Mutinda Mbai

HDB211-0082/2019

Financial risk Management

Bcom 4.2

5Cs of credit evaluation

1. Character

Character, the first C, more precisely relates to a borrower's credit history, which is their track
record of on-time loan repayment. The borrower's credit reports, which are produced by
significant credit bureaus, contain this information. Credit reports contain precise information
regarding how much an applicant has borrowed in the past and if they have repaid loans on time.

2. Capacity

Capacity measures the borrower’s ability to repay a loan by comparing income against recurring
debts and assessing the borrower’s debt-to-income (DTI) ratio. Lenders calculate DTI by adding
a borrower’s total monthly debt payments and dividing that by the borrower’s gross monthly
income. The lower an applicant’s DTI, the better the chance of qualifying for a new loan.

3. Capital

Lenders also take into account any funds that the borrower contributes to a possible venture. The
likelihood of default is reduced if the borrower makes a significant capital contribution. For
instance, borrowers who can afford a down payment on a house often find it simpler to get a
mortgage—even specialized mortgages made to open up homeownership to more people.
Contributions to the capital show the borrower's degree of investment, which might reassure
creditors about extending credit.

4. Collateral
Borrowers who have collateral may be able to acquire loans. It guarantees the lender that, in the
event of a borrower default, they will be able to recover some of their investment by seizing the
collateral. In many cases, the item for which the money is being borrowed serves as the
collateral. For example, auto loans and mortgages both use homes as collateral. Because of this,
loans secured by collateral are sometimes known as secured debt or secured loans. In general,
they are regarded as being less hazardous for lenders to provide. As a result, compared to other
unsecured types of financing, loans that are secured by some kind of collateral are frequently
provided at lower interest rates and with better terms.

5. Conditions

In addition to examining income, lenders look at the general conditions relating to the loan. This
may include the length of time that an applicant has been employed at their current job, how their
industry is performing, and future job stability. The conditions of the loan, such as the interest
rate and the amount of principal, influence the lender’s desire to finance the borrower.
Conditions can refer to how a borrower intends to use the money. Business loans that may
provide future cash flow may have better conditions than a house renovation during a slumping
housing environment in which the borrower has no intention of selling.

2. Financial instruments that can used in financing corporations.

Financial instruments are tools for financing businesses that make it easier for money to move
between parties. Many types of financial instruments are employed effectively to support firms
in pursuing their own business goals. The financial instruments utilized vary in line with the
many shapes and sizes that corporate financing might take, depending on the demands of the
organization. Most often, debt instruments are employed to finance businesses. Securitization,
notes, or corporate bonds may be used to accomplish this. Corporate bonds are merely borrowed
funds that the company promises to return with interest over a predetermined time period. Notes
are similar but tend to be far more extensive, including the terms and conditions of repayment.
And securitization refers to the bundling of multiple debt instruments into a larger, more liquid
financial instrument. These instruments can then be sold to investors interested in a higher credit
rating and a greater return.
Equity instruments are another way corporations finance their operations. When a corporation
needs additional funds to pursue growth opportunities, issuing additional shares of stock is a
popular option. These shares can be sold to both investors and shareholders in exchange for
capital. This type of financing allows the corporation to raise funds without having to incur the
additional costs of taking on debt. Corporations can also use derivative instruments when
financing their operations. These instruments include options and futures, which allow
corporations to hedge against the potential volatility associated with certain types of investments.
For example, they can use these instruments to enter into contracts that guarantee a certain price
for a certain period of time. This helps corporations offset some of the risk associated with their
investments.

Finally, businesses can finance their activities by using money market instruments. These highly
liquid securities, including Treasury Bills and Money Market Funds, give businesses simple
access to short-term borrowing. Corporations can swiftly access funds using this kind of
instrument, which also saves them money on long-term borrowing fees. In conclusion, a number
of financing choices are available to organizations thanks to financial instruments. Corporations
can raise money for their operations via debt, equity, derivative, and money market instruments,
depending on their needs. Financial tools assist businesses in effectively financing their goals,
but they also have related costs and dangers. With careful planning, organizations can use these
instruments to their advantage and reach their targeted financial objectives.

3. Discuss asset securitization

Asset securitization is the process of combining collections of assets, such as commercial loans
or mortgages, and then selling them as debt securities. The method is intended to spread out risk,
eliminate liquidity restrictions, and boost investment profits. The originator or issuer groups
comparable assets into a pool to start the asset securitization process. The sponsor is a financial
institution that carefully monitors and assesses this pool of assets. The sponsor will thereafter
transfer the asset pool to a special-purpose vehicle (SPV), a legally recognized organization that
in turn creates securities backed by the asset pool.These securities are then sold to both
institutional and retail investors. The issuer will keep some of the securities in order to keep track
of the pooled assets and help manage their risks. This leaves enough securities to be distributed
to the investors.
Payments from the anticipated cash flows produced by the pool are due to the investors. Under
the supervision of a regulator, such as the U.S. Securities and Exchange Commission (SEC) in
the United States, the entire asset securitization procedure is carried out. This promotes openness
and safeguards investors against fraudulent conduct. Asset securitization lowers costs, risks, and
liquidity restrictions. By turning them into securities, it also enables the asset's creator to get rid
of its liabilities. Most significantly, it enables investors to acquire interests in a variety of
different assets without having to bear the entire amount of risk associated with it. Combined
with the ability to sell their interests quickly and easily, investors can benefit significantly from
asset securitization.

References

Kinder, M. (2020, April 15). What Is Asset Securitization?. Investopedia.

https://www.investopedia.com/terms/a/asset-securitization.asp
Lins, K., & Servaes, H. (2002). Equity financing and the relation between ownership structure
and firm performance. European Financial Management, 8(2), 197-221.
doi:10.1111/1468-036X.00075
Small Business Administration. (2020). The Five Cs of Credit. Retrieved from
https://www.sba.gov/business-guide/manage-your-business/credit-and-financing/5-cs-
credit