The five Cs of credit form the basis for an analysis of customer credit by many organizations. These five conceptual areas provide evidence for whether a customer can pay back what it owes, or whether it will default. These five review areas are as follows:
Character. The character of a customer refers to its willingness to pay in a timely manner, usually as evidenced by its payment history. This information is available in a credit report, which is available from one of the credit bureaus. At a deeper level, understanding the character of a customer requires one to delve into the backgrounds of the people who own or manage the business. A good example of character is a business that has paid its bills when due for many years, without having had any litigation with its suppliers. Conversely, a history of late payments and litigation is a clear sign of lack of character.
Capacity. The capacity of a customer refers to its ability to pay back a loan or credit advance. A high level of capacity is evidenced by a history of strong positive cash flow and a reasonable ratio of liabilities to cash flow. An additional issue is whether the customer’s projected circumstances will change enough to alter its current cash flow or liquidity position.
Capital. The capital of a customer is its net worth, which is the residual amount of assets left after all liabilities have been subtracted. An examination of capital is intended to give an idea of the asset reserves that a customer has available to pay down its liabilities. A concern when examining this issue is that a customer could have a massive net worth, but it is entirely tied up in fixed assets (such as a factory) that are impossible to liquidate in order to settle outstanding liabilities.
Conditions. The conditions associated with a customer refer to the environment within which it operates. One must investigate the customer’s economic environment (such as highly seasonal sales), regulations impacting it, and the possibility of catastrophic events. If a customer’s sales are sensitive to any of these issues, it may be difficult to grant a significant amount of credit.
Collateral. Collateral refers to the ability of the customer to make a secondary source of repayment available to the company. This is especially important when the cash flows of the customer are weak or variable. For example, a customer could pledge its receivables, investment securities, or a building as collateral. The company can then seize these assets and sell them off to gain payment of the underlying debt. The investigation of collateral includes an examination of whether a customer’s assets have already been pledged to other creditors.
An examination of these five items will give a credit analyst a broad-based view of the ability of a customer to pay in a timely manner. The five Cs are especially useful when deciding upon large credit amounts; in these cases, the company is placing itself at risk of default on a significant amount of money, and so needs to employ every possible credit tool to minimize its risk. However, the five Cs are largely judgmental in nature, so a credit analyst may give varying amounts of credit to customers based on personal biases.