Borrowing capacity

Borrowing capacity
See also

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.

References

Author: Maksymilian Piaskowski