Invest By Assessing the 5 Cs of Credit

Many common equity investors have an unpleasant investment experience because they do not invest by assessing the 5 Cs of credit. A common equity investor, however, assumes the greatest degree of risk. This is all the more reason for the need to invest by assessing the 5 Cs of credit.

After completing my Master of Business Administration, I returned to the Canadian banking system as a Commercial Banking Account Manager at one of Canada’s largest banks. The first thing I learned was how to assess the 5 Cs of credit when analyzing a loan applicant.

The following are my thoughts on how the 5 Cs of credit apply to investing.

Character

A borrower’s character is the key starting point. If the character of a company’s senior management is suspect, do not even waste your time assessing the other Cs.

Disregard investing in a company where members of senior management have a criminal record or a track record of business failures. Some people deserve a second chance. My recommendation, however, is to let other investors grant these types of business people a second chance.

Why?

Try collecting on your collateral if a borrower’s character is flawed. Trust me on this!

Cash Flow/Capacity

Look at the following 5 basic types of ratios when you invest by assessing the 5 Cs of credit:

• Liquidity ratios - measure the availability of cash to pay the debt.
• Debt/ leverage ratios - measure the firm’s ability to repay long-term debt.
• Activity ratios/efficiency ratios - measure the effectiveness of a firm’s use of resources, or assets.
• Profitability ratios - measure the firm’s use of its assets and control of its expenses to generate an acceptable rate of return.
• Market ratios - measure the cost of issuing stock and the relationship between return and the value of an investment in a company’s shares.

Financial Ratios provide significant information about a company. Look at these ratios over years to identify a trend. Also, compare these ratios to those of the competition.

Many investors mistakenly overlook the Consolidated Statement of Cash Flows. This statement is vitally important because it indicates the immediate health of a company and helps determine a company’s ability to pay its current expenses.

I pay particular attention to the Free Cash Flow (FCF) a company generates. Deduct Capital Expenditures from Net cash provided by operating activities to calculate FCF.

Capital Expenditures are essential to keep the company operational. If a company has incurred an unusually greater or lesser level of capital expenditures than the historical norm, investigate why.

Some companies go through periods in which they may have negative FCF. If there is a chronic shortage of FCF, this is a ‘red flag’. The company will need to raise cash from:

• asset sales – this cannot continue in perpetuity otherwise the company will cease to operate;
• equity - the issuance of new equity dilutes your ownership in the company;
• debt – too much debt raises the degree of risk. Lenders want adequate compensation for the risk. The interest rate associated with the company’s short-term and long-term debt is an indication of the company’s degree of risk; refer to the ‘Debt’ section within the Notes to the financial statements. Abnormally high-interest rates could indicate the company’s credit risk is unsuitable for your investor profile.

I have made it a policy not to invest in companies with a chronic FCF shortfall.

Capital

Capital is generated from the equity raised to start the business, capital raised in subsequent years, and the profits/losses generated over the years.

Some companies also have hidden assets. Visa’s and Mastercard’s respective brands are hidden assets.

Assets on the financial statements are reflected at historical value. A real estate developer may have, for example, acquired large tracks of farmland a few decades ago. The land may have been rezoned for development and may have significantly appreciated but the financial statements reflect the historical value.

Conditions

Credit facilities-related information is generally found in the ‘Debt’ section in the Notes to the 10-Q and 10-K reports. Details regarding the amount, interest rates, maturity dates, security, and terms and conditions of the company’s various credit facilities are worth reviewing.

The Notes typically indicate when the credit facilities expire, when they were renegotiated, and what changes occurred at the time of renegotiation.

Collateral

Shareholders receive no collateral in exchange for their investment in a company. It is, therefore, exceptionally important to analyze the other Cs of Credit.

As part of my due diligence process, check if the major credit rating agencies (Moody’s, S&P Global, and Fitch) have assigned a credit rating to the company’s debt. When was the debt last rated? Are the ratings recently affirmed or under review for possible upgrade or downgrade? Cross-reference the assigned ratings to the credit rating codes and classes and the rating tier definitions. The vast majority of my investments are companies of investment-grade quality.

Credit ratings are pertinent to creditors. Common shareholders, however, do not have the same degree of recourse as debt holders. Investors should, therefore, determine whether they want to invest in companies whose credit ratings are non-investment grade.

Final Thoughts

A creditor negotiates a specific rate of return in exchange for the risk of lending to a company. Common shareholders, however, have no guaranteed rate of return and assume the highest degree of risk.

In exchange for assuming the highest degree of risk, common shareholders expect to generate an attractive rate of return. This added risk with no assurances of the desired return is all the more reason why common equity investors must invest by assessing the 5 Cs of credit.

If you conduct a proper analysis, you might determine the probability of generating an attractive return on your investment is unlikely. You might be exposing yourself to a permanent impairment to your capital!

I wish you much success on your journey to financial freedom.

Thanks for reading!

Note: Please send any feedback, corrections, or questions to [email protected].

Disclaimer: I do not know your circumstances and am not providing individualized advice or recommendations. You should not make any investment decision without conducting your research and due diligence.

I wrote this article myself and it expresses my own opinions. I do not receive compensation for it and have no business relationship with the company mentioned in this article.

Disclosure: I am long the companies referenced in the FFJ Portfolio.