Purposes Evaluation of loan applicant “Big” picture view Variety of information and sources to help in evaluation of applicant

The 5 C’s of Credit 1)Character 2)Capital 3)Capacity 4)Collateral 5)Conditions

Character The moral and ethical qualities of a loan applicant. Morals Management abilities Quality of insurance on assets Working relationships with others Personal and credit references Applicant’s reputation Level of honesty and integrity Level of education Credit Score

Capital The money, property, and/or other valuables which represent the wealth of the loan applicant; financial structure of a business through liquidity, solvency, and debt structure.

Capital Liquidity ratios  Working capital  Current ratio Solvency ratios  Debt-to-asset  Debt-to-equity

Capital Current loan obligations and details of each Contingent liabilities that may significantly impact financial stability Sources and uses of funds

Liquidity Ratios Working capital: Current assets-Current liabilities The larger, the better Current ratio: Current assets ÷ current liabilities >1.5 is preferred

Solvency Ratios Debt-to-equity: Total debt ÷ Total equity < 0.5, the lower the better Debt-to-asset: Total debt ÷ Total assets < 0.5, the lower the better

Analysis of Capital Things to look at: –Number and types of creditors –Amounts, purposes, repayment terms, and maturity dates of other debts –Income-producing ability Past and current income statements Marketability of assets –Sources and uses of funding

Analysis of Capital (Cont’d) –Financial position trend and identification of the sources increasing cash inflow Earnings Inflation Sale of equity capital Gifts Inheritance –Deferred tax liabilities, potential real estate tax liabilities, and contingent liabilities that may affect financial stability

Capacity The profitability and repayment ability of the loan applicant, as well as the applicant’s historic, current, and projected cash flows and sustained earnings

Capacity Adequate working capital Profit margins on income statements Analyze income and expenses Income-generating capacity Production and business trends Future plans Predicted economic outlook

Capacity Ratio Debt coverage ratio: Capital debt repayment capacity ÷ Scheduled principal and interest on term loans Capital debt repayment capacity = Net farm income + depreciation + net non-farm income – family living and income taxes + interest expense on term loans Must be as least 1:1

Collateral Property or assets that are offered to the lender to secure a loan or other line of credit; minimize loss to lender.

Collateral Marketability of collateral Current condition Quality Lien position (first position is always preferred) Reasonable protection from loss if loan is defaulted Measure  Net realizable value (NRV)

Collateral Measure Net realizable value (NRV): Market value (selling price) - costs Greater the NRV, the better

Conditions The guidelines and obligations drawn up in a loan contract; controlled by the loan officer. Loan purpose, structure, amount, pricing, financing Based on applicant’s cash flows, management skills, financial condition, and economic life of the project or asset being financed Level of loan risk Cost of extending the credit Competitive market factors

The 5 C’s Analysis Reminders Compare to similar sized entities Compare to similar industries Look at 5 C’s as a whole, not individually What an applicant may lack in one of the factors, s/he may more than make up for in another factor