|4 Cs OF CREDIT||
What are the 4 C's of credit? What do they mean? Are there 3, 4, 5 or 6 Cs of Credit?
Credit investigation could get intricate and dense. The information that is being gathered could be getting strewn and scattered all over the place. The 4 Cs of Credit helps in making the evaluation of credit risk systematic. They provide a framework within which the information could be gathered, segregated and analyzed. It binds the information collected into 4 broad categories namely Character; Capacity; Capital and Conditions. These Cs have been extended to 5 by adding 'Collateral', or extended to 6 by adding 'Competition' to it (Reference: Credit Management and Debt Recovery by Bobby Rozario, Puru Grover). How about 'Computer' being one of the Cs in this day and age?...or mere 'Common Sense'!
how many Cs we come up with, the fundamental question that remains to
be answered by the framework of our analysis is:
So let's discuss the structure of our credit analysis within the context of the 4 Cs of Credit
JP Morgan, a successful businessman once said that 'I will do business with anyone as long as he/she is honest!'
In analyzing Consumer Credit one would consider the following:
In analyzing Commercial Credit one would consider the following:
does one analyze under this segment?
Sometime a business that you are analyzing might not have the required Capacity in kind but the same could be latent and hidden in some other form. For example a start-up business should have a good business blue-print of succeeding namely a good business plan. A contractor might have a good media advertising plan, say an Ad in the local Yellow Pages. All this adds to the capacity of a business to carry on trade and perhaps be successful.
Education, Experience, Knowledge would be some other considerations. Management
should be able to foresee trends in the marketplace and blend accordingly.
It should have plans both for good and bad turns in the economy. Adoption
of sound management techniques and computer-related technologies is important.
Cash and Only Cash can pay bills. The capacity of a business to pay its bills would stem from good cash-flow. A business could become cash strapped if it does not collect its accounts receivable on time. You must have heard of DSO! What is DSO? Isn't it a measure of ones capacity to pay? Say if a business has a DSO of 55 days. This means that at an average this business gets paid by its customers in 55 days. The question then arises that when will this business then pay its suppliers? In all probability the answer is that its capacity to pay its suppliers will be after 55 days. In this event you may want to evaluate its borrowing capacity to see if you can cajole this company to pay you in time even if it means that this business borrows to pay you.
This would bring on the analysis of how the debt of the company is structured in terms of secured and unsecured debt with an operating lender, generally the bank. Short term borrowing could be calculated as a percentage of the inventory and A/R on hand. One should look at the line of credit and see if there is capacity for more borrowing. Also check for any negative occurrences as bad checks (cheques) or any default against operating loans or covenants.
The capacity of your product to influence payment is also important. If your product being sold is fiercely competitive then it may not have the capacity to influence timely payment. If your product does not directly contribute to the COGS of the buyer then again it might not have the capacity of influencing timely payment. Competition definitely influences Capacity.
The Capacity to expose and increase your credit risk also depends upon your own ability and resilience to getting hit with either slow payment or perhaps no payment! Credit departments that have a lot of confidence in their collection ability and ability to influence payment have a wider capacity to expose and absorb. Your product-margin will also influence this capacity.
would refer to the financial resources obtained from financial records
that a company may have in order to deal with its debt. Many a time's
credit analysts would make this portion of the credit analysis the most
important one. Weight is given on Balance Sheet items and components like
, Net Worth
and Cash Flow.
But one must be cognizant of the fact that financial records are snapshots of the past and credit analysis is trying to figure out the future. Thus all 4 Cs of credit are important in the overall analysis of a company or an individual where you combine elements of the past to make a futuristic prediction.
This refers to the external conditions surrounding the business that you are analyzing.
For example the construction industry might get influenced with the changes in the government's wide range of policies on immigration, interest rates and taxation.
might be likelihood that a company that you are evaluating deals in international
trade and a shift in the currency rates might have a detrimental or beneficial
effect on it.
Business with local economies would be prone to the social climate and their influence on the local society. Torontonians must have heard of the flamboyant discount retailer "Honest" Ed Mirvish who treats the local community to free turkeys every Christmas. On another note a lot of businesses became insolvent in the Ice Storm a few years ago in eastern parts of the US and Canada that were totally dependant on the local economy. If winter is very mild the businesses that depend on snow feel the crunch.
Again, one might look at how the internet is redefining business. Recently I was at a very small camera shop and soon realized that the business was generating big revenues on the internet and especially on Amazon & eBay. So the size of the shop really did not influence its revenues but the global reach of the world wide web does.
All of this can again influence the ability or intention of a customer to pay his/her bills.
Thus in evaluating
the degree of risk of a customer, information revolving around the 4Cs
of credit would be normally necessary.
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