The Five Cs of Credit: Deciding when to loan money

A blue tractor pulling  a red disc at the edge of a field


Every day, we make decisions about what loans to make. The expectation is that every loan will be paid back, in full, and on time – careful consideration of each opportunity helps ensure that’s what happens.

So what do lenders consider? It all boils down to the “Five Cs of Credit,” which include character, capacity, capital, collateral and conditions.

1. Character. It should be no surprise that personal and professional integrity is a key consideration when someone is deciding to lend money. Are you trustworthy? Does your background support your current goals? The best way to convey your character is to look your lender in the eye and come prepared with a strong business plan.

2. Capacity. The simple question capacity asks is: will your business have sufficient cash flow to make your loan payments? You can let your lender know that you have the necessary capacity by bringing a projected income statement and statement of cash flows. Keep in mind that each lender will have different requirements for financial ratios. One of the most commonly used is Debt Coverage Ratio (DCR) – and the higher the ratio, the better (shoot for 1.2:1 or higher).

3. Capital. Capital is a measure of your net worth, which is calculated as your total assets minus your total liabilities. If your assets are limited and you have significant liabilities –other loans, for example – your capital position won’t be as strong. Different types of loans carry different capital requirements, and in some cases, capital requirements will vary based on the type of operation. If you don’t have the strongest capital position, be prepared to explain mitigating factors, such as help available from relatives, off-farm income, or FSA guarantee or participation loans.

4. Collateral. Collateral refers to assets that can be used to secure the debt – in other words, assets such as real estate or machinery that could be sold for cash to repay the debt if income isn’t sufficient. To assure your lender that you have assets to cover the debt in the worst case scenario, bring lists of your machinery and equipment and legal descriptions of real estate. Keep in mind that the useful life of your asset needs to align with the terms of your loan: a combine with one year of useful life remaining won’t be very helpful for a long-term loan.

5. Conditions. Lenders look at the conditions of the borrower and the overall economy, including within the specific industry of the borrower, and then look for ways to mitigate any risks. For example, a dry-land farmer seeking a loan in the midst of a 100-year drought could mitigate the risk of crop loss, and therefore income loss, with crop insurance.

In any lending relationship, it is critical that the borrower honor the agreed upon conditions and covenants. This increases trust, which helps with the current and possible future transactions. And as in all relationships, communication is key: let your lender know if conditions change or challenges arise. They may be able to help – even if it’s just to offer advice based on their broad financial and agricultural experience.