Credit risk and the 5 C's of credit

Credit risk is an inherent element present in every credit transaction. It arises from the personal circumstances of the debtor, be it a person or a business entity, which prevent the payment of a debt obligation when due. The risky transaction is the one which creditors want to avoid, for they would spare themselves the losses and complication often resulting there from. Since all business endeavors and credit sales transactions involves risk, it is not the one which has any element of risk, but the one which has an abnormal and dangerous amount of risk that should be avoided.

This is the very reason why we have to be diligent in handling and evaluating credit risk. The principal factors to be taken into account in deciding whether or not credit should be extended, in what amounts, and on what terms, are simply called: the Five C’s of Credit, namely:

Character – represented by the aggregate of distinctive mental and moral qualities belonging to an individual borrower. Moral signifies an active sense of what is right and wrong. Character and/ or moral qualities include trustworthiness, fairness, responsibility, and integrity, among others. Character may be determined after a thorough investigation and evaluation of evidence made available or by asking a third party credit bureau. This answers the question, will the borrower pay on time?

Capacity – refers to a borrower’s ability to obtain the means of payment when his obligation becomes due. The importance of this factor is evident, for however desirous a debtor is of paying, if he lacks the ability to pay he is as surely a poor credit risk as though he was in want of willingness to do so. Capacity is determinable by analyzing a borrower’s financial statements, referrals to known associates as well as personal interviews and ocular inspection of his business premises. This answers the question, can the debtor pay on time?

Capital – is the financial strength of the risk, consisting of the amount of quality of assets expressed in money terms, which an individual or firm possesses in excess of what it owes. Accountants call it the net worth of the borrower. Capital can be determined out of the balance sheet of a credit applicant. This answers the question, how much can the borrower pay?

Collateral/ Co-Maker- any property or third party used as security in place of capacity or capital. This answers the question, what if something happens to the borrower?

Conditions – may be perceived as the general business environment or circumstances prevailing at the time a credit request is being made. The merit of an opportunity to extend credit upon the prevailing and prospective conditions, and these for the most part are beyond the immediate affairs of the individual or firm. General business conditions are one of the factors, which color the appearance of a credit risk at any given time.

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