Five Cʼs Of Credit Analysis

The five Cʼs are one of the most important elements a banker refer to when considering a
request for a loan. Namely, these are Cash Flow, Collateral, Capital, Character and
Conditions. These five Cʼs of credit analysis help the banker in approving the loan request.

Cash Flow

Cash Flow is the first "C" of the 5 C's of Credit. The banker needs to be certain that
borrowerʼs business is generates enough cash flow to repay the loan that s/he are
requesting. In order to determine this the banker will be looking at the borrower companyʼs
historical and projected cash flow and compare that to the companyʼs 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:

Debt Service Coverage Ratio = EBITDA – income taxes – unfinanced capital expenditures
divided by Projected principal and interest payments over the next 12 months

Typically the bank will look at the companyʼs historical ability to service the debt. This
means the banker will compare the companyʼs past 3 years free cash flow to projected
debt service, as well as the past twelve months to the extent the borrower company is well
into its fiscal year. While projected cash flow is important as well, the banker will generally
want to see that the companyʼs 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 the 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 the borrower projections, s/
he must be prepared to defend her/his future cash flow projections with information that
would give the banker visibility to future performance, such as backlog information.

The banker will also want to see a comfortable margin of error in the companyʼs 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 companyʼs performance that the company will still be able to meet its
obligations.

Collateral

In most cases, the bank wants the loan amount to be exceeded by the amount of the
companyʼs 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 companyʼs 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 (the companyʼs
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, bankʼs 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 bankʼs historical experience they have realized in a liquidation scenario against
the respective asset class. While the borrower might think that s/he 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
donʼt owe the entire amount, or, worse, they wonʼt 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 wonʼt 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 the borrower 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 companyʼs
carrying value of these assets on its balance sheet. Keep in mind that the borrower 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 the borrower
accounts receivable and inventory to confirm asset values as well as the reliability of the
reports s/he provide to the bank. This due diligence is called a “collateral exam” or “field
audit”, and involves the bank sending an auditor to the companyʼs offices to review books
and records to (1) ensure that the company-generated reports for accounts receivable (the
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 the
borrowerʼs 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 the borrowerʼs companyʼs premises.
Capital

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
companyʼs 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 companyʼs 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 ownerʼs financial profile. Commonly, the bank will look at the ownerʼs
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 companyʼs Debt to Equity
Ratio. This is a measure of the companyʼs total liabilities to shareholderʼs equity. Banks
typically like to see Debt to Equity Ratios no higher than 2 to 3 times.

Conditions

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 the borrowerʼs
company and its industry to determine the key risks facing his/her company, and also,
whether or not these risks are sufficiently mitigated. Even if the companyʼs historical
financial performance is strong, the bank wants to be sure of the future viability of the
company. The bank wonʼt make a loan to the borrower today if it looks like the viability of
his/her 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 the borrowerʼs company - who is the borrowerʼs

competition? How do s/he differentiate his/herself from the competition? How does the
access to capital of the borrower company compare to the competition and how are any
risks posed by this mitigated? Are there technological risks posed by his/her competition?
Is the borrower in a commodity business? If so, what mitigates the risk of his/her
customers going to his/her competition?

• The nature of the borrowerʼs customer relationships – are there any significant
customer concentrations (do any of customers represent more than 10% of the companyʼs
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 canʼt 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 companyʼs economics? Are there any trends emerging among customers or
suppliers that in the future will negatively impact operations?

The banker will need the help of the borrower to identify and understand these key risks
and mitigates, so s/he should be prepared to articulate what s/he see as the primary
threats to her/his business, and how and why s/he is comfortable with the presence of
these risks, and what s/he is doing to protect the company. The banker will need to
understand the drivers of his/her business, which is equally as important to the banker as
understanding the companyʼs financial profile.

Character

While we have left “Character” for last, it is by no means the least important of the 5 Cʼs 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 the borrower current and former
bankers to determine how s/he has handled her/his banking arrangements in the past. The
bank may also communicate with the borrower customers and vendors to assess how s/he
has dealt with these business partners in the past. The soft side of character assessment
will be determined by how s/he 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 the
borrower will be there and do her/his best to ensure that the company honors its
commitments to the bank. Even if the companyʼs financial profile is strong and the
company has scored well in all of the other “Five Cʼs 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 the
borrower company has gone through troubled times in the past. What is more important is
how s/he dealt with the situation. Was s/he forthright and proactive with the bank in
communicating problems? Or did s/he wait until a default situation was already in effect
before reaching out to the bank? Was s/he 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 Cʼs of credit forms the basis of the bankerʼs analysis as they are
considering the request for a loan. The banker needs to be sure that (1) the borrowerʼs
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 ownerʼs commitment to the company, (4) the
CONDITIONS surrounding the borrowerʼs 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.