What are the 5 C’s? And why do they matter for your business?
The 5 C’s of credit are: Character, Capacity, Capital, Collateral and Conditions. Banks use the 5 C’s to gauge the creditworthiness of a business looking for financing. All of these characteristics are considered in an attempt to evaluate the possibility that the loan might default.
As a potential borrower, business owners need to understand how these characteristics of their business could affect future loan opportunities. How does your business score with the 5 C’s?
Character refers to a business’ credit history and trustworthiness – including their track record for what they have borrowed in the past and how well they have paid it back. Banks want to lend to businesses who keep their commitments. Character also involves a borrower’s past experience in this type of business and their understanding of the market potential for their business. How can you improve your business’ character? Show your aptitude to manage debt, an understanding of the basics of financial management, and demonstrate your ability to live a disciplined life. In evaluating loan requests, a judgment of the character of the borrower may be the most important factor in the decision.
Capacity is the ability of a business to repay their loan. Does your business generate enough cash flow to cover your debt payments? Banks judge capacity by considering repayment history, debt and liquidity ratios, current and future cash flow. To better understand your capacity, calculate your business’ cash flow so you know how much debt you can comfortably handle. When discussing capacity with your banker, be sure to show that a profitable market exists for your product or service.
Capital refers to the resources a business has to cover their potential loan and includes the ability to withstand unforeseen changes the business may face in the future. When considering your capital, take a look at all debt – not just business related debt. If you or your business is overly leveraged, you will have a harder time enduring unexpected hardships. Consider investing your own money, to show a bank that you are taking on a portion of the financial risk as well. Banks are more willing to lend to business when you have “skin in the game.”
Conditions affecting the loan (and the business’ ability to repay it) include the landscape of the local, state, and national economy, industry trends, and pending legislation that could affect your business. Although often outside a business’ control, these conditions can affect your ability to pay back a loan. Banks will review your business plan and test your projections and assumptions to see how well you’ve researched your industry risks and how you’re prepared to handle economic downturns.
Collateral represents assets that act as a backup source of funding to help you repay your loan. Assets can include real estate, equipment, inventory and even your home. While this factor is significant, it is often the least important of the five C’s of Credit.
As a bonus to the five C’s of credit, banks will often consider common sense as a sixth C! Does the project and your strategy make sense? Are you making sound and prudent judgments and assumptions? This is often presented in your business plan, but more importantly in your conversations with your banker. Work with a local bank that cares about relationships. By working with a local, community bank, you’re building relationships with a lender that lives right in your community that wants to help your business succeed.