The 5 C's of Credit

The 5 C’s of Credit

All lending institutions have the responsibility to complete due diligence in order to be a reliable and consistent source of sound, adequate, and constructive credit. The degree of their due diligence can vary depending on the size and complexity of the loan along with the lending institution’s history with the borrower and other credit factors. In some cases, a lending decision (approval or denial) can be made after reviewing minimal customer information such as income verification and credit report. In other instances, a more thorough analysis is required, which can include requesting historical income statements (such as tax returns) and asset verifications (such as bank statements). Whether the lending decision is simple and straightforward or requires additional due diligence, five main areas are typically considered when evaluating a loan request. These “5 C’s of credit” are explained in more detail below.

Character – addresses the non-financial (management ability) qualities of an applicant.

• Current and prior work/farm/business experience
  • Details previous successes and how they were able to achieve those.
  • How will their previous experiences help with their future endeavors?
  • How long has the applicant been in their current line of work?
• Information on their current farm operation
  • What type and size of operation, what kind of risk mitigating tools do they use, etc.?
  • Historical yields, herd information, production metrics, efficiencies, or other competitive advantages are often considered.
• Credit scores / Credit report
  • Details on prior delinquencies, if any.
  • Discuss their credit score(s) and any factors affecting the score(s).
• Personal business interests and/or contingent/co-signed liabilities
  • Discuss ownership and/or involvement in legal entities (LLCs, corporations, etc.), what do the entities do, and what is the individual’s role for the entities?
  • Is the applicant(s) co-signed on any of the entity’s debts? How would these additional debts impact the individual’s financial position?

Capital – addresses assets (what is owned), liabilities (what is owed), equity (the ratio of what is owned relative to what is owed), and liquidity (the applicant’s ability to access cash).

• An updated personal financial statement (PFS) will be obtained for the applicant(s)
  • The PFS will list out assets owned – typical assets include cash, stocks/bonds, livestock, feed/seed/supplies, or other inventories, autos, machinery & equipment, retirement accounts, and real estate.
    • Verification of assets can be obtained, such as statements for checking and/or retirement accounts and tax assessment cards for real estate.
  • The PFS will also include details on any debts or liabilities -- this information is typically cross-referenced with their credit reports.
    • Not all creditors report to the credit bureaus, so it is important for sound lending that applicants provide all debt information including those debts that are not reported to the bureaus.
  • If an applicant has ownership in one or more related entities, current financial information may also be obtained for each entity.
    • Information requested may vary, depending on the ownership level or reliance on income from the entity to service the applicant’s debt obligations.

Capacity – addresses income sources and ability to repay debts (debt to income ratio, debt service coverage ratio, or other metrics).

• Focus on the scope and scale of primary and secondary sources of repayment (i.e., farm and/or non-farm income).
• Discuss other sources of income, such as cash, securities, or other disposable assets.
• Verification of income typically includes tax returns, W-2s, paystubs, or internal record keeping.
• Stress testing is often completed to document the applicant’s ability to handle unplanned circumstances or uncontrollable income interruptions.

Collateral – addresses the value and marketability of assets being pledged to secure the loan and how the lender will be protected from risk.

• Typical types of collateral include, but are not limited to, real estate, machinery, equipment, vehicles, and/or livestock.
• Real estate collateral requires an independent appraisal to verify its value.
  • Appraisals are completed by a licensed appraiser with expertise in the type of real estate being valued.
• Chattel (movable) collateral includes machinery/equipment, vehicles, livestock, etc.

Conditions – addresses the conditions in which the applicant’s farm/business operates and any related risks for the lender.

• Is the proposed loan structured appropriately to support the operation’s continued success?
  • Loan purpose, amount, term length, payment frequency, etc.
  • Post-closing servicing such as periodic reporting or follow-up visits may also be included.
• What are the economic (supply and demand) factors influencing the applicant’s revenue and expenses?
• Is the operation complying with all applicable regulatory requirements (such as environmental or licensing requirements)?

While all lending institutions consider the above factors, some lenders may place more or less emphasis on certain ones. Be sure to discuss the loan process and any questions with your loan officer. You can use your knowledge of the “5 C’s of credit” to help ensure your next loan application goes smoothly!

Author

Cristy Armell, Credit Analyst

Farm Credit of the Virginias