Borrower’s Capacity

What is Borrower’s Capacity?

Borrower's capacity refers to their financial ability to repay a loan. Lenders assess income, expenses, and debt obligations to determine if the borrower can meet repayment obligations comfortably and sustainably.

Many instances are possible where one might need to borrow money. You might need a mortgage, a tuition loan, or cash for your start-up business. Borrowing money, however, is more involved. Banks and lenders thoroughly analyze one's capacity to decide whether to loan a certain amount.

Borrowing money, however, is a risk for banks because there is a possibility the total amount of the funds will be paid after some time. Deciding whether someone gets a loan from the bank is determined by the bank's assessment of the borrower's capacity. 

They can pay back their whole amount of loans or debt payments on time. The most common examples of situations where knowing their borrowers' capacity is vital are a company in need of capital and someone looking to buy a home.

Knowing their capacity in these scenarios allows both borrowers and lenders to estimate how much they need and how much they would receive. They could base their financial decisions on capital investment or choosing a home reasonably based on their estimates.

A borrower's repayment capacity can also be used synonymously with the ability to borrow. The standard process to analyze repayment capacity follows an analysis of the 5Cs. 

What Are The 5 C's?

Parties who borrow and lend both are interested in understanding the likelihood of the borrowers' ability to pay timely and in full. To do this, they likely follow a process of credit analysis.

Credit analysis requires lenders and borrowers to consider the 5 C's. The borrower's capacity is one of the 5 C's. The 5 C's are: 

• Character
• Capacity
• Capital 
• Collateral
• Conditions

One's character for credit analysis is their financial behavior. It is both the consideration of their financial histories and their financial health. 

One's financial health refers to the state and management of one's finances. 

For example, if someone's investments are currently low in value and they have a lot of debt while not holding enough savings, a collection of this person's consideration towards investments, debt, and savings would tell a credit analyst that the person's financial health is poor. 

Considering one's capital is the amount of money in a borrower's possession which is interpreted as an extension of the borrower's means of repayment. Examples of one's money would be: 

• A business entity's investment in the firm
• Assets
• Savings 
• Retained earnings
• Investments

Credit analysis also focuses on the amount dedicated towards a project for which money is being borrowed, for example, a business. It is because it aligns the borrower's goals with the lenders' concerning the project since the borrowers are also financially invested. 

Understanding the involvement of collateral in a borrower's credit analysis is essential for borrowers who do not have a strong analysis report on the other credit analysis categories. 

The European Central Bank defines collateral as an item used to pay the lender if the borrower fails to repay a loan.

Suppose other areas of one's credit analysis show a high likelihood that a borrower will not be able to pay their loan fully on time. In that case, the collateral's ability to support the loan will be considered. 

Lenders are looking for secured items for collateral, making their loan a secured one instead of loans with no collateral backing when looking at the "collateral" aspect of credit analysis. 

Finally, the analysis of a borrower's conditions refers to the economic conditions in which the loan takes place. The lender is responsible for being realistic about the borrower's ability to pay their loan, which the condition analysis helps them with.

Understanding the economic conditions helps create realistic and reasonable agreements between the lender and the borrower. 

All five aspects are explored throughout this article, showing that they are all interrelated in credit analysis. This video further explains how the 5 C's of credit analysis are used: 

Importance of Borrower's Capacity

Someone might need to know their borrower’s capacity to understand the correct financial decisions concerning why they are borrowing the money. 

Suppose the concern is that they want to expand their business. In that case, there should be more consideration and attention paid to how they are growing their business, the exact amount they require, and other factors which investigate the health of their business crossed with the amount of their loan. 

A prominent and important part of lending money is to receive it back at an interest rate. Although they mainly depend on the governments to assist them with reserve requirements, obtaining the cashback is still vital for their sustainability. 

Lenders need to know about someone’s borrower’s capacity to establish whether it is a good idea to lend the borrowers the exact amount they are asking for.  

Knowing the proper management of finances to maintain a good borrower’s capacity is crucial to economies with banking systems with lower lending rates. 

In the United States, for example, as of 2022, smaller banks approve 49% of the businesses that apply to request funding, while larger banks approve only 25% of the companies asking. 

