The “6 C’s of credit” or “6C's of banking" are a common reference to the major elements of a banker’s analysis when considering a request for a loan.
Is the Borrower Creditworthy?
The question that must be dealt with before any other is whether or not the customer can service the loan –that is, pay out the credit when due, with a comfortable margin for error.
6 C’s of Credit
The first thing that loan officers look for when reviewing a proposal is evidence of your trustworthiness. Your loan application can be rejected without even reviewing your proposed business idea if loan officers find any evidence in your background indicating lack of integrity.
Responsibility, truthfulness, serious purpose, and serious intention to repay all monies owed make up what a loan officer calls character.
If the loan officer feels the customer is insincere in promising to use borrowed funds as planned and in repaying as agreed, the loan should not be made, for it will almost certainly become a problem credit.
If the bank feels that confident about your personal background and your ability to make good judgments when making business decisions, the next step for them is to determine the capability of your business to turn up a profit. They will now ask: "What is your ability to repay the loan? How are the loan proceeds to be used? How will they be repaid?"
The loan officer must be sure that the customer has the authority to request a loan and the legal standing to sign a binding loan agreement. This customer characteristic is known as the capacity to borrow money.
For example, in most areas a minor (e.g., under age 18 or 21) cannot legally be held responsible for a credit agreement; thus, the lender would have great difficulty collecting on such a loan.
Similarly, the loan officer must be sure that the representative from a corporation asking for credit has proper authority from the company’s board of directors to negotiate a loan and sign a credit agreement binding the company.
Where a business partnership is involved, the loan officer must ask to see the firm’s partnership agreement to determine which individuals are authorized to borrow for the firm. * A loan agreement signed by unauthorized persons could prove to be uncollected and, therefore, result in substantial losses for the lending institution.
This feature of any loan application centers on the question: Does the borrower have the ability to generate enough cash –in the form of cash flow –to repay the loan?
In general, borrowing customers have only 3 sources to draw upon to repay their loans:
a.) cash flows generated from sales or income
b.) the sale or liquidation of assets
c.) funds raised by issuing debt or equity securities.
However, lenders have a strong preference for cash flow as the principal source of a loan repayment because asset sales can weaken a borrowing customer and make the lender’s position as creditor less secure. Moreover, shortfalls in cash flow are common indicators of failing business and troubled loan relationships.
What is cash flow?
Cash flow= Net Profits + Noncash Expenses
(or total revenues (especially
less all expenses) depreciation)
Traditional cash flow measures point to at least five major areas loan officers should look at carefully when lending money to business firms or other institutions. These are: 1. The level of and recent trends in sales revenue (which reflect the quality and public acceptance of products and services). 2. The level of and recent changes in COGS (including inventory cost) 3. The level of and recent trends in selling, general and administrative expenses (including the compensation of management and employees). 4. Any tax payments made in cash.
5. The level of and recent trends in non cash expenses (led by depreciation...