The 5 C’s of Lending

As a business executive, understanding the 5 C’s of lending can be crucial in securing financing for your business. These 5 C’s are character, capacity, capital, collateral, and conditions.

1) Capital – From a business lender’s perspective, capital is usually first equated with owner’s equity – the net difference of assets minus liabilities on the balance sheet. But financial statements can be deceiving so it is important to understand” practical capital” also known as “skin in the game”, that stake hold that the business owner will fight to preserve even when push comes to shove. A good lender really wants to know if the borrower plans on using their own money to help the business succeed when needed. A sound capital base provides the ability to leverage responsibly with well structured debt. Lenders will look at your personal and business assets, including savings accounts, investments, and property. Having a significant amount of capital can increase your chances of getting approved for a loan and may even result in better loan terms.

2) Capacity – A businesses capacity to pay back money that is borrowed is the next crucial test of viability as to whether to extend new credit or not. Is there a track record of meaningful cash flow available to service the debt as proposed? Are there viable back up sources of repayment that compliment the primary source (business cash flow) such as outside income of the guarantors? The lender will request business and personal credit reports and complete an effective cash flow analysis. A business owner with a history of making loan payments on time is more likely to receive financing for their business than a business owner who regularly makes late payments or no payments at all. Credit scoring does have a place, especially as it relates to small ticket business loans that behave more like consumer loans than commercial loans. Lenders will assess income, cash flow, and debt-to-income ratio to determine if the business has the capacity to make regular loan payments. Businesses that have a steady income and a manageable debt-to-income ratio, are more likely to be approved for a loan. A simple way of thinking about a company’s cash flow when considering loan applications, is to look at the amount of cash coming in and going out of the business each month, and is an indicator of the ability to make loan payments. Lenders will typically assess cash flow by examining financial statements and bank statements, and may request additional documentation to verify the income and expenses. If the company has inconsistent or insufficient cash flow, it may need to explore alternative lending options or work to improve cash flow before applying for a loan.

3) Collateral – Collateral is used in a “secure loan” to further reassure lenders they will be getting their money back, one way or another (the second way out). Tangible assets such as real estate or machinery and equipment typically provide the best collateral because they can be independently valued and typically there is a market to liquidate such collateral if necessary. Prudent lenders need to apply a reasonable discount to market value because in the hands of a lender, collateral is almost always not worth what it cost or what it might sell for in a going concern situation. Collateral should be viewed as a secondary source of repayment in most business loan structures. collateral refers to assets that can be used to secure the loan. This is important for lenders as it provides them with a form of security in case the borrower defaults on the loan. If you have valuable collateral, you may be able to secure a larger loan or better loan terms. In the event that you’re unable to repay the loan, the lender can seize the collateral to recoup their losses. Collateral can help to mitigate the lender’s risk, and may be required for certain types of loans, particularly those with higher risk profiles.

4) Conditions – The conditions of the economy and the market are also taken into consideration prior to extending business credit. Lenders look to understand and analyze the business capacity in the context of current and future market conditions and by what the business borrower’s competitors may, or may not be doing. Additionally, lenders often recognize that the longer the term of the loan, the less certain they can be about conditions during the life of the loan. Seasoned lenders have probably experienced several difficult business cycles and negative trends and this experience can be built into the structure of the loan. Properly structuring the loan entails taking into account for things such as the loan amount, interest rate, repayment term, and any fees associated with the loan. Lenders will assess these conditions to determine if they are reasonable and if the borrower is capable of meeting them. Having a clear understanding of the loan conditions is crucial in making informed decisions about financing your business.

5) Character – Lenders need to be sure that they can believe in the character (trust worthiness) of the business owners and their business. In addition to character, the borrower’s ability to succeed will be closely examined. Business owners with the proper amount of education and relevant work experience are more likely to receive favorable responses. Having a positive personal attitude and a constructive business plan (supported by reasonable assumptions) is critical in a start-up business scenario due to the unproven track record of the business. Bottom line, people repay loans (through the business) so make sure you’re dealing with honest people. Firstly, character refers to the borrower’s reputation and history of paying back debts. Lenders will look at your credit score, payment history, and any past bankruptcies or defaults. Having a good credit score and a history of paying back debts on time can significantly increase your chances of getting approved for a loan.

In conclusion, understanding the 5 C’s of lending can be instrumental in securing financing for your business. By focusing on building a strong reputation, having the ability to repay the loan, having capital available, providing valuable collateral, and understanding the loan conditions, you can increase your chances of getting approved for a loan and securing the financing your business needs to succeed. Remember, it is essential to do your research, shop around for the best loan terms, and always read the fine print before signing any loan agreements.