Any credit professional who has prepared to take a designation exam will tell you the importance of understanding the Five C's of Credit. The fundamentals associated with these principles are so important to the world of effective credit management that a test without reference to them would be sorely incomplete. As a result, anyone who has assisted in leading review discussions for those preparing to sit for the exam will emphasize the importance of knowing the five C's forwards and backwards.
Even having sat through several review courses and having taught a few myself, remembering all five with rapid-fire response of one waiting to be tested can be a challenge. Yet, honestly, as credit professionals, we incorporate the principles contained therein on a daily basis. We just do not necessarily sit back and state that our work focuses upon them.
However, a formal review of the five C's is something that should be encouraged on a frequent basis to ensure you and/or your department are not overlooking key concepts that will help ensure your success as a credit manager and thus, in turn, the success of your company.
The Five C's of Credit include: character, capacity, capital, collateral, conditions.
Character - Of all the C's this one may be the most difficult to quantify. After all, how do you delve into the mindset of an individual or business to determine if they have good character and will pay their obligations? The bottom line is that credit managers depend upon the morality of the individuals that run a business to "do the right thing" and pay their bills. How do you measure morality?
When I worked in the field of investments, we were trained to let potential investors know that we could not predict the performance of their potential investments. We further informed them that the best predictor of future performance is that of past performance.
As credit professionals, we have the ability to review past performance by pulling credit reports and calling for trade and bank references. Verifying with state agencies can help determine if a company is properly registered to do business within a state. Where applicable, verifying if a business is properly licensed provides additional insight into whether or not a company has taken the initiative to properly establish itself.
Personal guaranties can also provide more detailed information on the individuals running the business. Never underestimate the insight that can be gained by not only reviewing payment history but the acquisitions of the individuals involved. Personal credit reports can also provide prior work history which can indicate if the business owner has worked previously in the industry and, if so, how many years of experience the individual brings to managing the current business.
The legal entity for the business can also offer some insight as to how much, if any, personal risk the owners are willing to take. Companies set up as sole proprietorships or partnerships reflect a willingness on the part of the business owners to accept full or partial responsibility for all debts incurred. Corporations and limited liability companies have legal safeguards in place to distance business owners from any personal exposure. Legal organization is an important factor that should be reviewed by credit managers to determine what, if any, additional measures may be needed to extend credit to a business.
Capacity - The information most needed by a credit manager is whether or not a business has the capacity/ability to meet its obligations. Given the current economic environment in which we work, many companies that were able to easily pay its bills three years ago have either gone out of business because resources that were once readily available such as timely collections of accounts receivable, savings accounts, bank lines of credit, and outside investors. They no longer have these resources available to meet current obligations. As a result, many have gone out of business. Others may be teetering on the brink of financial collapse.
The challenge for credit managers is to determine which businesses may be faltering and which are still on top of their game. Again, credit reports are an invaluable tool in obtaining such information. However, a simple review of a report when the account was first established some time ago is not sufficient to determine where a company currently stands. It is vital that credit managers establish a procedure to review existing accounts on a regular basis. Such a policy should focus on key accounts where large volumes of credit are extended as well as accounts where a change in payment history has been noted and warrants further investigation.
When possible, access to company financial statements can provide tremendous insight into where a company is positioned at any particular time. Balance sheets and income and cash flow statements give a snapshot of a company's current financial position. Comparing financial statements from year-to-year and/or from quarter-to-quarter, allows analysis of how the company is managing its current assets and liabilities. Such information is invaluable in determining if the company truly has the ability to meet any obligations it may incur with your company.
Industry trade groups, such as those made available by NACM, are another important tool that can help credit managers better monitor how customers are dealing with others in your industry. The sharing of factual data from peers can be invaluable. The insight offered in one meeting can easily offset the fees associated with membership in such groups if it results in reducing any amount of bad debt write-offs.
Capital - This third C of credit is very reliant upon the provision of financial statement information. Other creative approaches to filling in any gaps when a statement is not provided can help in providing the insight needed from this important component of credit evaluation.
A review of a company's equity or net worth in its financial statements from year-to-year or even quarter-to-quarter can show how effective management has been in growing its capital which, in turn, allows the business to invest in itself and take advantage of growth opportunities. If a company's net worth is stagnant or shrinking, a savvy credit manager will know additional information is needed before extending credit.
