Of Credit: Corporate Finance Institute®

5 Cs of Credit
Corporate Finance Institute®

Course Introduction

Learning Objectives
Identify the key credit strengths and

01. Define each characteristic in
the 5 Cs of credit framework 03. weaknesses of a company by examining
various sources of information
02. Discuss how the 5 Cs of credit are

used to assess the borrower

5 Cs of Credit Introduction
The five Cs of credit is a framework used by credit analysts to measure the creditworthiness of
potential borrowers.
Character Capacity Capital Collateral Conditions

• History • Ability to repay • Overall financial • Assets to • Economy
• Reputation strength secure the loan • Industry
• Management

5 Cs of Credit Introduction
How do lenders and borrowers use the 5 Cs of credit?
Lender Borrower
• Determine the risks of • Improve the 5 Cs
potential borrowers • Get more favorable terms
• Determine the loan terms and lower interest rates
and interest rates

Character

Character Overview
Character describes:
Strengths & Business &
• The company and management Weaknesses Financial Acumen
team’s reputation and credibility.
• The management team’s ability to
deliver on its promises.
Attitude Attitude
Towards Risk Towards Growth
Fulfilling Problems and

Commitments Possibilities

Character Overview
To evaluate character, we need to :
01 02
Assess the company’s Assess the
history and operations management team

Assessing the Company
Company History Current Operations Future Operations

How long has the company been in existence?

• Track record
• Customer base
How has the company grown?
• Organic growth
• Growth through acquisitions

Do we fully understand the operation of the

business?
• People
• Process
• Information systems

How will the growth occur?

• Organically
• Mergers & acquisitions
• Extension of existing or new
markets
• Extension of existing or new
products and services

Assessing the Management Team
Management Past Performance Reputation
What does their track What do customers, suppliers, and the

record look like? competition say about members of the
management team?
Directors
Planning Experience
Is there a clear and What business and financial

Shareholders consistent business strategy? acumen or skills does
management possess?
Attitude towards Risk
Have risks and risk

mitigation strategies been
identified?

Assessing the Management Team’s Skills in More Detail
Planning Organizing
• Business plans • Professional advice

• Succession plans • Board of directors
• Financial plans and • Resources
budget • Competency
Leading Controlling
• Communication • Financial reporting

• Measurement • Financial compliance
• Performance reporting

Capacity

Capacity Overview
Capacity refers to whether the borrower has To assess capacity, the credit analyst
the ability to service and repay its debt. needs to evaluate:
• What are the current and forecasted

levels of operating cash flow generation?
• How much cash is tied up in working
capital (e.g. inventory and accounts
The cash flow The drivers of
receivable) now and in the future? statement to sustainable
• Is there enough sustainable forecasted identify sources profitability and
cash flow to easily service and repay the and uses of funds growth
company’s debt obligations?

Analyzing the Cash Flow Statement
How to analyze the cash flow statement?
The statement of cash flows is used to identify the company’s sources and uses of funds.
Operating Activities Investing Activities Financing Activities

Identify cash flow trends and root causes
Increasing receivables – Are customers

Lax credit policies
taking longer to pay?
Increasing payables – Is the company

taking longer to pay its suppliers? Cash flow difficulties

Purchase and sale of
• Property, plant and equipment

• Investments
Positive cash flow in the Selling assets to

investing section sustain operations

Debt and/or equity
Any excess cash flows after Repay debt

investing activities are undertaken
can be used to:
Buy back shares
Pay dividends

Analyzing the Drivers of Profitability and Growth
Cash flows are driven by the income Ratios and trend analysis
producing ability of a company.
Credit analysts need to evaluate the drivers

Coverage Ratios Leverage Ratios
of a company’s profitability:
• Historic drivers
• Current drivers
• Future drivers
Profitability Ratios Efficiency Ratios
Liquidity Ratios

Coverage Ratios
Coverage ratios demonstrate the ability of a

company to cover its debt financing cash flows.
Debt Service Operating Profit

=
Coverage Ratio Interest + Principal Repayments
A low-debt service coverage ratio may indicate potential problems for a company
in covering its interest and principal repayments.

Leverage Ratios
Leverage ratios measure the degree to which a

company is financing its operations through debt
versus equity.
Total Liabilities
Debt to
=
Equity Ratio Total Shareholders’ Equity
A high debt to equity ratio may indicate potential problems for a company trying
to service and repay its debt.

