The 5Cs of Credit Analysis

When I consider whether or not to lend to companies on various crowdfunding platforms, I always use the 5Cs of credit analysis: Character, Capacity, Capital, Conditions and Collateral. For those without a credit background, here’s a brief introduction.

Character: Whether the borrower/guarantor is honest and has integrity. This is the most important factor and the most difficult to assess. I try to attend all of MoolahSense’s presentations to meet the borrowers. I like straight-talkers who can explain exactly why they need the money and how they plan to repay it. Many borrowers say they need money for “working capital”. What exactly does that mean? Is the loan for day-to-day expenses, inventory costs, or marketing campaign? If something doesn’t smell right, I’ll pass.

Example

Golden Care (MoolahSense campaign) took the effort to introduce its business, its management team and facilities. It also clearly explained why they need the money and how they plan to repay.

Capacity: Whether the borrower is able to repay the loans. Does the existing business model generates enough money to repay the loan? If it’s a new project, how long does it take to achieve payback? For new projects, they should be within their area of expertise. Finally, capacity of the guarantor to repay is also important.

Example

In a previous post, I discussed how Rex Cinema is taking up 2 new crowdfunding loans. Putting aside the fact that I don’t like companies taking up multiple crowdfunding loans, one can assess the repayment capacity of Rex quite easily.

Total repayment requirements is about $300k.
Total cash generation: estimate around $300k (using 2014’s net profit as a guide; 2015 is hit due to bug problem. Also, the new cinema would have opened and there is a chance it will be cashflow positive.

My conclusion? Rex has a decent chance of repaying its loans.

Capital: How much capital does the borrower have? How indebtedness is it? This is easy – I look at their gearing and leverage levels and try not to lend to companies that have too much debt relative to their capital.

Condition: What is the condition of the business, the industry and the economy? Some industries are inherently more cyclical. Within a certain industry, the relative positioning is also important. For example, lending to a subcontractor can be risky. Because the main contractor can delay payments and the subcontractor can do very little. But of course, there are exceptions.

Example

I like MKM (recent MoolahSense campaign) because its industry is stable and it is not too exposed to upstream or downstream risks. MKM operates a vehicle leasing business. Transport in Singapore should be stable because everyone needs to travel. Yes, there is GrabTaxi and Uber, but MKM doesn’t compete against them. MKM works with customers who leases on long-term basis, so the profitability is already assured at the start. And if a customer terminates early, there is a penalty. Also, MKM can always re-lease the vehicle out to another customer [at a lower lease rate just to ensure it covers the financing costs].

Collateral: We’ll skip this since most crowdfunding loans in Singapore are unsecured.

 

A final note

After my 5Cs assessment, I do look at other pieces of information such as DP credit rating, probability of default, rate of return, loan amount, borrower profile, etc. to cross-check my assumptions and finalize my thoughts.

 

However, I tend to rely more on my own credit assessment, and less on credit rating and probability of default. Because I find these information to be sometimes misleading. For example, credit rating are always retrospective based on some past year’s financials. Also, Funding Societies uses a different probability of default methodology, compared to MoolahSense and Capital Match. Comparing them side-by-side is a big mistake. Finally, even if you want to delve deep into understand how DP derives their credit ratings and probability of defaults, not much public information is available.