How do your five Cs of credit stack up with a lender?

As clients consider making improvements to their operations, land purchases, and business transitions, I am often asked what lenders are looking for when assessing their creditworthiness. The fundamentals of lending can be outlined in a concept called the “five Cs of credit.”

The five Cs of credit are key factors lenders use to assess a borrower’s creditworthiness when evaluating a loan application and relationship: character, capacity, capital, collateral and conditions. These factors help lenders determine:

• Whether they should approve a loan
• Interest rates based on their assessment of risk
• Other loan considerations

Most lenders go through a process of risk assessment that will consider all these factors in their decision-making.  Producers (and their consultants) need to consider how the information they provide contribute to the five Cs in the lender’s eyes.

1. Character

Character refers to your repayment history and trustworthiness. Lenders look for a consistent track record of paying debts on time.  They want to know that you have a track record of paying off debts as agreed.   If a loan request is to the current lender, they will have an assessment on your repayment history.   Payment history is most often verified with lenders requesting a credit report from one of the credit bureaus to verify debts and payment track records.  Loan applications that you sign with a lender will include language that gives the lender permission to request credit bureau reports.  Equifax^®, Experian^® and TransUnion^® are the three credit bureaus in the U.S. commonly referenced.

2. Capacity

This assesses your ability to repay the loan considering your income, expenses and debt obligations. This ultimately comes from the revenue that you generate versus your expenses.  Lenders will consider all your debt obligations, including your mortgage or term debt payments, living expenses, and taxes.   Your lender wants to make sure you can pay them back because they do not want to take your collateral as a loan payment.   They will consider primary sources of income based on past and expected future business results.  They will also consider secondary sources of payment, which may include your spouse’s income, other W-2 tax form income, and rental or investment income.

3. Capital

Capital is your net worth or the value of your assets after deducting liabilities. It indicates your financial strength and willingness to invest in the business or project.  This is analyzed using your balance sheet, providing a snapshot of your business strength.  A balance sheet will list your assets and everything you own versus your liabilities or everything that you owe.  Lenders will look at this to assess your ability to withstand the ebbs and flows of typical business cycles.

4. Collateral

This refers to assets pledged as security for the loan. This includes land and equipment.  It may also include feed, cattle and rights to the income from products you sell.  Lenders assess the value of the collateral to ensure they are adequately covered if you are unable to pay the loan from income generated.   If cash flow is unable to service the loan payments, then collateral (assets) pledged to the lender will be sold to provide payment to the lender. Most lenders will advance 60% to 75% of the market value of an asset. For example, $1,000,000 worth of land can support up to $750,000 of loan value. Lenders will typically require independent appraisals to verify the valuation of land if loan requests are more than $500,000.

5. Conditions

This encompasses the general economic and market conditions that could impact your ability to repay the loan.

Lenders consider many conditions of the industry:

• How stable are land prices?
• What is the outlook for the market values?
• What have been the trends in commodity prices, livestock and milk prices?
• What is the two- to five-year outlook for these markets?

You should consider what is your primary income source and how the market conditions may impact the level of that income.  What is the impact of a 5-to 10% increase in expenses or decrease in market prices?

Each of the five Cs of credit needs to be thoroughly explained and supported with historical data in a loan application submitted for lender consideration.

6. Cranium

Many would argue there is a sixth C, which has been referred to by David Kohl, Ph.D., professor of ag economics at Virginia Tech, as Cranium.  This refers to your ability to respond to your financial situation, think through your strengths and weaknesses, execute strategies and monitor results of your actions.  In other words, your ability to analyze, make decisions, manage challenges, and provide timely and accurate information to your lender.

Lenders do not like surprises. The more you can keep your lender informed and engaged as your financial partner, the quicker they can respond to your financial requests. Contact a member of the Agri-Business Consultants team for guidance through the five Cs of credit and other financial-related topics.