5C’S OF CREDITS

• Character,

• Capacity,

• Capital,

• Collateral and

• Conditions

• Each of these criteria helps the lender to determine the overall risk of the loan
 1. CHARACTER
• business owner’s personal history
• personal credit history, education, and work experience
• honest, ethical and fair
• knowledge, skills, and abilities of the owner and management team
• The difference between the ability to repay a loan and
the willingness to repay a loan is an example of a person’s character.
 2. CAPACITY
• evaluation of the company’s ability to repay the loan
• Cash Flow refers to the income a business generates versus the
expenses it takes to run the business analysed over a specific time
period-usually two or three years
• Payment history refers to the timeliness of the payments that have
been made on previous loans.
• Contingent sources for repayment are additional sources of income
that can be used to repay a loan. These could include personal
assets, savings or checking accounts, and other resources that might
be used. For small businesses, the income of a spouse employed
outside the business is commonly considered.
 3. CAPITAL
4. COLLATERAL
• Capital
• his own funds invested in the company
• most lenders want to see at least 25% of a company’s funding
coming from the owner
• Collateral
• Machinery, accounts receivable, inventory, and other business assets
• owner’s personal assets
 5. CONDITIONS
• Economic conditions specific to the industry of the business
• purpose of the loan is an important factor
• to invest the loan into business by acquiring assets or expanding its market,
there is more of a chance of approval than if it plans to use the fund for more
expenses
• the strength and number of competitors, size and attractiveness of the market,
dependence on changes in consumer tastes and preferences, customer or
supplier concentration, length of time in business, and any relevant social,
economic, or political forces
 3 R'S OF CREDIT

• 1. Returns from the investment

• ROI = Net Income / Cost of Investment

• The first version of the ROI formula (net income divided by the cost of an investment) is the
most commonly used ratio.
• Example of the ROI Formula Calculation

• An investor purchases property A, which is valued at Rs. 5,00,000. Two years later, the investor
sells the property for Rs. 10,00,000.

• We use the investment gain formula in this case.

• Return = sale value – purchase vale of property (1,000,000 – 500,000) / (500,000) = 1 or 100%

• ROI = profit / initial investment

• ROI =500000/500000 x 100 = 100%

 A. NET PRESENT WORTH

• Where,
• Bn = Benefits in nth Year
• Cn = Costs in nth Year
• n = life span of the project
• i = interest or discount rate
• To derive the present value of the cash flows we need to discount them at a particular rate.

• NPV takes into consideration the time value of money.

• The time value of money simply means that a rupee today is of more value today than it will
be tomorrow.

• Consider it this way: You have Rs. 100 today and you can buy ten chocolates. The same Rs.
100 will be able to get you not more than the same 5 chocolates may be after one year. So,
the cash flows earned today are of more value than as on a later date.
• After discounting the cash flows over different periods, the initial investment is
deducted from it.

• If the result is a positive NPV then the project is accepted (economically feasible).

• If the NPV is negative the project is rejected.

• And if NPV is zero then the organization will stay indifferent.

 ILLUSTRATION

• Let us say Nice Ltd wants to expand its business and so it is willing to invest Rs
10,00,000.

• The investment is said to bring an inflow of Rs. 1,00,000 in first year, 2,50,000 in the
second year, 3,50,000 in third year, 2,65,000 in fourth year and 4,15,000 in fifth year.
Assuming the discount rate to be 9%. Let us calculate NPV using the formula
Year Flow Present value Computation

0 -10,00,000 -10,00,000

1 1,00,000 91,743 1,00,000/(1.09)

2 250000 210419 250000/(1.09)^2

3 350000 270264 350000/(1.09)^3

4 265000 187732 265000/(1.09)^4

5 415000 269721 415000/(1.09)^5

• Here NPV is Rs. 29879.

• Since the NPV is positive the investment is profitable and hence Nice Ltd can go ahead

with the expansion.

 B. BENEFIT-COST RATIO (BCR)
• .

• If the BCR is greater than 1, then it is worth wile to invest on the project.
 C. IRR – INTERNAL RATE OF
RETURN

• IRR is that rate of discount which makes the present worth of benefits and costs equal or
the net present worth of cash flow equal to zero. If IRR is greater than the opportunity
cost of capital, the project is feasible.
 PROBLEM

• A machine can reduce annual cost by Rs. 40,000.

