5 C's of Credit
Know What Lenders Look For
You can improve your chances of getting a business loan by learning the factors that are considered important to your lender. While the approval process can vary greatly based on loan type and the complexity of your business operations, the key criteria used to analyze a request are commonly referred to as the 5 C’s of Credit: Character, Capital, Capacity, Conditions and Collateral.
When applying for a business loan, we will consider your prior history with the repayment of both personal and business obligations. We will also assess your experience and track record in your business and industry to evaluate the likelihood of the continued success of your operations. At times and with your permission we may use your personal credit report as a way to understand how reliable you have been in repaying past loans. Your credit report is primarily a detailed list of your personal credit history, consisting of information provided by lenders that have extended credit to you. Credit reports typically provide a numeric score - usually between 300 and 850. Generally, the higher the score, the lower the perceived risk.
Capital is a measure of the borrower’s investment in the business or project. Capital can take the form of a cash contribution, retained earnings, or other assets pledged as collateral. While the appropriate or required amount of capital is often determined subjectively, bankers tend to look more favorably on a business loan request when the owner has made a tangible personal investment.
Capacity refers to a borrower’s ability to generate sufficient profitability and cash to permit the timely repayment of both the requested loan and any related debt. A commonly used calculation to assess profitability is referred to a “debt service coverage ratio” and is often defined as follows:
Net Profit after Taxes + Depreciation Expense + Amortization Expense + Interest Expense
Scheduled Principal Payments + Interest Expense
A result for the above ratio consistently greater than 1.0x suggests that the subject business is generating enough income to repay the debt. A number of other factors may also be considered including the source and anticipated stability of the income. Further, since the loan is to be repaid with cash the borrower’s ability to convert assets to cash is essential. Important factors may include the borrower’s history with the collection of receivables and/or the amount of time required to produce a marketable product. The most desirable means for MBT to assess capacity is by analyzing historical financial results. However; at times projected results may also provide an adequate basis to form a conclusion.
This is a measure of the overall economic environment and an evaluation of the financial health of the borrower’s industry, their local market, and competition. Bankers need to understand how the economic environment affects the company’s ability to repay loans. Your discussions with us about your business’s competitive environment is an important part of this analysis.
Lenders strongly prefer to have a secondary source of repayment to provide support in the event that the borrower is unable to repay the loan. This normally takes the form of collateral which are assets that are pledged to the bank. The value of the collateral will be evaluated with an emphasis on the anticipated market value of the assets. Collateral may not be required in cases where a borrower has relatively strong levels of capital, cash and/or historical cash flow performance.
By understanding the 5 C’s, you can do a little self-evaluation in order to better position yourself for a successful lending experience.