The 4 C’s to Credit Approval

After presenting hundreds of credit applications, I’ve noticed a pattern in the credit approvers’ comments when they approve a deal. At first I didn’t think too much about it, but one day, I decided to ask the approver directly.

My suspicion was confirmed.

Risk approvers are naturally risk adverse. The less risky the deal, the more likely it gets approved. So when an application is submitted, they use 4 fundamental credit risk criteria to assess the creditworthiness of a company.

Let’s dive in.

In this issue, you will learn:

1. The 4 credit risk criteria
2. How to use these criteria to secure a loan approval

1. Capital

Capital is the money used to build, run, and grow a business. Every business needs capital to operate. Without it, the business will fail.

How do we get capital?

The first source of capital is from the owner. This is the first injection of funds (and life) into the company. As the company grows, the profit retained in the business becomes the second source of capital. When the company needs more money to grow, capital can come from its owners, investors, banks, private lenders, and the market (for public companies).

For businesses turning to the bank for loans, the owner is typically the primary source of capital. This means the credit approvers will need to know a few things about the owner.

• How much additional capital is available?
  • The amount of additional capital available is an important determinant of the credit approvers level of comfort. If there is enough capital to cover for the entire loan, this is viewed favorably.
• Is the source of capital reliable?
  • A reliable source of capital means that additional funds can be injected to support the company, when needed. Most businesses operate as a separate legal entity, which means the owner isn’t obligated to support the company. This can be problematic if the company starts to fail and the owner walks away, leaving all the outstanding debt to the bank. However, if personal guarantees are involved, the owner is personally obligated to support the loan, which makes his money a reliable source of capital.
• Is the capital accessible?
  • The most accessible form of capital is cash because it is already liquid. This cash can be injected into the company immediately. If the source of capital is locked into assets such as real estate, it can take months before any cash can be injected into the business.

2. Collateral

Collateral is a term describing the assets that have been assigned to the bank. This can be the company’s assets and/or the owner’s assets. Keep in mind that the bank doesn’t control all the assets. Instead, the bank has the rights to enforce the assets, when needed.

In a liquidation scenario, the bank can sell the collateral and use the proceeds to repay the loans. This is the last resort banks use to minimize their loss. So before the loan is approved, the credit approver needs to make sure the risk to the bank is fully covered.

While collateral comes in many forms, it is common for a business to pledge all of its assets to the bank. Assets can include items such as accounts receivables, inventory, property, equipment, and intangible assets. Going deeper into the collateral, the credit approver needs to know:

• What is the value of the collateral?
  • The value of collateral lies only in tangible assets because tangible assets have value in the liquidation market. For intangible assets, this market doesn’t exist because its value is subjective to the user’s needs. In short, the more tangible assets there are, the greater the collateral value is available to support the loan.
• How liquid is the collateral?
  • Similar to the discussion on capital accessibility, this also applies to collateral. When the bank enforces on the collateral, they want the loan to be repaid as soon as possible. So the quicker it is to convert the asset into cash, the better. As such, the ranking of collateral is: cash > accounts receivable > inventory > equipment > property.
• Are there preferred creditors or liens involved?
  • Preferred creditors are 3rd parties who have financed specific assets for the company (i.e. vehicle lease, equipment lease). Note that banks always want to get repaid first. If a preferred creditor has claims or a lien over the asset, the preferred creditor’s interest will rank ahead of the bank and will get paid first upon liquidation. In these instances, the bank will exclude these assets from its pool of security.

3. Cash Flow

While cash flow is the money that flows in and out of the company during the course of its business, banks consider cash generation to be a better benchmark. Specifically, banks like more incoming cash than outgoing cash (don’t we all?).

The most common metric banks use for cash flow is EBITDA. In a world where all sales and expenses are paid upfront, EBITDA reflects the amount of cash the company has generated.

