’s customer to whom a good was sold or service rendered) is legally required to pay their bill with the company, and in a liquidation scenario the bank will collect the accounts receivable and use those amounts to pay down the loan. In the case of inventory, equipment and real estate, the bank can sell these assets to someone else and use the proceeds to pay down the loan.
Secondly, the bank will discount or “margin” the value of the collateral based on historical liquidation values. For example, bank’s will generally apply margin rates of 80% against accounts receivable, 50% against inventory, 80% against equipment and 75% against real estate. These advance rates are not arbitrary. These are the amounts that in the bank’s historical experience they have realized in a liquidation scenario against the respective asset class. While you might think that your accounts receivable would collect 100% on the dollar, in actuality the amounts have been historically closer to 80% because in liquidation scenarios, account debtors will come up with reasons why they don’t owe the entire amount, or, worse, they won’t pay at all and force the bank to sue them for collection. In some cases, the amount of the receivable would be exceeded by the legal costs of collection, and thus the bank simply won’t pursue collection. In the case of inventory, 50 cents on the dollar is usual since the buyers of this inventory know that it is a distressed sale and are in a position of leverage to buy the goods for less than what it cost you to buy them.
In the case of equipment and real estate collateral the bank will need to have a third party appraisal completed on these assets. The bank will margin the appraised value of these asset classes to determine the amount of the loan, as opposed to using the company’s carrying value of these assets on its balance sheet. Keep in mind that you will be responsible for the cost of third party appraisals, and be sure to factor in the time needed to complete the appraisals.
Also, the bank will in many cases want to complete due diligence on your accounts receivable and inventory to confirm asset values as well as the reliability of the reports you provide to the bank. This due diligence is called a “collateral exam” or “field audit”, and involves the bank sending an auditor to the company’s offices to review books and records to (1) ensure that the company-generated reports for accounts receivable (your accounts receivable aging) and inventory are accurate and reliable, and (2) to determine and confirm the amounts of any “ineligibles” within these asset classes. In general, ineligibles are amounts that the bank will not lend against. For example accounts receivable over 90 days past due, accounts that are due from foreign counter-parties, and accounts that are due from counter-parties that are related by common ownership to your company. In the case of inventory, ineligibles will generally include any work-in-process inventory, any consignment inventory, and inventory that is in-transit or otherwise not on your company’s premises.
Importance of Capital to Banks
When it comes to capital, the bank is essentially looking for the owner of the company to have sufficient equity in the company. Capital is important to the bank for two reasons. First, having sufficient equity in the company provides a cushion to withstand a blip in the company’s ability to generate cash flow. For example, if the company were to become unprofitable for any reason, it would begin to burn through cash to fund operations. The bank is never interested in lending money to fund a company’s losses, so they want to be sure that there is enough equity in the company to weather a storm and to rehabilitate itself. Without sufficient capital, the company could run out of cash and be forced to file for bankruptcy protection.
Secondly, when it comes to capital, the bank is looking for the owner to have sufficient “skin in the game”. The bank wants the owner to be sufficiently invested in the company such that if things were to go wrong, the owner would be motivated to stick by the company and work with the bank during a turnaround. If the owner were to simply hand over the keys to the business, it would clearly leave the bank fewer (and less viable) options on how to obtain repayment of the loan.
There is no precise measure or amount of “enough capital”, but rather it is specific to the situation and the owner’s financial profile. Commonly, the bank will look at the owner’s investment in the company relative to their total net worth, and they will compare the amount of the loan to the amount of equity in the company – the company’s Debt to Equity Ratio. This is a measure of the company’s total liabilities to shareholder’s equity. Banks typically like to see Debt to Equity Ratios no higher than 2 to 3 times.
