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Bases of Credit

The word "credit" has been derived from a Latin word creditum. It means trust.Credit refers to
the ability to acquire something of value like goods, services, money, or securities at the present
time in return for a promise to pay at a certain future time. It involves risks. The possibility that the
borrower can not fulfill his promise due to circumstances beyond his control always exists.

In granting credit to borrowers, there are bases in evaluating their ability to pay and willingness to
pay:

Character. This refers to the personal integrity of the borrower. His determination to pay can be
evaluated by his past business record. Character also includes personal habits, attitudes, or vices of
the borrower.

Capacity. This has something to do with the managerial ability of the borrower. Could he use wisely
and efficiently his loan? Factors like responsibility, maturity and business competence of the
borrower determine his capacity to pay.

Capital. This refers to the resources owned by the borrower such as priorities. With such properties,
the ability of the borrower to obtain credit has become greater.

Collateral. Usually, the title of the land is required as a security of the loan. This is a safety measure
for the payment of the loan. Buildings, machines and other valuable properties are used as
collaterals.

Condition. Conditions in the community, industry, or the whole economy affect the ability of
borrowers to pay their loans. For example; peace and order, inflation, profitability of a project, etc

The Six Cs of Credit A person who is considered a good credit risk usually meets six basic
qualifications. These qualifications include character (credit reputation), capacity, capital, conditions,
collateral, and common sense. CHARACTER (Credit Reputation)A person with a good character is one
who willingly and responsibly lives up to agreements. One distinctive sign of a good character is a
responsible attitude toward paying bills and meeting obligations on time. CAPACITYThe ability to repay
a loan or make payments on merchandise with present income is known as capacity. Creditors want to
make certain that you will have enough money left over each month after other fixed expenses have
been met to pay your credit debts. CAPITALProperty and other assets that total more than debts are
known as capital. In other words, when you add up all that you own (assets) and subtract all that you
owe (liabilities), the difference (your net worth or capital) should be sufficient to ensure payment of
another bill. CONDITIONSAll other existing debts, stability of employment, personal factors, and other
factors that might affect a persons ability or desire to meet financial obligations are important
conditions to be considered. For example, a person who has moved six times during the past year might
not be considered a good risk because of living conditions that indicate some type of problem.
COLLATERALProperty or possessions that can be mortgaged or used as security for payment of a debt
are known as collateral. If a debt is not paid as agreed, the collateral is repossessed and sold to pay the
debt. COMMON SENSEA persons inner ability to make wise decisions is often referred to as common
sense. A loan officer or credit manager would determine that you have good common sense based on
how you answer questions (either orally or in writing). Good decisions are reflected in answers such as
reasons for leaving employment, number and types of credit cards and balances outstanding, or
references listed on an application. If a credit applicant meets all six of the above qualifications, he or
she is considered worthy of credit. The applicant has shown a willingness and ability to pay bills in an
acceptable and responsible manner.

Capacity to repay, capital, collateral, conditions, and character, are referred to as the "Five
Cs of Credit".
LEARNING OBJECTIVE[ EDIT ]
Name the Five Cs of credit

KEY POINTS[ EDIT ]


o Capacity to repay, the most critical of the five factors, indicates to the
prospective lender exactly how an individual intends to repay a loan. The lender will
consider the cash flow from the business, the timing of the repayment, and the
probability of successful repayment of the loan.
o Capital is the value of assets that a debtor currently
holds. Potential lenders may expect an individual to communicate their current
assets so as to indicate their ability to pay back a loan.
o Collateral is additional form of security you can provide the lender.
Giving a lender collateral means that you pledge an asset you own, such as your home,
to the lender with the agreement that it will be the repayment source in case you can't
repay the loan.
o Conditions focus on the intended purpose of the loan. Will the money be
used for working capital, additional equipment, or inventory? The lender also will
consider the local economic climate and conditions both within your industry and in
other industries that could affect your business.
o Character is the general impression you make on the potential lender or
investor. The lender will form a subjective opinion as to whether or not you are
sufficiently trustworthy to repay the loan or generate a return on funds invested in
your company.
TERMS[ EDIT ]
collateral
A security or guarantee (usually an asset) pledged for the repayment of a loan if one
cannot procure enough funds to repay. (Originally supplied as "accompanying"
security. )

Source: Boundless. The Five Cs of Credit. Boundless Business. Boundless, 26 May.


