What Are Those "C's" Again?

By Rick Wise, Executive Vice President Scott Valley Bank

Bankers ask a lot of questions…at least good bankers do. And prudent clients ask a lot of questions . . . at least they should.

A banker should welcome client questions because open communication makes for a good relationship. A healthy exchange of information enables the banker to recommend appropriate products to meet the client’s needs. From a banker’s perspective, the questioning process and the interchange of dialogue with a client regarding his or her business and industry is particularly critical in credit evaluation as the banker considers the banking industry fundamentals of “the five C’s of credit.” This brief look at the five C’s of credit, whether a refresher or a first exposure to the concept, is intended to help business credit seekers know what a banker is looking for.

Capacity - Does the prospective borrower have the wherewithal to repay the specific credit request as well as all other financial obligations? The banker must understand the borrower’s prospective cash flow and the capacity of that cash flow to service debt, meet dividend or withdrawal needs, and form capital or equity to support growth of the business. Bankers must understand the relationship between cash flow and earnings in the perspective of other financial benchmarks such as debt levels and available liquidity. Accurate, detailed historical financial information combined with reasonable and thoughtful projections are essential to evaluating capacity.

Capital - It is critical that a business be adequately capitalized. Higher amounts of equity retained in a business enable a company to handle expected and unexpected fluctuations in the business cycle and lessen risk for the bank. A company must retain an appropriate amount of capital in relation to a reasonable amount of debt and cannot expect to grow the business solely on debt.

Conditions - What economic factors impact the borrower’s business and what plans do they have to address these factors? How is the company handling the current challenging economy? Does the business plan take into account the impact of changes in economic variables and what alternatives does management have in response to changing conditions? Management’s abilities are often reflected in its planning and how it responds to the various economic factors it faces.

Collateral - Bankers must have a secondary source of repayment for all credit accommodations (and often identify a tertiary source, as well). While cash flow is typically the primary source of repayment, the bank looks for a pledge of collateral for a secondary source of repayment. The type of collateral relates to the type of credit accommodation. Lines of credit are usually supported by accounts receivable, while term debt is typically supported by equipment or real estate. Collateral should only represent a fall back source of repayment for a lender; it should not be “the” source of repayment. A business owner should be careful if the only thing the lender is interested in is the collateral value.

Character - This is an evaluation of the prospective borrower’s sense of responsibility.  Character can be defined as the borrower’s willingness to satisfy all obligations. It involves not only how prior credit has been handled, but also how the company treats its vendors, employees and clients. Some bankers believe character is an even bigger factor in repayment of debt than cash flow.

Communication - OK, I am just checking to see if you are paying attention. Communication would make a “sixth C.” No, it is not one of the iconic “five C’s of credit,” but it is essential to a good banking relationship. Bankers appreciate being informed in a timely manner about significant client developments whether positive or negative. Understanding clients’ businesses to serve their needs and to fulfill the bank’s credit management standards defines a successful banker.

So . . . there you have the five C’s of credit plus one more for good measure. Hopefully this adds perspective to your discussions with your banker.

View Scott Valley Bank - The Vault - May 2011