Extending Credit Strategies: The 5 Cs of Credit

Extending credit to a customer is about taking on a certain level of risk. There is no secret formula or mathematical equation that
ensures youre making the right decision. But by applying the 5 Cs of Credit, you can at least, make an informed one.

Number One: Character
What do you know about the customer? Has he exhibited integrity in former business dealings? Does he keep his word? One way to
handle those of questionable integrity is to get references. What are other business contacts saying about him? The important thing
is, a person can have the ability to pay, but if they dont keep their word or are in some way untrustworthy, they are a risk you dont
want to take. Its obvious that those who betray trust arent good candidates for extended credit.

Number Two: Collateral
By taking a lien, youre staking a claim to your customers assets. In that case, you become their secured creditor. It goes without
saying that you dont want to go back and re-claim products youve sold to your customer in the event that he doesnt pay his
invoices. But by using a security agreement and financial statement, thats exactly what you can do.

Number Three: Capacity
Capacity is all about cash flow. Most businesses experience the ebbs and flows of cash flow right along with the nations economic
health (or lack thereof). Even the most responsible and conscientious customer can experience a turn of events that throws a kink in
the works. But the bottom line is, can your customer still pay you even when theres a temporary hitch in his cash flow?

Number Four: Capital
Whats your customers net worth? By comparing several financial statements, youll be able to see any trends upward or
downward. If net worth is increasing each year, then capital is being put into the company.

Number Five: Conditions
The economy and market conditions play a role in everything across the board in business. For certain customers, tough economic
times can be particularly challenging. When conditions are good, orders come in and the money flows. When theyre not, well
theyre not and your customer may react to it by letting some bills slide. When that happens, its time to tighten up your policies.
To determine which of your customers is the bigger risk to you, start by taking into consideration the Five Cs of Credit. Its a great
beginning point before you make any credit decisions.



What does a lender look for when evaluating a loan request? While each lending
situation is unique, many lenders utilize some variation of evaluating the five Cs of
credit: character, capacity, capital, collateral, and conditions.
1. Character is the moral obligation that a borrower feels to repay the loan. Since
there is not a accurate quantifiable measure to judge character, the lender will
decide subjectively whether or not you are sufficiently trustworthy to repay the
loan. The lender will investigate your past payment experience, review a credit
bureau report, and consider your educational background and experience in
business. The quality of your references and the background and experience of
your employees will also be considered. Character and capacity (covered next)
are the most important of the 5 Cs.
2. Capacity refers to the companys ability to generate sufficient cash flow from
operations to meet the loan payments. Since this represents the primary source
of repayment for a loan, the prospective lender will want to know exactly how you
intend to repay the loan. The lender will consider the cash flow from the
business, the timing of the repayment, and the probability of successful
repayment of the loan.
We generally calculate cash flow by adding the depreciation and amortization
expense back to earnings before interest and taxes (EBIT - also called net
operating income). This sum is called EBITDA, for Earnings Before Interest,
Taxes, Depreciation, and Amortization. Since depreciation and amortization are
not cash expenses, they should be added back to EBIT to determine the cash
flow available for things such as loan payments, capital spending, and taxes.
Next the cash flow will be compared to the companys current obligations (debt
service). Debt service is simply the anticipated principal and interest payments
on all debt. Generally, an electronic spreadsheet is used to model the cash flows
(by assuming various levels for Sales) to determine the risk of not being able to
meet the principal and interest payments.
3. Capital is the money you personally have invested in the business and is an
indication of how much you will lose should the business fail. Lenders expect
you to contribute your own assets and to undertake personal financial risk before
asking them to commit any funding. If you have a significant personal investment
in the business, you are more likely to do everything in your power to make the
business successful.
Lenders will generally consider the company's debt-to-equity ratio to understand
how much money the lender is being asked to lend (debt) in relation to how much
the owners) have invested (equity).
4. Collateral or third-party guarantees are additional forms of security you can
provide the lender. If the business' cash flows are not adequate to repay the loan,
the bank wants to know there is a second source of repayment. Equipment,
buildings, accounts receivable, and inventory may be seized and sold by the
bank if the company defaults on the debt. The loan agreement should carefully
identify any items that serve as collateral. Business owners may be asked to
place personal assets (home, stocks, bonds, etc.) in addition to the business
assets as collateral for a loan. In some cases, the lender may ask for a third-
party guarantee where someone else signs a guarantee document promising to
repay the loan if you can't.
A lender will normally want the term of the loan to match the useful life of the
asset used as collateral. If equipment with a five-year expected life is used as
collateral, then the term of the loan will generally be five years or less.
5. Conditions refer to national and local economic conditions. How sensitive is the
company's sales to the overall economy? If the country enters a recession soon,
will the company's sales fall dramatically or can they be expected to be relatively
unaffected (like a grocery store chain, for example). Companies with stable
sales that are not tied closely to the overall economy are generally looked upon
more favorably by lenders.

Definition of 'Agency Problem'
conflict of interest inherent in any relationship where one party is expected to act in
another's best interests. The problem is that the agent who is supposed to make the
decisions that would best serve the principal is naturally motivated by self-interest, and the
agent's own best interests may differ from the principal's best interests. The agency
problem is also known as the "principalagent problem."


Credit period:
The time period a creditor extends credit to a customer. At the end of the credit
period, the customer of the business is expected to have met all financial
obligations in exchange for the goods or services which were obtained on credit.

Credit standard:
The guidelines issued by a company that are used to determine if a potential
borrower is creditworthy. Credit standards are often created after careful analysis of
past borrowers and market conditions, and are designed to limit the risk of a
borrower not making credit payments or defaulting on loaned money.
Cost Of cash discount:
An incentive that a seller offers to a buyer in return for paying a bill owed before the
scheduled due date. The seller will usually reduce the amount owed by the buyer by a small
percentage or a set dollar amount. If used properly, cash discounts improve the days-sales-
outstanding aspect of a business's cash conversion cycle.
Collection Policy: