Five C's, More or Less

Introduction:?C'ing is Believing?

Throughout my banking career, I have been teaching, training, and lecturing about the 5 C’s of credit—capacity, conditions, collateral, capital, and character—more or less in that order.? People seem to like alliteration—Coca Cola, Seven Sisters, Pride and Prejudice—repetitive consonant sounds make them easy to remember.? Maybe easy to remember, but nobody seems to remember where the 5 C’s came from, and I have not yet been able to find an origin story for them, just that they have been around for a long time.? Still, that is not a very satisfying answer, and I reasoned that with Google and other search engines, I ought to be able to discover the roots of the 5 C’s and trace them back to their origins.? What I found was that even the number of C’s has varied over time.

The Four C’s Fourever?

In their 1966 Basic Business Finance, Harvard’s finance professors Hunt, Williams, and Donaldson offered four C’s of credit—capital, capacity, character, and conditions—employed by “many financial officers . . . as basic criteria . . . in reaching a credit decision.” The implication is that corporate financial officers were unlikely to offer collateral to those other grantors of credit, the bank lenders.? The authors went? on to define capital as the financial resources of the company, capacity as the experience of the principals and the demonstrated ability of the concern to operate successfully indicated by the ability of the company to generate a profit, character as the reputation of the owners and management for honesty and fair dealing, and conditions as the possibility of placing special limitations or restrictions on extending credit to doubtful accounts or the business conditions or level of prosperity of the customer’s industry as a factor affecting its creditworthiness.[i]

The previous two editions were published in 1958 and 1961, so there is the possibility that the four C’s were in those editions.? Moreover, the definitions of the C’s have also changed over time to reflect, among other things, the shift from profits to cash flow as a measure of capacity.

The Three C’s of Credit, Plus Two

Possibly predating the Basic Business Finance was Kreps and Wacht’s Analyzing Financial Statements.? In its fifth edition, the authors advised bankers to structure credit analysis of the borrower by examining the three C’s of credit—character, capacity, and capital.? They defined character as determination to pay tested by hard times, poor business conditions, shortages of cash, and a lack of adequate credit.? Capacity is the ability of management to operate the business so that its obligations are met routinely.? The financial statements provide considerable evidence about capacity, but age, experience and education should also be considered in this aspect of creditworthiness.? Capital refers to the adequacy of funds used in the business that enable it to operate efficiently in generating cash flow and effectively in its competitive business environment.[ii]

But then Kreps and Wacht add a couple more C’s, conditions and collateral, to round out the credit picture.? Conditions take into account? the state of the economy and environmental influences on the firm’s financial health.? Collateral are the assets likely to retain their value in extreme circumstances and to be pledged by the borrower to offset weaknesses in the firm’s capacity, capital, or conditions.[iii]

The four earlier editions of Analyzing Financial Statements were published in 1970, 1956, 1951, and 1948.? Whether the C’s were discussed in those earlier editions is not known, but if they had been included, that might push back the origins of the C’s, or at least, some of them.

How About Six C’s?

In his 1966 text Credit Management, Robert Bartels spoke of three C’s plus three more:[iv]

“Even before 1920, credit practitioners and writers viewed creditworthiness not as a single qualification but rather as a combination of characteristics which warranted confidence in a person’s promise to pay later for values received.? These attributes found alliterative expression in what became known as the “C’s” of credit: Character, Capacity, and Capital.? To these three were added during later years three others:? Collateral, Conditions, and Country.”

Unfortunately, Bartels did not provide any footnotes with which to follow up on his pre-1920 source on the combination of characteristics comprising creditworthiness, but he did offer his own definitions of the six C’s:[v]

1.?????? Character:? those mental qualities and action of a debtor which impel him to pay his debts, that sense of obligation to fulfill the payment promise; sometimes summarized as ‘willingness to pay’

2.?????? Capacity:? those means and faculties which provide the funds with which payment is made; resources possessed or incoming; the ‘ability to pay’

3.?????? Capital: those possessions or equities from which payment might be expected when Character and Capacity become lacking; that from which payment may be taken under duress, if necessary

4.?????? Collateral: special forms of Capital which are usually negotiable or readily represented by conveyance of claim or title; specific security offered for credibility of the credit promise

5.?????? Conditions:? those circumstances external to and usually beyond the control of debtors which nevertheless affect their paying behavior

6.?????? Country:? those conditions of foreign and international character, reflecting cultural and political circumstances, which may further qualify creditworthiness as determined by the other factors

Bartels wrote this text more from the viewpoint of a trade creditor than a banker, hence his definition of capital as ‘possessions or equities from which payment might be expected’ and collateral as ‘special forms of Capital.’? As a banker, I see capital as an indicator of how much the borrower’s owners have at risk and collateral as assets the borrower might pledge to secure credit.? Still, Bartels took his turn at the C’s of credit and added a sixth C for country, which others might view as a subset of conditions because of the obvious external-and-beyond-the-control nature of a foreign setting on the borrower.

