5 Cs of Credit Course Presentation new.pdf

5 Cs of Credit
Corporate Finance Institute®

Course Introduction

Learning Objectives
01. Define each characteristic in
the 5 Cs of credit framework 03.
Identify the key credit strengths and
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
• History
• Reputation
• Management
Capacity
• Ability to repay
Capital
• Overall financial
strength
Collateral
• Assets to
secure the loan
Conditions
• Economy
• Industry

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

Character

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

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

Current Operations Future Operations
Assessing the Company
Company History

Current Operations Future Operations
Company History
How long has the company been in existence?
• Track record
• Customer base
How has the company grown?
• Organic growth
• Growth through acquisitions

Future Operations
Company History Current Operations
Do we fully understand the operation of the
business?
• People
• Process
• Information systems

Company History Current Operations Future Operations
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
Directors
Shareholders
Past Performance
What does their track
record look like?
Reputation
What do customers, suppliers, and the
competition say about members of the
management team?
Planning
Is there a clear and
consistent business strategy?
Experience
What business and financial
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
• Business plans
• Succession plans
• Financial plans and
budget
Leading
• Communication
• Measurement
Organizing
• Professional advice
• Board of directors
• Resources
• Competency
Controlling
• Financial reporting
• Financial compliance
• Performance reporting

Capacity

Capacity Overview
Capacity refers to whether the borrower has
the ability to service and repay its debt.
• 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
receivable) now and in the future?
• Is there enough sustainable forecasted
cash flow to easily service and repay the
company’s debt obligations?
The cash flow
statement to
identify sources
and uses of funds
The drivers of
sustainable
profitability and
growth
To assess capacity, the credit analyst
needs to evaluate:

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

Investing Activities Financing Activities
Identify cash flow trends and root causes
Increasing receivables – Are customers
taking longer to pay?
Increasing payables – Is the company
taking longer to pay its suppliers?
Lax credit policies
Cash flow difficulties

Operating Activities Financing Activities
Investing Activities
• Property, plant and equipment
• Investments
Purchase and sale of
Positive cash flow in the
investing section
Selling assets to
sustain operations

Investing Activities
Financing Activities
Debt and/or equity
Any excess cash flows after
investing activities are undertaken
can be used to:
Repay debt
Buy back shares
Pay dividends

Analyzing the Drivers of Profitability and Growth
Credit analysts need to evaluate the drivers
of a company’s profitability:
• Historic drivers
• Current drivers
• Future drivers
Coverage Ratios Leverage Ratios
Cash flows are driven by the income
producing ability of a company.
Ratios and trend analysis
Profitability Ratios Efficiency Ratios
Liquidity Ratios

Coverage Ratios
Coverage ratios demonstrate the ability of a
company to cover its debt financing cash flows.
Operating Profit
Interest + Principal Repayments
Debt Service
Coverage Ratio
=
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
Total Shareholders’ Equity
Debt to
Equity Ratio
=
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 Margin Ratio =
Gross Profit
Revenues
Operating Margin Ratio =
Operating Income (EBIT)
Revenues
Net Profit Margin Ratio =
Net Income (profit)
Revenues
higher numbers are better.

Efficiency Ratios
Efficiency ratios measure how well a company is
utilizing its assets.
Inventory Turnover Ratio =
Cost of Goods Sold
Average Inventory
Receivable Turnover Ratio =
Revenues
Average Accounts Receivable
Asset Turnover Ratio =
Revenues
Total Assets
Higher efficiency ratios indicate that a
company is more efficient and utilizing
and leveraging its assets.

Liquidity Ratios
Liquidity ratios measure a company’s ability to pay
its short-term debt obligations.
Current Assets
Current Liabilities
Current Ratio =
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
Analyze the trends over 5 or more years
Sales Profits
Assets Debt
Coverage Ratios Leverage Ratios Profitability ratios
Efficiency ratios Liquidity ratios

Capital

Capital Overview
Capital: the wealth of the borrower
Cash and Investments Property
Other Valuables Financial Structure
Capital – Overall financial strength
Capacity – Repayment of financing

Capital Overview
Capital explores:
• 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?
Leverage Other Sources of Capital
Working Capital

Adequacy of Working Capital
Accounts Receivable
Inventory
Accounts Payable
Working capital in Capital – The quality
and management
Working capital in Capacity – Sources and
uses of funds
• 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.
60% Equity
40% Debt
Company A
Debt to Assets: 0.40
10% Equity
90% Debt
Company B
Debt to Assets: 0.90
Debt to Equity Ratio =
Total Liabilities
Total Shareholder’s Equity
Debt to Assets Ratio =
Total Liabilities
Total Assets

Other types of leverage ratios
Funded Debt to EBITDA Ratio =
Interest Bearing Debt
EBITDA
Funded Debt to Equity =
Interest Bearing Debt
Total Shareholder’s Equity

Other Sources of Capital
Unutilized debt facilities
• Is the availability sufficient to fund existing and
future requirements?
Redundant assets
• Does the company have redundant assets that
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
had recently in raising equity?
• For a privately held company, what is the ability and
willingness of the company to raise additional
equity?
• Has this been demonstrated with recent
experiences?
Ability to access new debt
• What capacity and experience does the company
have with raising additional debt?
• Would the current lender be prepared to
increase their exposure?
Other sources of funding that a company may have access to.

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
Real Estate
• Land
• Buildings
Working Capital
• Inventory
• Accounts receivable
Machinery and Equipment
• Manufacturing equipment
• Vehicles
The collateral of a borrower relates to what assets the company has available in order to
secure debt in the event of a default.

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
secondary market to
sell the asset if
needed?
Is it easy to price or
value the asset?
Does the value of
the asset change
frequently?
Is it easy to transfer
ownership of the
asset?

Conditions

Conditions Overview
Industry Attractiveness
• Risks associated with the industry
• Current or future trends
• Forces that influence the
attractiveness
Competitive Advantage
• Competitive strengths
• Weaknesses
• Critical success factors
Specific Loan Contract
• Funding requirements
• Meet ongoing requirements

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

Assessing Industry Dynamics and Attractiveness
Threat of substitute
goods/services
Bargaining power
of suppliers
Threat of potential entrants
Bargaining
power of buyers
Power of complementary
good/service providers
Intensity of
industry rivalry
Porter’s 6 Forces

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

Competitive Position
Strengths
Threats
Weaknesses
Opportunities
• How is the company managing risk related to any threats or opportunities identified?
Internal
Factors
External
Factors
SWOT analysis
• 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?

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

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

Conclusion

5 Cs of Credit Summary
Character
• Management
assessment
• Understanding
the company
Capacity
• Sources of funds
• Sustainable
profitability
Capital
• Adequacy of
working capital
• Leverage of the
company
Collateral
• Working capital
• Other tangible
assets
Conditions
• Assessment of
industry
• Competitive position
• Performance
requirements

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

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