Question

a. Identify ad explain the 5 c's of credit management.

b. Describe the factors to consider when evaluating credit terms for a company.

Answer 1

A)

What are the 'Five Cs Of Credit'

The five C's of credit is a system used by lenders to gauge the creditworthiness of potential borrowers. The system weighs five characteristics of the borrower and conditions of the loan, attempting to estimate the chance of default. The five C's of credit are character, capacity, capital, collateral and conditions.

Character

Sometimes called credit history, the first C refers to a borrower's reputation or track record for repaying debts. This information appears on the borrower's credit reports. Generated by the three major credit bureaus – Experian, TransUnion and Equifax – credit reports contain detailed information about how much an applicant has borrowed in the past and whether he has repaid his loans on time. These reports also contain information on collection accounts, judgments, liens and bankruptcies, and they retain most information for seven years. The Fair Isaac Corporation (FICO) uses this information to create a credit score, a tool lenders use to get a quick snapshot of creditworthiness before looking at credit reports.

Capacity

Capacity measures a borrower's ability to repay a loan by comparing income against recurring debts and assessing the borrower's debt-to-income (DTI) ratio. In addition to examining income, lenders look at the length of time an applicant has been at his job and job stability.

Capital

Lenders also consider any capital the borrower puts toward a potential investment. A large contribution by the borrower decreases the chance of default. For example, borrowers who have a down payment for a home typically find it easier to get a mortgage. Even special mortgages designed to make homeownership accessible to more people, such as loans guaranteed by the Federal Housing Authority (FHA) and the Veterans Administration (VA), require borrowers to put between 2 and 3.5% down on their homes. Down payments indicate the borrower's level of seriousness, which can make lenders more comfortable in extending credit.

Collateral

Collateral can help a borrower secure loans. It gives the lender the assurance that if the borrower defaults on the loan, the lender can repossess the collateral. For example, car loans are secured by cars, and mortgages are secured by homes.

Conditions

The conditions of the loan, such as its interest rate and amount of principal, influence the lender's desire to finance the borrower. Conditions refer to how a borrower intends to use the money. For example, if a borrower applies for a car loan or a home improvement loan, a lender may be more likely to approve those loans because of their specific purpose, rather than a signature loan that could be used for anything.

B)

key factors you should consider.

Credit risk: Define the amount of risk your business is willing to accept. Do you have the financial resources to support the transaction? As part of this assessment, you’ll need to consider the possibility that you won’t get paid at all.
Credit terms: Decide how much credit you’re willing to extend and how long you can afford to wait for payment. The terms can vary all the way from 10-day terms to 90 days or more. Requiring a certain percentage down can minimize your risk. Many companies do this on the first few purchase orders before they offer 100 percent financing.
Credit qualification: Will you extend credit to both consumers and businesses? If so, how will you determine their creditworthiness? For consumers, you may ask for a simple credit application with references. Or you might take it a step further and run a credit check with a consumer credit agency. For business customers, you may want to ask for a credit application and check with a business credit agency. There are a variety of reports you can pull, and if you expect a large number of applications, you can even subscribe to a business credit bureau and get unlimited reports.
Credit policy: Develop a credit policy that covers the entire process when extending credit to customers, from application submission all the way to past-due collections. The more details you have worked out ahead of time, the better your accountant, sales staff, and management team can facilitate your program.
Credit review: Be sure to observe the number of purchases a particular customer makes after you extend credit by conducting a credit review every several months. After your review, you may consider increasing the credit limit, especially if the customer requests it and has a solid payment record. By extending credit to customers, you can separate yourself from competitors, increase sales, and gain a greater market share. While there is risk involved, if you use the key factors outlined above as a guide, you can provide yourself some protection.

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