When considering a request for a commercial loan, we are concerned with mitigating all possible things that could go wrong. We try to corral all risk into 5 categories which are called the 5 Cs of credit. If our 5 Cs are strong, the loan probably has a high chance of success. The 5 Cs are Character, Capacity, Collateral, Capital, and Conditions. Character examines the borrower’s experience and capability to remain in good standing. Capacity evaluates whether the business can generate enough income to repay the debt. Collateral provides a contingency plan should the income from business fail to pay the debt. Capital is also evaluated to assure the business has resources to fall back on in unforeseen events, and capital assures the lender is not taking all the risk in the transaction.
The remaining C that needs to be discussed is Conditions. Conditions are concerned with the business environment in which the borrower is operating. But what is unique about business conditions is they can be both external and internal. It is not difficult to understand that if the business is in a struggling industry, the business itself may be struggling.
Understanding “conditions” starts by understanding the current market. Every market will have two basic components, which are supply and demand. It will likely be impossible to exactly determine supply and demand in the specific market, but that doesn’t mean market conditions should be ignored! There are often various reports that can be used for different business types. Hotels will have Smith Travel Research (STR) reports, and there are several real estate research firms that help determine supply and vacancy of various real estate types. In dealing with commercial and industrial operations (C&I), supply and demand will be more challenging to determine. Detailed reports will not always exist for every industry in a specific market. The burden is on the lender to better understand who the borrower’s customers are, and whether they will have a continued demand for the borrower’s products or services.
One of the common mistakes I have observed is too much faith placed in reports that are available. There are firms that specialize in producing reports on specific industries, but what these reports provide is a broad overview of the national market that will not capture unique local conditions. For example, perhaps the fertilizer market will face a downturn if the national economy experiences a recession because of overbuilding in residential real estate. Several people leave their homes or are foreclosed upon, and then the lawns of those homes will be left unattended. While national data may show the fertilizer business is struggling because fewer people are buying fertilizer for their lawns, in the agricultural states like the Dakotas, the need for fertilizer for crops may be booming because of high commodity prices.
The internal conditions of the business are important too. We are interested in knowing if the business looks and operates like similar businesses in the market, and if the business can restructure itself if the market were to change. Internal conditions we are most interested in are profit margins and operating leverage. Profit margins tell us about the health of the business, as well as, the market that business is in. Stable profit margins from year to year indicate the business is effectively operating in its market and that market is likely stable too. Erratic profit margin reflects the opposite. What an ideal profit margin should be is hard to speak to, since this will vary depending on industry type. Generally speaking though, I think net profit margins that are 5% of revenue or less are concerning, no matter the industry type.
Profit margins will also be affected by operating leverage, which is the degree to which expenses are fixed. High fixed expenses means high operating leverage. This means as revenue increases, expenses will remain relatively the same, and profit margins will increase. This will also mean the business will suffer if revenue declines, because it will be unable to lower costs. In an ideal world, most expenses would be variable so they can track upward or downward with revenue to preserve a constant margin. It is the lender’s responsibility to understand the borrower’s operating leverage, so it is understood how well the borrower will handle changes in the market.
Just like there are reports that tell us about different industry markets, there are reports that compile different business operations to give averages and benchmarks. You can consult these reports to see typical profit margins and operating expenses for similar businesses. Again, we need to take these reports with a grain of salt, because the operation of a business should be put in context of the local market and not national averages. Nationally, widget manufacturers may have small profit margins because of strong competition, but if there is less competition in your local market coupled with strong demand, you would expect to see the local widget manufacturer to have a bigger profit margin.
To summarize, understanding the conditions of the business are also important because it gives us insight into the viability of the borrower. We should be careful to lend to borrowers in struggling markets or borrowers who have poorly structured operations. To understand the market, we need to understand supply and demand. Obtaining local data is paramount, and even though exact supply and demand will likely not be determinable, local studies by economic development bureaus and local information from federal agencies is helpful in understanding the market. To understand the internal conditions of the borrower, it is the lender’s responsibility to work with the borrower to know the business’ primary customers, the extent to which expenses are variable or fixed, and what the profit margins of the business are. If a lender cannot adequately understand the profit margins and expenses of a business, the lender is taking a big risk by extending credit without fully understanding his/her situation.
To wrap up the 5 Cs discussion, it is important to understand that extending credit really boils down to common sense. In reality, the 5 Cs are an exercise in sound judgment and common sense. Don’t the 5 Cs seem like readily obvious questions to address?
The goal of credit analysis is to assess whether credit can be repaid. If there is a concern that a loan may not be repaid, it can likely be articulated as a weakness in one of the 5 Cs that has been addressed. It is impossible to anticipate all of the reasons a loan could go bad, but if the 5 Cs are strong, it is likely the borrower will be well positioned to handle those risks, which means the institution will be well positioned to be repaid.--Trevor Plett