Understanding the 5 C's of Commercial Lending

Although a commercial loan is a financial transaction, it’s ultimately a relationship between borrower and lender. It is, therefore, at its base, more of an art than a science. Lenders are responsible for making decisions which are consistent with the business parameters and limitations of their institutions. They test each loan application against five elementary lending criteria to determine the overall soundness of the proposal. For the request to be considered seriously, the lender must be comfortable with the combined strength of the borrower with regard to these criteria. For instance, if the borrower has a weakness in one area, the deficiency may possibly be overcome with a stronger position in one of the remaining determinants. These lending criteria include capacity, capital, collateral, credit, and character.

The borrower’s capacity is a measure of their qualification to receive the loan requested. The lender will attempt to ascertain whether the borrower is operating within his or her abilities and not attempting to accomplish something beyond their limitations or means. Position in the market, experience in the industry, and track record in business will determine, in the lender’s eyes, if the borrower is a qualified candidate.

Capital is defined as the portion of the total cost of the deal which must be contributed by the borrower. Lenders will always limit their leverage in a transaction by requiring that the borrower also have a meaningful amount of capital at risk, thereby insuring the business owner’s commitment to the deal as well as reducing the lender’s exposure to loss. Different lenders have different capital requirements for borrowers in different situations, based on their use of proceeds, the availability and value of the borrower’s collateral, and the nature of the business operation.

Sufficient collateral shows the borrower’s ability to guarantee the loan with tangible assets as a secondary source of repayment. Lenders generally prefer collateralized assets to be valued on a discounted basis. This discounted value gives the lender a safe margin to cover the time and costs of converting those depreciated assets into cash, should the need ever arise.

Studying the borrower’s credit history provides a picture of how the business or its owners have handled previous financial dealings. The credit report also discloses whether the business has any civil judgments against it, any unpaid tax liabilities, liens against their assets, or if it has filed for bankruptcy protection. While not an exclusive indicator of how the business will perform in the future, credit information does relate to how the borrower and the business have performed in the past.

Although certainly the least quantifiable, character may well be the most important assessment that the lender can make about the prospective borrower. Regardless of the positive attributes of capacity, capital, collateral and credit that the borrower may show, if he or she does not demonstrate integrity and trustworthiness, any loan proposal will be declined. Character is important because, among other things, it can reveal intent. If the lender senses that the borrower is somewhat cavalier toward fulfilling responsibilities with regard to the deal, and even toward the business, the lender will most certainly back away from the proposal. The lender must be made to believe that, in addition to the legal agreement, the borrower feels a certain moral obligation to repay the loan.

The subjectivity of business lending cannot be overly stressed. Although there certainly are concrete, quantifiable things which the lender looks for, in the end the decision whether or not to make the loan will quite often come down to subjective measurements, the comfort level that can be forged between the two sides.