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

Banking)
Cash Flow
Collateral
Capital
Character
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.

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Cash Flow
Cash Flowis 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 metrics used by bankers to analyze 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 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.

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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 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 (your
company’s 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, bank’s 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 bank’s historical experience they
have realized in a liquidation scenario against the respective asset
class. While you might think that your 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 don’t owe the entire
amount, or, worse, they won’t 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 won’t 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 you 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
company’s carrying value of these assets on its balance sheet. Keep
in mind that you 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
your accounts receivable and inventory to confirm asset values as
well as the reliability of the reports you provide to the bank. This
due diligence is called a “collateral exam” or “field audit”, and
involves the bank sending an auditor to the company’s offices to
review books and records to (1) ensure that the company-generated
reports for accounts receivable (your 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 your 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 your
company’s premises.

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Capital
When it comes to capital, the bank is essentially looking for the
owner of the company to have sufficient equity in the company. This
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. 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 owner’s financial profile.
Commonly, the bank will look at the owner’s 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
company’s Debt to Equity Ratio. This is a measure of the company’s
total liabilities to shareholder’s equity. Banks typically like to see
Debt to Equity Ratios no higher than 2 to 3 times.

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Conditions
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. In this assessment, the banker
is going to look to things such as the following:

• The competitive landscape of your company - who is your

competition? How do you differentiate yourself from the
competition? How does the access to capital of your company
compare to the competition and how are any risks posed by this
mitigated? Are there technological risks posed by your competition?
Are you in a commodity business? If so, what mitigates the risk of
your customers going to your competition?

• The nature of your customer relationships – are there any

significant customer concentrations (do any of your customers
represent more than 10% of the company’s 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 can’t 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 company’s
economics? Are there any trends emerging among customers or
suppliers that in the future will negatively impact operations?

The banker will need your help to identify and understand these key
risks and mitigants, so be prepared to articulate what you see as the
primary threats to your business, and how and why you are
comfortable with the presence of these risks, and what you are
doing to protect the company. The banker will need to understand
the drivers of your business, which is equally as important to the
banker as understanding the company’s financial profile.

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Character
While we have left “Character” for last, it is by no means the least
important of the 5 C’s 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 your current
and former bankers to determine how you have handled your
banking arrangements in the past. The bank may also communicate
with your customers and vendors to assess how you have dealt with
these business partners in the past. The soft side of character
assessment will be determined by how you 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 you will be there and do
your best to ensure that the company honors its commitments to
the bank. Even if the company’s financial profile is strong and the
company has scored well in all of the other “C’s”, the banker will
turn down the loan if the character test is failed. To be clear - it is
not necessarily an issue if your company has gone through troubled
times in the past. What is more important is how you dealt with the
situation. Were you forthright and proactive with the bank in
communicating problems? Or did you wait until a default situation
was already in effect before reaching out to the bank? Were you
cooperative with the bank while getting through the distressed
period? The importance of character cannot be stressed enough.

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Conclusion
To summarize, the 5 C’s of credit forms the basis of your banker’s
analysis as they are considering your request for a loan. The banker
needs to be sure that (1) your 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
owner’s commitment to the company, (4) the CONDITIONS
surrounding your 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.

Hopefully this article 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.