Using the Five C's of Credit to Avoid Collection Problems


The five C's of credit refer to a simple system that a lender or merchant may use to assess the creditworthiness of a potential customer, client or buyer:

  • Character - Does the prospective debtor show signs of stability and ability to pay?

  • Collateral - What security can the prospective debtor provide to ensure that the debt will be paid or satisfied?

  • Capacity - What is the prospective debtor's capacity to repay the loan?

  • Capital - Does the prospective debtor's net worth, and how much money will be contributed to a down payment or deposit?

  • Conditions - What are the conditions of the loan and the circumstances of the transaction, and how might they affect repayment?

The system examines five basic characteristics of the borrower and the conditions of the debt or loan to try to estimate the chance of default.

Character

When examining the character of a prospective customer or client, factors to consider include:

  • Payment History - What is your experience with the client and the timeliness of past payments?

  • Integrity - When the customer has made promises or told you that a payment has been mailed, has the customer been truthful?

  • Credit Information - Does credit information obtained from third parties, including credit reporting agencies, suggest that the customer is financially responsible?

Collateral

If you are accepting a lien or other security in exchange for a loan or extension of credit, you need to consider the adequacy of the collateral. That is, in the event of default will the collateral be sufficient to cover the debt, as well as the cost of obtaining and liquidating the collateral?

As an alternative or supplement to collateral, you may consider requiring a guarantor for the debt. A guarantor is contractually obligated to pay the debt if the debtor defaults.

Capacity

Capacity relates to a debtor's ability to pay a debt, whether in terms of an individual debtor's income or a business debtor's cash flow. Factors that reflect on capacity include:

  • Amount of Income - How much income or revenue is the prospective debtor generating?

  • Stability of Income - Is the prospective debtor's income stable over time, increasing, decreasing, or fluctuating, and how does any trend or irregularity reflect on the debtor's capacity to repay a debt?

  • Type of Income - What are the sources of the debtor's income, and

  • Debts vs. Assets - If you divide the prospective debtor's liquid assets by their total liabilities, is the ratio greater than one? If so, the prospective debtor is probably a good risk for credit, but if not the risk level is increased.

  • Debt-to-Income Ratio - How much does the prospective debtor owe, as compared to their pre-tax earnings? The lower the ratio, the better the credit risk.

Capital

An examination of a prospective debtor's capital focuses on net worth as opposed to liquidity -- total assets minus total liabilities. The greater the net worth, the lower the credit risk.

Conditions

When making a loan or extending credit, it is important to consider the surrounding circumstances, and not just those of the specific prospective client or customer:

  • Conditions of the Loan - Given the amount of credit being offered, the interest rates and terms of repayment, does it make sense to offer credit?

  • The Debtor's Business - What conditions outside of the prospective debtor's business may affect creditworthiness, including any changes in their market or competition?

  • Your Own Business Conditions - Is your business and balance sheet strong, such that you can take the risk of extending credit to customers or to an additional customer?

  • Industry Conditions - XXX

  • The Economy - Does the economy as a whole appear to be slowing down, creating a risk of late payments or default?

  • Competition - If you do not offer credit terms to your prospective clients and customers will they be able to obtain credit terms from your competitors, potentially costing you the sale?

Copyright © 2016 Aaron Larson, All rights reserved. No portion of this article may be reproduced without the express written permission of the copyright holder. If you use a quotation, excerpt or paraphrase of this article, except as otherwise authorized in writing by the author of the article you must cite this article as a source for your work and include a link back to the original article from any online materials that incorporate or are derived from the content of this article.

This article was last reviewed or amended on Aug 15, 2016.