This lesson examines the systematic framework for evaluating a borrower’s creditworthiness, focusing on the 5 Cs of Credit and the distinction between financial and non-financial risk factors.

5.1 The 5 Cs of Credit Framework

The 5 Cs of Credit provide a structured approach to credit risk assessment, ensuring lenders evaluate both quantitative and qualitative dimensions of a borrower. Credit analysis involves both financial and non-financial factors :

  • Character: The borrower’s willingness to repay, assessed through credit history, references, and track record .

  • Capacity: The borrower’s ability to repay, determined by analysing income, cash flow, and debt-to-income ratios .

  • Capital: The borrower’s net worth and financial reserves.

  • Collateral: Assets pledged to secure the loan that can be liquidated in default.

  • Conditions: The purpose of the loan and broader economic factors affecting repayment .

5.2 Financial vs. Non-Financial Risk Analysis

Credit assessment comprises two complementary dimensions :

Financial Risk Analysis:

  • Financial statement analysis (balance sheet, income statement, cash flow)

  • Ratio analysis (liquidity, solvency, turnover, and profitability ratios) 

  • Cash flow analysis and debt service coverage ratio (DSCR)

  • Working capital assessment and term loan appraisal 

Non-Financial Risk Analysis:

  • Management quality and track record

  • Industry position and competitive dynamics

  • Business model sustainability

  • Regulatory and legal environment

5.3 The Role of Credit Scoring Systems

Credit scoring is essential for effective loan management and regulatory compliance . Modern credit risk management relies on statistical-based scoring systems to predict probability of default . Key components include:

  • Data preparation and variable transformation 

  • Univariate analysis and predictive power assessment of financial ratios 

  • Model estimation and performance measurement 

  • Internal validation and regulatory validation 

5.4 Borrower Legal Structures and Borrowing Powers

Understanding legal forms of business organisation is fundamental to credit assessment . Lenders must evaluate:

  • Types of business entities (sole proprietorship, partnership, public and private limited companies, one-person companies, limited liability companies) 

  • Borrowing powers of different company structures 

  • Legal documentation requirements for each entity type

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