Understanding Capital 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. Capital is one of those 5 C’s. It addresses the borrower's financial stake in their business. In other words, lenders want to know if a farmer has invested enough money into the business to have a significant financial stake in its outcome.
What is Capital?
Capital refers to the borrower's equity or net worth in their business. This is determined by the amount of money the borrower has invested in the business and any retained earnings. Lenders want to see that a borrower has a significant financial stake in their business and that they have something to lose if the business fails. You might hear solvency used in conjunction with capital. Solvency is a business's ability to pay off all debt if liquidated. It deals with the relationship between total assets, liabilities, and net worth.
To determine capital and solvency, 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 solvency ratios:
Net worth: Total assets – total liabilities
Debt to asset ratio: Total liabilities / total assets
< 30% strong
60-30% caution
> 60% vulnerable
Equity to asset ratio: Equity / total assets
> 55% strong
30-55% caution
< 30% vulnerable
Debt to equity ratio: Total liabilities / equity
< 42% strong
24-122% caution
> 122% vulnerable
Importance of Capital in Credit Evaluation
Capital evaluation is important because it helps lenders determine whether a borrower can manage risk and has a financial incentive to ensure the business's success. If a borrower has little or no capital invested in the business, they are considered a higher risk. A borrower needs to have some “skin in the game.” The borrower's capital is also important in building a relationship with the lender. Demonstrating a significant financial stake in the business makes a borrower more likely to have a positive relationship with their lender. This can lead to lower interest rates and easier access to credit.
How to Build Strong Capital
Improving capital starts with understanding and improving your current financial situation. Here are some tips that borrowers can use to enhance their capital:
Invest personal funds: The more money you have invested in the business, the stronger your capital position will be.
Maintain a healthy debt-to-equity ratio: A lower debt-to-equity ratio indicates a stronger financial position and a greater ability to manage risk.
Retain earnings: Reinvesting profits into the business can help build capital and demonstrate long-term viability to lenders.
Monitor the value of assets: Keeping an eye on the value of assets, such as land and equipment, can help improve overall capital.
