The Credit Formula

What goes into a credit decision when extending credit to a customer? There are four “Cs” to evaluate the eligibility for credit. They include character, capacity, capital, and conditions. Let’s explore what each C means and how it is measured.

Character is the most important aspect when determining eligibility. This means the integrity, honesty, and sense of responsibility of the customer. It is the hardest to assess, as you can imagine. Many times character is determined on the customer’s past track record. Did they handle credit well in the past? Well, then that must mean they have good character and they will continue to do so. I do not believe this is the best form of judging character, but it does seem to work well enough for those who use it. It definitely does not extend grace to the people that may have struggled in the past, but would shine if given a second chance.

Capacity refers to the financial strength and stability of the customer. This is much easier to assess than character. The overall debt ratio is determined of the individual to see if they will be able to pay back their line of credit. The general rule when it comes to credit is that debt should not exceed 30% to 45% of income. Stability of income is also determined when considering capacity. A good indicator of income stability is the how long the individual has kept their current job and the skill level required of their position.

Capital also refers to the financial strength of the customer, however, it is judged on the ultimate collectability to pay off credit. This is determined by establishing the net worth of the customer. This means that the individual’s assets are measured against their debts and liabilities. The higher their net worth, the stronger they are financially. Sometimes collateral will be involved if the customer is making a large purchase. For example, when a person buys a car, the value of the car is used to secure the credit.

Conditions mean any circumstance that might affect a credit decision. For example, today’s weakened economy plays a major role in the eligibility for credit and the set limit. Another condition may pertain to the health of a business. If a business is doing poorly then they might be more lenient with credit decisions to bring in more customers. There are a myriad of conditions that affect credit eligibility.

Extending credit to a customer might be essential for your business. It is important that good decisions are made about whom to extend the credit to. The success of your business could hang on the credit decisions your company makes. That is why it is so important to thoroughly evaluate your customer using the 4 “Cs.”