These statistics show that understanding a company’s finances and financial histories is crucial to economies with differences in lending rates as it would consider the flexibility of lenders’ consideration of factors impacting borrowers’ capacity. 

Factors that Affect a Borrower’s Capacity

Several factors impact one’s borrower’s capacity. The borrower needs to understand to manage and plan these factors and their economic and financial behaviors to prepare for their loan. 

The factors that affect the capacity the most are frequently used because they show the borrower’s financial habits, which is a primary concern for potential lenders. 

Analyzing the Internal Factors          

An internal factor is a factor that is in direct relationship with the borrower. These are factors that are realistic for the borrower to control and impact. 

Some examples of these factors are:

• Income and commitments
• Lifestyle and living standard
• Credit history

Since there are different types of borrowers, other factors impacting their capacity are also other. 

It can easily be explained by the idea that each type of borrower differs in how they plan on paying back the debt payments, their financial responsibilities, and the financial behaviors that are most concerning to the lenders.

Borrowing as a Company

Factors that affect businesses and why they affect them are mostly connected to the state of their operations and the factors that influence their financial performance. Additionally, business expenditure is higher in degree since it has a more significant impact on GDP.

Their effects are longer-lasting than consumer expenditure since corporate spending affects future economic expansion. Businesses plan their operations budgets and procedures based on their long-term plans and objectives for growth in value creation.

Their financial performance is predicated on that objective, and since their long-term growth is what the company had anticipated, it will ultimately boost the economy. Several instances of a more robust economy that can be linked to business expansion include:

• More job opportunities because business growth provides more job opportunities
• More production needs more labor, thus meaning higher wages
• More consumption of goods due to consumers having higher wages

Since businesses have long-term value-maximizing plans for their firms, the analysis of their capacity 

Financials and Ratio Analysis

Cash flow and profitability ratios highlight the comparison between the company’s current cash flows, profits, debt payment obligations, and other financial information. 

It shows whether the company can afford the current debts or, if there is a surplus or deficit, by how much it is a difference.

It is essential for lenders because it highlights a company’s liquidity. Any other debt obligations a company has are examples such as:

• Bills of exchange
• Accounts payable
• Wages and salaries
• Lease payments

Determining a company’s liquidity is essential for a lender because it might be making a lot of revenue but unable to pay back its debt obligations because its payments are not liquid. 

Instances where a corporation would have to devote its income elsewhere in the business, in salaries, or in the expansion of its company, are examples of situations where they might not be feasible.

The profitability margin calculation is the profit ratio that is most frequently employed. It is the proportion of sales that results in profits. It is a significant indicator because only profits may be used to pay off the debt necessary to keep the business operating.

Sales that disregard financial business responsibilities, such as manufacturing costs and properties owned by third parties that they use for their operations, make it impossible for the business to expand, which makes it impossible for the company to make payments.

Another cash flow example that is commonly used is the operating cash flow ratio which is a measure of how promptly and willingly the cash flows from their companies’ operations contribute to their liabilities. 

A company’s operations are day-to-day activities that are part of the company’s process of product or service provision. A company’s operations include:

• Inventory management
• Packaging and order management
• Marketing
• Research, design, and development

Any cash flow generated from the companies’ operations is calculated by subtracting the cost of goods sold and other associated operating expenses from their revenues. This payment amount, equal to net income, is considered before including new investments.

The operating cash flow, another example, measures how often a company can use the net income from its activities to pay off its current liabilities within the same period. It shows the efficiency and value of their current operating processes.

Position and State of the Business in the Market

A company's capital structure is its total debt and equity on its book. A high level of debt, if not backed by assets and cash flows, will increase the default and repayment risk of the firm by a lot.

This measurement can be looked at alongside the company's degree of liquidity, which can tell lenders whether the company is likely to have enough resources to pay back its specific loan. 

The coverage ratios measure how the company can pay its debt, interest payments, dividends, and other financial obligations. These ratios are also used to identify a company's financial standing.

The coverage ratios of a company show the trend of the debt positions and the current debt positions a company has. The movement of the debt positions highlights whether the company is offering a positive relationship with its finances concerning its debts. 

Potential lenders analyze a company's possible ratio by respecting their competitors' likely ratios because coverage ratios differ between industries. 

