The 5 C’s of Credit
by Kevin Stocking, Senior Vice President Heber Valley Bank
As I talk to business owners throughout the area on a daily basis, there continues to be a frustration that exists in regards to obtaining capital. “Why is it so hard to get a bank to lend to me?”, many ask. Others comment, “A bank will only lend me money when I don’t need it!” or we hear, “I have this great vision and plan to start a new business, but no one will believe in me.” If you have ever had similar thoughts, you are not alone.
As we are slowly creeping out of this economic downturn we have recently experienced, Business Owners are looking for capital to invest into their businesses.
I would like to share with you a few ideas of what we as a lender look for when making credit decisions. In banking, they are known as the “5 C’s of credit,” namely Cash Flow, Collateral, Capital, Character and Conditions. The “5 C’s of credit” are a common reference to the major elements of a banker’s analysis when considering a request for a loan. I hope to provide you with a brief overview of each of the 5 C’s of credit to help you understand what your banker needs to understand about your business in order to approve your loan. This will provide you with an insight as to where your banker is coming from, and therefore better prepare you to handle their questions and concerns.
Cash Flow is the first and most important "C" of credit. 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 your banker will be looking at your company’s historical and projected cash flow and compare that to the company’s existing and projected debt service requirements. The most common methodology to calculate this is the “Debt Service Coverage Ratio” generally defined as follows:
Debt Service Coverage Ratio = EBITDA - income taxes – unfinanced capital expenditures, divided by the total of existing and projected principal and interest payments over the next 12 months
The banker will 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.
Collateral is the next most important “C” of credit. In most cases, the bank wants the loan amount to be exceeded by the amount of 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. For example, bank’s will generally apply margin rates of 75% 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 bank’s historical experience they have realized in a liquidation scenario against the respective asset class.
Capital is the 3rd “C” of credit. 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 company’s 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 company’s 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.
Conditions is the 4th “C” of credit. It is important for us to review the overall environment that the company is operating in. The banker is going to assess the conditions surrounding your company and its industry to determine the key risks facing your company, and also, whether or not these risks are sufficiently mitigated. Even if the company’s historical financial performance is strong, the bank wants to be sure of the future viability of the company. The bank won’t make a loan to you today if it looks like the viability of your company is threatened by some unmitigated risk that is not sufficiently addressed.
Character is the 5th “C” of credit. While we have left “Character” for last, it is by no means the least important of the 5 C’s of Credit. 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.
Hopefully this discussion has succeeded in helping you understand where your banker is coming from. With a better understanding of how your banker is going to view and assess your company’s creditworthiness, you will be better prepared to deliver information and position your company to obtain the loan that it needs to grow and thrive. You should use these 5 C's as a credit management tool to run your company.
Here at Heber Valley Bank, we pride ourselves on personable, knowledgeable, and friendly service by our loan officers to help guide you through the lending process. We are a locally owned community bank and all of our lending decisions are made by our officers. We strive to understand your business and strive to help you succeed when searching for your financing needs.