The 5 Cs of Credit
By Christopher Himsl
Lenders come in all shapes and sizes, from the 3 Fs (Family, Friends and Fools) to bankers, private lenders and direct lenders. What they all have in common are the criteria they use when deciding whether or not to lend you money. This set of criteria is commonly referred to as the 5 Cs of credit: Character, Capacity, Capital, Collateral, and Conditions. These five criteria help a lender determine your risk level and whether or not to lend you money for your business. The five-Cs-of-credit method of evaluating a borrower uses both subjective and objective measures. Let’s explore the characteristics of the 5 Cs of credit.
Character combines credit history, reputation within the industry, length of bank relationship and credentials.
When it comes to credit history, one of the objective measures is the FICO score. FICO is a leading credit evaluation firm formerly known as the Fair Isaac Corporation. It uses the information on your credit report to create a credit score, which serves as a quick snapshot of creditworthiness. FICO scores range from 300 to 850 and help lenders predict the likelihood that an applicant will be 90 or more days late on any reported credit obligation within the next 24 months.
Many lenders have a minimum credit score requirement before an applicant can be eligible for a new loan. Minimum credit score requirements will vary from lender to lender and from one loan product to the next. The general rule is the higher a borrower’s credit score, the higher the likelihood of being approved. Lenders also regularly rely upon credit scores as a means for setting the rates and terms of loans.
Capacity refers to a business’ ability to take on and repay debt based on the earning potential and cash flow of the business. (See “How to Manage Small Business Finances.”)
Capacity measures the borrower’s ability to repay a loan by comparing cash flow and debt service coverage ratio (DSCR). Lenders calculate DSCR by dividing net operating income (NOI) by total debt service. Most conventional loans require a DSCR of 1.2 and SBAs 1.25. For example, if you want an SBA-backed $250,000 business-acquisition loan at 8% interest for five years, your annual net operating income would need to be $76,036 to meet the SBA’s 1.25 DSCR requirement. Your financial documents must demonstrate this capacity.
Capital refers to personal and corporate net worth reflected in personal and business financial documents (balance sheet, income statement, and cash flow), the equity invested in the business, and the ability to access other financial reserves.
Lenders also consider any capital the borrower puts toward a potential investment. A large contribution by the borrower decreases the chance of default. Down payment size can also affect the rates and terms of a borrower’s loan. Generally speaking, larger down payments result in better rates and terms.
Collateral includes accounts receivable, inventory, equipment, personal residence and commercial real estate.
It can help a borrower secure a loan. It gives the lender the assurance that if the borrower defaults on the loan, the lender can repossess the collateral. Lenders view collateral-backed loans (also called secured loans) less risky. As a result, loans secured by some form of collateral are commonly offered with lower interest rates and better terms than unsecured forms of financing.
Conditions encompass factors both within and beyond the borrower’s control. Lenders need to understand the current condition of the market, the industry in which a business operates, the economic environment, how the borrower intends to use the money, interest rate, and the size of the loan. They also want to know how a borrower plans on using the funds from a loan and how the conditions could impact that use.
The conditions of the loan influence the lender’s desire to finance the borrower. The more specific you are in detailing how the funds will be used increases your chance for approval. Conditions that are outside of the borrower’s control, such as the state of the economy, industry trends or pending legislative changes, are also factored into their decision.
It’s important to know that if you want or need a commercial loan you will need to create a business plan that includes financial statements addressing the 5 Cs.
Christopher Himsl is a retired U.S. Army colonel who planned and resourced intelligence operations worldwide. He now helps business owners plan and resource their business. You an learn more about him at himslconsulting.com.