• The cost of the machine is Rs. 223,000 and the useful life is 15 years with zero residual
value.

• Compute internal rate of return of the machine.

 SOLUTION

• Internal rate of return factor = Net annual cash inflow/Investment required

• = 223,000/40,000

• = 5.575
 2. REPAYMENT CAPACITY

• The ability of the borrower to clear off the loan obtained for production purposes
within the time stipulated by the bank.

• The loan amount may be productive enough to generate additional income to the
borrower, but it may not be productive enough to repay the loan.

• Hence, the necessary condition here is that the loan should not only be profitable but
also have potential for effecting repayment.
• The repayment of loan depends on the amount of surplus income available with the
farm household after providing some amount for the family expenses and pre-existing
liabilities, besides keeping a margin for the risk factor.

• As the farming family is likely to get income from the farm business as well as from off-
farm activities, the repaying capacity of the borrower should be judged by taking into
account their total income
• Where,
• Rc = Repaying capacity
• Y = Income from other sources.
• Fe = Family expenses
• OL = Other liabilities
• rf = risk factor margin
• I = Loan instalment
• i = interest on investment and working capital
• The two major components of the coverage ratio are

• 1. the Capital Debt Repayment Capacity (CDRC) and

• 2. the Annual Debt Service Requirements (ADSR).

• Table 1 illustrates the calculation of Capital Debt Repayment Capacity.

CAPITAL DEBT REPAYMENT CAPACITY
• The starting point in calculating CDRC is the projected net farm income from the business.

• Adjustments are then made by adding in non-farm income, term debt interest and
depreciation.

• Term debt interest is added back because it is part of the Annual Debt Service
Requirements.

• Depreciation is added back because it is a non-cash expense. Family living draws and
income tax expense are subtracted out in arriving at CDRC.
 ANNUAL DEBT SERVICE REQUIREMENTS

• Table 2 illustrates an example of Annual Debt Service Requirements.

• This is basically any term debt obligations that need to be paid out of the projected

cash flow for the year.

• Once these two components have been calculated, the Capital Debt Repayment Margin

and Coverage Ratio can be calculated.

• The Capital Debt Repayment Margin is simply CDRC minus the ADSR.

• The Coverage Ratio is calculated by dividing the CDRC over ADSR.

• In Table 3, the Capital Debt Repayment Margin is $8,985. The Coverage Ratio is 1.13, which

is above the 1.0 benchmark.

• This means that the business is projected to generate enough cash flow to meet its debt

servicing requirements.

• Most lenders will require a higher Coverage Level than 1.0 to provide cushion in the cash

flow.
• Different lenders will have different minimum Coverage Ratio requirements.

• However, it would not be uncommon to have a minimum Coverage Ratio requirement

of 1.15 or 1.20.

• While 1.15 and 1.20 is considered adequate, a Coverage Ratio of 1.50 or higher is

considered good.
 3. RISK BEARING ABILITY

• The beneficiaries of the project should have risk bearing ability (for repaying the loan

amount promptly), i.e., they should withstand the shocks of probable financial losses

irrespective of the fact that the project appraisal has taken care of all precautions to

prevent such losses.

• How far the beneficiaries of the project are having the capacity to repay the loan

promptly is revealed by repaying capacity test.

• The output and price are the factors which determine the farm income. Fluctuations in
output may be due to:

• 1) Natural causes like floods, droughts, pests and diseases etc.

• 2) Technical causes like break down of machinery, non-availability of inputs,

availability of defective inputs etc.

• 3) Social causes like theft, labour strike etc.

• Fluctuation in prices is due to demand and supply factors besides lack of storage,

transport and communication facilities, failure of government to control/regulate

prices etc.

• The variation in farm income over a period of years is measured by coefficient of

variation.
• The coefficient of variation is measured by the formula:

• Where,
• Since the coefficient of variation is 34 percent for this farm, to determine the repaying

capacity of the farmer, the gross income should be deflated by 34 percent.

• Suppose, if the farm income is Rs.10,000 and the coefficient of variation is 34 per cent,

the real farm income is Rs.6,600 only.