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The 12 Cs of Credit for Lending in (and out of) a Recession

By Linda Keith, CPA

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Depending on how long ago you took Banking 101 and what type of lending you were doing at the time, you may remember 3 or 5 or 6 Cs of credit.

12 Cs.PNGHere are my six:

  • Character
  • Capacity
  • Capital
  • Collateral
  • Coverage
  • Conditions

Before I add six more, I’ll show you how you can use tax returns as clues to the traditional six. Lenders in my tax return analysis training are often surprised you can use a tax return this way.
 
Character

Will they pay if they can?

The tax return is a great clue for this. Sometimes the borrower comes right out and tells you “Here is my tax return but it isn’t really what I make.” If they follow that with a wink, find a way to finish off the conversation in a hurry.

I am not talking about aggressive taxpayers who take every legitimate deduction available. I am one of those myself.

Those who do not report all of their income or knowingly take a business deduction for personal expenses have demonstrated they are willing to lie to a third party (the IRS) for financial gain (pay less taxes).

You are a third party. Enough said.

Be sure you know what they are saying

There are legitimate reasons that a tax return does not reflect what the borrower or their business makes. The difference between cash and accrual basis, significant net operating losses or a major nonrecurring expense just to name a few.
Hear them out before you assume they are ‘cheating’ on their taxes.

Clues to character

  • Reporting income the IRS would not know about otherwise (good character)
  • Taking lower deductions than they could easily get away with (good character)
  • Writing off personal expenses as if they were business expenses (shady)

Capacity
Does it look like they can repay it?
 
Many lenders think first of checking for adequate cashflow and liquidity. I agree that is important.

I also think of the experience of the owner or management. While there are some great things to be said about youth, having been a downturn before is a plus as well.
Review Schedule L in a business return to see the ‘Balance Sheet per Books’. Review the last three years returns to get a feel for recent history. Five years is better if you have it in the file.

Capital
Do they have enough skin in the game?
 
I don’t use the tax return to asses this one. Owners of closely held companies often take more compensation than adequate capital allows because their tax advisor suggested it.
Use a process that applies a ‘global’ analysis, though, and you are back in business. Combine a review of the business return with that of the owner/guarantors. Look at the balance sheets for both. Then decide if there is enough capital for comfort.

Collateral
What if they can’t repay it?
 
This one is certainly getting more interesting. Lending institutions are reeling under the weight of real estate they never planned to own. As the economy softens, the value of collateral softens too.

While the tax return cannot help you value collateral, a quick look at the Form 4562 can tell you if they are purchasing more fixed assets. By where they put it on the form, you can even tell what it is. (In my manual on Tax Return Analysis: Essentials and 1040 Review you see what types of items get listed where).

Coverage
Have they spread risk?
 
I train the lenders in my tax return and financial statement analysis training to look for insurance. It is a line item on a Schedule C but listed along with ‘other’ expenses on business returns. If the lender is not looking for it, they’ll miss it.

Look for insurance on the Cost of Goods Sold schedule, too. When my construction company built houses, that is where we listed course of construction insurance.
A newer lender may not know how much insurance is adequate for a particular business, but certainly could spot that it is not there at all.

Conditions
What else is going on?
 
Well, that is the big problem, isn’t it? While the tax return can give clues to the other Cs, the lender has to look elsewhere for conditions.

  • Understand the industry
  • Look to trade publications
  • Confer with others
  • Talk to the business owner more often

A review of the tax return may give some good hints about how the business is coping with conditions. In construction, compare contract labor to wage labor. Contract labor gives more flexibility, but may cause problems later when business picks up and the builder is competing for the subcontractors who are still in business.

The business’s response to conditions can create confusing signals for lenders. Something that would have been a red flag last year may be prudent this year.
A commercial lender who works for a client bank shared “Normally a dramatic drop in insurance or repairs is a red flag. I encourage my team to watch for it.

“But now, it may mean a prudent business that has taken a harder look at costs and cut where they can. They may not have reviewed insurance since they quit using extra warehouse space.

“Workers they are keeping busy instead of laying off may be reassigned to maintenance for now.

3 Cs of Credit Analysis

These are three to look for when reviewing lending staff. I focus on this with the lenders.

  • Competence
  • Confidence
  • Consistency

3 Cs for the Recession

Calm
Be it and Show it
 
In a recent CFO Podcast, the CFOs listed exuding ‘calm’ as one of their most important roles. Your lenders need that, too.

I have heard lenders say their bank is frozen until the SBA secondary market picks up. Lenders are playing solitaire because they can’t get the loans through.They are worried about their jobs.

In private conversations, the lenders see me as an adviser. This may not be the message they are conveying to the world. But what if they are?

Your lenders need to see you are calm, and need help in what the message is to put out to the borrowers and the public.

  • What messages are you sharing with employees?
  • Are you providing talking points about government bailouts, deposit insurance, and the safety of your financial institution?
  • What are you doing to help employees bleed off the stress?

Communicate
With all stakeholders
 

There is fear in the air. There is also opportunity. You feel it. So do your successful business borrowers. Acknowledge the challenges…too motivational is not believable.
Then share the vision of prosperity.

Cycle There is no new economic paradigm.

The economic cycle is a cycle and as surely as we are in the downswing, the upswing will return. And in the upswing, we’ll have a whole ‘nother set of lending challenges. By understanding the Cs of Credit and where to find it in borrower financials, tax returns and even conversations…you can help your borrowers and your lending institution as the recession turns to recovery.