Introduction to Corporate Finance

ONLINE CHAPTERS

lose if payment isn’t made, but on the other hand, potential profits are great. Companies selling products

with high variable costs (such as heavy-equipment manufacturers) will typically do extensive credit

checks before granting credit and shipping merchandise.

The amount of the credit limit is also an important factor. To reduce some of the costs associated with

making credit decisions, a company may routinely grant small levels of credit to new customers and then

allow the credit limit to rise as the customer proves to be a good credit risk.

Two popular approaches to the credit-granting process are the five Cs of credit and credit scoring.

Five Cs of Credit

The five Cs of credit provide a framework for performing in-depth credit analysis, but they do not provide

a specific accept-or-reject decision. This credit-selection method is typically used for high-dollar credit

requests. Although applying the five Cs does not speed up collection of accounts, it does lower the

probability of default. The five Cs are defined as follows.

1 Character refers to the applicant’s record of meeting past obligations. The lender would consider the

applicant’s payment history as well as any pending or resolved legal judgements against the applicant.

The question addressed here is whether the applicant will pay its account, if able, within the specified

credit terms.

2 Capacity is the applicant’s ability to repay the requested credit. The lender typically assesses the

applicant’s capacity by using financial statement analysis focused on cash flows available to service

debt obligations.

3 Capital refers to the financial strength of the applicant, as reflected by its capital structure. In assessing

capital, the lender frequently analyses the applicant’s debt relative to equity and its profitability ratios. The

analysis of capital determines whether the applicant has sufficient equity to survive a business downturn.

4 Collateral consists of the assets the applicant has available for securing the credit. In general, the

more valuable and more marketable the assets are, the more credit lenders will extend. However, trade

credit is rarely a secured loan. Therefore, collateral is not the primary consideration in deciding to

grant credit. Rather, it strengthens the creditworthiness of a customer who appears to have sufficient

cash flows to meet its obligations.

5 Conditions refer to current general and industry-specific economic conditions. It also considers

any unique conditions surrounding a specific transaction. For example, a company that has excess

inventory of a given item may be willing to accept a lower price or extend more attractive credit terms

in order to sell that item.

Credit Scoring

Credit scoring is commonly used with high-volume–low-dollar credit requests. Credit scoring applies

statistically derived weights for key financial and credit characteristics to predict whether a credit

applicant with specific scores for each characteristic will pay the requested credit in a timely fashion.

The weighted average score is the sum of the products of the applicant’s score and the associated

predetermined weight for each characteristic, and the resulting score determines whether to accept or

reject the credit applicant. That is, the procedure results in a score that measures the applicant’s overall

credit strength, and the company uses that score to make the accept-or-reject decision for granting credit.

Credit scoring is most commonly used by large credit card operations, such as those of banks, oil

companies and department stores.

LO18.4

five Cs of credit
A framework for performing in-
depth credit analysis without
providing a specific accept or
reject decision

credit scoring
Applies statistically derived
weights for key financial
and credit characteristics to
predict whether or not a credit
applicant with specific scores
for each characteristic will
pay the requested credit in a
timely fashion