Creditworthiness: 7Cs of Creditworthiness

Creditworthiness Factors Determining Creditworthiness

Creditworthiness consists of a record of trustworthiness, including borrowers’ moral character and the possibility of consistent performance. Lenders offer lower rates and better terms to borrowers with excellent credit scores. This is one of the most important eligibility requirements for most lenders.

Factors Determining Creditworthiness

  1. The debt burden
  2. Loan size
  3. The rate of borrowing
  4. The period of commitment

The debt burden

To be approved for a loan, lenders require your earning power to surpass the payment schedule requirements significantly.

The debt size is primarily restricted by the resources currently available. A secure debt to capital ratio makes it easy for lenders to approve loan applications.

Loan size

Lenders often prefer jumbo loans for a simple reason – the administrative costs lessen in proportion to loan size—borrowers as expected to have the potential to ingest a considerable amount of money.

The rate of borrowing

Clients who frequently borrow often establish a good reputation with lenders. This has a bearing on their capacity to obtain credit at better terms.

The period of commitment

Generally, lenders take more risks with the increase in the timeframe. To provide for the additional risks, lenders often increase the interest rate. They usually charge higher rates for loans that take a long time.

These are the basics the borrowers are supposed to keep in mind. These variables play a significant role when it comes to credit evaluation.

7Cs of Creditworthiness

Creditworthiness measures how deserving an applicant is to get a loan sanctioned in his favor. In other words, it assesses the likelihood that a borrower will default on their debt obligations. It is based upon factors such as their repayment history and credit score.

Lending Institutions also consider the availability of assets and extent of liabilities to determine the probability of default. The 7’Cs of creditworthiness indicate the characteristics or features of creditworthiness.

7C of creditworthiness are;

  1. Character
  2. Capacity
  3. Cash
  4. Capital
  5. Collateral
  6. Conditions
  7. Control

1. Character

Responsibility, truthfulness, serious purpose, and serious intention to repay all monies owed makeup what is called character.

The loan officer must be convinced that the customer has a well-defined purpose for requesting credit and a serious intention to repay. The loan officer must determine if the purpose is consistent with the bank’s loan policy.

Even with a good purpose. However, the loan officer must determine that the borrower has a responsible attitude toward using borrowed funds, is truthful in answering questions, and will make every effort to repay what is owed.

2. Capacity

The loan officer must be sure that the customer has the authority to request a loan and the legal standing to sign a binding loan agreement; this customer characteristic is known as the capacity to borrow money.

For example, in most areas, a minor cannot legally be held responsible for a credit agreement; thus, the lender would have difficulty collecting on such a loan.

Similarly, the loan officer must be sure that the representative from a corporation asking for credit has proper authority from the company’s board of directors to negotiate a loan and sign a credit agreement binding the company.

3. Cash

This feature of any loan application centers on the question.

Does the borrower have the ability to generate enough cash to repay the loan in the form of flow? In an accounting sense, cash flow is defined as:

  • Cash flow = Net profits + Noncash expenses.
  • This is often called traditional cash flow and can be further broken down into Cash flow = Sales revenues – Cost of goods sold – Selling, general, and administrative expenses- Taxes paid in cash + Noncash expenses.

The lender must determine if this volume of the annual cash flow will be sufficient to comfortably cover the repayment of the loan and deal with any unexpected expenses.

Loan officers should look at five areas carefully when lending money to business firms or other institutions. These are:

  1. The level of and recent trends in sales revenue.
  2. The level of and recent changes in the cost of goods sold.
  3. The level of and recent trends in selling, general, and administrative expenses.
  4. Any tax payments made in cash.
  5. The level of and recent trends in noncash expenses.

4. Capital

Capital represents the potential borrower’s general financial position, emphasizing tangible net worth and profitability, which indicates the ability to continuously generate funds over time.

The net worth figure in the business enterprise is the key factor that governs the amount of credit made available to the borrower.

Related: 3 Steps of Credit Analysis

5. Collateral

In assessing the collateral aspect of a loan request, the loan officer must ask, Does the borrower possess adequate net worth or own enough quality assets to provide adequate support for the loan.

The loan officer is particularly sensitive to such features as the borrower’s assets’ age, condition, and degree of specialization.

Technology plays an important role here as well. If the borrower’s assets are technologically obsolete, they will have limited value as collateral because of the difficulty of finding a buyer for those assets should the borrower’s income falter.

6. Conditions

The loan officer and credit analyst must be aware of recent trends in the borrower’s work, or industry and how changing economic conditions might affect the loan.

A loan looks very good on paper, only to have its value eroded by declining sales or income in a recession or by high-interest rates occasioned by inflation.

7. Control

The last factor in assessing a borrower’s creditworthiness status is control.

This factor centers on such questions as whether changes in law and regulation could adversely affect the borrower and whether the loan request meets the lender’s and the regulatory authorities’ standards for loan quality.

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