The 5 C’s of Credit and the story behind them.

Ever wonder what makes up credit? Is it more than just a score? The good news is, there is a method to the madness and it makes sense once we pull back the red velvet curtain and look at the scene as if it were a play.

SCENE: The Five C’s of credit – character, capacity, collateral, capital, and conditions.
Think of them as actors on the stage – each one playing a part to make up the whole scene as
we’re looking at both the qualitative and quantitative data. It’s not about one C carrying more
weight than the others; they work together like a team. Co-stars, if you will. Understanding
these factors (actors) is crucial when it comes to making decisions about loans and grading, as
well as during our yearly reviews. And just to set the scene, we’re diving into the world of
commercial lending here.

Character: Character is generally quantified by a credit score, as this is only a single indicator.
Other qualitative aspects include experience in their business, management history, background,
education or work history, and how they manage their life, business, and personal.

Capacity: Capacity is described as the ability to repay in the form of a ratio such as DSCR
(Debt Service Coverage Ratio), and most of our clients have floors of 1.20x to 1.25x DSCR. I
would point out that other ratios should be considered, such as working capital, liquidity, and
leverage ratios. The common mistake I witness in loan reviews is the bank stops at DSCR. For
me, I want to know if the plan doesn’t go just right, which they seldom do, does the borrower
have the balance sheet capacity for a capital injection, can the business cover the operating short-
fall in a lousy couple of months, or how long, in the case of Covid, can the company survive
without additional leverage or is the borrower all-in?

Collateral: Collateral is, for the most part, straightforward, so one thinks. Loan structure to
collateral is also essential. Does the bank have proper controls for fast-moving collateral, or
could it disappear in the middle of the night? Additionally, does the bank have enough in place
for the proposed loan type and structure? Over my 37 years in the banking industry, it is typical
for a bank to experience a 30% to 40% haircut on an involuntary liquidation.

Capital: Capital, in this case, is referred to as any equity from other businesses or real estate,
cash injection down payment, or a combination. Taking analysis further, can the borrower(s)
weather a storm, or are they all in? When something goes wrong, do they have enough runway,
or are they about to crash? Can the cash flow absorb additional leverage? We often see business
borrowers with a solid worth but little capacity to absorb additional leverage because the cash
and/or cash flow is insufficient.

Condition: Condition is anything not in the above. For example, interest rate, terms, structure,
and loan covenants. Conditions can be many things, such as curtailment agreements if certain
covenants are not met and a borrowing base required periodically for short-term loans. The more
complex a credit is, the more likely the conditions are more controlled, and the more covenants
required. Also, conditions could be an if-then with triggers creating the covenants or, in some
cases, capital calls.

The five C’s taken together are quantified to assign a risk grade. Those grades should be
defined in the loan policy and defended in the credit analysis.

I hope that helps you see the “parts” of the credit at play. Stay tuned, because I will do a series on financial statement
analysis, credit, loan underwriting, and loan review.

McSwain Consulting has several services to ensure your loan portfolio remains safe and does not
impose additional risk above and beyond what is expected and acceptable.


Please reach out to David McSwain at for a conversation or consultation.