Today’s C’s Sufficient?

Google is a wonderful search engine, but it has only been around for thirty years or so,? and looking for the origins of the 5 C’s requires looking around for banking and finance textbooks that predate Google.? Unfortunately, not many have been scanned into the Internet;? Googling for images related to the C’s of Credit pulls up mostly graphics of the 5 C’s.? My own 5 C’s presentation is built on recent interpretations of the C’s, and you can find “C’ing is Redeeming—5 C’s of Credit Relearned” on my LinkedIn site.[vi]

First, over time the C’s have generally settled on the number five—capacity, collateral, capital, conditions, and character—and quantitative measures have been added.? Capacity is typically evaluating where there is sufficient cash flow from operations to repay debt and measured by some variant of a cash flow/ current and proposed debt.? Collateral is usually evaluated in terms of the sufficiency of its liquidation value to repay all outstanding debt.? The debt/worth ratio often is the centerpiece of the capital evaluation on the basis of the higher risk associated with a rising debt/worth ratio.? Conditions has evolved into a review of the economy’s impact on the borrower and its industry.? Character tends to be measured inversely to personal credit scores, i.e., the higher the credit score, the better the character is judged to be.

The C’s do not cover all the credit factors. ?First, a big omission is the guarantee.? Bankers expect the owners to personally guarantee their firm’s debts, and while some lenders blend guarantor cash flow into capacity and guarantor assets into collateral, guarantor evaluation is absent in many of Google’s 5 C’s explanations, descriptions, and illustrations.? Second, one of the projects on my to-do list is to add a sixth C for compliance because regulatory compliance has exploded since the 2010 promulgation of the Dodd-Frank Act. Finally, competition might merit becoming a seventh C because competitive risk can be so deadly.? Just recall how the opening of Walmart stores in small towns has devastated small town merchant activity.? However, I treat competition as one aspect of conditions, and some other authors do the same.

Summary and Closing:? A? High-Five for the 5 C’s

After rummaging through some older finance and banking textbooks and surfing the Internet for traces of the C’s of credit, I have been able to establish that five C’s is the most prevalent number.? Most sources select capacity, capital, collateral, conditions, and character as their favorite 5 C’s, and they have also made their working definitions a little more quantifiable.? Capacity tends to be enough cash flow to repay, collateral enough liquidation value to repay, and character enough credit score to ensure ability and willingness to repay.? Capital is usually represented as a reasonable debt/worth ratio indicating ability to handle some more debt, and conditions are now typically evaluated in terms of economic growth, positive point in the business cycle, and satisfactory industry health.?

Former President Ronald Reagan once joked, “The best way to end up with a million dollars is to start with a billion and open a bank.”? The economist John Maynard Keynes observed, “If you owe your bank a hundred pounds, you have a problem.? But if you owe a million, it has.”? Both a president and an economist frame the risk bankers fear—a borrower unable to repay.? The 5 C’s continue to be a quick way to size up a borrower’s situation—so seize the C's today!

[i] Pearson Hunt, Charles M. Williams, Gordon Donaldson, Basic Business Finance, Third Edition, (Richard D. Irwin, Inc. Homewood, Illinois: 1966), pp.80-81.

[ii] Clifton H. Kreps, Jr. and Richard F. Wacht, Analyzing Financial Statements, Fifth Edition, (American Institute of Banking, American Bankers Association:, 1978), pp. 216-7.

[iii] Ibid., pp. 216-7.

[iv] Robert Bartels, Credit Management, (The Ronald Press Company, New York:? 1967), p. 211

[v] Ibid., p. 211.

[vi] Go to https://www.dhirubhai.net/pulse/cing-redeeming-5-cs-credit-relearned-dev-strischek/?trackingId=cvOHFnN5Sf%2BNuR9HO70VGw%3D%3D