The 5 C's of Credit

Instructor: Rana Abourizk

Rana has a Masters Degree in Business Administration and is pursuing a Doctorial Degree. She has been teaching online for over a year. She has a strong business background.

What's your creditworthiness? When a business owner needs a loan from the bank or financial institution, they will go through an evaluation process to determine their eligibility. Business owners need to consider what financial institutes look at. In this lesson you will learn about the process known as the 5 C's of credit.

Determining Creditworthiness

Let's say the shop next door wants to make their shop bigger and buy some new materials, but they don't have the money. What they will generally do is go into a financial institution such as a bank and apply for a loan. When they do so, the bank will usually go through a credit analysis process to find out if they can loan the shop money. The analysis that financial institutions go through is know as the '5 C's' of the credit analysis process. Of course, every financial institute has their own ways of determining credit worthiness. Let's look at the 5 C's process a bit closer.

Capacity: The ability to repay the loan. This factor is very important. Banks will look at how much debt the borrower has, their payment history of the debt, their cash flow, and their revenue and expenses. The banks use this information to run some financial calculations. Calculation examples include: the debt to asset ratio, the debt to equity ratio, and the cash flow ratio. The debt to asset ratio is calculated by dividing the total liabilities by total assets. This formula is used to figure out how much more debt a business can handle given its assets. The higher the percentage of debt to assets, the more risky the business is for lending to. Therefore, a business that has a low debt to asset ratio would be less risky to lend to. The debt to equity ratio is calculated by dividing liabilities with stockholders equity. Just like the debt to asset ratio, if the percentage is high, this indicates a higher risk. The cash flow ratio is calculated by cash flow from operations divided by current liabilities. It helps indicate what the current liquid assets are. Every bank or financial institution has their own policy for what the ratio percentages should be around. If the ratios are not in line with what the banks require, then it's possible for the borrower to have some complications with capacity.

Capacity

Capital: Capital is the cash and assets that owners have put into the business from their own pocket and must sacrifice if the business breaks down. A new business wants to open up next door. Let's say they have an awesome idea that shareholders want to invest in. Shareholders give the business money to build their business. The owner also puts in money to buy machinery for his employees and customers to use. Other examples of capital include: The business having a money market account at the bank or shareholders having investment accounts for the business.

Collateral: Collateral is the backup source if the business can't pay. Let's say a store takes out a loan with a local bank. The store doesn't do as well as it hoped. It has to close its business because it is losing money. However the loan still needs to be payed back to the bank. In this case, the bank can collect the shop's source of collateral. In this case, the store used its equipment and business vehicles as collateral. To sum it up, collateral is a backup source for repaying the loan.

Collateral

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