2016. Retrieved 11 Nov. 2016
from https://www.boundless.com/business/textbooks/boundless-business-
textbook/the-functions-of-money-and-banking-21/credit-124/the-five-cs-of-credit-574-
3205/

The 5C's
Capacity to repay is the most critical of the five factors, it is the primary source of repayment - cash. The prospective
lender will want to know exactly how you intend to repay the loan. The lender will consider the cash flow from the
business, the timing of the repayment, and the probability of successful repayment of the loan. Payment history on
existing credit relationships - personal or commercial- is considered an indicator of future payment performance.
Potential lenders also will want to know about other possible sources of repayment.
Capital is the money you personally have invested in the business and is an indication of how much you have at risk
should the business fail. Interested lenders and investors will expect you to have contributed from your own assets
and to have undertaken personal financial risk to establish the business before asking them to commit any funding.
Collateral, or guarantees, are additional forms of security you can provide the lender. Giving a lender collateral
means that you pledge an asset you own, such as your home, to the lender with the agreement that it will be the
repayment source in case you can't repay the loan. A guarantee, on the other hand, is just that - someone else signs
a guarantee document promising to repay the loan if you can't. Some lenders may require such a guarantee in
addition to collateral as security for a loan.
Conditions describe the intended purpose of the loan. Will the money be used for working capital, additional
equipment or inventory? The lender will also consider local economic conditions and the overall climate, both within
your industry and in other industries that could affect your business.
Character is the general impression you make on the prospective lender or investor. The lender will form a subjective
opinion as to whether or not you are sufficiently trustworthy to repay the loan or generate a return on funds invested
in your company. Your educational background and experience in business and in your industry will be considered.
The quality of your references and the background and experience levels of your employees will also be reviewed.

00:14
01:26

What are the 'Five Cs Of Credit'


The five C's of credit is a system used by lenders to gauge
the creditworthiness of potential borrowers. The system weighs
five characteristics of the borrower and conditions of the loan,
attempting to estimate the chance of default. The five C's of
credit are character, capacity, capital, collateral and conditions.

Next Up
1. LENDER
2. BORROWING BASE
3. CHARACTER LOAN
4. CREDIT RISK

5.

BREAKING DOWN 'Five Cs Of Credit'


This method of evaluating a borrower incorporates both
qualitative and quantitative measures. Lenders look at a
borrower's credit reports, credit score, income statements and
other documents relevant to the borrower's financial situation,
and they also consider information about the loan itself.
Character
Sometimes called credit history, the first C refers to a borrower's
reputation or track record for repaying debts. This information
appears on the borrower's credit reports. Generated by the three
major credit bureaus Experian, TransUnion and Equifax credit
reports contain detailed information about how much an
applicant has borrowed in the past and whether he has repaid his
loans on time. These reports also contain information on
collection accounts, judgments, liens and bankruptcies, and they
retain most information for seven years. The Fair Isaac
Corporation (FICO) uses this information to create a credit score,
a tool lenders use to get a quick snapshot of creditworthiness
before looking at credit reports.

Capacity
Capacity measures a borrower's ability to repay a loan by
comparing income against recurring debts and assessing the
borrower's debt-to-income (DTI) ratio. In addition to examining
income, lenders look at the length of time an applicant has been
at his job and job stability.

Capital
Lenders also consider any capital the borrower puts toward a
potential investment. A large contribution by the borrower
decreases the chance of default. For example, borrowers who
have a down payment for a home typically find it easier to get a
mortgage. Even special mortgages designed to make
homeownership accessible to more people, such as loans
guaranteed by the Federal Housing Authority (FHA) and the
Veterans Administration (VA), require borrowers to put between 2
and 3.5% down on their homes. Down payments indicate the
borrower's level of seriousness, which can make lenders more
comfortable in extending credit.

Collateral
Collateral can help a borrower secure loans. It gives the lender
the assurance that if the borrower defaults on the loan, the
lender can repossess the collateral. For example, car loans are
secured by cars, and mortgages are secured by homes.

Conditions
The conditions of the loan, such as its interest rate and amount
of principal, influence the lender's desire to finance the borrower.
Conditions refer to how a borrower intends to use the money. For
example, if a borrower applies for a car loan or a home
improvement loan, a lender may be more likely to approve those
loans because of their specific purpose, rather than a signature
loan that could be used for anything

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7 Cs of Credit: Currency
What is the recent history and outlook of the primary currency in which the
company will conduct its operations? Does the currency exhibit a history or
likelihood of losing its value? The more stable the currency, the more
attractive the loan request will be to a lender.

7 Cs of Credit: Country
Does the borrower conduct a significant portion of its operations in a
country with a history of political instability? Is there the possibility of an
expropriation of the borrowers assets due to a change in the countrys
government? Is the countrys current political and legal system hostile to the
interests of foreign countries? The more established the countrys
government has been and the more its legal system has demonstrated a
reverence for property rights and the rights of creditors, the more likely the
bank will be willing to make the loan.

The five C's of credit is a system used by lenders to gauge the creditworthiness of potential
borrowers. The system weighs five characteristics of the borrower and conditions of the loan,
attempting to estimate the chance of default. The five C's of credit are character, capacity,
capital, collateral and conditions

The 12 Cs of Credit for Lending in (and


out of) a Recession
The 12 Cs of Credit for Lending in (and out
of) a Recession
By Linda Keith, CPA
Download in PDF format

Depending on how long ago you took Banking 101 and what type of lending you were
doing at the time, you may remember 3 or 5 or 6 Cs of credit.

Here are my six:

Character

Capacity

Capital

Collateral

Coverage

Conditions

Before I add six more, I'll show you how you can use tax returns as clues to the
traditional six. Lenders in my tax return analysis training are often surprised you can use
a tax return this way.

