The Ultimate Guide to the 5 C’s of Credit

So you applied for a small business loan, but do you actually know what that lender is looking for in your application?

If you want to have the absolute best chances of grabbing that business financing—so you can afford some new equipment, another marketing campaign, or a fresh batch of inventory—then you’re better off understanding what a lender really wants to see from you. Guessing might pay off once in awhile, but it’s much more useful to grasp their priorities and major concerns.

Why take a shot in the dark if you can just turn on the lights, right?

As it turns out, there’s one pretty simple framework that basically all lenders use to appraise your “creditworthiness,” or how good of a borrower you’ll be. And best of all, it’s no secret.

This magic metric is called the 5 C’s of Credit: it’s what bankers and lenders have used to measure your borrowing reliability since time immemorial. (Or for a good long while, at least.) Understanding the 5 C’s of Credit will give you some insight into what those lenders like to see—and how you can work on your loan application the right way.

The 5 C’s of Credit: What’s the Big Deal?

The 5 C’s of Credit are character, capacity, capital, conditions, and collateral. We’ll dive deeper into each one, looking at what it means, why it’s important, and how lenders figure it out—but first, let’s talk about this whole system.

In short, the “5 C’s of Credit” is a lending industry-wide perspective on how to judge a borrower. Will they pay back the loan on time? Will they use that borrowed money on the right things? Will their business survive or fail?

Basically, is that borrower a good investment?

How do lenders use the 5 C’s of Credit?

The 5 C’s of Credit aren’t hard-and-fast rules or incredibly calibrated scales. Some lenders use point systems for each category, while others just “keep the 5 C’s in mind” when underwriting. They’re also not weighted the same from lender to lender—this bank might care more about collateral while an alternative lender is concerned with capacity.

What they are is a straightforward way of thinking about borrowers: a map of the important things to think about when considering lending out some money. The 5 C’s of Credit are used for mortgages, automobile loans, student loans, and all the rest, too—not just for small business financing. They capture what matters to a lender.

And for small business owners, they’ll help you understand what’s most important in a lender’s eyes. The better you look as a borrower, the more likely your business will get the loan you want.

5 C’s of Credit #1: Character

What is it?

Character measures how trustworthy and reliable you are. Really, it’s more or less what it sounds like—what kind of person are you? Can a lender have faith that you’ll pay them back on time, in full?

Sometimes character gets talked about in terms of “Are you a good person?” That might sound silly or even unfair, but it happens to matter to some lenders—and for good reason.

After all, borrowing and lending money started off way back purely on a system of trust: will my neighbor actually pay me back? A “good” person honors their debts and obligations, which is exactly what a lender wants to see. Plus, this is a pretty intuitive metric—you’re more likely to let a stranger borrow your phone, for example, if they come across as a decent person.

Lenders also occasionally say “credit history” instead of character, too: that might give you some insight into what they’re essentially after. Borrowers with good character pay their loans back on time, every time, usually giving them better credit scores. They’re customers who won’t cause any trouble.

For many, this is the most important of the 5 C’s of Credit—and it’s not hard to see why. Even a borrower with a booming small business could make late payments or stir up problems if they’re irresponsible or disrespectful.

Why does it matter?

When a lender gives you cash, it’s taking on a risk. Sure, that interest tacked onto your loan means they’re making money, but recouping payments from late or failing businesses takes up time, energy, and sometimes their own capital.

So, naturally, lenders want to take the fewest risks possible. The more reliable their borrowers, the more dependable their revenue—and the opposite holds true for borrowers without much character to speak of.

As you might guess, lenders are hesitant to hand out cash to borrowers with iffy histories or poor reputations, even if they can make money off the transaction. Why take the risk?

For you, that means you’ll want to cultivate the right sort of character—or you’ll endanger your chances of getting affordable business financing, if any at all.

How is it measured?

On the “credit history” side of character, lenders analyze your credit scores—business, personal, FICO SBSS, or more, depending on the lender and type of loan—and the accompanying credit reports.

Your credit score is meant to reflect your borrowing history… Which is pretty much exactly what every lender’s character assessment is trying to get at. The higher the score, the more reliable you’ve been, generally speaking. And lenders like to rely on past information to predict the future, which is why your old borrowing habits can decide whether or not you get a business loan in the present.

