The Five Cs of Credit Analysis

The preliminary credit investigation is a fairly standard process. By standardizing the steps taken to investigate a new or existing account and determine its desirability, the credit department minimizes the potential for slow payments and/or bad debt losses involving that customer. The key qualitative and quantitative measures examined in a credit analysis are known as the "C's of Credit" are:

• Character,
• Capacity,
• Capital,
• Conditions of the times,
• Collateral

Character:
This involves a customer's willingness to pay obligations; its reliability, integrity, trustworthiness, and quality of management: assess individual's business character based on their success, payment record, and information from current suppliers; use intangibles (family background, employment record, personal credit history) to form a tentative opinion.  In other words. is the customer willing to pay its debts on time or does the company tend to stretch payments to suppliers?

Capacity to pay:
Business's ability to operate successfully and pay when a debt is due; applicant's ability to generate cash flows. Actual prior business experience with related operations, particularly when large volume orders, exacting specifications, or tight delivery schedules are involved, e.g., major business acquisitions in an attempt to diversify; evidence of having people capable of operating successfully and paying their bills.  One way to evaluate capacity is to determine if the customer generates sufficient cash flow necessary to pay debts as they come due.

Capital:
Credit applicant's equity or net worth; signifies the financial strength as a credit risk and customer's ability to pay its obligations; business that shows increasing sales, profits, and net worth, and favorable trends of operations. Judge each case on its own merits, since many factors affect the financial condition of a business; some lines need a large investment in fixed assets; others require only a minimum investment in machinery and fixtures. Some lines need large amounts of ready cash and liquid assets to meet seasonal operating expenses, while others can rely on regular cash inflow to meet maturing debts.

Conditions:
Analysis of how current and expected general economic situations may affect the applicant's business; may include past and current political history, recent economic events and currency issues. Credit managers should analyze the business cycle of credit applicants and customers as well as their own. An industry and country in a period of dynamic growth with flexible and progressive economic provisions increases the likelihood of a satisfactory credit experience.

Collateral:
Collateral, such as property or other assets, helps to secure payment if those assets are pledged to the creditor.  Specific assets, such as accounts receivable or inventories can be pledged to creditors.  Other forms of collateral include Letters of credit, Standby letters of credit, Guaranties by the firm or its parent, or Personal guarantees from the principals.

The importance of each element will vary from customer to customer. In every case, the credit professional must evaluate an account under review against all "C's" before making a final decision about:

• Whether additional information is needed to make a final credit decision;
• Whether or not open account terms will be extended;
• What specific terms of sale are appropriate;
• What credit limit is appropriate;
• What if any additional assurances of payment [such as a personal guarantee in the case of a corporation] are required before establishing an account for an applicant.

Reprinted with the permission of Credit Research Foundation.

Edited by Michael C. Dennis.