The “5 C’s of Credit”
What Do They Mean to Your Small Business Loan?
One of the most common questions among small business owners seeking financing is: “What will the bank look for from me and my business?” While every bank has its own unique criteria, many use some variation of “the five C’s of credit” when making credit decisions. Broadly speaking, they are:
- Cash Flow
- Capitalization, and
Let’s take a look at each of these ingredients and review how they may impact your funding request. Review each category and see how you stack up.
Character — Your willingness to pay back your loan
What is the character of the management of the company? What is your payment history and patterns in other loans you have taken? What is management’s reputation in the industry and the community? Bankers want to lend their money to those who have impeccable credentials and references. The way you treat your employees and customers, the way you take responsibility, your timeliness in fulfilling your obligations are all parts of the character question.
This is really about you and your personal leadership. How you conduct both your business and personal life gives the lender a clue about how you are likely to handle leadership as a CEO. It’s a banker’s responsibility to look at the downside of making a loan. Your character immediately comes into play if there is a business crisis, for example. As small business owners, our personal stamp on everything that affects our companies is essential. Since the bank may not know you, your credit score tells the lender how you will pay your business loan. Many times, banks do not even differentiate between us and our businesses. A poor personal credit score is enough information for a lender to outright decline a business loan. In a commercial lender’s eyes, there is no differentiation between handling personal obligations and business obligations. They are one and the same.
Cash Flow— Your capacity to pay back your loan
What is your company’s borrowing history and track record of repayment? How much debt can your company handle? Will you be able to honor the obligation and repay the debt? There are numerous financial benchmarks, such as debt and liquidity ratios, that investors evaluate before advancing funds. Become familiar with the expected pattern in your industry. Some industries can take a higher debt load; others may operate with less liquidity. As a conservative guideline, you should have $2 of income (business and personal) for every $1 of debt.
Collateral — How lenders get paid if the business fails
While cash flow will nearly always be the primary source of repayment of a loan, bankers look at what they call the secondary source of repayment. Collateral represents assets that the company pledges as an alternate repayment source for the loan. Most collateral is in the form of hard assets, such as real estate and office or manufacturing equipment. Alternatively, your accounts receivable and inventory can be pledged as collateral. Generally, lenders will want a 1:1 ratio, or $1 of collateral for every $1 you borrow. Bankers typically discount an asset and lend on that basis. So for every $1 of collateral, the bank will lend anywhere from 70% to 85% of the value depending on whether it is fair market value or liquidation value.
The collateral issue is a bigger challenge for service businesses, as they have fewer hard assets to pledge. Until your business is proven, you’re nearly always going to pledge collateral. If it doesn’t come from your business, the bank will look to your personal assets. This clearly has its risks — you don’t want to be in a situation in which you can lose your house because a business loan has turned sour. If you want to be borrowing from banks or other lenders, you need to think long and hard about how you’ll handle this collateral question.
Capitalization — How much money have you put into the business?
How well-capitalized is your company? How much money have you invested in the business? Has your business grown? Have you reinvested the profits, or paid yourself a bigger salary? Investors often want to see that you have a financial commitment and that you have put yourself at risk in the company. Both your company’s financial statements and your personal credit are keys to the capital question. If the company is operating with a negative net worth, for example, will you be prepared to add more of your own money? How far will your personal resources support both you and the business as it is growing?
Conditions — SWOT: What are the Strengths, Weaknesses, Opportunities, and Threats that affect your business?
What are the current economic conditions and how is your company affected? If your business is sensitive to economic downturns, for example, the bank wants a comfort level that you’re managing productivity and expenses. What are the trends for your industry, and how does your company fit within them? Are there any economic or political hot potatoes that could negatively impact the growth of your business? (I wrote at length on SWOT analysis in my January blog, which you can find at: http://www.edwardalloncfo.com/category/budgets-strategic-plans/.)
Keep in mind that in evaluating the five C’s of credit, investors don’t give equal weight to each area. Lenders are cautious. One weak area could offset all the other strengths you show. For example, if your industry is sensitive to economic swings, your company may have difficulty getting a loan during an economic downturn — even if all other factors are strong. And if you’re not perceived as a person of character and integrity, there’s little likelihood you’ll receive a loan, no matter how good your financial statements may be. As you can see, lenders evaluate your company as a total package, which is often more than the sum of the parts. The biggest element, however, will always be you.