Credit Risk


There is one principle of credit management which is inviolable. In fact it’s as close to being sacrosanct as Canada’s right of sovereignty over the Northwest Passage. To break with this code would be to dismantle the basic principles of credit management and the outcome would be similar to the situation which I am certain that we have all experienced in the past, when the little boy visits the grocery store with his mother and is transfixed by the beautifully structured pyramid of apples. There always seems to be one apple that shines a little brighter and resides on one of the bottom corners. His mother looks at him and her eyes warn him “Johnny, don’t even think about it!” Regardless of his mother’s warning we all know that little Johnny dislodges the apple and we also know the effect his action has upon the pyramid. If we ignore this credit code we, as credit personnel, would be left, just like the pyramid, with absolutely no structure. Our ability to make consistent, logical decisions on the credit worthiness of an applicant would be governed by the law of averages rather than on the basis of sound analysis.


This code which I refer to is, of course the “4 C’s” namely CAPITAL-CAPACITY-CONDITION-CHARACTER.


In this article “the customer” will refer to either an applicant or an existing customer. The “4 C’s” are as important to the investigation of a potential customer as they are when performing an annual review of an existing customer.


The first two, Capital and Capacity are analytical and are mainly found in the financial statements of the customer. Condition is also analytical but is based upon the effect that external forces may have upon the profitability or even existence of the customer. Character is a two edged sword in the sense it can be either the character of the company or the character of the owner.


In this article I wish to concentrate on what I believe to be the forgotten duo of our code, namely Condition and Character.



In today’s unstable economic climate I believe more than ever, that the effect which external forces can have on an operation should be given an elevated position of consideration when evaluating a customer’s financial viability both present and when acknowledging the unpredictability of the future. The following are classic examples where external forces may play a major role in the credit manager’s deliberations.

Needless to say, depending upon the business category of the customer other classifications may have to be taken into consideration. Firstly, if you were to visit the majority of businesses, regardless of their field of operation, I am certain that you would find a large proportion of their inventory would, more than likely, have been acquired, either directly or indirectly from countries, other than Canada. If trade with the vendor country were to be suspended, how would this affect your client? Would it be able to find an alternate source of inventory?

Secondly, has the client exhibited an adeptness to respond to the changing times? I am thinking of the explosion in computer access purchases, for example a large percentage of books are now purchased ex-store. If the company failed to react promptly to this change in consumer purchasing habits would it adversely affect it’s hitherto core sales?


Thirdly, is the company competitive within its industry? Has it a product or a service which is required regardless of an economic downturn?


And fourthly, does the customer have a loyal clientele?  When assessing the potential negative consequences which your customer may experience from external conditions it is imperative for the credit manager to ascertain whether the customer has a “Plan B”. Obviously this point bears a greater degree of relevance when the company under assessment is of a larger nature. If the answer to the question is in the negative, further progress in the examination process should be undertaken with added vigilance.


The answers to some of the above may be found in the financial statements but I suggest that it would be remiss, if the credit manager did not take time to pursue the possibility of external interferences which may be lingering, neglected in the shadows.


For a credit manager one of the most under-rated requirements is that he or she is aware of not just their company, not just their industry but the political and economic realities which may affect their customer and their ability to retire their debt.



As previously stated, character can refer to both the business and the individual. However the relevance of character assumes greater consequences when the credit manager is investigating a small business, a partnership or a proprietorship. The character of the aforementioned very seldom deviates from the character of the owner and so the question that the credit manager has to ask is simply, what kind of financial citizen is the individual?

If the owner has a good personal paying record, is well regarded in his industry, operates within the realm of “my word is my bond”, then the probabilities are positive that his business will be operated with the same standards of veracity. Very seldom have I come across an individual who is honest and then operates his business on the peripheral of accepted business practices. The opposite is equally true.

Obviously occasions arise when a company will take a loss when dealing with a limited liability entity. The owner is not responsible for the company’s obligation, assuming a personal guarantee has not been taken, however the chances are that if the owner is honest and forthright he will have communicated his problems to the credit manager prior to the operation’s demise rather than surreptitiously syphoning funds and assets from his operation over a period of time.


Clues to the character of a large corporation can be determined through analysis of their financial statements, the perusal of their annual report and industry publications, discussion with other credit managers and on occasion personal knowledge. The role that the character of an individual plays in the analysis of a large corporation, in comparison to a partnership or proprietorship is quite different. The personal character of individual members of the board of directors or senior executive management may be diametrically opposite to the character of the corporation.


On too many occasions I believe we examine the financial statements, i.e. for the Capital and Capacity components of the “4 “C’s”, and if we are satisfied with the results, we approve credit facilities. In other words we tend to underestimate, or even in some instances completely ignore the value of the other two components namely Condition and Character. Our oversight can have haunting repercussions at some later date.

JPMorgan, the American banker and financier once said that “I will do business with anyone as long as he or she is honest.” Within the context of a complete credit investigation, sound advice indeed.

Source: Sandy Ferns, CCP

Published under: Credit Risk
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