The 5 Cs of Credit is a method to determine the creditworthiness of borrowers
With 5 characteristics – Character, Capacity, Capital, Collateral, Conditions – the worthiness and the potential risk of credit is approximated
The 5 Cs of the credit framework are used to estimate the potential risk of a credit to a certain borrower. The 5 Cs of credit concept does not have to be applied very often in consulting interviews in its pure-play form. Even if it is not one of the "must-have" skills, it is still worth looking at this concept. Especially if you are from a finance background or if you're applying at a consultancy with a strong financial services focus.
We will now go over these 5 factors in more detail – while you probably won’t need to learn all the factors by heart, knowing just the names of the 5 factors is probably the 80/20 way to go here.
Character is a subjective judgment about the potential borrower. Factors that are taken into account can include:
- First impression
- Reputation of the borrower
- Know-how and experience
- References and background
Capacity might objectively be the most important factor because it refers to the ability of a potential borrower to pay the loan back.
- Cash position/expected cash flows
- Revenue and expenses
- Credit history
In this context, capital is the amount the potential borrower has invested in the business/company. It is normally an indicator of how much the borrower is involved in the company and how much he/she has to lose if the investment fails. A higher (relative) capital investment of a potential borrower usually means more alignment with the incentives of the lender and the borrower.
Guarantees or other forms of security the potential borrowers can offer are known as collateral. These forms of security can include:
- The owner's private properties
Conditions are two-folded and include the overall economic environment and the intended purpose of the loan. As a rule of thumb, the economic circumstances, in general, are less favorable for a potential borrower if the economy is in a downturn/recession.
Taken together, these five factors usually give a reliable picture of the creditworthiness of a buyer from a qualitative and quantitative point of view.
- Method to determine the creditworthiness of borrowers.
- 5 factors of interest: character, capacity, capital, collateral, conditions.
- Occasionally used during case interviews, more specialized framework for financial cases.