The Basis of All Credit Decisions – the Five Cs of Credit
Credit is a well-defined process. Although this process can vary, the core principles that drive credit decisions don’t change. The foundation of the process begins with the five Cs of credit. These five Cs are the basis for analysis in a lending situation. The five Cs are…
The first two, cashflow and collateral, are considered the repayment Cs. Lenders will look to both cashflow and collateral as a form of repayment of the loan. Some banks will look to cashflow more than collateral and some will rely more on collateral than cashflow. The banks that put an emphasis on cashflow and very little emphasis on collateral are usually called cash flow lenders. The opposite is true, those that put most of the emphasis on collateral are considered collateral lenders. Some banks can do either and their decisions will be based on balancing their portfolio, which we will discuss in a later section.
The last three, capital, conditions and character, are the descriptive Cs. These Cs are relevant information to support the repayment Cs in justifying the credit decision. This information is extremely important in supporting the risk assessment of the first two, repayment Cs.
A lender will evaluate the five Cs and score them. For example, a bank will evaluate each one of the five Cs and give each one a score from one to ten with one being the best and ten being the worst (see exhibit 1). Then the banks will blend these scores to arrive at an overall score to rate the credit. The example in exhibit 1 has an overall blended score of 4.29. The blending, discussed in a later section, has some restrictions but has some flexibility determined by the individual banks. The score is then matched to a credit score risk rating that defines how much risk is in the lending transaction.
This whole process has some discretion along the way, which is why you can get a “No” from one bank and a “Yes” from another.
A sample credit scoring system might look like this.
The system creates a standard score to rate each lending request with consistency and in accordance with regulations and bank policy. The overall credit score gives the bank a guideline that their portfolio and risk management requirements are getting met.