Credit reports also show factors like open credit lines, liens, credit utilization, and more. Different lenders care differently about these smaller parts of your credit history, but don’t disregard them! You should check your credit reports from the three major bureaus—TransUnion, Experian, and Equifax—and contest anything that looks wrong. A small mistake could snowball into a big problem for your business.

Beyond your credit, lenders also might look to your reputation, references, and even how you interact with them. If it sounds a bit subjective, that’s because it is—but impressions matter. Be polite, prompt, and prepared when you talk to a lender. That might just make the difference to your loan application.

Finally, they’ll sometimes consider your overall “stability.” How long have you lived at your current address? How long have you worked at your current job? It could feel arbitrary, but a recent move or career change probably won’t hurt your chances—unless they demonstrate a pattern of erratic behavior.

5 C’s of Credit #2: Capacity

What is it?

Alright—we’re all done with that touchy-feely measurement. Let’s get down to business.

Capacity, sometimes called cash flow, is basically your financial ability to repay the loan. If a lender looks at your application and sees that you simply won’t have the capital to pay back what you’ll owe, they’ve got an easy decision to make. On the flip side, if it’s obvious that you’ll have their money in time (and you’ve been a good borrower in the past), then why would they hesitate?

The in-between gray area is what makes capacity tough to deal with. It might be difficult to tell whether a business will be able to repay—maybe because it hasn’t been around long enough, or the industry is changing, or its cash flow hasn’t been predictably stable in the past.

Why does it matter?

This one’s pretty straightforward: lenders want to make their money back, plus interest. If they loan to borrowers who can’t pay back, they lose money—which isn’t a great business model.

That doesn’t mean that lenders never take any risks, though! They just figure out which risks are worth it and which are bigger than they want to handle—and measuring your capacity to repay helps them determine whether you’re a good investment.

How is it measured?

For the most part, lenders will measure your capacity by your debt-to-income ratio or debt service coverage ratio and cash flow statements.

A debt-to-income ratio compares how much you owe with how much your business rakes in. The lower your ratio is, the more debt you can afford to take on.

For a simple example, let’s say two business owners make $100,000 through their businesses. One has $20,000 worth of debt—or a 0.2 ratio—while the other has a whopping $50,000—or a 0.5 ratio. These ratios reflect how much available income could be used to support more debt.

The debt service coverage ratio works similarly, demonstrating how much more debt you can afford to take on based on what you’re already tackling.

Your cash flow statements demonstrate how much capital you’ve got available in your business. Having a lot of revenue is good, but not if you funnel all that cash straight back into inventory purchases or equipment repairs immediately. If that were the case, how would you gather the money to pay back your lender every week or month?

Too much cash flow probably means you could be investing more in growing your business, but that’s not as concerning to a lender. They just want reassurance that you can pay them back.

Lenders will also sometimes take a look at your employment history and some other financials, but by and large, cash flow and debt-to-income are the numbers to worry about. So if you want to maximize your chances of getting business funding, make sure your financials show off some of your available business capital just waiting to be used for loan repayments.   

5 C’s of Credit #3: Capital

What is it?

Capital is the amount of skin in the game you’ve got—how much you’ve invested your own money in the business. It’s essentially your answer to the question: “If the business fails, what do you have to lose?”

This might just include the money you used to start up your business, but you could probably reach for more. What business assets do you rely on? Is this a family business that you’ve run for generations, or is it just one of a million new startups you’ve come up with? Are your other business debts collateralized with important assets, like your house or car?

Of the 5 C’s of Credit, capital measures your dedication to your business—in financial terms, more often than not.

Why does it matter?

If you’re not even investing in your business, then why should a lender?

Lenders want to see you put your money where your mouth is. You can prove your dedication, commitment, courage, and energy for your business by showing that you’ve built it up from your own sweat and blood—and, more importantly, that you truly stand to lose if the business goes under.

It might seem morbid, but lenders feel comforted knowing how much your business matters. The more sacrifices you’ve made, the harder you’ll fight to keep the business alive—and the more likely it is that they’ll get paid back the cash you owe.  

How is it measured?

As you’d probably guess, lenders measure your capital by, well, the capital you’ve invested in your business. The more money and assets, the more you care—and the less of a stake the lender will be making in your future finances.

