The Cs Of Credit

Character
Capacity
Capital
Collateral
Conditions

1. Character
Character is the first `C' in credit. It is important to investigate the character of a borrower.
This is usually done by obtaining character references from:
Other bankers that have had a relationship with the business in the past,

The major suppliers of the business,

The major customers of the business.

Competitors of the business and

The regulators

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 The Cs Of Credit
1. Character (Contd)

Information published by the press may also be useful but it is important

to check the veracity of such information.

It is however important to point out that, no matter how honest a borrower

may be, a loan will not get repaid if the borrower does not have the
capacity to repay (i.e. cash). It is thus important to distinguish between
willingness (character) and ability (capacity) to repay a loan.

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 2. Capacity
A borrower's repayment capacity is measured by:
1) Identifying his source of repayment, and
2) Carefully reviewing future cash income from that source to ensure that it is enough to
meet the borrower's cash obligations.

Although it is desirable for a borrower to have a good track record, it is future cash income that
repays a loan. Accordingly, it is critical that the lender reviews:

1) The level of future profitability of the core business of the borrower, and
2) Cash future income to be generated from core business (operating activities)

This is because, more often than not, the lender loans money to a borrower to finance his core
business. Usually, he also expects to get repaid from cash generated from core business. It is
therefore critical to ensure that cash generated from core business is enough to:

Repay debts in an orderly manner,

Pay a competitive return to shareholders and
Replace long term operating assets.

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 Capacity (Contd)
When evaluating a Speculative borrower's capacity to repay a commercial
loan, it is important to:

Evaluate the profitability of the underlying transaction/operating cycle

being financed
Evaluate the strengths of the cash flow of the transaction/operating cycle(
degree of free cash flow). In doing this, it is imperative that cash
generated from the cycle covers the following:
Operating expenses of the business for the period of the cycle
Interest expense
Principal repayment
Return owners equity contribution
Provide a return to the owner(s) of the business

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 Capacity (Contd)
The last of these parameters is so critical in ensuring that speculative grade borrowers repay loan obligations. Empirically it
has been proven that where the transaction/operating cycle yields a negative return to the owners, willingness to repay
loans becomes a problem.
For Speculative grade borrowers with financing needs/working investment needs that are permanent, cash generated from
the previous cycle should cover financing cost in addition to replacing trading assets for the next conversion cycle.

It is important for the lender not only to evaluate the repayment capacity of the borrower's source of repayment but most
importantly to put controls in place to ensure that the borrower performs.

In evaluating seasonal businesses, it is important to determine how much asset growth is attributable to seasonality. The
portion attributable to seasonality is usually repaid by asset sale (contraction of assets) off - season. It is therefore
important for a seasonal business to complete its asset conversion cycle (i.e. sell its products before the season ends).
Otherwise it will not be able to repay seasonal loans from asset sales.

Short-term borrowings are usually employed to finance seasonal build-up of assets. Such loans are repaid at the end of the
season, after the assets have been sold.
Prudent lenders usually ask seasonal borrowers to clear up the facility at the end of the season. This is to confirm whether
or not the borrower has completed his asset conversion cycle. Beware of a situation where the borrower borrows from
elsewhere to clean up in order to disguise the fact that he has not completed his asset conversion cycle.

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 3. Capital

Capital here means equity. Equity is defined here as shareholders' funds

and any other creditor that ranks lower than the lender in liquidation.

Equity is a cushion that a lender has. This is because, in liquidation, if the

assets of a company do not shrink by more than the value of equity, the
lender will get repaid in full.

Accordingly, it is not possible to make meaningful comments on the

adequacy of equity without reference to the quality of the underlying
assets.

Quality of assets can be measured in two principal ways:

1. The revenue generating capacity of the assets, and

2. What the assets can fetch in an open market.

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 3. Capital (Contd)

Due to the weak financial reporting process of Speculative grade borrowers, lenders
must assess the equity required on a transaction basis. In assessing the degree of
equity required by the borrower, the following should be considered:

1. The degree of shrinkage of the underlying assets being financed (for perishable
products and products with shelf life, the degree of equity contribution required
should be much higher)

2. Degree of business risk that could arise as a result of Supply, Demand,

Production, Macro and other Systematic risks that could impair the successful
completion of operating/Asset conversion cycle.

3. Please note that the equity contribution required is to cover business risk that is
imbedded in the transaction. This varies by obligor and transaction. It there infers
that assessing the degree of equity contribution should be done on a case-by-case
basis. Do not apply a one size fits all approach.

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 4. Collateral
No matter how well collateralised a loan is, it will not work out well as anticipated
without adequate operating cash flow. Accordingly, a lending decision based
solely on the adequacy of the collateral is unsound.
Collateral is not a substitute for repayment. Where a security is taken, it is important
to obtain an independent view of its value and marketability. A regular review of
the lending value of the collateral should be performed and any shortfall covered.
It is also important to ensure that there is adequate insurance cover on assets taken
as a security. It might be useful to also make the lender the loss payee in the case of
a claim. It is important to ensure adequate insurance of assets even when lending
clean.
When the assets of a business are taken as security for its obligations, this is
sometimes referred to as a "second way out" of the loan. The truth is that by
operation of the law, the assets of a company secure its obligations. Therefore what
taking a security does is to put a lender in a superior position relative to other
creditors. Creditors that are junior to the lender thus become "equity".

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 Collateral (Contd)
It is therefore important for a lender to avoid taking an inferior
position relative to other lenders.

A negative pledge is sometimes referred to as a collateral. A negative

pledge is a promise by the borrower not to pledge his assets as
security to any other lender without obtaining the lender's consent.
A collateral puts a lender in a superior position relative to other
lenders. Where there is no prior charge on the assets of a borrower,
all a negative pledge does is to ensure that all the creditors of the
borrower rank pari-passu. Hence, a negative pledge is not a security
but a documentation, which ensures that no preferential treatment is
conferred on any creditor of the business.

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 Collateral (Contd)
Collateral can take the form of:

A charge on the fixed assets of the borrower (a fixed charge),

A charge on the floating assets (working assets) of the borrower (a floating
charge), and/or
A guarantee or indemnity obtained from a third party.

When obtaining a third party guarantee or indemnity, it is important that the

lender thinks of how to also protect the interest of the guarantor or person
providing the indemnity. Otherwise he runs the risk of being accused of not
applying due diligence in managing the loan.

A charge on floating assets crystallises (i.e. becomes fixed) upon the default of
the borrower. This empowers the lender to foreclose; take possession of the
assets pledged as security and sell them in order to get repaid.

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 5. Conditions
A lender usually attaches conditions to a decision to loan money to a
borrower.Conditions or covenants are usually financial or non-
financial.

The goal of financial conditions is to ensure that the borrower

generates adequate profits from core business; and that these profits
are converted into enough cash to meet the borrower's obligations.

Non-financial conditions are usually imposed to protect the assets of

the borrower and ensure that the lender receives timely and relevant
information about the borrower's financial condition.

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