For a first-time business owner, applying for funding while gaining business experience can be a unique challenge to face when attempting to grow and scale. Running out of money is a small business’s biggest risk and keeping the flow of cash organized is the ultimate juggling act. But too often, small business owners are unclear about how much money they generate and where funds are needed most, and the disconnect can be disastrous.
Lenders have a special lens to determine if a small business can handle additional capital and it is called the “Five C’s of Credit.” The term “Five C’s” refers to the way lenders evaluate the credit-worthiness of an applicant. It can be used for individuals and couples applying for personal credit such as a loan, credit card or a mortgage. But it is also used to help assess the “worthiness” of business credit applicants.
Lenders review how well a business meets each of the Five C’s, and then use their findings to help make a lending decision. Understanding the Five C’s will help any small business owner be in the best position for a loan approval. The Five C’s are capacity, capital, collateral, conditions and character. Each of these criteria helps the lender determine the overall risk of the loan. This is not a silver bullet approach to guarantee the best loan package, but it does help get a good sense as to what areas a small business owner should anticipate being reviewed on when the time comes to seek a loan for a growth opportunity.
- Character
This is a highly subjective evaluation of the business owner’s personal history, but lenders must believe that a business owner is a reliable individual who can be depended on to repay the loan. Background characteristics such as personal credit history, education and work experience are all factors in this business credit analysis.
- Capacity
Capacity is the small business owner’s ability to repay the loan. The bank needs to know how you will repay the funds before it approves your loan. Capacity is evaluated by several components, including cash flow analysis, payment history and contingent sources of income.
- Capital
A small business owner must have his or her own funds invested in the company before a financial institution will be willing to risk their investment. Capital is the owner’s personal investment in his/her business which could be lost if the business fails. There is no fixed amount or percentage that the owner must be vested in his or her own business before being eligible for a business loan.
- Collateral
Machinery, accounts receivable, inventory and other business assets that can be sold if a borrower fails to repay the loan are considered collateral. Since small items such as computers and office equipment are not typically considered collateral, in the case of most small business loans, the owner’s personal assets such as his or her home or automobile are required for the loan to be approved. When an owner of a small business uses his or her personal assets as a guarantee on a business loan, that means the lender can sell those personal items to satisfy any outstanding amount that is not repaid.
- Conditions
Conditions evaluate the general economic climate and the purpose of the loan. Economic conditions specific to the industry of the business applying for the loan as well as the overall state of the country’s economy factor heavily into a decision to approve a loan. Clearly, if a company is in a thriving industry during a time of economic growth, there is more of a chance that the loan will be granted than if the industry is declining and the economy is uncertain.
- Bonus: Confidence
A successful borrower instills confidence in the lender by addressing all the lender’s concerns on the other Five C’s. Their loan application sends the message that the company is professional, with an honest reputation, a good credit history, reasonable financial statements, good capitalization and adequate collateral.
As a small business owner, understanding the Five C’s to credit is a valuable tool to use. When applying for a small business loan, do not forget the importance of personal relationships and maintaining a positive banking history. Ask to meet with the person who will be evaluating your application, such as the bank’s lending officer, rather than the teller who handles your day-to-day banking transactions, and have your Five C’s outlined in a business plan. It will surely impress your banker.
EDGAR RAFAEL OLIVO is a bilingual business educator, economic advisor, and contributor for several media outlets. He’s a nonprofit executive who is passionate about education. He is certified in finance and data analytics and holds a business degree from Arizona State University.
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