Profitability Ratios
Profitability ratios measure and evaluate the

ability of a company to generate profit.
Gross Profit
Gross Margin Ratio =
Revenues
Operating Income (EBIT)

Operating Margin Ratio =
Revenues
Net Income (profit)

Net Profit Margin Ratio =
Revenues
higher numbers are better.

Efficiency Ratios
Efficiency ratios measure how well a company is

utilizing its assets.
Revenues
Asset Turnover Ratio =
Total Assets
Cost of Goods Sold

Inventory Turnover Ratio =
Average Inventory
Revenues Higher efficiency ratios indicate that a

Receivable Turnover Ratio = company is more efficient and utilizing
Average Accounts Receivable and leveraging its assets.

Liquidity Ratios
Liquidity ratios measure a company’s ability to pay

its short-term debt obligations.
Current Assets
Current Ratio =
Current Liabilities
A high current ratio usually indicates that the company is able to maximize the
liquidity of its current assets to settle debt and payables.

Analyzing the Drivers of Profitability and Growth
Coverage Ratios Leverage Ratios Profitability ratios
Efficiency ratios Liquidity ratios
Analyze the trends over 5 or more years
Sales Assets Profits Debt

Capital

Capital Overview
Capital: the wealth of the borrower
Capacity – Repayment of financing

Cash and Investments Property
Capital – Overall financial strength
Other Valuables Financial Structure

Capital Overview
Capital explores:
Working Capital Leverage Other Sources of Capital
• What is the working capital position and ratio?

• Is leverage increasing or decreasing and how does it compare to industry averages?
• Does the company have sufficient equity to withstand a downturn?
• Is the company able to raise equity?

Adequacy of Working Capital
Working capital in Capacity – Sources and

uses of funds
Working capital in Capital – The quality

and management
Accounts Receivable Accounts Payable
Inventory
• High-quality or low-quality inventory

Leverage of the Company
Leverage of the company
How well would the company be able to withstand difficult

times?
How much equity has been invested?

• Significantly invested owners – more motivated to
manage and work with lenders.
What other interest-bearing debt does the company

have?
• Review the amounts, purposes, repayment terms, and
maturity dates of other debt.

Leverage Ratios
Measure the amount of capital that comes from debt.
10% Equity
Total Liabilities
Debt to Equity Ratio =
60% Equity
Total Shareholder’s Equity
90% Debt
Total Liabilities
Debt to Assets Ratio = 40% Debt
Total Assets
Company A Company B
Debt to Assets: 0.40 Debt to Assets: 0.90

Other types of leverage ratios
Interest Bearing Debt

Funded Debt to EBITDA Ratio =
EBITDA
Interest Bearing Debt

Funded Debt to Equity =
Total Shareholder’s Equity

Other Sources of Capital
Other sources of funding that a company may have access to.
Unutilized debt facilities Redundant assets

• Is the availability sufficient to fund existing and • Does the company have redundant assets that
future requirements? are not currently used in the business and could
be sold to generate cash?
Ability to access new equity

• For a publicly traded company, what success has it Ability to access new debt
had recently in raising equity? • What capacity and experience does the company
• For a privately held company, what is the ability and have with raising additional debt?
willingness of the company to raise additional • Would the current lender be prepared to
equity? increase their exposure?
• Has this been demonstrated with recent
experiences?

Collateral

Collateral Overview
Collateral relates to the assets a company has available

to act as security for a loan in the event of a default.
What collateral does the company have available?
Where are the assets to be used as collateral

located?
What is the most appropriate collateral to take?
Loans should never be made based on collateral alone. Cash flow capacity should be the main determinant.
Security is only a back stop to protect the lender in the event of a default.

Assets Used as Collateral
The collateral of a borrower relates to what assets the company has available in order to
secure debt in the event of a default.
Real Estate Working Capital Machinery and Equipment

• Land • Inventory • Manufacturing equipment
• Buildings • Accounts receivable • Vehicles

Assessing the Quality of Collateral
It’s important to assess the quality of the collateral using the 4 criteria outlined below:
Marketable Ascertainable Stable Transferable
Is there an active Is it easy to price or Does the value of Is it easy to transfer

secondary market to value the asset? the asset change ownership of the
sell the asset if frequently? asset?
needed?

