July 2018

The 5 C's of Credit and How They Impact Business Financing Decisions

The Five C’s of Credit and How They Impact Business Financing Decisions

July 30, 2018/in Credit, Manage Your Money/by Wil Rivera

If you’ve heard of the five C’s of credit, you may assume that this phrase is only associated with personal credit; however, it’s also a tool used by lenders to evaluate businesses pursuing credit options.

Here’s why the five C’s of credit are important to your business; how lenders evaluate each of them; and how to best position your business when applying for financing.

What are the 5 C’s of Credit?

The term “five C’s of credit” refers to one way in which lenders evaluate the credit-worthiness of an applicant. It can be used for individuals and couples applying for personal credit such as a loan, credit card or a mortgage. But, it’s also used to help assess the “worthiness” of business credit applicants.

Lenders review how well a business meets each of the five C’s, and then use their findings to help make a lending decision.

1. Character

Character refers to the likelihood that a business will pay back borrowed money. Information for the Character portion of the five C’s of credit often comes from the history noted on a business’ credit reports. It will also include the business credit score generated from these reports. Business credit reports come from business credit reporting agencies such as Dun & Bradstreet, Equifax, and Experian.

These detailed reports contain particulars of previous borrowing arrangements – including total amounts borrowed and repaid, as well as delinquencies and late payments. The reports also include details of judgments, liens, and accounts in collections going back through seven years.

2. Capacity

Capacity is your ability to pay back the money borrowed from the proceeds of your business. Before a lender gives a borrower any money, they’ll want some evidence that the borrower (being the business), generates enough money to make payments on the loan. So Capacity is the proof that the business has the cash flow to not only make the payments, but to also cover all the business expenses, other debts and obligations, and pay the wages of its employees.

To evaluate a business’ capacity, lenders will review the financial statements and financial ratios of the business, including:

Debt-to-Income Ratio (DTI)
Debt-Service-Coverage Ratio (DSCR)
Current Ratio
Debt-to-Tangible-Net-Worth Ratio
Inventory Turnover Ratio
Accounts Receivable Turnover Ratio (ART)
Payables Turnover Ratio
Cash Flow Statement
Income Statement

When it comes to evaluating business capacity, a lender may also consider your managerial capacity. This is your business knowledge and professional experience.

3. Collateral

Any lender faces the risk that borrowers won’t return the money they borrowed. So lenders look for ways to reduce that risk and secure their loan, which brings us to the third C of Credit: Collateral.

Collateral is any asset used as security for the lender. Lenders could seize secured business assets of value such as real estate, equipment, and machinery to sell and recoup some or all of the unpaid loan if the borrower can’t pay it off. For example, a business may get a loan secured against vehicles or a commercial building.

4. Capital

Another factor that influences lenders’ willingness to loan money to a business is the owner’s equity. How much of your own money have you invested in your business? Your “skin in the game” indicates your financial commitment to the business. This equity, referred to as capital, gives lenders an idea of just how risky the owners consider their own business. Generally, the more of your own money invested, the better it is in the eyes of a lender.

5. Conditions

The fifth C of credit is one that you have little control over, yet it also influences business lending decisions. The current macroeconomic and microeconomic conditions could impact a business’ ability to pay back a loan. So lenders carefully consider the economic environment as part of a lending decision.

Demonstrate that you have a good understanding of current (and forecasted) economic conditions, and how they’ll potentially impact your business by referencing them in your discussions and correspondence with your lender. This shows lenders you’re a forward-thinking and responsible business owner who is committed to growing your business through changing economic conditions.

Once you know about each of the 5 C’s of credit, you can better understand how lenders use them to make lending decisions for businesses. And you’ll have a better idea of what to watch out for, and what to work on when making financial decisions for your own business.

That “Cheap” Business Finance Rate Could Cost You a Bundle: Interest and Your Business

July 17, 2018/in Financing, Manage Your Money/by Wil Rivera

The last decade has been an era of cheap money for businesses, with interest rates at historical lows. But those days may be ending. How you look at financing — in particular choosing between fixed and adjustable rates — may have to change.

