The 5 Cs of Credit: a Worked Example

Credit training has used the 5 Cs for generations, because they are easy to remember and hard to fall short of by accident. Each one protects against a different way of losing money. A borrower can be honest and unable to pay, or able to pay and unwilling, or solvent in a good year with nothing to absorb a bad one. A lender that looked only at collateral would see none of those coming. A lender that looked only at the accounts would miss the second.

International supervisory guidance covers the same ground without using the words. The Basel Committee's 2025 Principles for the management of credit risk list the purpose of the credit and its sources of repayment, the borrower's repayment history and capacity under different scenarios, business expertise, the state of its sector, the terms of the credit and the adequacy of collateral or guarantees. The list reads very like the 5 Cs in a different order.

In consumer lending these questions are largely answered by a credit score, an income check and a property value. In business lending most of them need reading. Character is a record: how forecasts compared with outcomes, whether bad news arrived early, how the account has run. Capacity is about whether profit turns into cash. Capital is the amount the owners stand to lose before the lender does. Collateral is what a sale would bring after costs, not what the balance sheet says. Conditions cover the sector and the economy, and also the purpose of the loan in some versions of the list.

A maker of roof trusses, constructed for this page like every figure in it, asks for a US$3.0m five-year loan to buy a new saw line. Revenue is US$28.0m, EBITDA US$3.6m and the contribution margin 30%. Most sales go to house builders. It has banked with the same lender for twelve years without a missed payment. It pays US$0.9m a year on existing debt, and the new loan would add about US$0.8m in the first year. Total assets are US$18.0m and shareholders' funds US$6.0m. The premises are leased. No figure here is offered as a market norm.

Go through the list in order and it reads as a passable file: a trusted customer of long standing, cover above one, a third of the business in equity, and a charge over assets. Taken one by one, each C seems satisfied.

Read from the cash outwards and the same facts say something else. The line pays for itself only if housing holds. A 10% fall in revenue, which is not an extreme movement for a business tied to house building, puts cover well below one before any relief. Equity absorbs a loss but does not make a debt-service payment, and the line would fetch less than half its cost when it was needed. So capacity is the problem, conditions are the reason, and neither capital nor collateral answers it. The bank might respond by lending less, phasing the purchase, or setting a covenant that warns early. It would be weighing those by reference to the housing cycle rather than by ticking five boxes.

DEFINED IN ONE PARAGRAPH → · ALL FIVE, ON A WORKING CAPITAL REQUEST → · DEBT SERVICE COVER →

A list tells you what must be included. It does not tell you what comes first, or what happens when two items conflict. A desk generally starts with how the business makes and collects its cash and where repayment will come from, because the rest of the file depends on that. Structure and security come afterwards, as protection in case the first reading is wrong. That is why the primary source of repayment and the second way out are often discussed in a credit paper separately from the five headings.

The 5 Cs also differ from a credit score. A score is a statistical output. The 5 Cs are the questions a person asks, and much of the value lies in the parts that do not reduce to a number, such as whether a borrower raised a problem before being asked.

Where capacity holds, a weak C does not usually decline a loan by itself. It more often shapes the terms. Thin capital may bring an equity injection or a restriction on dividends. Uncertain conditions may shorten the term or add a covenant. Uneven reporting may bring a monthly information requirement. Character is the exception worth noting, because a lender that doubts what it is being told cannot rely on the numbers that go into the other four.

For a borrower, the most useful exercise is to write its own version before the meeting. Say what cash repays the loan, what happens in a bad year, what the owners have at stake, and what would go wrong. A request that has done that work reads differently from one that leaves the bank to find out, and the book goes further on how bankers read.

HOW BANKS APPROVE BUSINESS LOANS → · WHAT YOUR BANK HOLDS AS SECURITY →