When you apply for business loans, lenders may use the five C's of credit as a guideline for determining whether you qualify for financing. Sometimes referred to as the four C's, depending on the lender, these criteria are used to gauge your business's ability and likelihood to repay a loan. If financing is on the horizon for your business, either to consolidate debt, fund an expansion project or simply cover working capital needs, here's what you need to know about the five C's.
What Are the 5 C's of Credit and Why Are They Important?
Lenders look at your personal and business credit scores as a condition of approval. Lenders can review your personal FICO and VantageScore credit scores. On the business side, they can check credit scores issued by Dun & Bradstreet, Experian and Equifax.
Lenders can go deeper than your scores, however, and use the five C's to get a broader picture of your creditworthiness.
What are the five C's of credit that lenders look at? They are:
Here's more detail on what each one means.
Capacity refers to your business's ability to repay a loan based on your current cash flow. Lenders want to know that you'll be able to handle new monthly loan payments in addition to any other debt you owe and your everyday operating expenses.
Lenders may consider capacity by examining your monthly revenues and expenses, along with existing business debt and business assets, such as real estate, cash savings or investments. Business bank account statements, loan statements, accounts receivable and accounts payable can all be offered as proof of capacity.
The lender may want to know how easily you could liquidate assets if needed. In terms of business debt, the lender will look at how much of your business income goes toward repaying debt each month. The lower your debt-to-income ratio, the better.
[Read: Best Small Business Loans.]
Capital refers to how much skin you have in the game when getting a business loan. Often referred to as owner equity, capital could show that you have enough confidence in the profitability of your business to invest your own money. If you bootstrapped your startup from your own savings, for example, that can suggest to lenders that you're serious about repaying a loan.
If you don't yet have sufficient capital investment, lenders may ask for some. For example, if you're seeking financing to buy new equipment, the lender might require a down payment for approval.
Character encompasses several different measures of your business's creditworthiness. Think of it as your business resume. It can include your business and personal credit scores, and also factors including your business reputation, education, professional credentials and your personal integrity. For example, if you're seeking a loan to open a new restaurant, lenders will want to know about your previous experience in the restaurant business.
Lenders may also ask for personal and professional references as proof of good character.
Conditions are the state of the business and projections for future financial health. That can include individual business performance along with the industry as a whole. Conditions also consider loan use and how that benefits your business. If you plan to use a loan to buy equipment or inventory, for instance, the lender may ask for an explanation of how that will advance the bottom line.
Lenders can also look at how broader economic conditions or trends within your industry may affect your ability to repay a loan. Say you run an import business and want a loan to purchase more inventory. But new and potentially increasing tariffs could make profits thinner in the future. The lender will consider how that could affect your overhead costs, profit margin and cash flow, all of which can impact your capacity to repay a loan.
Secured business loans, or loans that involve the purchase of an asset such as real estate or major equipment, typically require collateral. Putting up collateral means pledging an asset you own as a guarantee. If you default on the loan, the lender could use the collateral for repayment. The lender will want to have an accurate assessment of the collateral's current market value and its estimated resale value.
Some lenders use the four C's of credit as a guideline instead, omitting collateral for some or all loans. Inventory financing, for instance, uses the inventory you plan to buy with the loan as collateral, so there is typically no additional collateral requirement with this type of loan. Merchant cash advances leverage your future credit and debit card receipts.
Keep in mind that if collateral isn't a requirement, you may still be required to sign a personal guarantee or agree to a Uniform Commercial Code lien. A personal guarantee is a legally binding agreement that makes you, not the business, personally responsible for the debt. A UCC lien is a blanket lien a lender can place against all of your business assets in the event that you default on a loan.
[Read: Best Unsecured Business Loans.]
Which of the 5 C's Are Most Important?
Rob Stephens, founder of CFO Perspective, a small business financial consulting firm, says the five C's provide a quick overview of what banks are looking for when deciding whether to make a loan and how to price it. "The stronger a borrower is across these, the more likely they will receive a loan and get better pricing," he says.
Stephens says character is the most important factor. But he suggests a possible sixth C: credibility.
"Character is integrity and commitment to the banking relationship," he says. "Credibility includes that but also reflects the business skills of the borrower."
Borrowers who possess both character and credibility may be better equipped to continue meeting their loan obligations in unexpected circumstances. For example, if a business owner goes through a divorce or experiences a disability, that person's character and desire to remain credible may motivate him or her to do whatever is needed to repay the loan.
Brock Blake, founder and CEO of online small business loan marketplace Lendio, offers a different take.
"All are important, but more importantly is the number of C's each business owner can check off," Blake says. "How many of them an owner can achieve dictates their perceived risk in the eyes of the lender, and the quality and terms of the loan."
You may be rated as low, medium or high risk based on the number and quality of the five C's your business possesses. If you're not able to get a traditional loan based on these criteria, you may have to consider alternative financing options, such as a merchant cash advance, inventory financing or invoice financing. These types of loans can be more accessible to businesses that have a shorter operating history, little or no cash to offer as collateral, or less-than-perfect credit ratings.
How to Improve Your 5 C's Profile
If you want to put your best foot forward when applying for business loans, there are a few things you can do to prepare.
With regard to capacity, reviewing your expenses and income can help you get a sense of where you are with cash flow. You may want to pay down some of your existing business debt or look at ways you can increase revenues, such as expanding your line of products and services. This can help you present the lender with better cash flow projections.
If you're considering a secured loan, look at what you have to offer as collateral. Again, with something like an equipment loan, the equipment is typically used as collateral. But if you're looking for a secured term loan or a line of credit, take stock of your business assets and their fair market value.
Character can be the hardest of the five C's to quantify, but it's not impossible. "Show your depth of experience, your customer loyalty and solid references," Stephens says, and "exhibit professionalism throughout the loan process."
If you haven't checked your business and personal credit scores, this is another helpful step to consider. When checking your personal credit, look for any errors or inaccuracies that could negatively affect your score. Dispute them with the credit bureau reporting the information. There's no formal process for disputing business credit errors, but it's still worth reviewing your credit history to know what a lender may see when it pulls your file.
What Else to Consider When Applying for Business Financing
Along with the five C's, remember to look at the bigger picture when researching loan options. Think about:
-- What type of financing you need
-- How much you want or need to borrow
-- What goals the loan is meant to achieve
-- The range of interest rates you may qualify for
-- How long you'll need to repay the loan
-- Loan funding speed
"The 'best' loan for your business will largely depend on how quickly you need the loan, how much revenue will be produced by acquiring the loan, and the ability and time to pay off the loan," Blake says.
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