Photo of workers with 5 Cs of Credit chart overlay

What if you could identify potential problem customers before you started working for them? What if there was a way to tell which customers would be slow to pay ahead of time? Turns out, there is — and most contractors don’t use it. Credit professionals use a tool called the 5 Cs of Credit.

Most contractors don’t do any sort of credit research on their customers. They rely on the terms of their contract to enforce payment terms when necessary. Enforcing terms after they’ve been broken is backward.

Instead, contractors should be doing some research on the front end, identifying potential problem customers, and then either making plans to deal with payment delays — or choosing not to work with them. 

What are the 5 Cs of credit?

The 5 Cs of credit are character, capacity, condition, capital, and collateral

These factors are part of a tool used by financial institutions and credit managers to gauge the creditworthiness of a customer. It helps credit teams determine the chance that a borrower will default on their payments and allows them to make educated decisions on whether to loan money to them or not.

“The 5 Cs really are another way to say ‘Know your customer,’” says Thea Dudley, a long-time credit manager and renowned consultant for construction businesses. “Ask questions, get answers and use your experience and logic. Balance that against your risk/reward philosophy of your company.”

While there is no set rating system or official grading scale for determining credit worthiness based on these 5 Cs, credit teams can make a judgment call based on the information available, the size of the project or loan, and other factors they deem important.

Contractors struggle with asking for financial information from their clients. Most contractors trust that they’ll get paid, and only think about protecting themselves after payments are delayed. While it’s standard business practice for suppliers and other credit-giving companies to ask for financial information, it isn’t considered normal for contractors. 

Contractors have a right to know that they will get paid just like any other company. In fact, the 2017 version of the AIA contracts states that contractors can stop work if they don’t have proof of financial capacity from the owner. So, it makes sense for contractors to seek credit information before a project starts, so they can protect themselves and make better decisions about the projects they want to work on.

The 5 Cs of Credit Chart

Using the 5 Cs to make credit decisions

Construction businesses can use the 5 Cs of Credit to decide if a customer is creditworthy — but the Cs are not all created equally. Different businesses will put more weight on different factors depending on their knowledge, experience, and goals. 

“Of the 5, is any one in particular any more important than the other?” asks Thea. “Should any more weight be put on one C over another? That depends. How can you leverage it? How much knowledge or information do you have in regards to each? If the character is solid but the capital is mediocre — does that tank the deal, or can you work with it?” 

How you use these factors will ultimately depend on your own business philosophy and risk preference. 

1. Character

The first C of credit, character, refers to a company’s credit history. Checking a contractor’s credit history shows you their history of payment on other debts. Company credit histories are available for purchase from Dun & Bradstreet, Experian, and Cortera. These reports show the amount of debt the company is currently carrying, as well as their payment history. 

You can also see past bankruptcies, collections, liens, and judgments. If your customer is a general contractor, you can also check Levelset’s contractor payment history report to get valuable information on their payment history. This is a great way to get a feel for the financial stability of the company.

Note that not all companies have a company credit history. If it’s a new venture or a relatively small business, you may need to look up the personal credit report of the company owner(s). Personal credit reports can be purchased from the three credit bureaus: Experian, TransUnion, and Equifax.

What to look for: You want to see that the company has used credit but has paid it off within the terms of their agreements. Any negative events, such as judgments and liens, should be considered red flags. You’ll want to proceed with caution or ask for additional payment guarantees before you start work.

2. Capacity

Capacity refers to a company’s ability to pay its debt. When assessing the financial position of a borrower, lenders often use a debt to income ratio as a measure of their ability to pay. This ratio is calculated by dividing their total monthly debt payments into their monthly income. The resulting percentage shows how much debt they have compared to their income. Obviously, lower percentages are better.

It can be difficult to gauge a company’s credit capacity without looking at its financial records. If you’re looking to work with a new client, whether it’s a general contractor or a project owner, you can request financial statements and other documentation to show their financial standing.

This is a regular business practice, and they should be willing to comply. If the company doesn’t want to release their financial information for some reason, you can ask them to provide certain figures, such as their debt to income ratio, to help you decide whether you want to work with them.

