The 5 Cs of Credit - CHARACTER & CAPACITY

What are the Five C’s of Credit?

Character, Capacity, Capital, Collateral, Conditions.

How do lenders use the Five C’s framework?

To determine borrower risk and set loan terms and interest rates.

How do borrowers use the Five C’s framework?

To improve their credit standing and negotiate more favourable terms and lower interest rates.

Define “Character” in the Five C’s of Credit.

The company and management team’s credibility, reputation, and ability to deliver on promises.

Why is an owner’s personal credit history relevant to corporate Character?

It serves as a proxy for the owner’s likelihood to honour corporate commitments.

Name the six key areas a credit analyst evaluates when assessing Character.

1) Management/board strengths & weaknesses, 2) Attitude toward risk, 3) Attitude toward growth, 4) Fulfilling commitments, 5) Owner’s personal credit history proxy, 6) Track record of tackling past problems.

When assessing the company’s history for Character, what four aspects should you explore?

Firm age, economic-cycle track record, customer-base status (size/diversification), and method of growth (organic vs. acquisitions).

What three things do you assess under “Current Operations”? (Assessing Character)

Worker quality, nature of business processes, and quality of information systems.

List four possible paths for “Future Operations” growth. (Assessing Character)

Organic growth, mergers/acquisitions, new or extended markets, new or extended products/services.

Besides the management team, which two groups may also need assessment?

Directors and shareholders.

What five “Things to look for” in the management team? (Assessing Character)

Past performance, planning, attitude toward risk, reputation, and experience.

Under “Planning,” what three specific plans should be evaluated? (Assessing Character)

Business plans, succession plans, and financial plans/budgets.

What makes a business plan reflect strong Character?

It’s realistic, responsive, and duly considered.

What do robust succession plans identify? (Assessing Character)

Who will run the company in the future and how management continuity is maintained.

How should financial plans and budgets be prepared to demonstrate Character?

With annual frameworks and detailed monthly projections that support the business plan.

In “Organising,” why is professional advice important? (Assessing Character)

It shows the company seeks and maintains good relationships with advisors and uses advice when needed.

What board characteristics signal strong Character?

Independence and a diverse set of skills among directors.

How does resource management reflect Character?

By securing sufficient resources so the company can operate efficiently.

Why is staff and system competency critical to Character?

competent staff and reliable systems ensure effective, consistent operations.

Under “Leading,” what two practices should management excel at? (Assessing Character)

Clear communication of expectations and establishing/trusting key performance measures.

What types of performance measures demonstrate Character?

Short-, medium-, and long-term KPIs aligned with the business plan.

In “Controlling,” what three attributes must financial reporting have? (Assessing Character)

Timeliness, transparency, and reliability.

How does financial compliance play into Character?

By actively monitoring activities to ensure compliance with loan terms and conditions.

How does evaluating past problem-solving track record inform Character?

It reveals how management tackled challenges, learned from them, and improved operations over time.

What is the goal of “performance reporting” under Controlling? (Assessing Character)

To measure results, manage outcomes, identify successes, and admit and assess failures.

What is the definition of Capacity in the context of credit analysis?

Capacity refers to whether the borrower has the ability to service and pay the debt.

Why is it important to evaluate a company’s operating cash flow when assessing Capacity?

Operating cash flow indicates whether the company can sustainably generate enough cash to meet its debt obligations.

What financial statement is key to analyzing Capacity and why?

The cash flow statement, as it reveals the sources and uses of funds, and whether operations generate enough cash to cover debts.

What are the three components of the cash flow statement used to evaluate Capacity?

Operating activities, investing activities, and financing activities.

What does a consistently positive cash flow from operating activities suggest about a business?

It suggests that the company can support its operations and potentially repay its debts from internal cash generation.

How might increasing receivables signal a Capacity issue?

It may indicate customers are taking longer to pay, possibly due to relaxed credit policies, reducing available cash.

What could increasing payables reveal about a company's cash position?

It might suggest the company is delaying payments to suppliers due to cash flow difficulties.

Why is reinvestment through investing activities crucial for assessing Capacity?

Reinvestment ensures the business remains sustainable and can support future growth, which is essential for long-term debt repayment.

What could a positive cash flow in the investing section indicate, and why might it be a red flag?

It might mean the company is selling off assets to sustain operations, which could indicate financial stress.

How does the financing section of the cash flow statement relate to Capacity?

It shows changes in debt and equity financing, revealing whether the company needs external funding to meet obligations.

What are some uses of surplus cash flow after investing activities?

Repaying debt, paying dividends, or buying back shares.

What do credit analysts analyze to understand a company’s profitability and growth capacity?

The historic, current, and projected drivers of profitability.

Why is trend analysis over multiple years important when assessing Capacity?

It helps identify patterns and sustainability of financial performance over time.

What is the purpose of coverage ratios in assessing Capacity?

They evaluate the company's ability to meet its debt obligations from its operating profit.

How is the Debt Service Coverage Ratio calculated?

Operating Profit / (Interest + Principal Repayments)

What does a low Debt Service Coverage Ratio indicate?

That the company may struggle to meet interest and principal repayments.

What do leverage ratios reveal about a company’s financial structure?

The extent to which a company relies on debt versus equity for financing its operations.

How is the Debt to Equity Ratio calculated, and what is preferred?

Total Liabilities / Shareholder’s Equity — lower ratios are preferred.

What do profitability ratios evaluate?

The company’s ability to generate profit from its revenues.

List the three key profitability ratios and their formulas.

• Gross Margin = Gross Profit / Revenues

• Operating Margin = EBIT / Revenues

• Net Profit Margin = Net Profit / Revenues

What do higher values in profitability ratios indicate?

Stronger profit generation capability.

What is the Asset Turnover Ratio and what does it show?

Revenues / Total Assets — it shows how efficiently a company uses its assets to generate revenue.

How is the Receivables Turnover Ratio calculated and why is it important?

Revenues / Average Accounts Receivable — higher values mean quicker collection of receivables, improving cash flow.

What does the Inventory Turnover Ratio measure?

Cost of Goods Sold / Average Inventory — indicating how efficiently inventory is managed.

How is the Current Ratio calculated and what does it measure?

Current Assets / Current Liabilities — it measures a company’s ability to meet short-term obligations.