IIBF CCP MODULE-A: CREDIT- 6 Cs OF CREDIT APPRAISAL

IIBF | CCP | MODULE – A: INTRODUCTION & OVERVIEW OF CREDIT | 6 C’s OF CREDIT APPRAISAL

In this article, we will be getting some insight on what is credit appraisal and what are the 6C’s of Credit.

OVERVIEW OF CREDIT | CREDIT APPRAISAL 

Credit appraisal is the assessment of a loan application or proposal thoroughly to estimate the repayment ability of the loan applicant. This assessment is done with the purpose to make certain that the bank will get back its money which is lent to the customers.

Credit appraisal is a detailed and systematic credit appraisal process and it is done in respect of every loan applicant whether it’s an individual or a corporate entity. This is a comprehensive process where management, market, technical, and financial elements are evaluated.

It is a crucial process as it ensures that the borrower will be able to repay the entire loan amount on time without missing any due dates so as to determine the interest income and the capital of the bank & to avoid default risk.

Lenders, therefore, customarily analyze the credit worthiness of their borrower by analysing the 6C’s of Credit i.e.

1. Character 
2. Capacity
3. Capital
4. Conditions
5. Collateral &
6. Cash Flows. 

Each of the above criteria helps in determining the overall loan risk. The above factors don’t ensure access into financing in themselves but they are only evaluation factors to determine as to how much is the risk of the potential borrower. 

• CHARACTER

It is a subjective assessment of the personal history of the potential borrower. Lenders must have trust that the business owner is trustworthy & can be trusted to pay back the loan. The factors related to the credit history of the borrower such as credit, education & job positions are studied to check the creditability & ethics that are followed by the borrowers. The creditability is essential as bank or a lender need to trust and believe that the loan will be paid on time. The knowledge, skills, & abilities of the owner & management team are also some of the vital credit factor components.

Although character is vital but it should be the least important factor as one may be misjudged or one may not seem to be serious, but that really does not mean that the person/borrower will not be a good & trustworthy loan candidate.

• CAPACITY

The second C, here referred to as capacity, which indicates the borrowers’ ability to pay back the loan. Any borrower would want to ensure that whatever amount he/she will lend, he/she will get back in full. So, when we look at capacity, the lender will review your capability to repay a loan in both, legally and financially, aspects. Meaning, the institution needs to know if one can access the credit and payback on time.

Capacity can be evaluated by the following components:

1. Cash Flow:  It means the income that a business generates versus the expenses of running a business are analyzed for period which is generally 2 or 3 years. But if the business is a start-up, a monthly cash flow statement for 1st Year is prepared.
2. Payment history: The timeliness of the previous loan payments are evaluated to determine the commercial credit ratings.
3. Contingent sources: The additional sources of income for repayment that can be used for the repayment of a loan are known as contingent sources. These may be in the form of personal assets, savings accounts etc. While for small businesses, the income of a spouse who is employed outside the business is commonly considered.

• CAPITAL

The proportion of the money invested by the borrower in her/his own business also play an important role in the consideration of the risk of credit. The owner of a company must have his/her capital invested in the firm before a bank decides to risk in its investment. Capital is the proprietor’s investment in his / her company that he/she is at a risk of losing if the business turned out to be unsuccessful. 

Undercapitalization is one of the main reason for the failure of new companies & though there is no fixed amount that the owner ought to receive in the business until he/she is eligible for commercial credit, but the 4th part of the company funds are the expected to be financed by the owners. And almost in every case, any principal that will own > 10% of the company is required to sign a personal guarantee for the business debt.

• CONDITIONS

Conditions, hereby, are referred to as the overall assessment of the current economic environment & the objective of the credit. While taking a decision to accept credit, economic conditions that are unique to the business sector who has applied for the loan & the country’s economic factors. While in a time of economic growth, a a growing enterprise is more likely to get the loan approved than if the its business sector is deteriorating & the economy is unpredictable.

The loan objective also plays an important factor i.e if the business plans to invest the loaned amount into business by acquiring assets or expanding its market, then it has more chances of approval than if it were to use for more expenses. 

Typical factors that are considered in this evaluation step includes: the strength & the level of competition, market size and its attractiveness, dependence on changes in consumer tastes & preferences, concentration of customers or suppliers, length of time in business, & any relevant social, economic, or political forces that have the potential to impact the business.

• COLLATERAL

Collateral is the security which a bank or a lender uses to get the repayment of its loan if the borrower fails to repay it on time. The collateral could be borrowers’ heavy equipment, stocks, receivable accounts, & other assets. While for the individuals’ borrowers it’s their personal assets such as his/her home or automobiles: cars, scooters by providing a personal guarantee on a business loan, that means the lender can sell the borrowers’ personal items to satisfy any outstanding amount that might not get repaid. 

Collateral is considered a “secondary” source of repayments, as banks just want cash as a repayment of their loans & not the sale of business assets.

Financial institutions will generally advance < 80% of valid accounts receivable.

• CASH FLOW

Cash flow is referred to the borrower’s profits over its operation cost which the the borrower has incurred over a fixed period. 

Thus, above are the 6 Cs of Credit that are seen/checked/assessed/considered when under scrutiny. They are highly considered when providing loans of big amounts while in lending small amounts of money, the general eligibility depends largely on personal & business credit scores. 

There are some ratios also when an applicant is considered for the loan approval such as Fixed obligation to income ratio (FOIR), Installment to income ratio (IIR) and Loan to cost ratio etc.