Conditions

Conditions Overview
Industry Attractiveness Competitive Advantage Specific Loan Contract
• Risks associated with the industry • Competitive strengths • Funding requirements

• Current or future trends • Weaknesses • Meet ongoing requirements
• Forces that influence the • Critical success factors
attractiveness

Assessment of Industry
Assessing the industry means assessing the market conditions that are
affecting the industry and its attractiveness.
• How likely is the industry to survive over the next several years?
• What factors will influence its sustainability?
Porter’s 6 Forces PEST Analysis

Assessing Industry Dynamics and Attractiveness
Porter’s 6 Forces
Threat of potential entrants
Power of complementary Bargaining

good/service providers power of buyers
Intensity of
industry rivalry
Threat of substitute Bargaining power

goods/services of suppliers

Assessing the General Business Environment
PEST Analysis + Environment & Legal
Political
Legal Economic
Environmental General Social

Environment
Technological
Competitive Position
• How is the company managing risk related to any threats or opportunities identified?
• Has management spent time conducting a similar analysis?
• Do they understand their own strengths and weaknesses?
• What are the critical success factors required for the company’s own sustainability?
SWOT analysis
Internal
Strengths Weaknesses
Factors
External
Opportunities Threats
Factors

Loan Contract and Requirements
Conditions – guidelines & obligations in a loan contract
Purpose Amount Term Pricing Covenants
Specific loan
Better understanding
conditions
Lender Borrower

Loan Contract
Specific loan conditions can have a large impact on the overall risk associated with a specific loan.
Lower Risk Higher Risk
Commitment Demand loan Term loan
Covenants Full package Basic
Security Asset based Unsecured
Repayment Monthly Bullet payment at maturity

Conclusion

5 Cs of Credit Summary
Character Capacity Capital Collateral Conditions
• Management • Sources of funds • Adequacy of • Working capital • Assessment of

assessment • Sustainable working capital • Other tangible industry
• Understanding profitability • Leverage of the assets • Competitive position
the company company • Performance
requirements

5 Cs of Credit Summary
Combine the 5 Cs of credit to evaluate a company and provide informed recommendations.
Company ownership History and background Loan structure and purpose
Industry analysis Business analysis Management analysis
Financial analysis Loan security Covenants and conditions
Environmental comments

Of Credit: Corporate Finance Institute®

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5 Cs of Credit

Corporate Finance Institute®

Corporate Finance Institute®

Identify the key credit strengths and

02. Discuss how the 5 Cs of credit are

Corporate Finance Institute®

Character Capacity Capital Collateral Conditions

Corporate Finance Institute®

How do lenders and borrowers use the 5 Cs of credit?

Corporate Finance Institute®

Corporate Finance Institute®

Fulfilling Problems and

Corporate Finance Institute®

To evaluate character, we need to :

Corporate Finance Institute®

Company History Current Operations Future Operations

Corporate Finance Institute®

Company History Current Operations Future Operations

How long has the company been in existence?

Corporate Finance Institute®

Company History Current Operations Future Operations

Do we fully understand the operation of the

Corporate Finance Institute®

Company History Current Operations Future Operations

How will the growth occur?

Corporate Finance Institute®

Management Past Performance Reputation

What does their track What do customers, suppliers, and the

Is there a clear and What business and financial

Attitude towards Risk

Have risks and risk

Corporate Finance Institute®

• Business plans • Professional advice

• Communication • Financial reporting

Corporate Finance Institute®

Corporate Finance Institute®

• What are the current and forecasted

Corporate Finance Institute®

How to analyze the cash flow statement?

Operating Activities Investing Activities Financing Activities

Corporate Finance Institute®

Operating Activities Investing Activities Financing Activities

Identify cash flow trends and root causes

Increasing receivables – Are customers

Increasing payables – Is the company

Corporate Finance Institute®

Operating Activities Investing Activities Financing Activities

Purchase and sale of

• Property, plant and equipment

Positive cash flow in the Selling assets to

Corporate Finance Institute®

Operating Activities Investing Activities Financing Activities

Debt and/or equity

Any excess cash flows after Repay debt

Corporate Finance Institute®

Credit analysts need to evaluate the drivers

Corporate Finance Institute®

Coverage ratios demonstrate the ability of a

Debt Service Operating Profit

Corporate Finance Institute®

Leverage ratios measure the degree to which a

Corporate Finance Institute®

Profitability ratios measure and evaluate the