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Think Like a Lender: A Miniseries on the Five Cs of Business Credit (Part 2 – Character)

Trustworthy businesswoman working at office desk, using laptop computer.

Past actions do not always foretell future outcomes, but nearly always provide meaningful insight into future behavior.  As Part 1 of our miniseries outlined, the Five Cs of Credit framework, long a mainstay of commercial lenders, provides a structured approach for trade vendors evaluating their customers’ creditworthiness.  The first C, Character, assesses a customer’s willingness, intent, and ability to pay its debts as they become due, based in large part on past actions and reputation.

The first C, Character, refers to the customer’s reputation, integrity, and trustworthiness. B2B character evaluation extends to the company’s organizational culture, business practices, and ethical standards. It is a qualitative measure of the customer’s commitment to fulfilling financial obligations and conducting business with integrity.  A business with good character tends to incur only those obligations it reasonably intends—and expects to be able—to repay, and manages its overall affairs in a manner that positions the business to be able to do so in the future.

Let’s look at the importance of character as the first of the five Cs. 

Why is Assessing Character Important for B2B Trade Creditors? 

Assess Reputation and Trustworthiness

Character assessment in business-to-business credit considers the customer’s standing among its existing trade vendors, lenders, and other creditors, the industry, and the business community. Trade creditors should consider various factors, including the company’s history of compliance with its contractual obligations, supplier and vendor fulfillment, and upholding positive customer and partner relationships. A solid reputation for honesty and dependability is a sign of decreased default risk and improved creditworthiness.

Ensure Ethical Business Practices and Regulatory Compliance

Business ethics and regulatory compliance are an important leading indicator of creditworthiness.  Failure to timely file tax returns and make regulatory filings, and other failures of ethical compliance, are frequently a red flag of poor character and a harbinger of future defaults.  A customer’s compliance with ethical business practices, financial transparency, and regulatory requirements are all considered when evaluating character. Savvy creditors will assess the company’s internal controls, corporate governance framework, and legal and regulatory compliance commitment. 

Payment History and Trade Credit Performance Suggest Future Trends

A customer’s trade credit performance and payment history can reveal its financial discipline and its willingness and capacity to fulfill commitments. Vendors should rigorously investigate trade references, supplier relationships, and payment patterns to determine whether a prospective customer has consistently met itsfinancial obligations. A positive payment history strengthens the character assessment by demonstrating dependability and economic stability. Conversely, a negative payment history may suggest an unwillingness to pay bills as they come due, an inability to do so, or both.

Gauge Industry Reputation and Standing

The customer’scharacter is further evidenced  by its standing in the market and industry. Creditors should consider a prospective customer’ss standing in the market, edge over competitors, customer feedback, and reputation. Strong market position and industry reputation suggest that a customer is less risky and better able to withstand economic downturns.  Conversely, a business with a poor reputation – especially among its end customers – may quickly find itself losing customers even in strong economic times.

Ensure Long-Term Relationship Building

In B2B credit, character evaluation goes beyond short-term transactional concerns.  The ideal trade credit relationship is a partnership – a cooperative, symbiotic, long-term relationship between vendor and customer.  The ideal customer has demonstrated mutual trust, ethical behavior, and sound financial management with its existing vendors and lenders, the strongest available indicator that the customer will exhibit those characteristics in its business with you as well.  But relationships are a two-way street:   Establishing rapport and trust with customers through open communication, shared values, and a dedication to honesty improves the trade credit relationship,encourages continued cooperation, and can prove invaluable when customers encounter financial trouble or other speed bumps.

How to Evaluate the Character of B2B Customers

Assessing a customer’s character involves gathering and evaluating information about the company’s reputation, compliance with legal, regulatory, tax, and other requirements, and general financial responsibility.  The data for this multifaceted analysis can come from a variety of sources:

Business Credit Reports

Like personal credit reports, business credit reports aggregate data regarding an organization’s credit background, payment trends, outstanding debts, and publicly available records. Lenders can obtain business credit reports from commercial credit bureaus. These reports provide a comprehensive overview of the company’s financial health and behavior, helping lenders evaluate its character and risk profile.

Credit References and Trade Credit History

B2B lenders may request credit references from other companies that have previously given the borrower credit. The borrower’s trade credit history, which comprises their payment history to vendors and suppliers on schedule, offers essential information about their dependability and sound financial standing. By examining trade references and payment histories, lenders can determine a borrower’s commitment to fulfilling financial obligations within the business ecosystem.

Credit Groups

Industry-focused credit groups consisting of your peers are one of the most valuable sources of B2B credit data overall, but particularly with respect to character.  How a prospective customer has managed its credit relationships with your peers is perhaps the best leading indicator of how the customer will act when it comes time to pay you.  But credit groups can provide far more than just payment data.  Your peers can share anecdotal information (historical, of course, and always being mindful of antitrust restrictions) about how the customer actually behaves as a credit obligor.  Does the customer make excuses for late payments?  Is the customer honest and forthright?  Are the customer’s personnel accessible when problems arise?  Qualitative, intangible information shared by other creditors puts invaluable context and color around the raw numbers of payment history.

Financial Statements and Performance Metrics

Financial statements come into play at every step of the 5 Cs analysis.  From the standpoint of character, financial statements help you understand two things:  (1) whether the customer pays its obligations as they come due and (2) what the customer has done to position itself to be able to pay its obligations as they come due well into the future.  Does the customer have excessive leverage?  Burn cash on dividends and stock buybacks to the exclusion of establishing adequate capital reserves, engaging in appropriate levels of capital expenditures and 

Business Reputation and Industry Standing

Beyond the qualitative information provided by references and credit groups, other sources of information about the customer’s standing in its industry, segment, and local community can help to inform the assessment of its character.  Among other things, creditors can look to a customer’s industry accolades, feedback from its own clients and customers, and media coverage for context clues about the customer’s integrity, dependability, and commitment to customer satisfaction.  

Personal Guarantees and Principals’ Character

For smaller customers, B2B trade creditors sometimes seek a personal guaranty from the business owner or other principal, and consider the financial standing and personal credit history of the guarantor or business owner.  Even where you don’t seek a personal guaranty, though, conducting due diligence about the character of the customer’s principals can be important.  Have the principals been involved in other businesses in the past?  Were those businesses successful?  Did they honor their debts and pay trade creditors and lenders when due?  Or did they get sued, file bankruptcy, default with lenders or trade creditors, or otherwise engage in any behavior that might suggest less than favorable character?.

Legal and Regulatory Compliance

Adherence to legal and regulatory mandates, such as tax liabilities, license requirements, and industry standards, showcases a customer’s dedication to conducting business ethically and responsibly.  License checks, disciplinary history review, assessment of third-party complaint history with relevant dispute resolution providers (such as the customer’s local Better Business Bureau branch), litigation searches, and lien searches can aid the character assessment by revealing the presence or absence of patterns of noncompliance.  Many of the relevant data sources are free or available for a nominal charge. 

By utilizing these evaluation techniques and considering both quantitative and qualitative data from public and private sources, B2B trade creditors can develop a thorough picture of the character of a potential customer and make well-informed ccredit decisions.  While the other 5 Cs of Credit deal with the customer’s ability to pay, Character assesses the customer’s willingness to pay, and to make prudent financial and operational decisions to be able to continue to pay its debts well into the future.  That is the foundation upon which the other 5 Cs of Credit are built.  Our next installment in this miniseries will address Capacity – the core analysis of a customer’s ability to pay.

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