The 5 C’s of Credit When Applying for a Loan
When you apply for a loan, the lender will evaluate your request in order to determine whether or not it is a good decision to lend you and your business money. A common evaluation framework is the Five C’s of Credit: capacity, capital, collateral, conditions and character.
Capacity refers to your ability to meet the loan payments. The prospective lender will want to know exactly how you intend to repay the loan. The lender will consider the cash flow from the business, the timing of repayment, and the probability of successful repayment of the loan. Lenders will also consider payment history as an indicator of future payment potential. For example, if you have a history of not paying back loans then it becomes more difficult to obtain additional loans.
Capital is the money invested in the business and is an indicator of how much is at risk should the business fail. Lenders will generally consider the company's debt-to-equity ratio to understand how much money the lender is being asked to lend (debt) in relation to how much the owners have invested (equity). A high debt-to-equity ratio also indicates that the company already has a high level of loans and could be a higher financial risk.
Collateral is a form of security for the lender. Banks usually require collateral as a type of insurance in case you cannot repay the loan. If you default on the loan, then the lender takes possession of the collateral in place of the debt. The loan agreement should carefully specify all items serving as collateral. Equipment, buildings, accounts receivable, and inventory are all potential forms of collateral. A lender will normally want the term of the loan to match the useful life of the asset used as collateral. For example, if equipment with a five-year expected life span is used as collateral, then the term of the loan will generally be five years or less. In some cases, the lender may ask for a third-party guarantee where someone else signs a document promising to repay the loan if you cannot.
Conditions refer to the intended purpose of the loan, for example working capital, additional equipment, or new offices. The size of loan in relation to the specific use will help the lender evaluate your loan request. Conditions also include the national, industry level, and local economic situation. A volatile or unstable economic situation can negatively impact the evaluation. However, positive expectations can increase the likelihood of obtaining the loan.
Character is the obligation that a borrower feels to repay the loan. Since there is not an accurate way to judge character, the lender will decide subjectively whether or not you are sufficiently trustworthy to repay the loan. The lender will investigate your payment history, review a credit bureau report, and consider your educational background and experience in business. The quality of your references and the background and experience of your employees will also be considered.