Another key factor in the five C’s of credit is the overall environment that the company is operating in. The banker is going to assess the conditions surrounding your company and its industry to determine the key risks facing your company, and also, whether or not these risks are sufficiently mitigated. Even if the company’s historical financial performance is strong, the bank wants to be sure of the future viability of the company. The bank won’t make a loan to you today if it looks like the viability of your company is threatened by some unmitigated risk that is not sufficiently addressed. In this assessment, the banker is going to look to things such as the following:
• The competitive landscape of your company – who is your competition? How do you differentiate yourself from the competition? How does the access to capital of your company compare to the competition and how are any risks posed by this mitigated? Are there technological risks posed by your competition? Are you in a commodity business? If so, what mitigates the risk of your customers going to your competition?
• The nature of your customer relationships – are there any significant customer concentrations (do any of your customers represent more than 10% of the company’s revenues?) If so, how does the company protect these customer relationships? What is the company doing to diversify its revenue base? What is the longevity of customer relationships? Are any major customers subject to financial duress? Is the company sufficiently capitalized to withstand a sizable write-down if they can’t collect their receivable to a bankrupt customer?
• Supply risks – is the company subject to supply disruptions from a key supplier? How is this risk mitigated? What is the nature of relationships with key suppliers?
• Industry issues – are there any macro-economic or political factors affecting, or potentially affecting the company? Could the passage of pending legislation impair the industry or company’s economics? Are there any trends emerging among customers or suppliers that in the future will negatively impact operations?
The banker will need your help to identify and understand these key risks and mitigants, so be prepared to articulate what you see as the primary threats to your business, and how and why you are comfortable with the presence of these risks, and what you are doing to protect the company. The banker will need to understand the drivers of your business, which is equally as important to the banker as understanding the company’s financial profile.
While we have left “Character” for last, it is by no means the least important of the 5 C’s of Credit or Banking. Arguably it is the most important. Character gets to the issue of people – are the owner and management of the company honorable people when it comes to meeting their obligations? Without scoring high marks for character, the banker will not approve your loan.
How does a banker assess character? After all, it is an intangible. It is partly fact-based and partly “gut feeling”. The fact-based assessment involves a review of credit reports on the company, and in the case of smaller companies, the personal credit report of the owner as well. The bank will also communicate with your current and former bankers to determine how you have handled your banking arrangements in the past. The bank may also communicate with your customers and vendors to assess how you have dealt with these business partners in the past. The soft side of character assessment will be determined by how you deal with the banker during the application process and their resultant “gut feeling”.
In the end, bankers want to deal only with people that they can trust to act in good faith at all times – in good times and in bad. Banks want to know that if things go wrong, that you will be there and do your best to ensure that the company honors its commitments to the bank. Even if the company’s financial profile is strong and the company has scored well in all of the other “Five C’s of Credit”, the banker will turn down the loan if the character test is failed. To be clear – it is not necessarily an issue if your company has gone through troubled times in the past. What is more important is how you dealt with the situation. Were you forthright and proactive with the bank in communicating problems? Or did you wait until a default situation was already in effect before reaching out to the bank? Were you cooperative with the bank while getting through the distressed period? The importance of character cannot be stressed enough.
Five C’s of Credit Management
To summarize, the 5 C’s of credit forms the basis of your banker’s analysis as they are considering your request for a loan. The banker needs to be sure that (1) your company generates enough CASH FLOW to service the requested debt, (2) there is sufficient COLLATERAL to cover the amount of the loan as a secondary source of repayment should the company fail, (3) there is enough CAPITAL in the company to weather a storm and to ensure the owner’s commitment to the company, (4) the CONDITIONS surrounding your business do not pose any significant unmitigated risks, and (5) the owners and management of the company are of sound CHARACTER, people that can be trusted to honor their commitments in good times and bad.
Hopefully this article has succeeded in helping you understand where your banker is coming from. With a better understanding of how your banker is going to view and assess your company’s creditworthiness, you will be better prepared to deliver information and position your company to obtain the loan that it needs to grow and thrive. You should use these 5 C’s as a credit managment tool to run your company.