Five C’s of Credit

It is important when preparing financial projections and considering debt finance that the business has a good understanding of how a potential lender will view and assess their business.

Debt finance is usually provided by commercial finance institutions who rely on their assessment of risk and return to guide lending decisions.

The decision to lend is based on the credit worthiness of the business and the perceived risk that the business will default on the debt, this in turn will influence the size of the fee, and the interest rate charged on the loan.

The traditional method used by lenders to determine credit worthiness and the risk associated with a business, is the Five C’s of Credit. The method weights five characteristics of the business and attempts to assess the chances of default.

five Cs of credit

The Five C’s of Credit

In no particular order, the five C’s of credit are as follows:

1. Character

The lender is looking to gain confidence in the ability and willingness of the business and its owners to operate the business successfully and repay the debt.

Who are you and do you know what you’re doing?

The lender will take into account such things as industry knowledge and experience, and the financial competence of the business owners, including the ability to keep good financial records, and plan ahead.

The lender will almost certainly rely on references and previous debt repayment records to show that the business owners have past experience of satisfactorily dealing with the repayment of debt finance.

2. Capacity

Capacity refers to the businesses ability to pay back the debt. Looking at the financial projections and historical cash flow patterns (if any), the lender will seek to ensure that the business will generate sufficient operating cash flow to cover the debt repayments.

Do you have the cash flow to pay back the debt?

The financial projections can help demonstrate that the business has adequate liquidity and working capital to operate the business and meet its future obligations and commitments including repaying the debt.

3. Commitment

The lender is looking for a firm financial committment from the business and in particular the business owners. The commitment can be by way of an initial cash capital injection by the owners or retained earnings of the business; either way, the lender needs to know that if things start to go wrong, the owners will do everything they can to overcome the financial difficulties.

How much cash are you putting in?

It is unusual for a lender to lend more than the owners have committed, so use the financial projections to check the leverage ratios to the see that the gearing ratio is less than 0.5, and the debt equity ratio is less than one.

4. Collateral

Collateral, sometimes referred to as security, relates to the businesses ability to pledge suitable assets to secure the debt. Ultimately if the business cannot make the debt payments, the lender wants collateral it can liquidate in order to repay the amount outstanding.

How do we get our money back if it all goes wrong?

When lenders examine collateral offered by a business, they will rely more heavily on assets which are more easily liquidated (turned into cash). A willingness by a business to offer collateral is seen by a lender as an additional commitment to repay the debt, however, try to restrict the collateral given or keep it to specific assets, as once committed, it limits the businesses ability to raise additional finance elsewhere.

5. Conditions

Conditions relates to the economic environment in which the business operates, including for example, current consumer trends, and how this environment might impact on the ability of the business to repay its debts.

Can the business operate in the current market?

As part of the process, the lender will look at and compare the businesses performance with that of its competitors.

Debt finance is primarily concerned with risk and return, it is important to know what the lender is looking for when you approach them for funding. By understanding the five C’s of credit, the business, armed with its financial projections, will have a better chance of satisfying the lender that in the current environment (conditions), it knows what it is doing (character), has the cash flow to repay the debt (capacity), is prepared to inject cash from its own resources to at least match the lender (commitment), and can offer assets to secure the debt (collateral) if it all goes wrong.

Last modified August 14th, 2019 by Michael Brown

About the Author

Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.

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