The 5 C's of Business Credit
Lending institutions want to lend money because it's the way they make money. However, they only want to lend money to a borrower who is able to repay the loan on time and in full.
When lending financing over a certain limit to small businesses, lenders customarily analyze the worthiness of the borrower by using the Five C's: capacity, capital collateral, conditions, and character. Each of these criteria helps the lender to determine the overall risk of the loan. While each of the C's is evaluated, none of them on their own will prevent or ensure access to financing. There is no automatic formula or guaranteed percentages that are used with the Five C's. They are only a variety of factors that lenders evaluate to determine how much of a risk the potential borrower is for the financial institution.
Note: When lending small amounts of money under $50,000 (small is a relative term to each lender) typically eligibility depends solely on personal and business credit scores. A credit analysis is not usually performed. Depending on the personal and business credit scores, they either will or will not approve the loan.
Understanding Credit Analysis
To determine if you will be able to establish business credit, consider each of the following C's to see how you would look to a potential lender:
- Capacity – This is an evaluation of your ability to repay the loan. The financial institution wants to know how you will repay the funds before it will approve your loan. Capacity is evaluated by several components, including the following:
- Cash Flow refers to the income a business generates versus the expenses it takes to run the business analyzed over a specific time period. For example, if a company regularly generates $10,000 a month of revenue, and it has expenses of $8,000 a month, the lender would determine that there is $2,000 a month in cash flow that could be used to repay the loan. If a company has the same amount of expenses as income, that would mean the cash flow would be zero, and the lender would have reason to be concerned about how the company plans to repay the debt.
- Payment history refers to the timeliness of the payments that have been made on previous loans. In the past, it was more difficult for commercial institutions to determine whether a small company had a good payment history. However, today there are companies that evaluate commercial credit ratings (such as Dun & Bradstreet) that are able to provide this kind of history to lenders.
- Contingent sources for repayment are additional sources of income that can be used to repay a loan. These could include personal assets, savings or checking accounts, and other resources that might be used.
- Capital – Typically, a company's owner must have his own funds invested and at risk in the company before a financial institution will be willing to risk their own investment. Capital is an owner's personal investment in his business which could be lost if the business is a failure. There is no fixed dollar amount or percentage that the owner must be vested in his own company before he is eligible for a business loan. However, most lenders want to see at least 25% of a company's funding coming from the owner before they will step up.
- Collateral – Heavy machinery, stocks and bonds, and other expensive business assets that can be sold if a borrower fails to repay the loan are considered collateral. Since small items such as computers and office furniture are not typically considered collateral, in the case of most small business loans, the owner's personal assets (such as his home or automobile) are required in order for the loan to be approved. When an owner of a small business uses his personal assets as a guarantee on a business loan, that means that the lender can sell those personal items to satisfy any outstanding amount that is not repaid.
- Conditions – This is an overall evaluation of the conditions surrounding the loan including general economic climate at the time the loan is requested and the general purpose of the loan. Economic conditions specific to the industry of the business applying for the loan as well as the overall state of the country's economy also factor heavily into a decision to approve a loan. Clearly, if a company is in a thriving industry during a time of solid economic growth, there is more of a change that the loan will be granted than if the industry is declining and the economy is uncertain. The purpose of the loan is also an important factor. If a company plans to invest the loan into the business by acquiring assets or improving its equity, there is more of a chance of approval than if it plans to use the funds for more risky expenses such as expanding into new markets. Most financial institutions require that the borrowed funds are used solely to increase income or decrease expenses.
- Character – This is a highly subjective evaluation of a business owner's personal history. Lenders have to believe that a business owner is a reliable individual who can be depended on to repay the loan. Background characteristics such as personal credit history, education, and work experience are all factors in this business credit analysis.
Ultimately, capacity is the main requirement for lending and business credit. The ability to receive regular payments generated by a company's cash flow is the easiest way a financial institution can be repaid.
Note: When applying for a small business loan, don't forget the importance of personal relationships. Apply for a loan at a bank where you already have a positive business relationship. Also, make an attempt to meet with the person who will be evaluating your application, such as a bank's lending officer, rather than the teller who handles your day-to-day banking transactions.