5cs of Credit

Topics: Balance sheet, Asset, Debt Pages: 8 (2496 words) Published: September 13, 2013

The five key elements a borrower should have to obtain credit: character (integrity), capacity (sufficient cash flow to service the obligation), capital (net worth), collateral (assets to secure the debt), and conditions (of the borrower and the overall economy).

Five C's of Credit (5 C's of Banking)

1. Cash Flow
2. Collateral
3. Capital
4. Character
5. Conditions

The “5 C’s of credit” or "5C's of banking" are a common reference to the major elements of a banker’s analysis when considering a request for a loan. Namely, these are Cash Flow, Collateral, Capital, Character and Conditions. This article will provide an in-depth description of each of the 5 C’s of credit or banking to help you understand what your banker needs to understand about your business in order to approve your loan. By the end of this article, you will have insight as to where your banker is coming from, and therefore better prepare you to handle their questions and concerns.

Capacity/Cash Flow Importance¶
Cash Flow is the first "C" of the 5 C's of Credit (5 C's of Banking). Your banker needs to be certain that your business generates enough cash flow to repay the loan that you are requesting. In order to determine this the banker will be looking at your company’s historical and projected cash flow and compare that to the company’s 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. (Other analysts just use EBITDA as numerator)

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

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

Importance of Collateral¶
In most cases, the bank wants the loan amount to be exceeded by the amount of the company’s 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 company’s 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...
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