The 5 Cs of Credit are the ABCs of credit. They describe the basic way credit managers evaluate applications, but they’ve been used for so long it’s easy to wonder if they are still relevant.
They are, and here five experts share how credit managers can use them to make better credit decisions.
The 5 Cs of Credit are shorthand for the main factors lenders, and companies that extend credit, use to determine whether borrowers are creditworthy. They include the following criteria:
Whether you’re a bank making a commercial loan, or a credit manager extending supplier credit, these factors are more important than ever. Together, they help credit managers evaluate applications as well as set credit limits and establish credit terms.
Character refers to a borrower’s willingness to repay debts and this factor is often measured by checking credit reports. Business credit reports and scores from commercial credit bureaus such as Dun & Bradstreet, Creditsafe, Experian and Equifax allow credit managers to evaluate this factor when reviewing applications for vendor credit.
“Character is probably the most important aspect of commercial lending,” says Erik Beguin, CEO and founder of Austin Capital Bank. “There are companies that will have the financial resources to repay you but will find every excuse not to repay you. Then there are people who barely have the resources to repay you but will make every effort to repay you,” he explains.
Commercial credit scores use information from credit reports, including payment history, debt usage and other factors such as liens or judgments to predict risk.
“Credit scores are a good indicator of character,” says Austin, Texas-based Beguin. But he also warns that small businesses may not have established good business credit scores, either because of a lack of awareness, or because of the challenges that often come with establishing business credit from scratch.
“There’s no user manual of how to build a business credit profile,” he notes.
To help fill that gap, Austin Capital Bank offers Credit Strong for Business, a business credit builder loan that reports payment history to multiple commercial credit agencies: Experian, Equifax and the Small Business Financial Exchange (SBFE). “We allow them to demonstrate their willingness and ability to repay that loan and we report it to business credit,” he adds.
In addition to checking credit to make credit decisions, credit managers can help their customers establish business credit by reporting payment histories to one or more of the major commercial credit bureaus. This also helps other credit managers make better decisions, and contributes overall to a more robust credit environment.
Capacity refers to the amount of debt and monthly payments the borrower can afford.
“If we can measure the customer's capacity when analyzing financials, we can understand the purchasing power of that customer, and also the amount of business the relationship will bring to the company,” says Christian Figueroa credit manager for Indorama Ventures in Woodlands, Texas.
He looks at the Income Statement and Balance Sheet of the business, as well as credit report data, to determine capacity. Figueroa says he also looks carefully at the amount the company buys from his firm when setting credit limits.
He gives this example: “If a customer is asking for a $10 million credit limit but they only buy $8 million a year, 8 divided by 12 months is only about $666,000 (in spending per month). And that’s assuming our company will be the only supplier.” He goes on to explain that he would approve a limit of 30% to 50% of that amount. “This is to start a business relationship and grow from there. Also, only if their financial stance is in good shape. It is not good to put all the eggs in one basket or become the sole supplier of a company,” he adds. “It would not make sense to take on all the risk.”
When reviewing a credit report, he’ll look at the largest credit limit granted, as well as the recommended credit limit and combine that information with the financial information he’s gathered to help determine capacity.
Figueroa says he will review capacity at least once a year, or more often as needed. If a client bumps up against their credit limit, for example, he’ll review their information again to make sure he’s set the right limit.
Collateral typically refers to assets pledged to secure a loan. Not all loans are secured with collateral, but as Brian Probst, president of BA Probst Consulting in Austin, TX points out, collateral “is the only C that actively participates in the loan after it is underwritten because the lender may seize the asset to offset their loss.”
With trade credit, collateral can be in the form of a lien on work, a personal guarantee by the vendor, or inventory, says Probst. “Equity vendor financing is common with start-up businesses,” he adds.
“Collateral provides a loss mitigation measure during default,” he notes, and it “provides a motivational measure for the debtor to not default. This provides ‘skin-in-the-game’ for the debtor to do all that is possible to refrain from defaulting.”
Borrowers can also benefit with better terms, he adds, such as increased loan amounts or lower interest rates.
Traditionally, there are a variety of ways business loans may be secured with collateral. They include:
Loans secured by collateral require a legal agreement. “This provides the legal
conduit for the transfer of asset ownership if the loan is defaulted upon,” says Probst.
UCC filings are often used by commercial lenders to notify the public of their interest in the property of the business.
Capital can refer to a down payment, or more broadly to the capital available to the business to repay the debt.
“Capital refers or relates to a customer’s financial condition, and its ability to pay invoices as they come due, explains Michael Dennis, a business consultant and partner at DC Associates based in Miami. “This assessment revolves around a review of the customer’s financial statements including the Balance Sheet, Income Statement and Cash Flow Statement.”
Dennis, author of books including “Credit & Collection Handbook,” suggests credit managers look for the following:
Dennis also recommends regularly reviewing updated financial information. “Customers’ financial conditions change every day, sometimes for the better and sometimes for the worse. It is dangerous for a credit pro to rely on out-of-date customer financial information,” he warns.
Relying on information from an out of date credit application can be a mistake credit managers can’t afford to make.
Conditions can include the conditions of the loan, such as the length of the loan, the interest rate and payment schedule. It can also refer to how both internal and external conditions affect the likelihood the borrower will repay the loan, points out Firas S. Hussein, a risk manager and consultant in microfinance in Lebanon. In microfinance, Firas says that internal conditions can be harder to evaluate and may require field visits to the business and even the owner’s residence.
For credit managers in trade credit, it may mean reviewing the terms of credit offered in light of the businesses current conditions, such as the market for current products or services, competition, and capacity for growth.
External conditions refer to industry and economic factors. For 2023, these can include macro and micro conditions, Firas notes. He suggests the credit manager consider questions such as, “What if global fluctuation of prices for oil and gas affect the business? What if less supply against high demand of raw materials increases the price of the cost of goods sold in the business?”
These questions may vary depending on the business and the industry, but evaluating the conditions that may affect the ability of the business to repay the loan are essential to managing credit risk. Credit managers in trade credit will often review the terms of credit offered in light of the businesses’ current internal and external conditions, such as the market for current products or services, competition, and capacity for growth.
The common theme throughout the 5 Cs of Credit is that the credit manager must verify the information provided by the borrower in the application, and carefully review it in the context of the amount of credit requested and the proposed terms. Since vendor credit is often offered at short terms -- say Net 15 or Net 30 terms -- credit managers can manage risk by setting appropriate credit limits, and reviewing account information regularly.
Check business credit when the application is submitted, then regularly review credit to ensure terms make sense. Bank verification provides another level of assurance that the information provided is correct. If bank account information doesn’t match financials provided, for example, the credit manager will want to dig deeper before extending credit or increasing a credit line.
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