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.
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.
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.
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.
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.
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.