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What You Need to Know About the 5 Cs of Commercial Lending


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I have often been asked over the years what I look for when analyzing a commercial loan. While all commercial loans are not the same and certainly there is no magic box to decide the fate of a commercial loan, there are some very easy secrets that all commercial lenders and credit analysts look for to determine the credit worthiness of a Borrower. One such method, and a great starting point, is known as the 5 C's of Commercial Lending.

1) CASH FLOW - This is the most important of the 5 C's as that is how my loan is going to be repaid. Historical cash flow is a good indicator of future cash flow just as the history of anything is a good indicator of any future event. My Detroit Lions are historically a bad team and indications are that they will be bad in the future. A company that has historically struggled in cash flow often will struggle in the future as that may be an indicator of miss-management, lack of desire for a product, or an excessive amount of fixed expenses to name a few. Conversely, strong historical operations often, but not always, bodes well for future earnings. Simple cash flow is often calculated as: Net Income Depreciation Amortization Interest Expense divided by 12 months of loan payments on the subject loan plus any other debt obligations of the company. The rule of thumb is that this ratio should be 1.20 times or greater.

2) CHARACTER- Many banks may have this ranked in a different spot, I have always felt this was the second most important “C" and in some cases equally as important as Cash Flow. Character represents the strength, ability and desire of a Guarantor to support the debt if called upon to do so. Credit history of a Guarantor, like historical cash flow noted above, is a good indicator of a Guarantors propensity to pay. A loan team will look at assets and liabilities of a Guarantor exclusive of the subject loan. Moreover, Guarantor's personal cash flow exclusive of the income derived from the subject business is analyzed. These three factors: Credit History, Personal Assets, and Personal Cash Flow are essential facets in determining the character of a Guarantor.

3) COLLATERAL - In event of default, collateral is often times the only way a bank can recover some or all of the loan proceeds and hence is usually the secondary source of repayment on a loan (cash flow is first). Collateral can comprise a myriad of item such as cash (my favorite), various forms of real estate and land, assets of a company such as accounts receivables, inventory, equipment, vehicles, and many, many other choices. Other than cash, banks will margin the amount that they will lend on a type of collateral. For example: for a commercial apartment complex the b ank may lend 75% of the value versus 50% of the value of inventory. This is the hedge in case the loan goes sideways that may allow the bank to recover most, and hopefully all, of the principal outstanding on the loan.

4) CAPITAL - A bank is a partner in an endeavor with a borrower. The loan officer wants to make sure that a borrower has some skin in the game so as to lose something if they walk away from the loan. Capital is the amount of equity or money that is put into a transaction or has been built up by a company through historical profits (retained earnings). The amount of equity in or necessary retained earnings differs based upon the type of commercial real estate, the situation in the market (today you need more equity in), or the type company you are lending to. No magic secrets here but a bank should not have to take on all of the risk. Look at the mortgage industry today to see what happens when the Borrowers take no risk - they easily can walk away from their house and not lose their down payment, because they never had one!

5) CONDITIONS - This “C" is usually such things as competition, management succession, and most importantly today market conditions which you lend in. Some lenders can easily remember to the turning of the century and all concerns over whether businesses were Y2K ready from their computer and operational standpoint. Certain companies were deemed to be more susceptible to Y2K concerns than others. In today's market, certain businesses or real estate are more likely to experience cash flow concerns or failures than others. In my market, companies tied to the automotive operations, or Tier 1 suppliers, will likely experience cash flow concerns and hence should be evaluated tougher when analyzing the credit worthiness of a Borrower.

As noted heretofore, commercial lending is not done in a box and is not an exact science. Much goes into determining whether a Borrower is credit worthy. Different banks have different criteria but all commercial banks use the 5 C's of Commercial Lending as a tool to assist with that process.

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