How can I use the 5Cs to evaluate credit

How can I use the 5 C’s of credit to assess my customers?

The 5 C’s of credit are normally use by all credit personnel to assess the credit status and conditions of potential customers and existing customers. They are:

Character
When you offer loans or credit limits, they are actually offered to individuals (i.e. the people managing the biz entities). Therefore, the character of every customer must be acceptable to you. You must check the way how they usually conduct biz and their biz integrity before substantial loans or credit limits be given out.

To ensure that they are presently not been sued by any creditors, please check our Credit Watch. You must also check your customers do not have the habit of owing money to suppliers & bankers.

Bankers and suppliers talk to each other when they are processing loans or credit applications. Help yourself by building up a good credit record with banks and major suppliers

The customer who promises an order and then withholds it; who makes an appointment and breaks it; who promises to phone back but doesn’t, then he would naturally be equally unconcerned about meeting promises to pay his debts.

Therefore, a good credit professional should compile the character of debtors over time including using techniques such as “credit interviews” and “reference checks”.

The purpose is: we want to know that our customers will pay when credit is due, not when it suits them.

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Capacity

Who will be paying for the loan borrowed? Do you have the means to meet your financial obligations regularly throughout the repayment period?. Very often, applicants do not place importance on this factor.

The customer’s ability to generate sufficient funds to meet his business obligations is measured by the payment record with your organization.

The sales personnel are again requested to provide this information. The usual question is how efficiently does the customer run his or her business. Appearances are sometimes deceptive but as a general observation good housekeeping is a reflection of concerned management.

The personnel who knows what to look for can for example, provide invaluable insights into the quality and maintenance of the customer’s plant and equipment, the upkeep of buildings and premises, the general level of manufacturing activity and how well the front-office if run.

Capital

It is the measure of financial strength of a customer. The credit manager is particularly concerned with the tangible net worth of a debtor debts and ratio analysis of his most recent financial statements. .

In most cases, the most recent financial statements are frequently several months out of date. Any additional information provided is of good value. The sales personnel usually have access to his customer’s business premises which are frequently barred to outsiders. For example, the sales personnel calls on the customer who is located in the warehouse. Knowing what to look for, the sales personnel can provide the credit manager with invaluable information on changes in the stock level, condition or even marketability of the customer’s raw materials or finished goods stock.

Experience shows that unexpected increases in the observed physical level of customer inventories are as much a danger signal as to sudden and unexplained decreases. It would immediately arouse suspicion if there is a sudden dispositions of, or increases in fixed assets.

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Collateral

Providing credit to a borrower or debtor on a secured basis, as in the case of asset-based finance, is usually meaningless on its own.

This type of financing must be based on the borrower’s viability as a going concern with adequate cash flow. Loans to otherwise weak borrowers should not be disguised as secured lending.

If the borrower cannot make a go of it, how can the bank expect to? It is always important to remember that collateral is not a substitute for repayment.

Collateral can however, provide incremental protection: it precludes other lenders from controlling the borrower’s assets and places the lender in a stronger negotiating position because the assets are usually necessary to operate the business.

Three factors must be considered in evaluating collateral: control, marketability and margin. If you think you have to take collateral, do so immediately. Do not just secure the right to it. Recognising that other creditors may prevent you from enforcing that right.

When a debtor is going bad, good credit management is the first line of defense to generate cash to pay creditors at month end. When we hold the the assets of the debtor as collateral and in which that asset is very critical to his operation, he will pay you promptly .

Conditions

This refers to the changes in the industry, the general economic conditions; seasonal shifts in supply and demand; and specific industry characteristics. For example, the building and construction industry constitutes a major segment of economy. It is extremely sensitive to the economic cycle but has a unique characteristic in that it consistently lags some six to nine months behind the economy as a whole.

Without realising, the construction industry tends to become over-crowded. The problems are compounded by the fact that at the start of an economic slowdown there are still a large number of contractual committed buildings still on the drawing board. Many construction companies have full order books long after other business have started to feel the squeeze.

Let us now consider the position of the credit manager in a building supplies company at the start of the downswing. Routine analysis of his company’s records will show that sales are holding steady at their previous high levels and no apparent problems are manifested in debtors’ payment records. It takes a knowledge of the economic conditions affecting builder customers for the credit personnel to realise that while they may appear to have no less work on hand, substantially less new business in now flowing in to take place of completed projects.

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A specific industry consideration pertains to the spread of progress payments on a contact. Building project are customarily broken down into stages, and progress payments are made to the builder against architect’s certification as each successive stage is completed.

Frequently, because many builders lack cashflow planning, forecasting and budgeting expertise their position erode to the point where the drawdown for funds is for the previous stage use and not the next one. Thus the down payment on a new project is actually funding the final stages of a contract just completed. So long as new projects keep coming in, the builder can stretch credit lines without ringing any alarm bells. The moment the new project starts drying up funds, the situation becomes worsen .

The sales personal who is aware of the significance of this payment pattern must provide sufficient information as to the number of contracts terminating, still in progress and those that have recently taken in, and perhaps more importantly, advise his senior management when the final stages can be reached.

If his senior management has doubts about a building customer, some form of salvage operation can be undertaken in the early stages of a contract with a number of progress payments still to be made. The need to pull in credit personnel is extremely urgent however if there are only one or two draws still to come. Very few suppliers can get fully paid because most are still owed by the retention sum

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