The Five C’s: Cash Flow, Capital, Collateral, Conditions & Character


Accessing credit or capital is one of the many challenges facing farmers. Agricultural financing can be a crucial tool to continuing production, expanding operations, or trying different enterprises.In seeking better profits, more and more farmers and farm-entrepreneurs are turning away from simple commodity crops, into more complicated or diversified enterprises. Farmers and farm-entrepreneurs who turn to business models that are unfamiliar to agricultural lenders need not struggle to communicate their business plans.

Through a better understanding of agricultural lending, business planning, and other ways of communicating to a lender, farmers may improve their chances for success. The “Five C’s” are used to explain what lenders need in order to approve a loan application:

  • Cash Flow is a measure of the enterprise’s capacity to repay the loan.
  • Capital is the measure of the farmer’s equity investment in the enterprise.
  • Collateral is the question of how the loan is to be secured against business failure or loan default.
  • Conditions are the lender’s consideration of the big picture within which your business plan will fall.
  • Character is how the lender looks at the farmer’s capacity to execute the business plan successfully, and involves both management capacity and examination of credit history.

Cash Flow (Capacity to Repay the Loan)
Cash flow tells you how much of the cash you generate remains after expenses and repayment of debt. A Cash Flow Projection shows your income and expenses looking forward into the future. A lender will look at Cash Flow as a measure of your capacity to repay a loan. While you can look at cash flow for a period as short as a month, a quarter, or a year, most lenders want to see cash flows projected three to five years into the future.
Cash flow is sometimes measured by earnings before interest, depreciation and amortization (EBIDA). Some businesses call it a pro forma projection.

Lenders use cash flow to determine whether a business is able to meet monthly loan payments. They use your cash-flow statement to derive a ratio often called a minimum-debt-service-coverage (DSC) ratio requirement. A lender will want to see that you have more cash coming in each month from income than you have going out from expenses and loan repayment. Lenders use different ways of figuring DSC ratios, but a good rule of thumb is to shoot for a DSC ratio of 1.2 to 1.25. That means that for every $1,000 of debt repayment you have to make each month, you should have $1,200 to $1,250 of cash after expenses. By having more income than you need to pay expenses, you create a buffer that protects you (and your lender) from the unexpected, like rising costs or falling prices.


Capital (Equity Investment in the Enterprise)
Capital is the money you have personally invested in the business and is an indication of how much you have at risk should the business fail. Lenders and investors will need to know what you have put “on the line” before asking them to commit any funding. They will expect you to have undertaken personal financial risk to establish the business. You could say that capital is the measure of your equity investment in the project.
What percent of the total cost of your project will be covered by your own equity? Some community lenders may agree to some amount of “sweat equity” investment in the business. However, most lenders want to see some capital investment as well. Lenders typically look for a significant investment by the individual applying for the loan, seeing this as a measure of your commitment to your business plan.

Capital can go beyond the question of what money YOU plan to invest: What other equity sources are invested? Are you getting friends and family (or others) to invest in shares of the business? Consumer Supported Agriculture (CSA) is an alternative way of raising short-term capital by selling shares of your production, in advance of harvest, directly to your customers.


Collateral (Security for the Loan)
Lenders have to consider all possibilities, and must plan for the worst case scenario. In the case of a loan, what can the lender turn to in the event the business fails? If the borrower is unable to repay the loan, how does the lender get back their money? Collateral is the land, equipment, houses, cars, and other things of value that a lender can hold as security for a loan, and repossess if the loan is not repaid.

The value of the property being held as security is an important factor: Lenders will likely require their own appraisal of the property or other assets. Often, assets are not valued according to market-value, but at what a lender can get for the item if they have to foreclose or liquidate. That often means the lowest-commodity price for crops and livestock and a severe discount on equipment. Remember lenders are not in the business of operating the farm business and/or buying and selling farm products, so the lender may not get the best price on live animals, crops in the field, perishable, or repossessed goods.

Also, most lenders have policies regarding loan to value ratios. For example, lenders might only loan 80% of the value of a parcel of property, or 25% to 50% of the value of a particular piece of equipment. Other lenders require 150% collateral because of the costs and losses incurred in a liquidation of the collateral. The kind of collateral is important, too: Lenders may ask that you secure the loan with your house, on the theory that you will be less likely to default if your home is at risk.

Why Is Collateral Discounted? Why is it that lenders discount collateral so deeply? While a lender is investing in the potential for your success, he or she must prepare for your failure. This is how financial institutions are successfully run. If you run into trouble with your loan, and the lender is unable to help you get back on track with loan payments, the lender must recover the money through your collateral. In these cases, lenders often cannot sell the property, equipment, etc. at market for the same value it might bring under different circumstances. Sometimes the collateral must be sold for pennies on the dollar. This is why so many lenders require 150% or more collateral to loan value.


Conditions (Considering the Big Picture)
Conditions refers to the lender’s consideration of the broader conditions within which your proposal must be evaluated. The lender first looks at the intended purpose of the loan: Will the money be used for working capital, inventory, or additional equipment, and does that make good business sense within your overall enterprise? Will the investment make sense within local economic conditions and the overall business climate, both within your industry and in other industries that could affect your business?


Character (Capacity to Start & Finish the Project Successfully)
Character is about your personal, professional capacity to execute your plan successfully. Different people, including lenders, evaluate character differently. For some, a firm handshake is a sign of strong character. Others will want to see a steady employment history and a good credit record. Your credit history is a record of your past borrowing performance. Lenders look at past performance carefully and evaluate the borrower on his or her potential for future bankruptcy. Depending on your business plan and the loan you request, the lender may look at the credit history of the business, the individual borrower, and any co-signors, guarantors, or investors.
There are three major credit rating institutions in the United States — Equifax, Experian, and TransUnion. All lenders use one or more of these institutions when examining your credit history. It is important that you know what is on your credit record prior to applying for a loan. A bad mark on your credit record does not necessarily keep you from getting a loan. However, it is important that you have taken steps to address any negative marks on your credit record and that you can explain to your lender why you received those marks in the first place.


Recommended Reading: