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The New 5 C's - Sep 3, 2009

Posted by: David Alan Buslee in Articles

Recently I read another blog about the 5 C's of credit -- character, capacity, capital, collateral, and conditions – the mnemonic criteria used to assess a borrower's creditworthiness. Character, capacity, capital, and collateral refer to the borrower's willingness and ability to repay the debt. Conditions include the borrower's situation as well as general economic factors. While these concerns have long be the basis of banks and customers to understand the credit process, in today’s market we need to look at other “C”s to be able to assess the commercial relationship.

Character – This is always listed first as it is the basis of the commitment. This comes from the day when a banker could look the borrower in the eye from across the table and judge by the firmness of the handshake and the reputation in the community just what sort of person was asking for money. “How is the owner considered in the community” is a good example of a character question and while asking such questions can be revealing about the owner, what really needs to be considered is the Culture of the organization he runs. How do they treat customers? Vendors? Employees? How the organization treats these stakeholders will reflect how they will think of their credit relationship, because the organization reflects all of the people who affect performance as well as the markets in which the organization operates.

CAPACITY – This reflects the way in which the company intends to repay the loan. CASH FLOW is what we should really be thinking about – not a formulaic EBITDA number, but has the company thought about the additional inventory that is demanded for this expansion. What about the increase in Accounts Receivable? More to the point – does the customer track and project their cash flow and cash requirements? It is one thing to provide a static spreadsheet at the time of the credit request based on what the company thinks the cash flow will be, but do they have a way to track and project their cash needs? If not, how will they be able to maintain their cash flow to insure repayment?

CAPITAL – This reflects the value that the owner has retained in the business – retained earnings, contributed capital, capital stock. How much money has been invested in the company? A common mistake in looking at financial statements of privately held companies is to think that capital acts the same as in public companies. Not true and dangerous. By adjusting their draws – which are on top of their salaries – owners can change the capital investment in the company during the year. Monitoring the CAPITAL FLOW – are the owners taking more out in draws than the company is generating in earnings – is difficult if the financial statements aren’t being generated according to GAAP on a timely basis.

COLLATERAL – Traditionally is what “security” is being offered in the transaction? But let’s face it, no lender wants to be liquidating collateral; the nation is awash in REO property. But a key intent of collateral was to measure the borrower’s COMMITMENT to their business and to their lender. Commitment is easier to measure than the value of the collateral, which can change based on the market, technology, or ability to attach. Commitment can be measured by whether the company generates and maintains budgets. Does it “plan the work and work the plan?” Does its performance to the plan matter or is the owner more likely to be found on the golf course than at a customer?

CONDITIONS - the intended purpose of the loan. Will the money be used for working capital, additional equipment or inventory? What are the current economic conditions and how does your company fit in? Does the company know who their competitors are? What their market share is? What will happen if the conditions change? In today’s environment, does the company have a CONTINGENCY to react to changes? If so, they have thought through foreseeable impacts and have a handle on managing their company.

CULTURE, CASH FLOW, CAPITAL FLOW, COMMITMENT and CONTINGENCY are the new 5C’s of credit or any commercial relationship. B2BCFO works with companies up to $100 million to provide answers to these new 5C’s – establishing and maintaining a 13 week CASH FLOW forecast, generating and maintaining timely GAAP compliant financials, establishing and maintaining strategic plans and operational budgets and asking the hard “What If” questions to consider CONTINGENCY planning. Does the company have the CULTURE and CHARACTER to bring on board B2BCFO? If it does they will have made a COMMITMENT to the future.