Question

Describe the “five Cs of credit” used in evaluating creditworthiness and

Describe the basic assumptions that underlie the Economic Order Quantity (EOQ) Model.

Answer 1

A] The 5 Cs of credit are:

1] Character:

This is possibly the most important one.

It is the credit history of the borrower. It reveals the reputation of the borrower or his track record in repaying his debts. It would be available in the borrower’s credit reports prepared by credit rating agencies.

2] Capacity:

Capacity refers to the borrower’s ability to pay the interest and repay the principal as and when they become due. The judgement is made by comparing the borrower’s income [cash inflows] with his debt service obligations. When the ratio is not comfortable there would be defaults.

3] Capital:

It refers to the owner’s contribution to the total resources. Where the ratio of equity is high with respect to total assets, the lenders’ position would be safe.

4] Collateral:

Collateral refers to the assets that the borrower offers as security for the loan. Higher the value of the collateral, higher the safety for the lender.

In some cases, the collateral offered is the subject of the loan. For instance, for automobile loans the object of the loan, the vehicle, will be the collateral.

5] Conditions:

These include the purpose of the loan, whether it is general or specific, the riskiness attached to the purpose and so on.

Conditions also refer to the state of the industry in which the borrower is in and also to the general economic conditions.

B] The basic assumptions of the EOQ model are:

1] Demand is known and is deterministic, that is demand is constant.

2] The lead time [the time between placement of an order and the delivery of goods] is known and constant.

3] Delivery is instantaneous, that is the delivery happens in a whole lot and not piecemeal.

4] There are no quantity discounts; that is irrespective of the quantity ordered the price per unit remains the same.

5] The costs that are relevant are the “cost of placing an order” and the “cost of carrying” one unit in the inventory.