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Keys for Determining the Creditworthiness of a Customer

What Is Creditworthiness? Determining the Creditworthiness of a Customer

Ann Marie Smith

11/26/2024

Whether you're a small business owner or a corporate credit manager, making solid decisions about who receives credit terms can mean the difference between a healthy cash flow and costly write-offs.

While digital payments and instant transactions dominate headlines, the fundamental challenge remains: how do you know which customers will honor their payment commitments? The answer lies in a systematic approach to evaluating creditworthiness, which has stood the test of time.

What Is Creditworthiness?

Creditworthiness is a measure of how likely a customer is to pay what they owe you on time. An assessment is made of whether a customer is worthy of getting credit and under what conditions.

Banks and lenders evaluate creditworthiness before making loans. Businesses assess a customer’s credit before making decisions about extending credit.

Such decisions are crucial to protect your business. Tracking by the Federal Reserve shows a continuing increase in delinquency rates for commercial loans with banks. The results for Q2 2024 show a delinquency rate that is at its highest point since 2015.

Businesses of all sizes are experiencing financial uncertainty. According to Equifax, the small business default rate is about 2.5%, according to its Small Business Delinquency Index (SBDI). After record highs over the past year, Equifax analysts do predict that defaults will peak in 2024.

So, if you’re wondering how to determine the creditworthiness of a customer to avoid taking unnecessary financial risk, we’ll show you what you should look for.

How to Determine the Creditworthiness of a Customer

Every commercial you see for investing has some form of this disclosure: “Past performance does not guarantee future results.” It applies here, too. Just because someone has paid their bills on time for years doesn’t mean they won’t go past due in the future. Conversely, someone who has struggled in the past may be fine now.

However, past behavior is a good indicator of how someone has managed their credit, and analyzing their credit history is the best way to mitigate risk.

The 5 Cs of Credit

You may hear lenders talk about the 5 Cs of credit:

  1. Character
  2. Capacity
  3. Capital
  4. Collateral
  5. Conditions

The 5Cs are often used as a guideline for how to determine the creditworthiness of a customer, but different organizations weigh these factors differently to ensure they align with their risk tolerance.

Character

Character is the measure of a borrower's trustworthiness, integrity, and track record of meeting financial obligations.

Reviewing payment history in business credit reports can provide insights into character. A history of timely payments and avoiding bankruptcies and legal issues can demonstrate that a business lives up to its credit obligations. References from other businesses can also help, showing that their accounts are in good standing.

Capacity

When discussing what is credit worthiness, capacity refers to  the borrower's practical and financial ability to repay the debt, based on cash flow and income.

Checking their business credit score can give you an indication of a customer’s overall financial health. A deeper evaluation of items like outstanding credit obligations and credit utilization ratios will provide a more comprehensive picture.

Capital

Capital is the amount of money and assets a borrower has invested in their business, indicating their financial commitment and cushion.

Evaluating a company’s debt-to-income (DTI) ratio will show whether it has available assets to pay off its debts. If possible, review financial statements and cash flow statements.

Collateral

Collateral represents the assets pledged by the borrower, which can be seized and liquidated if they default on the loan.

You can review Uniform Commercial Code (UCC) filings. UCC filings are public notices that show when creditors have a legal interest in someone’s assets and are being used as collateral for a loan or lease. Some business credit reports will list UCC filing information.

Conditions

Conditions are the external economic, industry, and market factors that could affect the borrower's ability to repay the debt.

Depending on the type of business credit report you pull, you may also be able to evaluate industry risk ratings, business structure and ownership, and parent-company relationships to evaluate additional risk factors.

Making Solid Credit Decisions

Making credit decisions is not a perfect science, but a structured approach using the 5 Cs framework, combined with modern credit reporting tools, provides a solid foundation for risk management. By implementing consistent credit policies and evaluating each customer, you can build a robust credit policy that balances growth opportunities while reducing risk.

What is creditworthiness? Contact Command Credit today and get the tools you need to make better credit decisions.