For many small business owners, credit will make or break their long-term success. Borrowing in lean months, during expansions, or early on when still building the company can keep the business moving forward when the revenue is not yet there. Then, when things pick up, paying off that debt can allow for greater freedom. But in order to get credit, especially as a new business, you need to understand the 5 C’s of credit, so that you understand what a lender is looking for from you. Otherwise, you might get overcharged in your rate or be completely excluded from lending, and either of those can quickly bankrupt a business.
Capital – Most lenders want to see cash in reserves before they will even consider lending. This can be as little as a few months’ payment reserves or as much as the full amount borrowed. This is not going to be secured, it simply shows that you will have an ability to make payments should revenues drop or expenses grow in the future. Banks do not want to lend you money you can’t repay, and excess capital helps ensure you can make payments.
Character – This is the most subjective of the 5 C’s, and is largely based on your credit score and history. Every lender will weigh this differently and come up with a rating for you. It can be directly linked to your personal credit history or it can be based more on the business’ history of payments. But ultimately, this is a measure of your likelihood to repay the loan based on your past experiences. This is where they will evaluate late payments, foreclosures, bankruptcies, collections, and so on. So the cleaner your history, and the more likely you are to repay the loan, the better your rating will be in this regard. If you’ve settled for less than the amount borrowed in the past, how likely is a lender going to be to lend to you again?
Capacity – This is your ability to take on more debt, and is measured by your debt-to-income ratio (DTI). Your DTI is a measure of all of your current recurring debts against your income. This looks at things like loans, mortgages, lines of credit, and any other secured or unsecured debt. The lender will see what that ratio is, then assess whether or not you can handle making more payments monthly – you may have tons of reserves, great character, and be an excellent borrower, but if you are maxed out, a lender will not want to put you in a situation where you can’t afford your payments.
Conditions – This is a very large category and is also very subjective. This has to do with both the conditions of the loan, which will determine the lender’s appetite for the loan. This is things like the interest rate, term, and principal. And it also has to do with the conditions of the loan outside of the pure finances. This is things like the market outlook for your industry, the use of the funds, the overall economy, government regulations, etc. So what this means for you is that if the margins are very small, a lender may simply not be interested in the loan, as there are limited earnings. Or, if you are looking to borrow money to start a restaurant with no experience, a lender may see that as too risky. This is all about the likelihood of you being successful and the profit gained from the loan. Those two things are compared and the lender determines if the reward is worth the risk.
Collateral – This is for loans which are secured by collateral. This can be a home, commercial property, car, equipment, truck, accounts receivable, cash, or any other tangible item. This item is then securitized by the lender, meaning the lender gets to take that item should you default. The lender will value the collateral and use it to help justify the loan, as a default will not lead to a complete loss – at least there will be the overtaken collateral.
By understanding the 5 C’s of credit, you will best be able to position yourself to acquire financing at desirable terms if, and when, you need it to sustain your business.
Thank you, Randy McCoy of Randal McCoy Insurance, for contributing, Randy offers great insight coming from corporate America to open his own business. Credit was one of the components he had to overcome in establishing a successful business.