Furthermore, other ratios, like the debt-to-equity ratios in a capital structure, also differ based on industries. The reasoning for this is that different industries require different levels of capital and resources, as well as different natures. 

Similar to cash flow and profitability ratios, there are different coverage ratios. Some common ones are: 

• Interest coverage ratio
• Debt service coverage ratio
• Preferred dividend coverage ratio
• Liquidity coverage ratio
• Loan-life coverage ratio
• Asset coverage ratio

Where a company lies in the market plays a significant role in how robust the measurement of its ratios is. As mentioned, these ratios are all factors in determining the company's liquidity. A company's liquidity depends heavily on the health of its business to its consumers. 

These ratios drive attention to the company's likelihood of paying back the loan. If a company's position in the market depends on specific seasons or products or is generally volatile, the ratios they have determined are unreliable. 

This area of analysis focuses on the effectiveness of the borrowing company's processes. The strategies used throughout the growth and progress need to be tracked for energy so lenders have an idea of the prospective borrowing company's potential for growth.

Lenders may find it helpful to look at the company's goals to determine whether their chosen management strategies are appropriate. 

It can help determine their chosen strategies: long-term value creation or short-term value goals, which may hinder a transition to a more sustainable economic model.

Lenders might also review the source of the capital to highlight their reliance on their debt compared to the equity in their capital structure. 

In summation for management strategy and execution, after considering all of these aspects, the methods the company pursues in varying stages of its company growth will likely be reviewed for effectiveness. 

The main question will be: is the company able to strategize throughout their company's position movement in the market?

Borrowing As An Individual

Individuals and companies' capacities are analyzed differently because they have different drivers leading to their financial behaviors. It is evident as they have other financial goals and responsibilities.

An individual's potential to borrow poses a different set of risk expectations and concerns for lending actors because they need to consider that their spending is much more unpredictable than companies' spending. 

As discussed, the capacity of a company to borrow depends, specifically, on its operating expenses. An individual's spending does not consist of these activities to the same degree because their spending supports their personal lives and enjoyment purposes.  

However, they are interrelated in the economy, highlighting their difference. In 2019, the U.S. was concerned with the sustainability of the economic expansion driven by consumer spending being raised by 4.3% in the second quarter, threatened by low business investments.

It was explained by consumer spending rising because of solid job growth and wage increases, while business spending was impacted by "trade tensions and associated uncertainty" (PNC Chief Economist Gus Faucher). 

Each type of spending is driven by different factors and impacts the economy differently, showing that, although related, they are different. 

Usually, companies have a schedule for when and why to spend money on these things. However, individuals' lifestyles are not as predictable, and loans are usually devoted to stricter budgets. Some examples of uses of personal loans would be: 

• Wedding costs
• Vacation
• Debt clearing
• Home renovations

Financial Lifestyle

When borrowing as an individual, the primary concern, similar to lending companies, is to be able to pay the loan back. Determining an individual's current financial lifestyle consists of reviewing their spending habits and the nature of their spending habits, their financial obligations, and their sources of income. 

How spending habits factor into the borrower capacity relies on their nature, which refers to what kinds of purchases are being made, how consistently purchases are being made, and whether they are good purchases. 

"Good" purchases can be defined as purchases that carry potential long-term value, such as tuition to a college or university or a camera that one might use for a photography career. These purchases have the potential to create value. 

Reviewing the financial lifestyle may reveal that many purchases are being made which are not beneficial for one's financial journey or are not necessary and may hinder the likelihood of repayment of the borrowed money. 

The more financial obligations an individual has, the less likely they will be able to pay back an additional loan. It is helpful for an individual to watch their economic lifestyle to manage their financial obligations to keep them manageable. Examples of financial commitments are: 

• Other debt payments
• Mortgages
• Car payments

Sources of income and any other assets an individual has been helpful to be reviewed to identify their stability and growth potential. It highlights whether one's income is reliable for a long-term loan. 

Reasons for a Loan

Identifying why a loan is being requested identifies whether the reasons are reasonable given the financial lifestyle of the borrower. 

For example: if the borrower’s financial lifestyle shows they are a heavy spender on clothing items and their financial solvency is low. Their reason for applying for a loan is for a mortgage, which doesn’t show that the borrower is financially reliable. 