Character
Will they pay if they can?

The tax return is a great clue for this. Sometimes the borrower comes right out and tells
you "Here is my tax return but it isn't really what I make." If they follow that with a wink,
find a way to finish off the conversation in a hurry.
I am not talking about aggressive taxpayers who take every legitimate deduction
available. I am one of those myself.

Those who do not report all of their income or knowingly take a business deduction for
personal expenses have demonstrated they are willing to lie to a third party (the IRS) for
financial gain (pay less taxes).

You are a third party. Enough said.

Be sure you know what they are saying

There are legitimate reasons that a tax return does not reflect what the borrower or their
business makes. The difference between cash and accrual basis, significant net
operating losses or a major nonrecurring expense just to name a few.
Hear them out before you assume they are 'cheating' on their taxes.

Clues to character

Reporting income the IRS would not know about otherwise (good character)

Taking lower deductions than they could easily get away with (good character)

Writing off personal expenses as if they were business expenses (shady)

Capacity
Does it look like they can repay it?

Many lenders think first of checking for adequate cashflow and liquidity. I agree that is
important.

I also think of the experience of the owner or management. While there are some great
things to be said about youth, having been a downturn before is a plus as well.
Review Schedule L in a business return to see the 'Balance Sheet per Books'. Review the
last three years returns to get a feel for recent history. Five years is better if you have it
in the file.

Capital
Do they have enough skin in the game?

I don't use the tax return to asses this one. Owners of closely held companies often take
more compensation than adequate capital allows because their tax advisor suggested
it.
Use a process that applies a 'global' analysis, though, and you are back in business.
Combine a review of the business return with that of the owner/guarantors. Look at the
balance sheets for both. Then decide if there is enough capital for comfort.

Collateral
What if they can't repay it?

This one is certainly getting more interesting. Lending institutions are reeling under the
weight of real estate they never planned to own. As the economy softens, the value of
collateral softens too.

While the tax return cannot help you value collateral, a quick look at the Form 4562 can
tell you if they are purchasing more fixed assets. By where they put it on the form, you
can even tell what it is. (In my manual on Tax Return Analysis: Essentials and 1040
Review you see what types of items get listed where).

Coverage
Have they spread risk?

I train the lenders in my tax return and financial statement analysis training to look for
insurance. It is a line item on a Schedule C but listed along with 'other' expenses on
business returns. If the lender is not looking for it, they'll miss it.

Look for insurance on the Cost of Goods Sold schedule, too. When my construction
company built houses, that is where we listed course of construction insurance.
A newer lender may not know how much insurance is adequate for a particular
business, but certainly could spot that it is not there at all.

Conditions
What else is going on?

Well, that is the big problem, isn't it? While the tax return can give clues to the other Cs,
the lender has to look elsewhere for conditions.

Understand the industry

Look to trade publications


Confer with others

Talk to the business owner more often

A review of the tax return may give some good hints about how the business is coping
with conditions. In construction, compare contract labor to wage labor. Contract labor
gives more flexibility, but may cause problems later when business picks up and the
builder is competing for the subcontractors who are still in business.

The business's response to conditions can create confusing signals for lenders.
Something that would have been a red flag last year may be prudent this year.
A commercial lender who works for a client bank shared "Normally a dramatic drop in
insurance or repairs is a red flag. I encourage my team to watch for it.

"But now, it may mean a prudent business that has taken a harder look at costs and cut
where they can. They may not have reviewed insurance since they quit using extra
warehouse space.

"Workers they are keeping busy instead of laying off may be reassigned to maintenance
for now.

3 Cs of Credit Analysis

These are three to look for when reviewing lending staff. I focus on this with the lenders.

Competence

Confidence

Consistency

3 Cs for the Recession

Calm
Be it and Show it

In a recent CFO Podcast, the CFOs listed exuding 'calm' as one of their most important
roles. Your lenders need that, too.
I have heard lenders say their bank is frozen until the SBA secondary market picks up.
Lenders are playing solitaire because they can't get the loans through.They are worried
about their jobs.

In private conversations, the lenders see me as an adviser. This may not be the
message they are conveying to the world. But what if they are?

Your lenders need to see you are calm, and need help in what the message is to put out
to the borrowers and the public.

What messages are you sharing with employees?

Are you providing talking points about government bailouts, deposit insurance,
and the safety of your financial institution?

What are you doing to help employees bleed off the stress?

Communicate
With all stakeholders

There is fear in the air. There is also opportunity. You feel it. So do your successful
business borrowers. Acknowledge the challenges...too motivational is not believable.
Then share the vision of prosperity.

Cycle There is no new economic paradigm.

The economic cycle is a cycle and as surely as we are in the downswing, the upswing
will return. And in the upswing, we'll have a whole 'nother set of lending challenges. By
understanding the Cs of Credit and where to find it in borrower financials, tax returns
and even conversations...you can help your borrowers and your lending institution as
the recession turns to recovery.