A framework used to evaluate the strength of a borrowing request
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The 5 Cs of Credit is a framework used by financial institutions and other non-bank lenders to evaluate the creditworthiness of a borrower, as well as the strength of an overall borrowing request.
The 5 Cs are:
The 5 Cs of credit impact pricing, structure, and the general terms under which credit is advanced to a borrower.
The 5 Cs are Character, Capacity, Capital, Collateral, and Conditions.
The 5 Cs are factored into most lenders’ risk rating and pricing models to support effective loan structures and mitigate credit risk.
The 5 Cs must be taken collectively; no single C in isolation can provide sufficient insight to approve or decline a transaction.
Strength in one C can help to offset weakness in another.
Understanding Credit Risk
Credit is defined as one party (a creditor) providing resources to another party (the borrower) in exchange for future repayment. Credit risk is the risk that some (or all) of the repayments may not be made, and that the creditor may lose some (or all) of its principal.
Lenders employ a variety of risk rating and loan pricing tools to understand a prospective borrower’s financial health. Broadly speaking, these tools and models support the measurement and mitigation of credit risk.
The 5 Cs of credit are heavily factored into these risk rating and pricing models.
The 5 Cs of Credit
The following is a breakdown of each of the 5 Cs in specific detail:
Character tends to be a very comprehensive, though sometimes subjective, aspect of the evaluation of creditworthiness. The premise is that a borrower’s historical track record of managing credit and making payments should serve as a proxy for future creditworthiness, too.
For individual borrowers, the assessment seeks to assess what kind of “person” they are by understanding their credit history, often using a credit score (such as FICO).
A corporate borrower is a little more complicated, particularly if it’s a private company that’s new to a lending institution. Loan officers will want to try and understand the character of the business by unpacking the management’s (and ownership’s) reputation and credibility.
Capacity really speaks to a borrower’s ability to service debt obligations into the future. A borrower’s capacity, whether personal or corporate, is typically measured using a variety of financial ratios like total debt service (TDS) or debt service coverage (DSC).
Evaluating capacity requires a lender to look at a borrower’s ability to generate cash flow relative to their total obligations, not just the borrowing request at hand.
For commercial lenders, seeking to understand a borrower’s sources of competitive advantage is also extremely important since this will impact the borrower’s ability to maintain pricing power, margins, and cash flow.
Capital can be thought of as a borrower’s overall financial strength, but in particular, what other unencumbered assets (or sources of cash) may be available to support debt repayment if cash flows were to dry up?
For a personal borrower, are there marketable securities or real estate assets that could be sold to free up cash in the event the borrower needed it?
For business and commercial borrowers, an important thing to understand is the company’s capital structure – meaning what proportion of funding comes from debt vs. equity. If a company is generally under-leveraged, then a lender is likely more willing to extend credit than if that company were already over-leveraged.
Also, is there an opportunity to take a personal guarantee from the owner (or a corporate guarantee from a related company) to backstop the proposed exposure?
Collateral is when an asset is pledged to a lender as security against credit exposure. Understanding what (if any) collateral is available, particularly for senior secured lenders, is absolutely essential.
When structuring credit, collateral security plays a really important role in mitigating credit risk. After all, if a borrower triggered an event of default and the lender were required to take enforcement action against their security, the quality of the collateral would dictate the likelihood of full repayment.
The nature, condition, and overall desirability of an asset will influence the loan-to-value (LTV) that a lender is willing to extend, as well as the terms under which the loan will be structured.
Conditions are a broad umbrella, but an important one. They, at least in part, refer to the purpose of the credit that’s being requested. It also includes forces in the external environment (such as macroeconomic factors) as well as industry-specific risks and opportunities.
Factors like where we are in the economic cycle, what (if any) political or technological risks may exist that could impact the borrower’s cash flow, and other similar questions should be asked when seeking to understand the strengths and weaknesses of a borrowing request.
Balancing the 5 Cs
Strength in one C can offset weakness in another. For example, a lender may be willing to extend credit with very little collateral if the borrower’s cash flows are strong and consistent, their access to other sources of alternative capital is clear, and their historical use of leverage has been reasonable and measured.
Similarly, a lender may be willing to extend higher than normal leverage to a borrower that has a very liquid collateral position (like a portfolio of stocks and bonds) which they’re willing to post as collateral.
In general, no single “C” can be taken in isolation; a lender evaluating a credit request must understand all 5 Cs together to get a complete picture of the borrowing request.
Thank you for reading CFI’s guide to the 5 Cs of Credit. To keep learning and advance your career, the following resources will be helpful:
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