Borrower’s Capacity Case Study

An interesting case study is a paper written by S. K. Singh titled "Factors Affecting Repayment Capacity of Borrower Farmers: An Analysis." 

This paper looks at the borrowing status of a group of people who are a first-hand and robust industry. Their industry is vital to the growth of the nation where this paper was written, India. 

It shows that the credit analysis, specifically an investigation of their borrower's capacity, would show different health indicators of that specific economy. Understanding a borrower's power also indicates an economy's health. 

The paper found that the influence of different factors such as caste, educational status, and per capita farm income impact the repayment abilities of the farmers. 

The caste system, according to Kaivan Munshi, who wrote a paper titled "Caste and the Indian Economy," is heavily related to the economy because of caste politics' presence in the discussion of their access to public resources. 

This access initializes the relationship between Singh's paper's factors and the health of the economy in the Indian economy. Thus, the health of the economy, which, as established, can be indicated by a country's trend of capacity analyses, is related to the capacity indicators themselves. 

This research paper states that the non-repayment rates affect the development of the banking system by impacting its profitability and the reusing of funds, which is another concern for both lenders and borrowers and would prompt a proper understanding of borrower capacity. 

Borrowers and lenders are interested in the banking system's health because that is a significant financial resource. The report concluded that the growth of businesses through loans and debts heavily depends on the ability of banks to provide funds. 

Credit Risk Management

The main idea throughout the concept of borrower's capacity is that lending financial institutions aim to avoid meeting their loan's credit risk. Credit risk is the risk of a borrower failing to meet their agreed-upon responsibilities. 

Managing credit risk is crucial for lending institutions as that determines the overall risk of their loan book. Without a robust framework, the loans given may have a higher chance of default and will ultimately impact the lender's cash flows and bottom lines.

Credit risk analysis models are used to analyze a borrower's credit risk.

Identifying the various details of constructing one's borrower capacity clearly defines a financial institution's credit exposure. Credit risk exposure is the estimated maximum loss for a lender. Credit exposure varies based on one's ability to borrow and the requested loan amounts. 

Lenders who lend to multiple borrowers, such as banks, have great interest in maintaining their credit risk because a high amount of credit risk can result in a significant obstacle in their cash flow.

They might have to thoroughly examine each borrower's credit risk using credit analysis mechanisms to avoid this collective hinder to their cash flow. 

Forbes wrote an interesting article about the relationship between banks lending money and them creating money. They explain that a new demand deposit is to be made by banks whenever they create a new loan asset. 

When the Central Banks, according to the practices of the Bank of England, measure the amount of money circulating in the economy, known as "Broad Money," they consider the demand deposits as part of their calculations. This way, it is now a liability for the borrower.

Summary

In summation, borrowing and lending is not a process that consists of agreeing on an amount and time for repayment. It is a process that closely examines several aspects of the borrower's financial behavior, which impacts their repayment capacity.

Borrower's capacity is the amount that a lender estimates the borrower will be able to pay back to them on time. It is calculated by analyzing various indicators of the borrower's financial habits, which show the lender information, such as whether they should lend and how much.

It is also essential for the general public to understand the borrower's capacity in case they need to borrow in the future. It is because one's capacity to borrow is exceptionally structured by their past, and it is developed over time as it considers the pattern of financial behaviors. 

A proper understanding of one's capacity may assist the borrower in structuring their financial goals, specifically those that the loan is taken for, to present the best repayment capacity to the lenders. Apart from giving, it also increases the likelihood of a better financial standing for the borrower.

It is suitable for the borrower's financial history record, so it is documented that the borrower had a reliable and healthy set of financial habits. These are essential concerns for the borrower to address because they affect their short-term and long-term financial goals and lifestyle.

Along with the borrowers, the lenders also have a great interest in inspecting every borrower's capacity because their credit risk needs to be maintained to manage their cash flows properly. Thus, the process needs to be as thorough as it is for lenders to manage their finances.

Borrowers must ensure that their financial state is in the best possible condition for the amount they request to be approved as a loan using the methods in this article. 

Wall Street Oasis offers a Financial Modelling Course, which discusses the organization and management of finances.

Researched and Authored by Taahna Zubery | LinkedIn

Reviewed and Edited by Aditya Salunke I LinkedIn

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