“Don’t be afraid to ask questions regarding the financial statement,” Thea says. “If something does not make sense to you or does not add up, question it. There may be a perfectly logical explanation. It also gives you the chance to see how well your potential customer really knows their business. If they stammer their way through it and can’t tell you anything except ‘we will get our accountant or bookkeeper to call you,’ this may be another red flag for you.” 

What to look for: Depending on the size of the project, lenders look for a debt to income ratio of less than 35%. If your customer has a higher percentage, you may want to ask for more information to determine what type of debt they have.

If there is a large amount of unsecured debt, that could be a red flag. Equipment or vehicle financing, as well as building loans, are standard for most businesses, so shouldn’t be seen as a negative for the business.

3. Condition

Condition refers to the specifics of the project you are going to work on together. What type of construction project is it? Condition includes characteristics of the project like the purpose of the building, funding sources (public or private), and the size. Once you know more about the project as a whole and what your portion of it is, you can gauge the riskiness of working with the new customer.

Payment problems can stem from the top, so it’s important to look at the project or property owner as well. Do they have a history of problems or payment disputes on past projects? Do they have funding in place for the entire project, or are they trying to finance it as they go? 

What to look for: Large private projects are often the riskiest when it comes to the possibility of payment problems. Public projects usually have a low default rate and are often protected by payment bonds, so they’re typically pretty safe. 

You’ll also want to look at the relative size of your contract for the project. If it’s a small contract for you, a bit of risk may be okay. However, on larger projects payment issues could significantly hurt your business, so you’ll want to proceed with caution or get additional guarantees.

4. Capital

Capital refers to the cash your customer has available for paying their bills. In traditional lending, this is often measured by the size of the down payment. Most construction projects don’t require a down payment, so this can be tougher to measure. If you have access to the company’s financial statements, you can assess the amount of cash they have available and the liquidity of their assets. Other documents, like a letter of loan approval from a financial institution, can also serve as proof of capital.

Obviously, more money is better, but it shouldn’t be the only factor in assessing a customer’s credit-worthiness. You can also request proof of financing as a way to ensure cash flow on the project. Once you get the proof, confirm that the loan has closed, meaning that funds are ready to disperse. If you have to wait for the loan to close, payments could be delayed 60 to 90 days.

What to look for: There’s no magic formula for how much cash a customer should have on hand prior to starting a project. It’s going to depend on the size of the project, the type of work that’s being done, and where they’re getting the project financing. 

5. Collateral

Collateral includes any assets that can be used to secure funding for a project. They help ensure that payment will be received by providing property that can be sold to finance outstanding payments. In the construction industry, lien rights provide a way for contractors and suppliers to use collateral by securing rights to the project work and property.

If a customer fails to pay a contractor or supplier for work on a construction project, the contractor or supplier can file a mechanics lien on the property and building. If payment delays continue, then the contractor or supplier files for perfection or foreclosure of the lien, forcing the client to sell the property to pay the amount owing.

As powerful as mechanics liens can be, sometimes you may want additional assurances. If a potential customer needs credit, but has red flags in some of the other 5 Cs, consider negotiating an agreement that uses other assets as collateral. These could be company assets or personal assets. 

“Try to keep an open mind on anything someone brings to the table,” Thea writes in her book, Confessions of a Credit Overlord. “I do have one rule I live by in looking at security: Never take anything that eats or poops! Everything else is fair game.”

What to look for: Since contractors have lien rights for all their work, collateral security is implied. If you’d like additional security, you can review your customer’s financial statements to see if there are assets available to act as additional collateral. Or you can ask them for a list of their properties, vehicles, equipment, and other assets.

Why credit prequalification matters

Instead of waiting to see whether a customer pays you or not, be proactive in researching their payment history, so you can take steps to reduce your risk and protect your bottom line. Ultimately, the 5 Cs are a helpful tool for contractors to make credit decisions, but they are not set in stone. 

“The 5 Cs of credit are one of the staple items of the credit manager,” says Thea. “They have been around for longer than I have been in credit — but the way we interpret them should be refreshed.”

It’s important to approach the 5 Cs with your business philosophy and goals in mind.

Customers with a better rating on the 5 Cs of credit are more likely to pay on time. Payment issues can cost your company both time and money, reducing productivity and profits. If you know a customer has payment issues, you can plan for them and prepare financially.