Capital: Borrowers Must Share in the Risk of Their Loan

I am continuing to talk about the 5 Cs of Credit. Already, I have addressed Character, Capacity, and Collateral. In this piece, I address Capital.

Capital is best understood through the accounting equation of Assets = Liabilities + Capital. In a simplistic financial institution, assets are loans and liabilities are deposits. Capital is funding provided by the owners. Now, let’s say a $1 million loan goes bad and is not repaid. Assets will be reduced by $1 million. Since Assets = Liabilities + Capital, that means Liabilities or Capital must also be reduced by $1 million. Since the Liabilities are deposits provided by other people, regulators will force the institution to reduce $1 million in Capital, so the owners take the entire loss and not the depositors.

Capital, in a commercial lending transaction, is the investment the borrower has at risk. When an institution makes a large commercial loan, they are putting millions of dollars at risk. Even though Capacity, Collateral, and Character may look great, the bank should not provide financing unless the borrower has some of his/her own money at risk as well. Why? Because if a project goes bad, then the lender will experience all the loss and the owner will lose nothing if they have invested nothing.  And if the owner has something at stake, the owner does not only suffer part of the loss should it go bad, but it he/she will also have incentive to make the loan work.

A common ratio used in C&I and Agriculture is the debt-to-net worth ratio, although a debt-to-assets and equity-to-assets are also used, and they all effectively measure the same thing. When we look at debt-to-net worth, we are dividing total liabilities by net worth to determine how much of the balance sheet is funded with debt, and how much is funded with owner’s capital. Going back to the equation of Assets = Liabilities + Capital, we can tell all assets are funded with either Liabilities or Capital. Liabilities are someone else’s money; Capital is the owner’s money. The more assets are funded with capital, the more risk the owner is assuming. The more assets are funded with liabilities, the more someone else is taking the risk.  Naturally, we would like to see the owners take as much risk as possible with their own capital and as little as they can with liabilities from someone else.

For example, let’s say we have $10 in assets and $5 in liabilities, which gives us $5 in capital. Debt-to-net worth, which is total liabilities divided by capital, comes to $5/$5 or equals 1.00. This means for every $1 of debt, the owner contributes $1 in capital to fund all assets. Now let’s say we still have $10 in assets, but now have $9 in liabilities, which means we have $1 in capital. Now debt-to-net worth is equal to $9/$1 which is 9.00. As you can tell, Liabilities (or other peoples’ money) are funding almost all of the business assets, and the owner is contributing very little of his/her own money. The owner is only providing $1 for every $9 he/she borrows! Generally speaking, the larger the ratio, the less risk the owner is taking and the more risk others are assuming.

The appropriate amount of capital for C&I operators will depend on the specific industry. For example, service providers will likely have only a small amount of fixed assets like computers and telephones, but they will have a high amount of A/R and accounts payable (A/P). Because A/R and A/P grow rapidly together, debt-to-net worth may also increase rapidly. A/P is a liability, so if A/P increased and capital remains relatively constant, debt-to-net worth will increase. In general, a high debt-to-net worth ratio for a service provider is 3.00 or higher.

For C&I operations that require a substantial amount of fixed assets, like land and large machines, there will be a more stable level of assets constantly on the balance sheet and any resulting term debt should remain at a stable level too. Because of this, we would expect debt-to-net worth to remain more stable.  But, we want to see the ratio lower because the asset values of these fixed assets are subjective and can vary, and they may be specialized and illiquid. It is normal for capital-intensive C&I operators and Ag operators to have a nominal debt-to-net worth ratio of 1.50 or less.

In commercial real estate (CRE), there are also ratios to judge a borrower’s capital position. The most common you hear of is loan-to-value, or LTV for short. As the name would imply, this means dividing the loan amount by the value of the real estate to obtain a ratio. Generally, we like to see an LTV between 70% and 75%, but this could be higher or lower depending on several circumstances. This implies the owner would have 25% to 30% equity invested into the property. This seems good in theory, but consider the following example: An investor needs to borrow $1 million to purchase land and $1 million to construct an apartment building. An appraiser estimates the finished apartment building will be worth $3 million. The investor comes to your institution and wants to borrow $2 million, and can prove he will have a 67% LTV loan ($2 million loan / $3 million finished value). With an LTV of 67%, does the borrower really have 33% of his capital invested in the project? No, he doesn’t, because he is asking for 100% of the cost of the project. This brings us to the second CRE measure of capital; loan-to-cost or LTC.

LTC is the loan value divided by the cost of the project. Much like LTV, we like to see LTC around 75%, and it could be higher or lower depending on the circumstances. Often with CRE, there can be some unique wrenches thrown into the LTC calculation. When we want to see an LTC of 75%, what exactly constitutes the 25% capital that the owner has to provide? Total cost is made up of several components: land, materials, labor costs, developer fees, architectural work, engineering, etc.

Capital is a tricky element to assess in this situation, but instinctively, we like to see cash up front before any costs are incurred. Cash has a determinable value, and having to forego other uses for that cash really ties the borrower to the project. Other sources of equity are less desirable, but may be considered, depending on special considerations. One example is allowing a developer to contribute equity in the form of land. That may be acceptable, since land has an easily determined value, but the true value of the equity is less reliable than seeing cash in hand. Other forms of equity deserve more scrutiny and generally should not be considered under normal circumstances.

Now that we have looked at the role of capital in both C&I and CRE, we see that capital actually serves two unique purposes. Capital ensures that the borrower also shares in the risk by facing the same consequences and losses the lender faces, and capital also provides a buffer for the unknown and unexpected. For C&I, when debt-to-net worth is adequate, borrowers can fund a significant amount of assets themselves and not rely entirely on borrowing. This should provide borrowers with the ability to handle any unforeseen events.

Equity in real estate is measured differently. As discussed in my Collateral article, I noted adequate LTV protects from changes in market value or unforeseen issues with real estate. In this way, LTV assures equity remains in the property and also serves as a buffer for the unknown. Capital should also be controlled through LTC to prevent 100% financing.

To summarize, Character assures us the customer can remain in good standing and continue to repay. Capacity evaluates whether the borrower’s business operations are satisfactory to repay the proposed debt. Collateral provides us with a contingency plan, if cash flow from the business is unable to repay the debt. To assure the customer is well invested in their business and can handle the unknown, we like to see an adequate level of Capital. The last C we need to investigate is Conditions, which we will look at next week.--Trevor Plett