Introduction
Commercial lenders consider five factors – the “Five Cs of Credit” – when assessing the creditworthiness of a prospective borrower. The Five Cs are also valuable to trade creditors. This six-part series introduces the Five Cs from the standpoint of a trade creditor considering whether to extend credit to a new customer or extend additional credit to an existing customer.
The Five Cs include:
Character
Character considers the customer’s reputation for honesty and reliability. Does the customer have a history of paying bills on time? What is the customer’s reputation in its industry? Has the customer been sued by vendors in the past for nonpayment? Filed bankruptcy?
Although character is typically viewed as a subjective, qualitative assessment of trustworthiness, there are objective measures of character as well, such as credit scores based on on-time payment performance.
Capacity
Capacity refers to the customer’s ability – from a technical, financial perspective – to repay amounts it owes. In the commercial lending context, lenders look at a borrower’s financial statements and cash flow projections to determine if it has the capacity to make the debt service payments on the loan.
The capacity inquiry typically focuses on liquidity, cash flow, and leverage, frequently using ratio analysis to assess debt service coverage and total leverage. These metrics are similarly valuable in the trade credit context. The Capacity installment of this series will dive more deeply into the assessment of a customer’s financial capacity.
Capital
Capital refers to the customer’s total assets, both tangible and intangible. Capital is the financial foundation underpinning a company, providing financial flexibility to seize opportunities, as well as a reserve to sustain the company in the event of industry headwinds, a general economic downturn, or another financial or operational shock.
Collateral
Collateral comprises the assets that a customer has available to pledge as security. While security interests are not always common in trade credit relationships, circumstances do exist where a customer will grant a purchase money security interest or a security interest in other assets. Collateral can include property, inventory, and equipment. Just like commercial lenders, trade vendors that receive a pledge of collateral want to know that they have an asset they can readily liquidate if the customer defaults.
Conditions
As the name suggests, conditions are the external factors – general macroeconomic forces, industry trends, geopolitical situation, and otherwise – that impact the customer’s overall economic viability and its ability to repay its debts. The evaluation of conditions is predominantly a qualitative exercise and will vary from customer to customer. The Conditions installment in this series will address some examples of the factors to consider.
Conclusion
The following five blog posts in this series will address each of the Five Cs in turn from the standpoint of trade creditors. Although trade vendors are not making loans in the traditional sense, trade credit is a major source of corporate capital: At the time of writing, US vendors have nearly five trillion dollars of trade receivables outstanding.
Although trade vendors are not making loans in the traditional sense, but are selling goods and services on credit terms, the principles underlying the Five Cs of business credit still apply when evaluating customers’ creditworthiness.
The Five Cs enable trade vendors to manage risk by ensuring they are selling to the customers most likely to repay on time and in full. Credit Workbench™ provides an integrated trade credit management platform that enables high-performing credit departments to manage their customer credit relationships from credit application through the entire customer lifecycle.
The next five Credit Workbench™ blog posts will dive into the Five Cs in detail and provide helpful credit evaluation tips and strategies for savvy trade vendors.
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