What are the four Cs of credit analysis and how is 'capacity' evaluated?

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AcadiFi · Accepted Answer

The Four Cs of credit analysis are Capacity, Character, Collateral, and Covenants. They provide a structured framework for evaluating borrower creditworthiness. 1. Capacity — ability to pay 2. Character — willingness and track record 3. Collateral — security backing the loan 4. Covenants — legal protections for lenders Capacity is the foundation: can the borrower actually generate enough cash flow to service debt? Key capacity metrics: Coverage ratios: - EBITDA / Interest expense: >3x investment grade, 2-3x crossover, <2x high yield - EBIT / Interest expense: more conservative (subtracts D&A) - (EBITDA − Capex) / Interest expense: captures real cash available after sustaining capex - Fixed charge coverage: (EBITDA + rent) / (interest + rent) Leverage ratios: - Debt / EBITDA: <3x IG, 3-5x crossover, >5x high yield - Net debt / EBITDA: subtracts cash - Debt / Capital: accounting-based structural leverage Cash flow adequacy: - Free Cash Flow / Total debt: >20% strong, <5% weak - FFO (Funds from Operations) / Debt: Moody's preferred metric - CFO / Debt: pure operating cash flow view Worked example — assessing Everpine Paper Company (hypothetical B+ rated): - EBITDA: $380M - Interest expense: $95M - Capex: $120M - Total debt: $2.1B - Cash: $180M Metrics: - EBITDA / Interest = 4.0x (solid) - Debt / EBITDA = 5.5x (high yield territory) - Net debt / EBITDA = 5.1x - (EBITDA − Capex) / Interest = 2.7x (tighter) - FCF / Debt = ~7% (moderate) Interpretation: Everpine has adequate interest coverage but elevated leverage. The cyclicality of the paper industry means capacity is vulnerable in a downturn — stress-test at EBITDA down 30%. Forward-looking capacity assessment: - Forecast EBITDA under base, downside, severe scenarios - Layer in debt maturity schedule - Check refinancing risk - Evaluate liquidity sources (cash + undrawn revolver) vs. 18-month cash needs Capacity is necessary but not sufficient — even solvent firms default if character is poor or covenants trigger.

What are the four Cs of credit analysis and how is 'capacity' evaluated?

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