What determines credit worthiness? A question that I get asked quite often is “what does a credit analyst actually do?” Usually I find myself answering that my job entails looking at tax returns and financial statements and crunching numbers. In all honesty, though, that’s just part of the story. While the financial aspect is important in analysis, it is only one factor of what we in the financial business call “The Five C’s of Credit” – Capacity, Capital, Collateral, Conditions and Character.
Capacity – This word conjures up the idea of how much something can hold or withstand. The same concept applies to lending. When looking at capacity, the officer or analyst is evaluating repayment of the loan. The best method to determine capacity is to examine the customer’s cash flow, which requires a tax return or income statement (usually multiple years). This gives the officer or analyst an idea of how much debt the customer can carry and still have enough income available for family living expenses and other discretionary purchases. It can also indicate to the officer at what times of the year capacity is tight. If the customer is a cattle or crop producer who only receives one large check a year, monthly payments may not be the best option unless there are additional sources of income (such as a spouse working in town).
Capital – When a customer comes in looking for a loan, he/she is really asking for capital and for the lending institution to share in the risk of the business. The balance sheet that the officer requests is to give him/her an idea of what kind of and how much capital the customer has to offer. What is his/her investment in the business? The balance sheet provides an overall picture of the customer and his/her operation, confirming net worth, liquidity, leverage, etc.
Collateral – A lender must look at sources of repayment for the loan. The primary source of repayment should come from the cash flow (i.e. income of the operation). If all things should go wrong, however, the officer will need a secondary source to look to, and that most often is collateral. The collateral offers assurance to the lending institution that regardless of what happens down the road, the loan will be repaid.
Conditions – In today’s economy, no one wants to be involved in an industry that is declining or in trouble, whether it be the customer or the lending officer. So when looking at approving a new loan for a customer, the officer or analyst will also research some of the industry that customer is involved in. What kinds of cattle are raised by this operation and for what purpose? What is happening in the corn and soybean markets lately? Do the weather analysts foresee an end to or a continuation of the drought this year? Knowing the industry one is lending into allows the lending officer to make a better informed lending decision and to structure the loan accordingly.
Character – Last but not least is character. How well has one managed commitments in the past? When hard times hit, how does one handle that adversity? Those who have experienced a rough spot or two, and persevered through it, inspire respect. Just as one wants a lender who will stick with one through the good and the bad, a lender desires the same from his/her customers.
So, next time you are considering expanding or diversifying your operation, remember the Five C’s.
Jessica Bailey is a Credit Analyst in the Agricultural Loan Division at Arvest Bank in Neosho, MO.
