What is credit capacity?

Credit capacity means determining one’s ability to manage credit. The credit capacity of the individual or an organization is measured based on the details of the earnings, expenses, and previous debts. Credit capacity valuation is crucially required in obtaining huge debt obligations from a lender such as housing loans, car loans, and business loans.

Ratio’s used in calculating credit capacity

Debt to income ratio (DTI)

In this ratio, total monthly debt payments are divided by monthly gross income. Gross income means the income of the borrower before paying taxes and other deductions. This method is helpful for lenders to identify a borrower’s ability to repay the loan. If the debt-to-income ratio is higher, it reflects that the borrower is facing financial struggles to settle monthly loan payments. The 43% debt-to-income ratio is recognized as the highest debt-to-income ratio to get a qualified mortgage.

Loan to Value ratio (LTV)

This ratio is used by lenders to estimate the risk of lending. The LTV ratio is computed by dividing the borrowing amount by the appraised value of the asset. It compares the loan amount against the value of assets purchased using the loan. The appraised value of an asset means the selling price of the assets. Lenders conduct asset valuation by the appraisal team to calculate the appraised value of an asset. A higher LTV ratio represents a higher risk of lending. This LTV ratio shows the borrower’s credit score, capacity to repay, and the asset bought.

Debt to Equity ratio

The debt-to-equity ratio compares the total liabilities against the total equity share capital. This ratio specifies the relative proportion of debt and equity share capital utilized to invest in assets. The debt-to-equity ratio shows the extent to which equity share capital is available to settle debt obligations in the event of liquidation. The debt-to-equity ratio is known as the gearing or leverage ratio.

Current ratio

The current ratio is otherwise known as the working capital ratio. It compares the value of current assets with the value of current liabilities. Current assets include cash and bank balances, accounts receivables, inventory, short-term deposits, and prepaid expenses. Current liabilities include accounts payables, expenses payable, and short-term loans. The general working capital ratio is 1:1. It represents that the value of current assets is equal to the value of current liabilities. If the current ratio is more than one, it means the person or an organization is in good condition in terms of liquidity.

Five C’s of credit

Before issuing loans to borrowers, lenders should analyze the borrower’s ability to settle the credit. The 5c’s of credit helps lenders to mitigate the loss and risk that arises from the credit issued. The 5c’s of credit assist lenders to determine the credit score and credit history of the borrower. The 5c’s are capacity, capital, conditions, character, and collateral.

Capacity

Capacity shows the individual or entity’s ability to repay the loan obligations on or before the due date. Lenders calculate the debt to income ratio to assess the borrowers’ repayment capacity. The lenders are ready to lend the borrower whose debt-to-income ratio is lower.

Capital

Capital refers to the investments and contributions made by the borrowers. Capital also includes reserves and other benefits managed by the borrower. While borrowing, the capital of the borrower should be considered by the lenders. If the borrower is not getting sufficient income to manage the debts, his capital should be used to settle borrowings. The organization or person with high capital has a high capacity to settle credit.

Conditions

Conditions refer to the terms and conditions of the borrowings. Conditions mean the particulars of the loan such as principal amount, loan term, interest rate, and the repayment period. Conditions also include the purpose for which the loan is obtained. Lenders should analyze the purpose of a loan to assess repayment risk and to secure the loan.

Character

Character in financial credit means the borrower’s reputation. The borrower’s reputation and debt repayments are stated in the credit history of the borrower. Credit history and past cash flow statements help lenders to understand the character of the borrower, whether the borrower has made regular debt repayments or defaulted in making debt payments. If the borrower defaulted on loan repayments, it should affect the credit score of the borrower.

Collateral

Collateral means the pledging of assets by the borrower against a loan. Organizations pledge their fixed assets and receivables as collateral, whereas individuals pledge their vehicles, homes, deposits, and savings. When the loan is granted upon collateral, these loans are called secured loans. Lenders should prefer secured loans more than unsecured loans. Lenders can collect money from the pledged assets if the borrower is not well on its way to repaying debts.   

How to measure the credit score of a customer?

The credit score of the borrower can be determined using the following particulars:

Previous year cash flow statements

Lenders should use previous period cash flow statements to assess the cash inflow, cash outflow, and operating income. These cash flow statements represent whether the debt repayments are made regularly or not. Thus, lenders can identify the credit score of the borrower using the previous year's performance.

Credit report

Credit reports provide the particulars of the borrower's credit history, payment history, default if any, and previous credit data. Credit scores can be identified using the credit report of the borrower.

Trade reference

Trade reference helps to evaluate the credit score of the borrower. Trade references include obtaining data about the borrower’s bank account details, trade creditors, and debtors. These trade references help to assess the creditworthiness of a borrower.

Debt to income ratio

The computation of the debt-to-income ratio shows the credit score of the debtor. This computation shows that for how much income, how much debt should be managed.

Context and Applications

This topic is significant in general studies, professional exams, and also for both undergraduate courses and postgraduate courses and competitive exams, especially for,

• Bachelors of Commerce
• Master of Commerce
• Bachelors of Business Administration in Finance
• Master of Business Administration in Finance

Practical Problems

Question 1: Which tool is used to measure the credit capacity of a borrower?

1. Sample analysis
2. Ratio analysis
3. All of the above

Answer: Option (b) is correct.

Explanation: The credit score of a borrower is determined using ratio analysis. Various ratio analyses are used by lenders based on the income, equity, and debts of the borrower. Some of the ratio analyses are debt to income ratio, working capital ratio, debt to equity ratio, and debt service coverage ratio.

Question 2: Which ratio analysis is not used in measuring the credit capacity of a borrower?

1. Debt service coverage ratio
2. Current ratio
3. Price-Earnings ratio

Answer: Option (c) is correct.

Explanation: Price-earnings ratio is determined by using an entity’s price and earnings. This ratio is used to evaluate the entity’s share value as compared to the earnings.

Question 3: What are the 5c’s of credit?

1. Character
2. Conditions
3. All of the above

Answer: Option (c) is correct.

Explanation: The 5c’s of credit are capacity, capital, conditions, character, and collateral. The 5c’s of credit assist lenders to determine the credit score and credit history of the borrower.

Question 4: Which one is not the 5c’s of credit?

1. Cash
2. Collateral
3. Capacity

Answer: Option (a) is correct.

Explanation: Cash is not included in the 5c’s of credit. The 5c’s of credit are capacity, capital, conditions, character, and collateral.

Question 5: What is the normal current ratio level?

1. 2.5
2. 1
3. 1.5

Answer: Option (b) is correct.

Explanation: General current ratio level is 1. The current ratio identifies the organization’s liquidity using current assets and current liabilities. If the organization has a current ratio of 2.5, it means the company is in good condition to settle its short-term debts.