Why do lending institutions carefully evaluate how well a business meets certain criteria before making loan?

Financial institutions attempt to mitigate the risk of lending to borrowers by performing a credit analysis on individuals and businesses applying for a new credit account or loan. This process is based on a review of five key factors that predict the probability of a borrower defaulting on his debt. Called the five Cs of credit, they include capacity, capital, conditions, character, and collateral. There is no regulatory standard that requires the use of the five Cs of credit, but the majority of lenders review most of this information prior to allowing a borrower to take on debt.

Lenders measure each of the five Cs of credit differently—some qualitative vs. quantitative, for example—as they do not always lend themselves easily to a numerical calculation. Although each financial institution employs its own variation of the process to determine creditworthiness, most lenders place the greatest amount of weight on a borrower's capacity.

Capacity

Lenders must be sure that the borrower has the ability to repay the loan based on the proposed amount and terms. For business-loan applications, the financial institution reviews the company's past cash flow statements to determine how much income is expected from operations. Individual borrowers provide detailed information about the income they earn as well as the stability of their employment. Capacity is also determined by analyzing the number and amount of debt obligations the borrower currently has outstanding, compared to the amount of income or revenue expected each month.

Most lenders have specific formulas they use to determine whether a borrower's capacity is acceptable. Mortgage companies, for example, use the debt-to-income ratio, which states a borrower's monthly debt as a percentage of his monthly income. A high debt to income ratio is perceived by lenders as high risk, and it may lead to a decline or altered terms of repayment that cost more over the duration of the loan or credit line.

Capital

Lenders also analyze a borrower's capital level when determining creditworthiness. Capital for a business-loan application consists of personal investment into the firm, retained earnings, and other assets controlled by the business owner. For personal-loan applications, capital consists of savings or investment account balances. Lenders view capital as an additional means to repay the debt obligation should income or revenue be interrupted while the loan is still in repayment.

Banks prefer a borrower with a lot of capital because that means the borrower has some skin in the game. If the borrower's own money is involved, it gives them a sense of ownership and provides an added incentive not to default on the loan. Banks measure capital quantitatively as a percentage of the total investment cost.

Conditions

Conditions refer to the terms of the loan itself, as well as any economic conditions that might affect the borrower. Business lenders review conditions such as the strength or weakness of the overall economy and the purpose of the loan. Financing for working capital, equipment, or expansion are common reasons listed on business loan applications. While this criterion tends to apply more to corporate applicants, individual borrowers are also analyzed for their need for taking on the debt. Common reasons include home renovations, debt consolidation, or financing major purchases.

This factor is the most subjective of the five Cs of credit and is evaluated mostly qualitatively. However, lenders also use certain quantitative measurements such as the loan's interest rate, principal amount, and repayment length to assess conditions.

Character

Character refers to a borrower's reputation or record vis-à-vis financial matters. The old adage that past behavior is the best predictor of future behavior is one that lenders devoutly subscribe to. Each has its own formula or approach for determining a borrower's character, honesty, and reliability, but this assessment typically includes both qualitative and quantitative methods.

The more subjective ones include analyzing the debtor's educational background and employment history; calling personal or business references; and conducting a personal interview with the borrower. More objective methods include reviewing the applicant's credit history or score, which credit reporting agencies standardize to a common scale.

Although each of these factors plays a role in determining the borrower's character, lenders place more weight on the last two. If a borrower has not managed past debt repayment well or has a previous bankruptcy, their character is deemed less acceptable than a borrower with a clean credit history.

Collateral

Personal assets pledged by a borrower as security for a loan are known as collateral. Business borrowers may use equipment or accounts receivable to secure a loan, while individual debtors often pledge savings, a vehicle, or a home as collateral. Applications for a secured loan are looked upon more favorably than those for an unsecured loan because the lender can collect the asset should the borrower stop making loan payments. Banks measure collateral quantitatively by its value and qualitatively by its perceived ease of liquidation.

The Bottom Line

Each financial institution has its own method for analyzing a borrower's creditworthiness, but the use of the five Cs of credit is common for both individual and business credit applications. Of the quintet, capacity—basically, the borrower's ability to generate cash flow to service the interest and principal on the loan—generally ranks as the most important. But applicants who have high marks in each category are more apt to receive bigger loans, a lower interest rate, and more favorable repayment terms.

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