What goes into making a loan decision?
You’ve completed the application, submitted all the documents and answered any questions that have come your way. You feel as though you’ve given the lender everything they could possibly need, and you’re wondering what could they possibly be doing with the information?
While every lending institution will have different credit approval standards used in underwriting and approving loans, the framework is typically based on something known in the industry as the Five C’s of Credit —character, capital, capacity, collateral and conditions. Below is a high-level overview of what the Five C’s are, and how they’re are used to make lending decisions.
The Five C's of Credit
While historical financial information can provide insight into the financial health of the applicant, the character question is looking to answer the following:
- the depth of the management team, does the applicant have qualified people in the key roles, how has the management team performed historically
- Willingness to repay the loan, despite unanticipated adversity, honesty, reputation in the community or industry.
- Is there a succession plan in place, is there an appropriate amount insurance in place to protect from loss, are industry best practices being followed
- What type of litigation is or has there been in the operation, including but not limited to bankruptcies, foreclosures, other creditor judgments
For smaller individual applications where a credit scoring methodology is utilized character can manifest itself in the individual’s credit score, as this will factor in payment history, delinquencies and reported litigation.
This is really the first foray into evaluating the financial position of the company. When evaluating capital, the focus will primarily be on the customer’s balance sheet. The quality of assets, amount of working capital, liquidity, debt structure, leverage, and changes in balance sheet composition over time will all be examined. While an income statement is evidence of current year’s results, the balance sheet reveals the impact of management choices over time.
When evaluating the balance sheet lenders will typically look at the following ratios:
- Current Ratio (current assets ÷ current liabilities)
- Leverage Ratio (total liabilities ÷ owner equity)
- Equity Ratio (net worth ÷ total assets)
The higher the liquidity and lower the leverage position of the borrower, the more flexibility management will have to react to changing operating conditions. What is an appropriate measure of the above ratios can vary by industry and economic conditions.
Capacity is the evaluation of the earnings of the customer and the ability of those earnings to meet current debt payments, proposed debt payments, taxes, fund business growth, replace assets, provide for adequate family living expenses and build a reserve to draw upon in the event of adversity.
Lenders will typically look to understand both a primary repayment source, typically ongoing earnings of the business or individual, and a secondary repayment source such as liquidity or other assets that could be converted to cash.
Capacity is often measured as some expression of Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) over required expenditures. Two variations are presented below:
- Debt Coverage Ratio (EBITDA ÷ debt service obligations)
- Fixed Charge Coverage Ratio: (EBIDTA – Maintenance Capex – Taxes - Dividends ÷ Debt Service)
For both of the ratios above the higher the number the more adversity a borrower can withstand before being unable to make their loan payments.
For most operating and all real estate loans collateral is required as a condition to receive the loan. The type of collateral will vary depending on the purpose of the loan and can include crops, inventory, accounts receivable, equipment and real estate. Most lenders view collateral as a secondary or tertiary source of repayment in the event that earnings are not sufficient to liquidate the loan and a collection action becomes necessary.
There are many factors that can go into determining the acceptability of collateral offered. Collateral offered will be inspected by the lender or a qualified representative of the lender to evaluate the condition and market value. Advance rates will also vary by the type of collateral offered.
Conditions refers to the both the status of the business, the industry in which it operates and the current outlook for the overall economy. Is the business growing, shrinking, profitable, losing funds, a leader in the industry or a startup, is the industry growing or shrinking, are all items that will addressed in the evaluation of conditions. Additionally, conditions to extending the credit such as covenants, down payment amounts, financial reporting requirements and other terms required by the lender to make the loan to reduce risk in any particular area would be considered here.
The Five C’s of Credit allow lenders to individually assess the strengths and weaknesses when evaluating a loan request so that we can give our members and ourselves the best chance of success.