The 5 Cs Of Credit

Character, Collateral, Capacity, Conditions, Cash Flow

I recently had a discussion with a commercial loan officer about the 5 Cs of Credit. Some of them are obvious, all are important.

Character refers to the integrity of the borrower. For mid size companies ($2 million to $20 million in revenue) it means the operational and credit history of the company. But most important, it refers to the reputation and integrity of the company owner(s). The owner’s credit history is important, his or her credibility is critical.

Collateral is easy. What will be the secondary source of repayment, if the cash flow does not pan out? What is the liquidity and excess value of any collateral that the lender could look to, before having to pursue collecting on any personal guarantees? Collateral is the asset the banker or investor refers to when saying: “Don’t tell me about the return on my money, tell me about the return of my money.”

Capacity generally refers to the excess net worth of the company and the owner beyond any current debt balances. The lender will consider business net worth, and personal net worth. How highly leveraged is the borrower already? Can this loan be successfully repaid under agreed original terms, considering current leverage and debt repayment obligations?

Conditions means general market and industry economic circumstances. Is the economy in recession or expanding? What about the particular niche in which the company operates? I also use this “C” to remind clients that there will be borrowing conditions: debt covenants, fixed charge coverage ratios, limits on future borrowings, etc. Conditions in the economy and particular industry are very important, but don’t forget the conditions that will be placed on the borrower. Constraints would be a good reminder as a 6th C of credit.

Cash Flow. This is most important. All other Cs notwithstanding, the lender wants to know how the cash flow will repay the loan. And how reliable are the cash flow projections? Will the loan still cash flow if the projected increased sales, or reduced costs, or investment returns don’t turn out to be as strong as projected? How aggressive are the assumptions driving the cash flow model? Lenders want the loan to pay back with conservative assumptions. Will it? The demand for cash flow from use of the loan proceeds is what causes banks to avoid lending to start ups, because start ups invariably suffer start- up cash flow losses for expenses, marketing, design, business development, etc. That is not cash flow in, that is cash flow out. Banks lend on positive anticipated near term cash flow in.

5 Cs of Credit. Clients seeking new loans, or expanded loan capacity, must consider them. Because the banker wants to know.