Understanding Capacity in the 5 C’s of Credit
The 5 C's of credit in agriculture lending are a set of criteria used by lenders to evaluate the creditworthiness of borrowers. The capacity component specifically addresses the borrower's ability to repay the loan. In other words, lenders want to know if an individual or business has the financial resources to make loan payments.
What is Capacity?
Capacity refers to the borrower's financial ability to repay a loan. Lenders want to see that a borrower can make timely loan payments without putting undue financial strain on their budget. You might hear the term liquidity used in conjunction with capacity. Liquidity is concerned with the ability of the farm business to generate sufficient cash flow to pay themselves and their taxes and service their debt.
To determine capacity and liquidity, a lender will calculate a series of ratios from the income statement, balance sheet, and statement of cash flows. Here are some generally accepted guidelines for capacity ratios:
Debt Coverage Ratio:
Net income + interest + depreciation/debt service (principal + interest)
> 1.75 strong
1.25-1.75 caution
< 1.25 vulnerable
Current Ratio:
Current assets / current liabilities
> 1.5 strong
1.0-1.5 caution
< 1.0 vulnerable
Working Capital to Gross Revenue:
Working capital (current assets – current liabilities) / gross revenue
> 30% strong
10-30% caution
< 10% vulnerable
Importance of Capacity in Credit Evaluation
Capacity evaluations help lenders determine whether a borrower is financially capable of making loan payments. Borrowers with insufficient cash flow or a low debt coverage ratio are considered riskier. The borrower's capacity determines the loan amount and interest rate. Lenders typically only extend credit up to a certain percentage of the borrower's income or cash flow. A higher income or stronger cash flow can result in a more significant loan amount and a lower interest rate.
How to Improve Capacity
Improving capacity starts with understanding and improving your current financial situation. Here are some tips that borrowers can use to enhance their capacity:
Create a detailed financial plan: In your plan include projected income, expenses, and future expected cash flow.
Reduce consumer debt: A low debt coverage ratio can make it difficult to obtain financing for your farm. Look for ways to reduce personal debt, such as paying off credit cards or refinancing existing debt.
Keep cash in the bank: Farming is not about limiting tax liability. To keep your current ratio strong, keep cash. In strained years, cash can help cover living expense and debt payments.
Increase income: Can you diversify your operation? Grow a more valuable crop? Or you may need off-farm income to cover family living expenses. Many farms aren’t large enough to support a family full-time.
Limit new debt: Avoid taking on new debt, especially consumer debt, unless absolutely necessary. This can help improve your debt coverage ratio.
Maintain a positive cash flow: Regularly monitor your cash flow and adjust your budget as needed to maintain a positive cash flow.