The grim reality is, more often than not, detailed financial information is not or will not be made available for review. Credit mangers need to have other "tricks" up their sleeves to determine if a business has the appropriate amount of capital to succeed in the industry.
Again, industry trade groups can provide a pulse for credit managers to monitor how a potential customer is conducting themselves. A sense of how the company is trending can be obtained while listening to others share their experience in working with a customer.
Credit reports can also give information as to how buildings and equipment are being financed. If a company has many UCC filings referenced in a credit report, it is safe to determine that business operations are being financed through outside sources which may, in turn, put your company further down the line in the event of a default or bankruptcy.
Never underestimate the quality of information you can obtain from within your own company. Your sales staff can help fill in many blanks associated with searching for information associated with locating the capital within a business. Salesmen are beating the bushes daily looking for sales. They know what is taking place in the industry. Do not hesitate to ask them what they have heard on the street about a particular business. Many times they will have a sense for how a business is utilizing its assets. They know if equipment is being properly used to its full advantage.
Conditions - Of all the C's, this is the one where all credit managers have been able to commiserate the most over the past three years due to the downturn in the economy. Few industries, if any, have been left untouched by the "Great Recession." Economic indicators say we are officially out of the recession, yet, so-called "advances" have been slow if not unrecognizable in some sectors.
Again, credit reports are invaluable in getting a snapshot of where a business currently stands in meeting its obligations. This universal truth aside, other "conditions" must be taken into consideration.
Is the customer a seasonal business? Have there been any recent changes in the management of the company? Has it expanded or cut back in its various lines of business? Has the product line increased or decreased? Have business locations increased or decreased? How is the industry performing overall? Is the customer performing in a similar manner?
All of these questions should be examined as your company determines whether or not to extend credit to a new or existing customer.
Site inspections or even drive-bys can offer much information as to the current condition of a company. Such visits can confirm the accuracy of details provided and, in some cases, give even more insight as to the current condition of a business. The phrase "a picture is worth a thousand words," is very applicable when a simple premise visit can offer so much information in determining the condition of an enterprise.
Collateral - The fifth C of credit is one that is not always needed if the character, capacity, capital and conditions of a business are deemed to be satisfactory. However, in the event that any concerns are raised when the credit worthiness of an account is reviewed, securing the assets of a business and/or its owners can provide a safety net while doing business.
Many companies automatically include a personal guaranty on their credit application in an attempt to secure the personal assets of the individual signing the guaranty in the event the company applying for credit defaults. Often times this section of the application will be left unsigned or even crossed out when returned. If upon further review of the application the credit worthiness of the company is questioned, a credit manager can re-assert the requirement for a personal guaranty from a credit worthy individual before credit can be extended.
Obtaining a personal guaranty does not necessarily mean an adequate pledge of collateral has been received. For this reason credit managers should utilize the five C's in reviewing personal guaranties. It is not uncommon for an owner of a business to shelter personal assets by having all assets owned by a spouse or protected by a trust. If such measures have been taken, it is in the best interest of the potential creditor to also secure guaranties from the spouse and/or trustee of the trust.
Other forms of collateral can also be used including obtaining UCC filings on equipment or a trust deed on property. Keep in mind collateral is only as valuable as the position you have on it. Others may be ahead of you which can greatly impact the worth of the encumbrance. A clear understanding of what position you have on the property/equipment is vital to understanding what potential value you have secured.
If material and/or labor have been provided to a property, a properly filed lien can also provide a type of collateral after credit has been extended. Care should be taken to ensure all necessary requirements have been met to pursue and retain lien rights as laws differ from state to state.
Although technically it is not a form of collateral, joint checks are another tool that can help reduce the risk associated with the transaction if you know your customer is contracted with a reliable third party. However, joint check agreements are only as good as the issuing party of the check. Joint checks require additional vigilance on the part of the issuer. Again, a review of the 5 C's in reviewing the credit worthiness of the check issuer is highly recommended.
Summary - The five C's of credit are second nature for most credit professionals. However, periodic review of the principles associated with them is vital to ensure important aspects of the credit review process are not being overlooked in determining the credit worthiness of potential customers and existing accounts. Periodic review and implementation of the five C's will help ensure the success and value of the credit function within any company.