Assessing creditworthiness using 5C - FFM, F9

One of the key areas in accounts receivable management is credit analysis. This is done before granting credit to the customers and the main element of credit analysis is to assess the creditworthiness of the customers. There are a number of ways such as analysing customers' financial statements, trade reference, reference to report from credit agency etc. Bank uses 5C and this gives us some ideas on how to assess creditworthiness. The 5Cs are capacity, capital, collateral, condition and character.

Capacity
This refers to how capable is the customer in repaying the debt. Statement of cash flows provide an indicator of such capacity so bank might require a projected statement of cash flows from customer.

Capital
Customer should have sufficient assets so that in the event of making losses, he/she can continue to run the business. Capital can also refers to debt vs equity level so bank is interested at gearing ratio.

Collateral
This refers to the assets provided by customer as the security for the loan so that in the event of default, the assets can be used to compensate the bank. This may not be applicable in a trade.

Condition
The business condition of the customer or the overall environment that customer is operating in are considered to determine the key risks faced by customer. A customer in difficult environment is more likely to delay payment or default.

Character
This refers to whether the customer can be trusted by looking at his/her characteristic. For a business, referring to the customer's supplier or bank is one way to check the character of the customer.

A business can also apply a number of these criteria in credit assessment. It is important to choose a correct customer to minimise default risk.