“The 5 C’s of Lending”

Putting on your banker hat.

There’s a saying to remember - “Loans and debts make worry and frets.” For those of us in business, loans are a way of life and the past six months may certainly have lived up to the proverb. What’s important for us to understand is that the basis for making a loan has not changed, nor has the wisdom provided by America’s Father of Entrepreneurship, Ben Franklin. Let’s start with understanding the basics of a loan, a secured loan and leverage.

Recall that a loan is an arrangement in which a lender gives money or property to a borrower and the borrower agrees to return the property or repay the money, usually along with interest, at some future point(s) in time. Usually, the lender has to bear the risk that the borrower may not repay a loan. A secured loan is a loan which is backed by assets belonging to the borrower in order to decrease the risk assumed by the lender. The assets may be forfeited to the lender if the borrower fails to make the necessary payments. Loans are generally made to take advantage of a demand in a market for a product or service, and to properly balance the leverage in the business.

Leverage or leveraging refers to the use of debt (a loan) to supplement investment. Companies usually leverage to increase returns to stock, as this practice can maximize gains (and losses). Leveraging then is done to finance a business that may be growing at a faster rate than equity alone would allow. With that in mind, let’s put on the banker hat and see if we can pass the test of lending using the 5 C’s — Character – Cashflow – Capital – Collateral - Conditions. Now Mr. Banker, we want you to make a loan to your business.

Character is the first test of any loan. It implies that the borrower(s) are trustworthy people and that we can trust them to act in good faith at all times - in good times and in bad. Every business hits a bump in the road. The question is how the borrower handled it. Were they forthright and proactive in discussing the situation? At a “gut” level, do you get the feel that the borrower is honest and therefore a solid credit risk? Experience and intuition help sort through this question, possibly the most important criteria for making the loan. Ben Franklin said it best, “He is ill clothed that is bare of virtue.”

Cashflow is the test of the borrower’s ability to pay back the debt. Historically Debt Service Coverage Ratio needed to be 1.20 greater than the debt service payment (Principal and Interest). That number may have changed to 1.25 - 1.30 depending upon each industry because of the recent recession. In other words, for each $1.00 of debt service, the Company must produce $1.20 for “coverage”. A pretty simple test that quickly let’s us know where we stand as the Chief Loan Officer. Again, Ben Franklin observed astutely, “Watch the pennies and the dollars will take care of themselves.”  

Capital is the amount of “skin in the game” the borrower is willing to invest as equity. Today more than ever, leverage ratios are considered to be a key to making sure if there’s a bump in the road, that the business can withstand it. It also is a key to understanding if a borrower will be sufficiently motivated to work through tough times and turnaround the company. Generally we like to see Debt to Equity ratio as no higher than 2 times. Ben Franklin reminded us, “Creditors have better memories than debtors.”

Collateral is the amount of assets available to us as the lender to be comfortable that it will be able to recover its loan by liquidating the collateral and using the proceeds to pay off the loan. Even though our borrower thinks s/he should be able to borrow on a 1:1 basis, we know that’s not the case. The assets in a troubled situation are worth less, much less, than in a profitable situation. For more liquid assets, like Accounts Receivable we might utilize 70% - 80% of asset value; for hard assets such as machinery and equipment, we may look at Orderly Liquidated Value (OLV) from a certified appraisal, usually about 50%-55% of Fair Market Value-In Place (FMV-IP); and for Inventory, we might even look at 40% - 50% of Raw Materials and Finished Goods. In manufacturing, Work In Progress (WIP) is generally modified Inventory not ready for sale and excluded in the calculation for lending. So collateral is a key for us to see our way out of the credit should it go bad. And Ben Franklin noted, “A change of fortune hurts a wise man no more than a change of the moon.”

Conditions surrounding our borrower’s company and industry are keys to understanding the risks facing the business, and also, whether or not these risks are sufficiently mitigated. We need to ask the questions and understand — the industry, the competitive landscape, the customer base, supply risks, availability of labor, political, international — those areas of risk that confront the business. And we have to articulate how we mitigate each of these risks so that our loan does not get impaired. It’s not about hoping things will go right, as Ben Franklin reminded us, “He that lives upon hope will die fasting.”

The 5 C’s of making a loan — Character – Cashflow – Capital – Collateral - Conditions are as relevant today as in Ben Franklin’s time. He was certainly wise when he wrote, “If you would know the value of money, go try to borrow some.” The age old 5C’s banking test for making a loan can be very helpful for every business owner to understand and apply before approaching the next lender.

David W. Wimer, CBI^® - is Principal of Marathon Business Group, LLC a boutique investment banking firm and founder of Culhane Capital, LLC an Investor In Business. Mr. Wimer provides insightful business transition expertise to owners of privately-held businesses at www.davidwimer.com . He can be reached at Mobile: 484-269-7700 or Email: david@davidwimer.com .

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