Left: In the field, literally
Most recently I was introduced to the “5 Cs of credit approval” applied to rural entrepreneurs in developing Ethiopia. Each “C” is used to assess whether a loan applicant is eligible for credit:
When evaluating an applicant, it’s essential that the individual is trustworthy, honest and reliable. You must determine their willingness to repay and entrepreneurial zeal. The challenge here is to gauge their proclivities through indirect questions:
- Cross-check references – credit and repayment history (if available), reputation among the community, partners, customers, suppliers, family relations, employees (punctual wage payments)
- Extract examples of the applicant resolving strenuous circumstances in the past (think job interview)
- Compare their lifestyle and spending habits to income level
- Distinguish their degree of openness in answering questions
The majority of owners do not keep a formal record of their financials, forcing the loan officer to depend on the individual’s oral account of the business. To evade false information, verify numbers with competitors and speak with the applicant on multiple separate occasions. If the character is questionable, rejection is the only reasonable decision.
Assess the business’s capacity to repay. Primarily, the cash inflows and outflows are the lifeblood of the company. Without cash or profitable operations, the company will fail to repay. Management, technical and labour capacity also contribute to the health of the business. Examine:
- Income statement – operating profitability
- Cash flow statement – monthly operational debt service ratio (operating cash / debt payment; 2 and higher indicates a strong candidate)
- Sensitivity analysis (ie: reduced sales, higher input costs)
- Other sources of income
Most if not all small and medium enterprises deal in cash. Credit is seldom used but informal lending is practiced. Typically, cash is the critical factor. Incorporating household expenditures in the income statement is advisable to be conservative. Businesses with less than 6 months experience are unlikely to be approved. In the case of microfinance loans, analyzing the character and capacity to repay is enough.
Less important than Character and Capacity, Capital refers to what is financing the business. Basically, a balance sheet:
- Assets: cash, accounts receivable, fixed assets
- Liabilities: debt, accounts payable
- Equity: Family contribution (equity)
- Current ratio, liquidity ratio, level of indebtedness
Typically the more equity, the better the indication that the entrepreneur is committed to the success of the business (although my supervisor argues the opposite – anyone know a study on whether equity or debt financing is more correlated to default?). Most applicants lack debt so the balance sheet is simply constructed by plugging for equity.
Assets the applicant is willing to pledge to the borrower in order to secure the loan. Obtain the market, historical, marketability and psychological values of the assets like buildings, land, equipment and vehicles. Certain assets, regardless of their actual worth, can be advantageous to secure because of their perceived psychological value. For example, a processing machine may have a low resale value but in seizing the machine, the processor cannot conduct business thereby motivating them to repay responsibly. Surprisingly, assets tend to appreciate in value because of Ethiopia’s high inflation. A well-used year old machine may be worth more today than at the time of purchase. Collateral can be a make or break factor for banks because collateral ensures the bank will recover the costs of default. Unfortunately, if entrepreneurs lack brick (or other non-mud) buildings, it is very difficult to obtain a loan. To overcome insufficient collateral, banks can partner with a third party through a credit guarantee agreement. MEDA has one such agreement with an Ethiopian bank.
Religion can impact business operations. In Ethiopia, some applicants choose to not work on the (plethora of) religious days. Others, mostly Muslim, do not take loans because of the interest rate.
The external environment impacts the applicant. Market factors, economic indicators, inflationary risk, competition, politics and legislation, and other conditions should be taken into account.
Applying the 5 Cs
I’m working with a bank and two loan applicants and will post about it soon. The descriptions above are brief, and are simply intended to be a starting point and guiding structure to appraising a client.