Borrowing capacity

From CEOpedia | Management online

Borrowing capacity refers to an assessment of the maximum amount of money that a company or an individual are able to borrow and repay along with advances, commitments and other credit accommodations in a timely manner, depending upon the company or individual current financial situation. In another perspective, borrowing capacity is a total amount of debt that a company or an individual can incur within a specified period of time as restricted by the terms and condition of loan agreement (S. Moulton and others 2013, p. 376).

Methods of borrowing capacity evaluation

The following list gathers some of the contemporary methods for assessing and measuring credit risk which may be used to verify the borrowing capacity and solvency of customers (S. Abbadi, S. M. Abu Karsh 2013, p. 151-152):

  • The 5C's Method - in banking practice when assessing credibility, so-called 5C’s of a borrower are taken into account i.e. five criteria of credit risk assessment:
  1. Capacity - refers to borrower's debt-to-income ratio i.e. the ability to repay the loan.
  2. Capital - is the amount of money the applicant possesses.
  3. Collateral - is a form of security for the lender in case the borrower cannot repay the loan.
  4. Conditions - refer to the economic and political condition of the country as well as to the market position, production capacity, etc. of the borrower.
  5. Character - the willingness to repay the loan which is reflected by the borrower’s educational background, work experience, job stability and credit history.
  • The 5P’s Method - was developed by the Federal Reserve Center (Fed 2004) which consists of:
  1. People - refers to the borrower’s history of being honest, trustworthy and reputable as well as to the history of honouring their financial obligations in a timely manner.
  2. Purpose - is reflected by an explanation of how the applicant will use the funds.
  3. Payment - refers to the source of repayments on the basis of which the loan repayment schedule is prepared.
  4. Protection - the collateral or any other secondary sources of loan repayment which acts as a form of security for the lender.
  5. Prospective - is a plan which should specify how the loan will be monitored and what actions the bank will take in case of the borrower’s failure to repay the loan.
  • CAMPARI ICE Method - the name derives from the initial letter of 10 variables which must be taken into account while assessing credit applications. This method partially combines some methods of the 5C's, and some of the 5P's (B. Young, R. Coleman 2009):
  1. Character - personality of the company, borrower.
  2. Ability - ability to repay the loan; similar to capacity.
  3. Means - refers to whether the company will provide a significant financial contribution to the venture for which credit is needed.
  4. Purpose - the desire to borrow money must have a clearly defined, economically justified purpose.
  5. Amount - what proportion of the client's net assets is represented by the loan amount.
  6. Repayment - the customer must clearly document the manner in which repayment of the loan will take place.
  7. Interest - refers to whether the price of the loan adequately compensates the risk to which the bank is exposed.
  8. Income - essentially refers to whether the bank receives adequate compensation for its own costs incurred in assessing the loan application and in ongoing monitoring of the loan.
  9. Collateral - the security in case the borrower fail to repay the loan.
  10. Extras - any other additional features; e.g. if there is a possibility to sell more banking services to a given enterprise.
  • LAPP Method developed by G.V. Benz (1979) is more frequently used for assessing corporate applications than individual borrowers. LAPP stands for the following variables:
  1. Liquidity - describes how well a company can liquidate its assets in order to honour its current obligations.
  2. Activity - measures the size of the company and its operations.
  3. Profitability - a business's ability to produce a return on an investment based on its resources.
  4. Potential - describes strength of a company such as financial or human resources, management level and other economically significant factors.

Examples of Borrowing capacity

  • Personal Borrowing Capacity: It is the maximum amount of loan that an individual can borrow from a bank or any other financial institutions without any risk of defaulting. The personal borrowing capacity depends on the individual’s current income, regular monthly expenses and other financial obligations.
  • Corporate Borrowing Capacity: It is the maximum amount of loan that a company can borrow from a bank or any other financial institutions without any risk of defaulting. The corporate borrowing capacity depends on the company’s current revenue, regular expenses, and other financial obligations.
  • Tax-Exempt Borrowing Capacity: It is the maximum amount of loan that a company can borrow from a bank or any other financial institutions without the risk of tax-liability. The tax-exempt borrowing capacity depends on the company’s current revenue, regular expenses, and other financial obligations.
  • Local Government Borrowing Capacity: It is the maximum amount of loan that a local government can borrow from a bank or any other financial institutions without any risk of defaulting. The local government borrowing capacity depends on the local government’s current revenue, regular expenses, and other financial obligations.

