Five C analysis of borrower creditworthiness

When a company is trying to borrow money, executives, entrepreneurs and consultants should be aware that there are five criteria that most lenders care about

What are lenders looking for?

IT IS important to understand what lenders look for when they lend money because companies often need to borrow money for various reasons: increase cash reserves, refinance existing debt, pay regular operating expenditures, research and development, capital expenditure, product development, expansion into new markets, strategic acquisitions, etc.

There are five criteria that most lenders use to assess a borrower’s creditworthiness:

capacity to generate sufficient cash flows to service the loan;
collateral to secure the loan in case the borrower defaults;
capital that shareholders have invested in the business;
conditions prevailing in the borrower’s industry and broader economy; and
character and track record of the borrower and the borrower’s management.

It is important to keep in mind that lenders don’t give equal weight to each criterion and will use all five criteria to create an overall impression of a company’s creditworthiness. Lenders are typically cautious and weakness in one of the five criteria may offset strength in all of the others. For example, if a company is in a cyclical industry (e.g. construction, auto, or aviation) the company may find it difficult to borrow money during an economic downturn even if the company shows strength in all of the other criteria. Similarly, if a company’s management has a bad reputation and poor track record then the company may find it difficult to borrow money even if it has strong financial statements.

Taken together, these five criteria indicate a borrower’s ability and willingness to repay its debts. As such, if you are advising a company in relation to raising finance, you must ensure that each of the five criteria is fully addressed in your loan request.

Let’s consider each of the five criteria in a little more detail:

1. Capacity

Capacity to repay a loan is the most important criterion used to assess a borrower’s creditworthiness. The borrower must be able to satisfy the lender that it has the ability to repay the loan. To satisfy itself of the borrower’s capacity, the lender will consider various factors including:

Profitability: What are the revenues and expenses of the borrower?
Cash flows: How much cash flow does the business generate? The lender is interested not only in cash flows from operations, but also cash flows from investing and financing activities. What are the timing of cash flows with regard to repayment?
Payment history: What is borrower’s payment history and track record of loan repayment?
Debt levels: How much debt does the borrower have? How much debt can the borrower afford to repay?
Industry evaluation: What is the normal debt/liquidity level for companies in the borrower’s industry?
Financial ratios: There are a number of financial ratios, such as debt and liquidity ratios, that lenders will evaluate before lending money: e.g. debt to equity ratio, debt to asset ratio, current ratio, quick (acid test) ratio, operating cash flow ratio, working capital ratio, etc.

2. Collateral

While cash flows are the primary source for the repayment of a loan, collateral provides lenders with a secondary source of repayment. Collateral represents the assets that are provided to the lender to secure a loan. In the event that the borrower fails to repay the loan, the collateral may be seized by the lender to repay the loan.

The borrower must usually provide the lender with suitable collateral. To do this, the borrower normally pledges hard assets like real estate, office equipment or manufacturing equipment. However, accounts receivable and inventory might also be pledged as collateral.

Service businesses and small companies may find it difficult to provide lenders with the collateral they require because they have fewer hard assets to pledge. If the borrower doesn’t have the necessary collateral, the lender may require personal guarantees from the borrower’s directors or from a third party such as the borrower’s parent company.

3. Capital

Capital is the money that shareholders have personally invested in the business. Capital represents the money that shareholders have at risk should the business fail.

Lenders are more likely to lend money to a borrower if shareholders have invested a large amount of their own money in the business. If the business runs into financial difficulty, then the capital of the business provides a cushion for repayment of the loan. If shareholders have a large amount of capital invested in the business, this indicates they have confidence in the business venture and that they will do all that they can to ensure the borrower does not default on the loan.

4. Conditions

Conditions refer to two factors that the lender will take into account. Firstly, conditions refer to the overall economic climate, both within the borrower’s industry and in the economy generally, that could affect the borrower’s ability to repay the loan. For example, during recessions and periods of tight credit it becomes more difficult for small businesses to repay loans and more difficult for lenders to find money to lend. Thus, during these periods a small business will find it difficult to borrow money and must present lenders with a flawless loan application.

In considering the overall economic climate a lender may consider various questions including:

What is the current business climate?
What are the trends for the borrower’s industry? How does the borrower fit within them?
What is the short and long-term growth potential in the industry?
How is the market characterised? Is it an emerging or mature market?
Are there any economic or political hot potatoes that could negatively impact the borrower’s growth?

Secondly, conditions refer to the intended purpose of the loan. The borrower’s reasons for seeking the loan should be spelt out in detail in the loan application. Will the money be used to buy new equipment for expansion? Will the money be used to replenish working capital to prepare for a seasonal inventory build-up?

5. Character

Character refers to the general impression that the borrower makes on the prospective lender. The lender will form a subjective judgement as to whether the borrower is sufficiently trustworthy to repay the loan.

Lenders want to put their money with companies that have impeccable credentials. Relevant factors that a lender may consider in deciding whether the borrower is sufficiently trustworthy include:

What is the character of each member of the management team?
What reputation do management have in the industry and the community?
What educational background and level of experience does management have?
What is management’s track record?
What is the overall consumer perception of the borrower?
Is the borrower progressive about its waste disposal, quality of life for its employees, and charitable contributions?
Does the borrower have a track record of fulfilling its obligations in a timely manner?
What is the borrower’s payment history and track record of loan repayment?
Are there any legal actions pending against the borrower? If so, what is the reason for these legal actions?

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