The Three Cs of Lending: Cash Flow, Character, and Collateral

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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 in an attempt to estimate the likelihood of a credit default. This technique of assessing the borrower takes into account both qualitative and quantitative measures. It is imperative to understand the basic criteria for personal debts, commercial credit, or bank loans for educational or other reasons as well as the role they play in meeting your financial needs.

1. 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, cash flow of an individual eventually defines their capacity to repay a loan. Consequently, a lender looks at the cash flow of a borrower to determine their capability to pay back 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 take into account cash flows that are 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 is able enough to meet the regular monthly debt payments. Thereby, they ask for their cash flow statement to obtain a ratio usually known as a minimum-debt-service-coverage (minimum DSC) ratio requirement. The ration helps them see whether a business has enough cash coming in every month 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.

2. Character

In terms of lending, character is also known as credit history, which is the most important of the three Cs. This is because it determines a borrower’s overall reputation by taking into account all track records of repaying debts. The shareholders who will guarantee the debt and the management of a company eventually all come under effective scrutiny in order to figure out whether they are dependable and will certainly pay back the owed money. Consequently, the lender will often take into consideration the credit history of a company owner as well 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 had before initiating the business

When ascertaining the character of the borrower, lending institutions might also consider the creditworthiness of the key principals of a business. This score is numeric, usually ranging from 300-850, 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 their unique standards, most of them utilize credit scores in order to guide them in the evaluation process.

3. Collateral

Inventory, real estate, accounts receivable, equipment, and savings are all of the asset classes of a business 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 give the lender assurance that they can repossess the collateral in case the borrower defaults on the debt. Consequently, the assets can be collected or sold to generate required funds to pay the loan in the event of the borrower’s insolvency. Commercial lenders take into consideration the loan-to-value ratio which is 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 take into account. In most cases, lenders simply want the debt amount to be an amount surpassed by the borrower’s collateral.

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