These are the good old days.

Access to capital can often make or break a business. Each year, fifty-three percent of business owners kick in additional funding, according to the Small Business Administration. Almost a quarter add more than $50,000.

The adage that it takes money to make money is fine — if you have the cash on hand. If you don’t, it’s time to look at outside financing. But that may take some unlearning of recent lessons.

The global economic collapse beginning in 2008 was brutal, but it did have one benefit for some businesses: Because the U.S. Federal Reserve and other regulators slashed interest rates to stimulate buying, over the last decade the cost of money has been incredibly low.

Businesses who were approved for traditional forms of financing had enviable choices, including taking adjustable rates over fixed ones to keep borrowing costs down.

The Two Types of Interest Rates

A quick refresher: whether talking consumer or business financing, there are two general types of interest rates: fixed or variable.

A fixed rate is just that; the borrower pays a set interest percentage of the principal. Monthly payments don’t change.

Variable rates start at one rate. After some time, they shift to an amount based on any one of several common benchmark rates.

The Fed’s federal funds rate is one example of a benchmark rate. So is the prime rate, which is based on the federal funds rate, and is often what a bank’s best customers get. Another benchmark is the London Interbank Overnight Rate (Libor) — the rates banks charge one another on short-term borrowing.

The variable financing rate will be some number of percentage points over a benchmark rate. When the benchmark goes up, so will the variable rate. If the benchmark drops, the variable rate does as well.

Most people are familiar with variable rates from mortgages and credit cards. They are common in small business financing as well.

Variable Rates Have Been Low

In the past, business owners chose variable rates that were initially low. The idea was that when the rate increased, either revenues would have grown enough to more than offset it or refinancing at a lower rate would eliminate the extra costs.

For the last decade, however, variable rates have acted strangely. Because benchmarks were so low, you could effectively get a great rate for the life of the financing. There was always the gamble that the rate would climb, but in hindsight, for years you could win the game. Variable became almost the same as fixed.

No longer. By June 2018, the Fed had increased the federal funds rate seven times in three years.

As job growth remains brisk and the economy improves, regulators could keep increasing their rates, making all the benchmarks increase. Variable rates will follow, making the era of super-cheap money over. Opting for a variable rate instead of a fixed rate could now cost you.

Create a Financing Strategy

If you’re looking for financing, you’re best off doing some calculations in advance to see how a variable and a fixed rate might compare. Consider that a variable rate loan might increase a couple of times during the life of the financing:

Look at how much the Fed has raised the key interest rate over the previous 12 months and assume for a moment that the increases will continue in the near future, given how low rates have been.
Calculate the full principal, the length of the business loan, and the initial rate. Then use an amortization schedule to calculate how much you pay in the first year.
For the second year, calculate with an increased interest rate (initial rate plus the last 12-month increased in a benchmark) and the remaining financing time. Use an amortization schedule to calculate how much is paid in the second year.
Keep doing this for at least one or two more years with benchmark increases.
Finally, calculate the remaining principle, time left on financing, and the “final” interest rate. (Remember that this is an estimate and there might be additional rate increases.)
Add the payments over all the years and compare that to what you’d pay with available fixed rates.

You might choose to run estimates for different numbers and amounts of rate increases. This modeling can help you manage risk and choose an option that works for your business.

Borrowing and Business: What You Don’t Know Can Hurt Your Finances

July 13, 2018/in Financing, Manage Your Money/by Wil Rivera

So, you’re feeling confident enough about your business to go shopping for a loan. Congratulations! But before you start looking you should understand these five important areas impacting loans, beginning with the difference between interest rates and APR.

What is APR?

APR is the annualized percentage rate, which measures the cost of borrowing money. It includes the total cost for the loan including covering all fees that the lender might charge.

By looking at the APR, you can objectively compare the costs of loans from different banks. That’s entirely different from looking at the headline interest rates that sometimes get advertised. Such headline rates frequently don’t include all the fees that you must pay to get the loan.

