5csofcredit

The 5 Cs of credit, and what they mean to me

Sep 26, 2018
Jim Legare

With commercial loans, much of the “Old School” Lending analogies still apply.  The basics of how to make a decision on a commercial loan still fall under the time-tested 5 Cs of Credit.  Those Cs are: Capacity, Collateral, Character, Capital, and Conditions.

Capacity

Capacity measures a borrower's ability to repay a loan by comparing income against recurring debts and assessing the borrower's debt service coverage (DSCR) ratio. Basically, that is done by adding your company’s net income, depreciation, amortization, and interest expense to come up with your cash flow or “Earnings Before Interest, Taxes, Depreciation, and Amortization” (EBITDA) and dividing that by all of your businesses loan payments during the year.  Your financial institution may also add any new loan payments to see if your company would have been able to service your new debt obligations.  Financial institutions typically look for a DSCR of around 1.20:1. 

My tip:  If you have a year that there are extraordinary expenses, or if you purchased a significant amount of equipment or other assets that your accountant allows you to write-off in one year instead of capitalizing and just taking the depreciation, bring that to your lender’s attention, as it might be an additional item that they will add to your cash flow. 

Collateral

Collateral can help a borrower secure loans. It gives the lender the assurance that if the borrower defaults on the loan, the lender can repossess or foreclose on the collateral. The collateral’s ability to hold its value, and how easy it is for the financial institution to liquidate the collateral will determine how much they will lend against it. 

My tip:  Lenders have acceptable Loan-to-Value (LTV) Ratios that they’ll lend against a certain type of property.  Generally, it is 80% for real estate and equipment and less for accounts receivable and inventory.  However, your “equity” in a certain piece of collateral doesn’t begin until the LTV is lower than the acceptable amount. 

Character

Also called credit history, this C refers to a borrower's reputation or track record for repaying debts with your primary lending institution or with others. This information appears on the borrower's credit reports. Generated by the three major credit bureaus – Experian, TransUnion and Equifax – credit reports contain detailed information about how much an applicant has borrowed in the past and whether they have repaid their loans on time.

These reports also contain information on collection accounts, judgments, liens and bankruptcies, and they retain most information for seven years. The Fair Isaac Corporation (FICO) uses this information to create a credit score, a tool lenders use to get a quick snapshot of creditworthiness before looking at credit reports. For business loans, financial institutions may also look to Dunn & Bradstreet data to see how your business creditors report that they have been paid. 

My tip:  If your credit isn’t perfect, but you’ve paid your primary lender on time, start any loan requests with them, as the direct experience can sometimes outweigh some of the negatives that can pop-up on credit reports.  If your primary lender or financial institution cannot do business loans, ask for a referral.  Most people know others in the industry and can refer you to someone else that might be able to help you.

Capital

Lenders consider capital in two ways.  The first way is the funds a borrower puts toward a potential investment, because a large contribution by the borrower decreases the chance of default.  The second way is the net worth that a company and its owners show on their balance sheets.  Net worth is what would be left if you liquidated all assets and paid off all liabilities for an individual or company.  Having a net worth shows the lender that there is money put aside for a rainy day, or that unexpected catastrophe.  It also shows discipline on the company and its owners to save for the future.

My tip:  If you don’t have much personal or business capital, there are things that you can do to make a loan less risky for the lender such as: asking a seller to carry back a loan, borrowing funds from friends or relatives, looking to your city’s or region’s economic development groups for revolving loan programs, or considering a Small Business Administration guaranty. 

Conditions

Conditions can be seen two ways in business lending.  There are the economic conditions of a project, and there is the structure of the loan request.  For economic conditions, lenders look at things like how much competition there is in the industry, location of the project, management experience of the owners and managers in the company, and the condition of the economy.  Conditions also refers to the structure of the loan, such as, its interest rate and amount of principal as well as how a borrower intends to use the money. For example, if a borrower wants to purchase a car, but wants to amortize the loan over 10 years, there is a good chance that the value of that car will not keep up with the loan balance. 

My tip:  Lenders are willing to discuss conditions with you and generally have some wiggle-room.  It helps if you’ve done some homework to explain what is going on in the market and why your request is reasonable.  Remember, for business loans, it should be a 2-way discussion between you and your lender.  While you may not always be able to get everything that you want, you should be able to get what you need.

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