Here are a few considerations on cash flow:

• Is there sufficient cash flow to service the interest and principal payments?
  • This is simple. The bank wants to be paid the interest and principal that is owed to the bank. Sufficiency is tested with financial covenants such as the interest coverage ratio or the debt service coverage ratio.
• How consistent is the cash flow?
  • Cash flow consistency is important because it demonstrates the company’s ability to meet its loan obligations year after year. The ideal scenario is consistent year over year cash flow growth.
  • When cash flows are volatile, this implies a risk that the company cannot meet its loan obligations in a down year. For extraordinarily good years, this is viewed as an anomaly that may not be repeated. The key here is consistency.
• Is cash flow reliant on key customers?
  • If the company is reliant on several key customers, this is known as customer concentration risk. The loss of a key customer can significantly reduce the company’s cash flow, which impairs the company’s ability to repay the loan. In this situation, there are other considerations to make.
  • If there is a long-term contract in place, this provides stability to the source of revenue and incoming cash flow.
  • If the company has been selling to the key customer for over 10 years, this consistency and relationship is viewed to be positive.
  • If the product being sold is a core component of the key customer’s without another competitor involved, there is inherent reliance from this customer.

4. Character

Character is a term used to describe the values, beliefs, and behaviors that the company embodies and practices daily. This concept extends not only to the owner, but also the management team. Character is extremely important because it is the essence of the company. Unfortunately, the true test of character only comes during hardships, which is why credit approvers are interested to know about:

• How experienced is the business owner?
  • Experience is built through past experiences where the owner/management team is incentivized to use this experience to build a successful, profitable company. The more experience the owner/management team has, the less risk there is for the bank.
• How many years has the company been in business?
  • The company’s tenure is important because it demonstrates whether the company has weathered through economic cycles. A mature company has experienced the booms and navigated through recessions, making it more resilient as a survivor. Also, mature companies have an established reputation and brand that is harder to displace (think Wal-Mart).
• Do the owners have a vested interest in the company?
  • Banks like to see is buy in and commitment from the owners. Sometimes, a company is simply an investment vehicle for the owner with no guarantees in place. This creates a layer of separation between the owner and the bank because the owner can simply walk away.
  • If the owner has demonstrated willingness to fund or have retained significant earnings within the company, this gives the bank tremendous comfort, even if guarantees are not involved.
• Who are the key decision makers?
  • While banks normally liaise with the company’s management team, it is the owner who makes the final decision. When business is booming, management has the autonomy to run the show. When business is bad, the owner calls all the shots. Remember, the management team is ultimately employed by the owner.

Based on the 4 criteria above, the better the company is at satisfying each criteria, the lower the risk, and ultimately, the easier it is to get the loan approved.

Now that we know the 4 key criteria, let’s learn about…

How to use the 4 criteria to secure an approval

Meeting all 4 criteria above gets the best odds of a loan approval. However, this isn’t always the case. There’s no special formula that can maximize the chances of approval. Instead, I use a blended approach.

In all the cases I’ve seen, the requirement for cash flow is a mandatory There’s a saying within the banking industry: “Having extra collateral doesn’t make a bad deal good”. Without cash flow, no matter how much capital the owners inject or collateral to pledge, the company will eventually burn through the cash.

In the instances where there isn’t enough capital, this can be compensated by pledging more collateral (i.e. assigning your personal residence) or demonstrating character (i.e. providing a personal guarantee). This gives the bank more hard assets to lean on and shows the owner being “all in” on the deal.

If character is lacking because the owner is young, unestablished, or simply just getting started, bridge the gap by providing more capital to share the risk. Banks typically finance 65-70% of the asset’s value. By contributing 40-50% of the equity, this lowers the bank’s risk and makes it more palatable to get support.

When there’s not enough collateral to support the loans, banks will have a hard time approving the loan. In a realization scenario, the liquidation value of the assets need to cover for the outstanding amount of the loan. In these situations, businesses can turn to government support systems that were created to support entrepreneurs. In Canada and USA, organizations include Business Development Bank of Canada (BDC) and the U.S. Small Business Association (SBA), respectively. These entities can guarantee a portion of the loan to provide banks with more security and comfort.

TL;DR

There are 4 credit risk criteria that risk approvers follow every time they review a loan application. These criteria are Capital, Collateral, Cash Flow, and Character. Maximizing the success in each criteria will reduce the risk profile of the company, which makes loans much easier to approve. Not all of the criteria need to be met to get the approval; a combination of criteria is usually enough to get the job done.

That's it for this week. Thank you for reading Financing Journey. See you next Saturday.

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