The “three Cs of lending” is a system that banks and other lending institutions use to determine the creditworthiness of potential borrowers. The system typically measures the three characteristics of a client and the loan’s conditions to estimate the likelihood of a credit default. This technique of assessing the borrower considers both qualitative and quantitative measures. Understanding the essential criteria for personal debts, commercial credit, or bank loans for educational or other reasons and their role in meeting your financial needs is imperative.
Cash Flow
Your cash flow shows how much of the money you make remains with you upon debt repayment and expenses. A Cash Flow Projection demonstrates your income and expenditure looking forward into the future. Thus, an individual’s cash flow eventually defines their capacity to repay a loan. Consequently, a lender looks at a borrower’s cash flow to determine their capability to repay the loan.
While anyone can look at their cash flow for a very short period, such as a month, a quarter, or a year, you must know that most lenders want to consider cash flows projected at least three years ahead into the future. Some businesses take cash flow as earnings before amortization, depreciation, and interest and call it a pro forma projection.
Banks and other lending organizations use cash flow as a financial tool to gauge whether a company can meet the regular monthly debt payments. They ask for their cash flow statement to obtain a ratio usually known as a minimum-debt-service-coverage (minimum DSC) ratio requirement. The ratio helps them see whether a business has enough monthly cash from its profits after debt repayment and expenses. Different lenders use different ways to calculate DSC ratios. However, the rule of thumb is to maintain a 1.2-1.25 DSC ratio.
Character
Regarding lending, character is also known as credit history, the most important of the three Cs. This is because it determines a borrower’s overall reputation by considering all track records of repaying debts. The shareholders who will guarantee the debt and the management of a company eventually come under effective scrutiny to determine whether they are dependable and will certainly pay back the owed money. Consequently, the lender will often consider the credit history of a company owner to assess their honesty and reliability. Thereby, consideration regarding owners may also include:
- Whether or not they have utilized credit before
- Whether or not they pay their bills on time
- How long they have been in business
- How long they have resided at their respective postal addresses
- What professional, entrepreneurial, or other positions they have before initiating the business
When ascertaining the borrower’s character, lending institutions might also consider the creditworthiness of the fundamental principles of a business. This numeric score, usually ranging from 300-850, is derived from the borrower’s bookkeeping and financial information in their credit report. Lower scores give a red signal, while high scores typically accompany a lower risk. Although every lender has unique standards, most of them utilize credit scores to guide them in the evaluation process.
Collateral
Inventory, real estate, accounts receivable, equipment, and savings are all a business’s asset classes and fall under the broad umbrella of collateral. It can help you secure a loan. Here, the lending institution is concerned only with collateral or assets that assure the lender that they can repossess the collateral if the borrower defaults on the debt. Consequently, the assets can be collected or sold to generate the required funds to pay the loan in the event of the borrower’s insolvency.
Commercial lenders consider the loan-to-value ratio similar to homeowners’ debts or residential loans. Collateral is especially valuable for private lenders. When you want to use a property to be considered as collateral, its quality, location, and adaptability are essential features your prospective lender will consider. In most cases, lenders simply want the debt amount to be an amount surpassed by the borrower’s collateral.
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