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Ag Finance 101: The Five C's of Credit

07:32AM May 31, 2013
piggy bank money

Learn the factors that lenders use to determine whether your credit is good—and how you can leverage them to your advantage.

By Joel Harlow

Most agricultural lenders go by what is known as the Five C’s of Credit:

A. Character—Does the applicant have a history of repaying his debts and possess the experience and managerial ability to have a reasonable chance of success?

B. Capacity (to repay the loan)—How will the loan be paid? Does the applicant have the resources to repay?

C. Collateral—Is the collateral marketable? Will it adequately secure the loan? (Cost does not always equal value, especially when dealing in specialized equipment.)

D. Conditions—What are the current conditions in the industry? Is the applicant in the financial position to weather the storm if conditions are not ideal? This also covers what loan funds will be used for (expansion, operating expenses and change in direction of the operation).

E. Capital—How much does the producer have invested in the operation? A lender has a greater comfort level when the producer has some "skin in the game" because this is an indication this producer will not walk away when things get tough. He or she will want to preserve the equity in the operation.

A lender needs enough information from the producer to formulate an opinion as to the strengths and weaknesses apparent for each of the Five C’s.

Three Notes of Caution Regarding the Five C’s of Credit

A. When a producer with significant assets is not willing to pledge enough assets to more than cover the loan, this raises a red flag to a lender. A producer should be confident enough in his or her operation to share the risk with the bank. The bank does not want to take 100% of the risk. By the same token, the bank should not require the producer to overcollateralize the loan to the point of unreasonableness. This is a red flag that the lender is not comfortable with the loan request, and it is best to find another lender. The lender has the right to a fully collateralized loan that more than covers the loan request; however, a good lender will not tie up a producer’s assets unnecessarily since this limits the producer’s ability to operate if conditions change.

B. Beware of the lender who looks at collateral as being the most important "C" of the Five C’s. Collateral only becomes important in the case of liquidation and in reflecting the producer's confidence in his plan of operation. Collateral is irrelevant if the loan is performing. A good lender will be cognizant of collateral, but will place more weight on the other four C’s.

C. At the end of the day, if the character of the producer is in question, none of the other four C’s matter. I have made very high loan-to-value agricultural loans with absolutely no problem to those producers of good character and passed on extremely low loan-to-value loans if the producer had a reputation for not paying his obligations. It is not worth the trouble to deal with a person who has no intention of paying you back or having to threaten liquidation to get a payment. Life is too short. Very seldom will a bank profit in the event of agricultural loan liquidation, regardless of the loan to value. The collateral margin disappears rather quickly if there are liquidation expenses, costs involved in locating collateral and a legal battle over ensuing liquidation. Fortunately, most agricultural producers will do anything they can to repay an obligation, which is why I chose agricultural lending as a career. I have talked with many lenders, and their losses are almost always on loans where the collateral margin is the best but character was in question.

In closing, agricultural lending has been very good to me. I do not loan in industries I do not understand. I either pass on the request or refer it to a loan officer who understands it. The best part of my career has been working with a group of people who are honest and reputable; very seldom have I lost sleep over an agricultural loan, regardless of the size. I have made agricultural loans from $500 to more than $6 million. I think agriculture is the best industry for lending.

Joel Harlow has 30 years' experience in agricultural banking. He is executive vice president of First State Bank of Ben Wheeler in Van Zandt County, Texas.