Commercial Loan Demand: 5 Important Criteria for Banks
5 criteria in order of importance banks are evaluating when lending a commercial loan (a.k.a. the 5 “C's” of credit)
When lending money to businesses, banks and financial institutions based their decision on different criteria which follow an order of importance. We are going to go through these 5 elements starting by the most important.
The world of business is not an exact science where decisions are always carefully calculated. Many decisions are based on a level of trust between individuals. Honesty between two parties often gives a boost to a good business partnership. In the case of lack of trust, business relations become extremely difficult and often go nowhere.
The same rule applies when banks are lending money. The first element in importance when they evaluate a potential client is the character of the borrower, i.e. the quality of the management and their will to reimburse. A business that has a good administration with a good reputation will have an easier time to exchange with banks and have access to credit. After all, on a medium and long term, a company that is passing through a rough time but is managed by a competent administration has better chance to succeed than a successful company managed by unqualified people.
The character of the borrower also integrates the years of experience, references of other business partners, advertising, employee turnover, history (for example, was there any fraud?) and the ethic code.
These qualitative elements are the first step for a business relationship and goes in front of any quantitative data.
In second place of importance is the capacity of reimbursing. This part is necessarily the element that will decide if a company can manage a loan. It is evaluated on the capacity of the company to generate revenues and profits, which is measured by exploring the Statement of Income and the Cash Flow.
A business unable to generate revenues and profits will never be able to respect their credit engagements. Also, a business that generates an important sales number, but is increasing sales by giving credit and can't be paid quickly enough, will be having cash flow problems and will not be able to reimburse its debt on time. We have to remember that only cash will pay debt.
In a case of a start-up company, banks ask to be provided with a business plan and cash flow projections. However, the level of education and the experience of the management on start-up companies will play a determinant role in the process.
The capital is the element where we analyze the financial structure of the company. In that case, the financial institutions look over the financial ratios (working capital, debt ratio, gross margin, etc.) This part often takes most of the credit analyst's time, because he is looking to evaluate the long term aspect of the company.
This section calculates the solvency of the business, i.e. how much the assets can cover the liabilities. A business that accumulated an important amount of retained earnings over the years will have an easier time passing through rough periods and face deficit, and therefore would be better position to obtain a credit loan.
A bank will be more comfortable lending to a company that was generously financed by the shareholders. In general, financial institutions request the shareholders to finance more than 25% of the assets. Under this, banks will feel that they take most of the risk and will ask the shareholders to inject a more important amount of money in the company.
Conditions inform the potential lender about external elements that could influence the normal course of business and affect the performance of the company.
What can influence the general conditions is the economy, with its period of growth and recession, change rate, interest rate, tax rate, inflation, etc. Also, we have the competition, the conditions specific to the industry and the business's position in its sector.
Other factors can influence the “business as usual” such as bad weather, natural catastrophes, political decisions, wars, terrorist acts, etc. They are all aspects that a company has no control over and can influence credit decisions.
Collateral is the last element in importance. By collateral we are talking about guarantees that lenders have if the borrower is in default. A financial institution searches to secure itself on the company's assets such as the inventory, equipments, furniture, real estate or vehicles to recuperate the amount of money corresponding to the unpaid balance from the client.
It is the last aspect in importance because, when a bank comes to seize the assets of the company to repay itself, it probably did record a loss. The loss is recorded when legal procedures are intended to recuperate assets; legal procedures cost money and banks probably won't recover the entire unpaid balance. Also, the bank is considering the opportunity cost, where they could have used the money to invest on a less risky client and generate profits.
The collateral is considered mainly to minimize losses in case of default, but not as acceptance criteria in the credit decision.
We have here 5 elements that banks use to evaluate the credit risk when lending commercial loans. We see that the world of business is mainly people interacting, and that decisions are often subjective. It is important in that case to always project a good image when comes to dealing with banks.