5 C’s of Credit Analysis

Whether you need new equipment or would like to make other improvements to your business, it’s helpful to know what financial advisors are looking for when evaluating credit.

Detailed and thorough underwriting standards of financial institutions are of the upmost importance, particularly in today's economy. The 5 C’s of credit analysis is a general guideline that my colleagues and I use when assessing loan requests.

The following 5 C's are evaluated in conjunction with each other.

  • Character. Financial advisors evaluate both the trust they have in the ownership and the confidence they have in the management team. We also look at your history with financial providers and your experience in the industry. References from clients, vendors or community leaders are helpful in establishing confidence or trust.
  • Capacity. The second C concerns your ability or intent to repay the loan. Where is the cash coming from? If the loan is to purchase new equipment or open a location, the hope is that those investments will be a source of new cash flow to help service the loan. We’ll look at historical data and your projections for future earnings, as well as contingent cash flow or back-up to make the payment. The debt coverage ratio is a widely used tool when reviewing capacity. It’s your revenue minus cash expenses divided by debt payments for a year. There’s no magic number, but bankers usually like to see a ratio of 1.25:1 or greater, if not 2:1 or 4:1 in some industries. I advise my clients to plan for a cushion. What would you do if you lost a major client? How would you still service that debt?
  • Capital. We want to know how much the owner has financially contributed to the business. We’re looking for a commitment that shows they’re willing to take some of the risk. The debt/equity ratio from the balance sheet is helpful. Again, there’s no magic number, but we typically like to see clients with a 2.75:1 debt/equity ratio or less. Your banker should be able to provide benchmarks based upon your industry, how long you’ve been in business and whether you’ve recently made an acquisition.
  • Collateral. These are the assets pledged for the loan, whether in cash, securities, equipment, real estate or accounts receivable. This is considered a secondary source of loan payment. How much collateral we require depends on several factors, including its liquidity and stability.
  • Conditions. There are two common kinds of conditions we look at. The first is economic conditions of the industry. Is it highly regulated, like a title or insurance company? Is it high risk, such as coal mining? What is the product life cycle? The second is what’s happening in the business and domestic economy. Can you react quickly in a downturn?

Once the loan is made, your financial advisor is an active partner in an ongoing relationship. It’s in your best interest to keep your banker informed about changes in the company or other relevant details. Part of your advisor’s job is to use that information to evaluate risk and provide sound advice to help you run your business smoothly.

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Kim Ciukowski can be reached at (865) 766-3032 or kim.ciukowski@pnfp.com.

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