The Five Cs of Credit

"The five Cs of Credit" - What do lenders look for in a loan package? You, the borrower, provide part of the information, but the potential lenders will also use their own credit files and outside sources. A traditional, time-tested checklist is the five Cs of credit: character, capacity, collateral, conditions and capital. By understanding each of these from the lender’s viewpoint, you can anticipate your strong and weak points as they may appear to a potential lender.

1. Character - To the potential lender, character means that you will make every possible effort to repay the loan. You must be a good manager, be honest, and have a good reputation as perceived by the lender. Therefore, it is important to be honest about your personal strengths and weaknesses.

2. Capacity - Will your new business generate the cash flow to repay the loan? Do you have the capacity to repay the loan? Lenders not only look at the business’s financial projections, but also your ability to repay the loan if the business does not work out as planned. Do you have outside income (investments, a working spouse)? Would you be able to return to your present job? Do you have other skills that could produce income? Be prepared to provide solid answers to these questions and be able to offer real evidence.

3. Collateral - In case the new venture is not successful and the lender must foreclose, will the collateral cover the loan? Is the collateral adequately insured? Is the collateral marketable? In the past, a co-signer (someone who signs the loan along with you) has been used as collateral for many small business ventures. However, banks and traditional lending institutions now look less favorably at co-signers as collateral. Collecting from co-signers is becoming increasingly hard, and bankers then lose not one, but two customers. You can use your home or other real estate, cash value of life insurance policies or marketable securities as collateral for business loans. However, before borrowing against these items, consider carefully the consequences of the worst possible situation in your business if you are forced to liquidate.

4. Conditions - Conditions are those factors over which you have little or no control. The lender will look at the conditions, or trends, in the overall business economy, the trends in your community, the seasonal character of your business, and the nature of your product or service. Other factors entering the decision-making process are whether the lender may have already invested in a competing business and how much competition there is in your market. Be prepared to tell the lender how you plan to deal with these conditions, how you have assessed the market, and how your business will weather economic changes.

5. Capital - Knowledgeable lenders will not put money into a new business unless they have concrete evidence that you have personally made a sizable financial commitment to the business. They know from experience that if the venture turns bad it will be easier for you to back out if you do not have your own money at risk. From your personal resources, you should try to provide as much of the needed capital as you can afford to put at risk. Depending on the capital needs, you cannot expect any lender to loan 80 percent or more of the capital, as they may for a home or investment real estate. New small businesses fail at a rapid rate and when they do fail, the assets cannot be easily turned into cash for payment of the loan. Therefore, a new business is a much higher risk for them than a home loan. You should expect to invest a much higher percentage of the needed capital for your new business.

Types of capital - Different types of small businesses require different amounts and types of capital to get started. In some cases, the new businesses may only need capital for short periods of time for inventory purchases or salaries. In other cases, facilities and equipment must be bought or leased, inventory purchased, and you must have enough cash left over to run the business until revenue can support the needed cash flow. Knowing the type and amounts of capital needed will help you figure out the best source of capital for your new venture.

Equity versus debt capital - If you do not have enough personal capital, you can sell equity or you can incur debt. If shares of equity are sold in a partnership or corporation, the capital is not repaid, but the investor takes an ownership interest in the business and receives a portion of the business’ profits. Even though equity capital does not burden a new business with loan repayments and interest charges, it reduces the primary owner’s share of the profits. Debt must be repaid with interest, but normally the lender has no ownership control. Borrowing money at the very start of a new business will drain off income to make the debt payments.

Commercial loans - There are three types of commercial loans that are usually defined in terms of the length of time the loan is made.

• Short-term commercial loans (30 to 90 days) are the most common loans made to a small business. They usually cover business operation expenses such as rent, insurance, advertising, inventory or salaries. Short-term loans are often unsecured and repayment is usually a lump sum, including interest when the loan matures.
• Intermediate-term loans are for one to five years to purchase business equipment, buy fixed assets or provide working capital. Intermediate-term loans are usually secured by the new equipment or business assets. They sometimes have low monthly payments, with a large balloon payment at the end of the term.
• A long-term commercial loan is for five years or more to purchase an existing business, buy real estate, or construct or improve a building or facility. The long-term loan is always secured by the assets for which the loan was made, usually requires constant monthly payments and often has a variable interest rate.