5 Cs of Credit

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by Tim McLellan

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 Cs of credit when making credit decisions. Broadly speaking, they are: Character, cash flow, collateral, capitalization and conditions.

Let’s take a look at each and review how they may impact your funding request.

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? What is management’s reputation in the industry and the community?

Bankers want to lend 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.

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, bankers 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. There should be an adequate cushion in the company’s cash flow that allows both principal and interest to be repaid.

Collateral: How lenders get paid if the business fails. While cash flow will nearly always be the primary source of a loan repayment, bankers look at secondary sources of repayment. Collateral represents assets the company pledges as an alternate repayment source. Most collateral is in hard assets, such as real estate and office or manufacturing equipment. Alternatively, your accounts receivable and inventory can be pledged as collateral.

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.

Most lenders will also require collateral based on the business owner’s individual assets such as personal real estate and/or a personal guarantee supporting the business loan.

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 it grown? Have you reinvested the profits, or paid yourself a bigger salary?

Banks often want to see that you have a financial commitment and 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, are you prepared to add more of your own money? How far will your personal resources support you and the business as it is growing?

Conditions: What are the strengths, weaknesses, opportunities, and threats (SWOT) 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 you’re managing productivity and expenses. What are your industry’s trends, and how does your company fit within them? Are there any economic or political hot potatoes that could negatively impact your business’ growth?

When evaluating the five Cs of credit, remember bankers don’t give equal weight to each area. One weak area could offset all the other strengths you show. 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.

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