What are the “5 Cs of Credit”?

The credit process or the process of granting a loan involves several steps, which leads to either disbursement of the loan or rejection of the loan application. The process starts with the lender assessing the borrower’s ability and willingness to meet future financial obligations associated with the loan. There are 5 Cs of credit that play a key role in credit analysis and these are:

  • Character
  • Capacity
  • Capital
  • Collateral
  • Conditions

Key Learning Points

  • Lenders conduct credit analysis on potential borrowers to assess their risk of default i.e. the risk the borrower stops paying back the money they have borrowed
  • The 5 Cs of credit are specific guidelines lenders use to decide whether a loan application should be granted or not
  • There are a many factors that are taken into account during the credit process including the borrower’s historical records of credit, the strength of cash flows, collateral, levels of contribution as well as the type of loan being offered

The 5 Cs of Credit Explained

These 5 Cs are the governing framework used to consider the creditworthiness of borrowers, who can either be individuals or companies. Based on the five characteristics of the borrower and conditionalities of the loan, this governing framework helps in determining the risk that the borrower could default and the consequent financial loss to the lender.

what-are-the-5cs-of-credit-diagram

Diagram listing the 5cs of credit and explaining what they check for.

Character

The character represents the borrower’s track record (good or bad) of repaying interest and principal on a loan or loans on time. Lenders look at the borrower’s financial statements to assess the amounts borrowed by them in the past and their track record vis-a-vis the aforesaid payments. Wherever available, lenders also look at ratings and reports from financial intermediaries such as banks and credit bureaus to assess the above. For example, there are three major credit bureaus – Equifax, Experian, and TransUnion – which provide credit scores for businesses in the US.

Capacity

Capacity stands for the ability of the borrower to repay the loan. Lenders look at past financial statements of borrowers to determine the strength and reliability of cash flows. Additionally, in the case of companies, they also analyze leverage ratios such as total debt/EBITDA and EBITDA/interest expense to understand the relationship between a company’s income and its debt obligations. If it is a new business or a start-up, lenders may ask for a detailed business plan and future revenue projections.

A higher debt to EBITDA ratio reduces the capacity to take on new debt.

In the above example, Company A has a lower debt to EBITDA ratio than Company B, which indicates that its (i.e. the former’s)  borrowing capacity is higher.

Capital

Lenders look to borrowers to make some contribution, investment, or down payment towards the loan that they want or see. Making a contribution indicates to the lender that the borrower is willing to take risks too and provides an incentive to them not to default on the loan.

If a company makes a large contribution, it decreases the chances of default. Lenders tend to look carefully at the amount and quality of capital that a company has to offer.

For example, in an LBO transaction, the private equity sponsor must commit upfront funds of between 10% to 50% of the LBO price.

Size of the deal (million) 100.0
Capital or contribution of the sponsor (40%)  40.0
Loan required 60.0

In this example, the sponsor contributes 40% or 40 million to the total size of the deal (100 million). The remaining 60 million is to be funded by the bank.

Collateral

Debt can either be secured or unsecured. Secured debt is backed by collateral, which stands for the assets that can be repossessed in the event of a default on the repayment of the debt. Examples of collateral include land, plant & machinery, or personal assets of business owners. In the event of an LBO transaction, the assets of the acquired company can serve as collateral.

Having stated the above, the first 4Cs determine the cost of a loan. For example, the greater the risk involved, the higher will be the borrowing cost.

Conditions

The 5th C stands for conditions around the loan, such as its purpose, cost, and tenure. Examples of purposes are financing capital expenditures, repaying existing debt, or acquiring a business. Lenders of a loan must be convinced about the borrower’s purpose and ability to generate revenues for scheduled interest payments and repayment of principal.