It’s also good to show that you’ve invested in the right things. Did the money you put in better the business? Did you think carefully about how to improve? If so, that lender would feel more confident that you’d spend their money on the right things, too.

5 C’s of Credit #4: Conditions

What is it?

Most of the 5 C’s of Credit are pretty narrow categories, but conditions is big. We can divide it into 2 questions:

1. What are the larger circumstances surrounding your business?

We’re talking the state of the economy, the trends in your business’s industry, current environmental conditions, and even geographic or political events—although most of that is probably a bit too abstract for most lenders. 

The point is that, for conditions, lenders look for factors beyond your business alone that might affect whether or not you can make good on your debt.

Maybe that kind of jewelry you sell isn’t doing too well nation-wide, or a main ingredient in your ice cream just got hit with a bad harvest. It could be any number of things—but lenders certainly don’t want to invest their money without exploring every possible outcome.

2. What will you use the loan’s funds for?

This question is basically asking how you’ll react to those outside circumstances.

If your type of jewelry is selling pretty poorly, then you might impress a lender by dedicating your loan funds to a brand new marketing campaign. Likewise, restore your lender’s faith by using that working capital to stock up on good ingredients before they’re off the shelves.

In other words, prove that you’re a thoughtful and conscientious business owner. You’re not just chugging along—you’re aware of what’s going on in the outside world, too.

Why does it matter?

Lenders want to minimize their risks by loaning money to businesses in the right conditions. While you might not be able to help your business’s industry, you can try to show that you know what you’re doing—and you’re being proactive if anything seems to be going wrong.  

There are historically “riskier” industries, whether that’s because they suffer more variability, they’re politically charged, or something else entirely. Different states have their own laws overseeing this kind of business or that, and plenty of lenders pick and choose certain areas to stay away from. “Edge case” businesses get cut out of a lender’s plan if the economy is doing poorly.

Whether any of those reasons apply to your business or not, work your hardest to demonstrate that you’re in control of your environment and not the other way around. Sometimes there’s really nothing you can do—but barring natural disasters or unpredictable events, try to prepare for everything. (And even then, the right sort of business financing can help!)

How is it measured?

Lenders will look at your competitors, supplier and customer relationships, industry-specific trends, and more. It might be that your lender has a rigid and formulaic approach to appraising your conditions, or maybe they wing it, adjusting to each individual business.

It’s hard to guess exactly what each lender’s process is, but rest assured that they’ll consider how you plan on using their money—and why. They’ll also investigate whether you’ve put those past loans to good use, as well as how you’re doing relative to your competition.

5 C’s of Credit #5: Collateral

What is it?

Simply put, the assets you can pledge to support your loan make up your business collateral.

Whether those assets come in the form of inventory, equipment, real estate, accounts receivable, or something else usually doesn’t matter for traditional loans, although asset-based lenders make their decisions based on those specifics.

Why does it matter?

Collateral is a lender’s “backup” in case you wind up unable to repay your loan. It represents what they can take, if you default, in order to recoup their losses.

Essentially, lenders want to know that—somehow, to some degree—they won’t lose every bit of cash they spent on helping to finance your business. Even if they’ll have to make do with liquidating your inventory, equipment, and real estate, it’s better than nothing. Plus, the fear of losing your business assets might motivate you to make payments you would otherwise try to avoid.

How is it measured?

Your business collateral gets measured by your equipment, inventory, real estate, accounts receivable, and whatever else your lender can liquidate in order to recover some of the money they lost. This is the most straightforward of the 5 C’s of Credit, and some kinds of lenders don’t even take collateral that much into account.

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All in all, the 5 C’s of Credit are a simple, straightforward way for lenders to decide if you’re a borrower they can rely on. Each C is a different measurement of whether you’ll repay their loan or default because of mismanagement, bad economic timing, other debt obligations, or something else they can foresee. 

Understanding what your lenders are looking for will help you craft a better loan application—and, hopefully, secure a better loan for your business.

The post The Ultimate Guide to the 5 C’s of Credit appeared first on Fundera Ledger.

from Fundera Ledger https://www.fundera.com/blog/2016/04/26/5-cs-of-credit/