The practice of lending has been in existence for centuries, and has been guided by what is popularly known as the ‘4 Cs of credit’. This refers to the basic factors that lenders consider among other things in extending credit to companies or individuals.
The four Cs are: character, capacity, capital and collateral . Condition has on occasion been added to the list as the fifth ‘c’ of lending.
Character is determined by looking at what kind of "financial citizen" the intended borrower is. This is determined by looking at the borrower’s history of meeting financial obligations. Credit history provides a picture of how the business or its promoters have handled previous financial dealings, the existence of civil judgments against them, unpaid tax liabilities, liens against their assets, or if the business or its owner has filed for bankruptcy protection. It may well include experience in business and industry; the quality of references as well as the background and experience levels of employees. Albeit, character is a subjective opinion, and certainly the least quantifiable of the ‘Cs’. Yet it is important and shows whether or not borrower is sufficiently trustworthy to repay the loan. It also demonstrates integrity and credibility, among other things, and can reveal intent.
Capital is the portion of the total cost of required investment which must be contributed by the borrower. It is money personally invested by prospective borrower in his/her business. This is a measure to assure the lender of the business owner’s commitment as well as reduce the lender’s exposure to loss. Lender’s capital requirement is determined by the nature of business, level of perceived risk, availability and value of borrower’s collateral.
Collateral or guarantee is additional form of security provided by the borrower as a secondary source of repayment. Collateral usually is a tangible asset owned by borrower, while a guarantee is just that someone else who signs a guarantee document promising to repay the loan if borrower is unable to).
Capacity refers to the ability of the business to repay the loan on agreed terms from revenue generated from its operations in the normal course of business. This is cash flow from excess of income over expenses. To the lender, this represents the primary source of repayment for the loan, liquidation of collateral is never considered a primary source of repayment and lenders only revert to it as a last resort. There are several indicators of capacity to generate cash for repayment. the financial statement is a valuable source of information to determine capacity through calculation of key indices like: Earning before interest; tax; depreciation and amortization (EBITDA); debt service coverage ratio(DSCR); liquidity; profitability; trading cycle and other sales and asset turnover ratios; debt equity ratio and the changes in cash position from the cash flow statement. In addition, factors like the firm’s position in the market, experience in the industry, and track record in business will determine, in the lender’s eyes, if the borrower is a qualified candidate.
Condition refers to the national and local economy, the industry and the lending institution’s current level of losses and problem credits. Here the lender is looking out for interest rate, trends in industry, consumer purchasing power, economic cycle, recession or expansion to determine how these factors would affect the business.
How important a particular 'C' is to the lender is often times dictated by prevailing economic conditions as well as the lenders financial position and the comfort level that can be forged between the two sides. Character for one is often the forgotten ‘C’ during good economic times. For instance, in the days of easy credit of the past decade, banks were willing to extend credit even with borrower’s poor credit rating. 'No documentation loans' became very popular where the borrower revealed little information about him/herself. From the lender’s viewpoint, the single most important of the ‘Cs’ of credit is probably capacity, because the ultimate goal of the lender in extending credit is to receive repayment which preserves the lender’s capital and allows him/her to remain in business. The collateral is at best a tertiary source of repayment. Majority of lenders would rather not be involved with collateral liquidation as this is not their primary business and the financial reporting requirements make the reporting of non-performing assets an unattractive item. Character, though an excellent portrayal of past behavior and an indicator of intent, is not an assurance of future capacity to repay, as borrower’s circumstances do change. A downturn in the economic climate can lead to poor product or service performance or financial structure all of which can impair a business's ability to repay it debts. A combination of all five ‘Cs’ certainly provides a superior measure for appraising lending decisions.
The importance of the 'Cs' from the borrower 's viewpoint is a function of the financial capacity of the borrower and the nature of the project to be funded. For the brand new product launch it may be impossible to objectively determine the acceptability of the product or service, and hence its capacity to generate cash inflow. Therefore the business owner is unable to demonstrate capacity in an objective manner. Nevertheless, the lender may decide on the strength of character and collateral to extend the credit facility.
Sources
http://biztaxlaw.about.com/od/financingyourstartup/a/4csofcredit.htm
http://www.loanuniverse.com/credit.html
http://www.finweb.com/loans/the-five-cs-of-lending.html
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