5 C's of Credit
Last Updated: May 30, 2019
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The five C's of credit is a description of the important general characteristics that lenders should consider and evaluate when it is considering making a loan. These considerations incorporate both qualitative and quantitative measures and require both intuition and judgement as well as analysis of facts.
The five C's of credit are character, capacity, capital, collateral and conditions.
Character is often a moral judgement, and refers to a borrower's reputation, integrity, moral force, and mental qualities distinctive to an individual. These are items that you cannot physically see that define the way someone thinks feels and behaves. It is an evaluation of ones moral qualities, and may imply a variety of attributes including the existence or lack of virtues, such as empathy, courage, fortitude, honesty and loyalty, or of good behaviors and habits. No matter how strong the true financial strength of a loan may be, character of the individuals involved in your loan is an essential step of the analysis to extend credit.
Capacity measures a borrower's ability to repay a loan by comparing its income and cash flow based on its income and cash flow, against all of its needs and obligations.
Lenders also consider the amount of capital that is invested in the business, and the ability of the borrower to raise or provide additional capital if necessary. Capital can serve as a buffer or cushion if it turns out that the original loan amount did not provide enough to allow the client to meet its needs due to changes in the company’s operations or unexpected events or set backs. Capital is a source of additional funds to the borrower if needed. A large cushion of capital or the ability to raise capital increases the probably that the borrower will be able to pay its debts.
Collateral consists of assets that are pledged to the lender that reduces the risk of lending by providing another source of repayment if the borrower is unable to otherwise repay its loans. In event the borrower defaults, a sale of the asset properly pledged to lender can be used to repay the loan. In the event the borrower lacks the ability to repay the loans from the cash flow of its operations, and defaults on its loan, the proceeds fro a sale of the collateral can be used to repay the loan.
The conditions of the loan are very important, and help guide the expectations of the relationship and can be objectively followed. These include how borrower may be allowed to use the money that is loaned, how lender gets repaid, financial covenants that are expected to be met, he reporting required, timing of payment, interest rates, and other rules and expectations clearly defined that are expected to be met and govern the relationship.