Advantages of Borrowing capacity

A borrowing capacity is a valuable tool for companies and individuals to access capital, finance projects, and grow their businesses. There are several advantages to having a borrowing capacity:

  • Access to Capital: Having a borrowing capacity allows a company or individual to access capital for investments, operations, and projects that would otherwise be unavailable. This gives companies and individuals the ability to take advantage of opportunities that may arise, leading to potential growth and profit.
  • Borrow Low-Cost Funds: With a borrowing capacity, a company or individual can access low-cost funds from lenders, thus reducing the cost of borrowing and increasing the return on investments.
  • Ability to Manage Cash Flow: Having a borrowing capacity allows a company or individual to manage their cash flow more efficiently. This is especially important for businesses, allowing them to purchase inventory, equipment, and other items in advance while still having the ability to pay back the debt when the revenue starts to come in.
  • Lower Risk: Borrowing capacity provides companies and individuals with the ability to spread their investments across multiple sources, thus reducing the risk of any one investment’s performance. This helps to reduce the overall risk of a company or individual’s portfolio.
  • Increased Credit Score: Having a borrowing capacity can also help to improve a company or individual’s credit score, making them more attractive to lenders in the future. This can help to save money on future loans and credit lines.

Limitations of Borrowing capacity

Borrowing capacity is affected by a number of factors, which can limit an individual or company’s ability to borrow money. These limitations include:

  • Credit Score: A credit score is a numerical representation of the creditworthiness of an individual or company. It takes into consideration many factors, such as credit history, current debt, income, etc. A low credit score can restrict an individual or company’s ability to borrow money.
  • Collateral: Banks and lenders often require collateral, such as real estate or other assets, before they will loan money. If an individual or company does not have enough collateral to secure the loan, their borrowing capacity will be limited.
  • Debt-to-Income Ratio: Lenders look at the debt-to-income ratio of an individual or company to determine their capacity to repay the loan. If this ratio is too high, their borrowing capacity will be limited.
  • Loan Amount: Some lenders have a maximum loan amount that they are willing to lend to an individual or company. This can limit the borrowing capacity of an individual or company, even if they have a good credit score and low debt-to-income ratio.
  • Interest Rates: The interest rates offered by lenders can also influence an individual or company’s borrowing capacity. Higher interest rates can make the loan unaffordable, while lower interest rates can increase the amount of money that can be borrowed.

Other approaches related to Borrowing capacity

Borrowing capacity is also determined by looking at various approaches which include:

  • Financial strength: This approach evaluates the borrower’s financial position, such as cash flow, current assets, and long-term debt to assess their ability to pay back the amount owed.
  • Creditworthiness: This approach evaluates the borrower’s credit history, including past payment habits and credit score, to determine their likelihood to repay the debt.
  • Risk assessment: This approach evaluates the borrower’s risk profile, including the potential for default, to determine the probability of repayment of the debt.
  • Collateral: This approach evaluates the collateral available to the borrower, such as real estate or equipment, to determine the security of the loan.

In summary, borrowing capacity is determined by assessing the borrower’s financial strength, creditworthiness, risk assessment, and collateral. By looking at these four aspects, lenders can more accurately determine the borrower’s ability to repay the debt.


Borrowing capacity — recommended articles
Capital Base — Borrowing Base — Capital gearing — Credit Review — Total capital — Non current liability — Customer deposits — Evergreen Loan — Debenture Redemption Reserve

References

Author: Maksymilian Piaskowski

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