In short, if you looked only at the headline interest rates, then you might think you got a good deal when in reality you didn’t.

Always ask the loan officer for the APR in any loan. If they won’t provide it, then choose another bank.

LIBOR and interest rates.

The cost of a lot of business credit moves up and down in line with something called LIBOR, the London Interbank Offered Rate, which is an interest rate charged by banks to lend to other banks.

When the banks see little risk of lending to each other, then the LIBOR will be lower than it would be otherwise. When they see heightened risk of lending to each other, then the LIBOR typically rises as it did during the financial crisis.

Commercial businesses typically pay a fixed amount above the LIBOR for the duration of the business loan, see the Small Business Administration website for examples. The prime rate, which is a common benchmark lending rate for both commercial and consumer loans, is usually between 2.5 and 3.5 percentage points higher than the LIBOR rate, according to the FinAid website.

The LIBOR is also partly determined by decisions made by the Federal Reserve, which is a target interest rate for short-term overnight loans between banks. When that rate changes you can usually expect the LIBOR rate to change as well. In the simplest terms, if the Fed Funds rate rises then you should expect LIBOR to increase.

Recently, the Fed has been transparent about likely future changes in Fed Funds rates. If you regularly read the business press, you’ll be aware of most likely future changes in the costs of borrowing.

Fixed versus floating interest rates.

Not all business loans have interest rates which vary. Some have a fixed rate for the term of the loan. Such loans reduce the uncertainty about what would happen to the company’s profitability due to changes in short-term interest rates.

The cost of these loans is typically far higher than for variable rate loans. That’s because the bank takes on the risk of the interest rates changing over the term of the loan.

When a company purchases a long-lived asset, such as a factory building, it can make sense to seek out a fixed rate loan. That’s similar to seeking out a fixed rate home loan mortgage. Often, purchasing a building is a major expense and the predictability of the same monthly payment can help managers plan better for the future.

On the other hand, working capital typically gets funded through credit lines with variable rates of interest. That makes a lot of sense. When times are lean in business, then interest rates are lower and so are working capital needs. Conversely, when the economy is expanding, then although the cost of borrowing is usually higher, so is the demand for goods and services.

Sensitivity and the cost of borrowing.

Before you take out a loan, you need to understand what would happen to your profitability if the cost of borrowing increased.

For instance, if the cost of borrowing is $5,000 a month in interest and your company still would likely be profitable, then that is a good start. But then you also need to know if the business would remain in profit if the cost of borrowing increased. For instance, what would happen it the interest expense was half as much again, or $7,500 a month. Making theoretical changes and then calculating the likely outcomes is known assensitivity analysis. It is something that your Chief Financial Officer or accountant should be capable of doing.

If a change in interest rates of relatively small magnitude would vastly reduce profitability, then you might want to consider a smaller loan.

Likewise, when you conduct the interest rate sensitivity analysis, you may want to consider what would happen to the earnings if revenue fluctuated when the company also had a new loan. If even a small dip in sales would cause the company to lose money then perhaps it would make sense to be cautious by reducing the possible size of the loan.

Wall Street Prep has some useful tips on running sensitivity analysis.

Derivatives and interest rates.

Interest-rate derivatives exist to help companies guard against changes in the cost of borrowing. Rather like knives, when appropriately used, they can be a useful tool. However, when wielded incorrectly they can be harmful.

So-called interest rate swaps can be used to convert a variable rate loan to a fixed rate loan, and vice versa. These products can be useful, but the customers should have a high level of sophistication.

Unfortunately, in the United Kingdom, some banks inappropriately sold small businesses some of these products. That eventually led to losses by some buyers of these derivatives. Given that many of the people selling these swaps hold higher-level finance degrees it is frequently the case that the buyers are far less sophisticated than those selling the products.

Two things to take away from this episode. First, if you have any doubts that you truly understand the product then don’t buy it. Second, just because these problems occurred in the U.K. don’t think they couldn’t happen in the U.S.