Use the 5Cs of Credit to Determine Creditworthiness
Creditworthiness is one of the most basic concepts in business credit, whether you’re a company seeking a line of business credit or you’re a company considering extending a line of credit to a customer.
Creditworthiness is how a company is evaluated or considered by another company to determine if they’re “creditworthy.” If you’re a company seeking a line of business credit, imagine how your suppliers might view you and what their concerns might be when considering if and how to work with your company. Most of the time, it all boils down to this: Is your company capable of paying the invoice in full, on time, and within terms?
Most companies that extend business credit have a set of criteria that they use to determine a customer’s creditworthiness. These criteria can be both subjective and objective. Subjective criteria can include things like whether the customer seems easy to work with or comes across as honest and trustworthy over the phone or in person. Objective criteria tend to include things such as whether your financial statements show you have sufficient cash flow to pay the invoice or whether your trade references show your company has previously paid on time.
One of the most well-known formulas to determine creditworthiness is the “5Cs of credit”: capacity, capital, character, collateral, and conditions. After reading about the 5Cs of credit, imagine again how your company may be perceived by a supplier evaluating you for trade credit.
5Cs of Credit
Capacity – What is the business’s financial capacity to pay its invoices? Does it have sufficient cash flow? Is it heavily saddled with debt? Business credit applications typically ask the applicant to supply bank references, trade references, and financial statements. These documents will reveal the applicant’s capacity to pay. If an applicant can’t provide financials or references, credit managers will need to find other ways to assess the company’s capacity to pay. Many consult business credit reports, which contain scores and ratings that can reveal a potential credit risk.
Capital – Capital describes the financial and non-financial assets that a business holds, as well the amount of money the business owners have invested in their company. If the financial assets listed in the financial statement demonstrate growth (such as owning instead of renting a vehicle fleet), that may imply a lower risk of non-payment. Of course, having a financial statement makes it easier for a credit manager to assess the credit-seeker’s capital strength.
Some industries are more capital-intensive than others, and this is where the non-financial assets – including real estate, inventory, machinery, and other equipment – can be helpful in determining creditworthiness. Those industries that require major investments in inventory and equipment may seem riskier than those that operate with a lower overhead, but this is where the credit manager’s expertise comes into play. Their knowledge of various industries and trends can help assess financial strength.
Character – Credit managers use a character judgement to help determine if an applicant seems willing to honor their debt. Trade references, payment records, and a clean legal history in the business credit report help illustrate character. Otherwise, character is subjective, and many used to consider it the most important “C.” Before credit decisions were automated, the credit profession placed a strong emphasis on the applicant’s character and the professional relationship between the customer and the credit manager. If they knew their customer’s business well, they would be more willing to work with that customer account in times of slow payments. A customer that doesn’t return phone calls or emails may wind up having their invoice sent to collections, which can hurt the business’s chances for future credit requests.
Collateral – Applicants with a questionable credit history may be asked to put up collateral to secure their debt obligation for a high line of credit, the same as any other type of loan. Here, the inventory, machinery, and other equipment noted under Capital as assets can be used as collateral. While collateral offsets the lender’s risk, it’s important to remember companies would rather work out a payment plan with their customers than try to seize an asset as part of the collections process.
Conditions – Conditions allows the credit manager to look at the big picture and consider economic conditions within the applicant’s industry, its competition, and its geographic location, to name a few. For example, two companies of the same industry and the same size each seek a line of credit, but one is located in a city with thriving demand and the other is located in a smaller market and has been losing customers to the competition for years. The thriving company seems low risk, but the other one may have growth potential if it has recently changed its business strategy to account for the competitive impact. Stepping back and considering macro-level conditions and opportunities for growth enables credit managers to make more calculated risk decisions.