Business owners exploring financing options often wonder how lenders decide whether their business qualifies for a loan. Homebuyers know mortgage lenders look at credit scores and income-to-debt ratios when making decisions, but the process is not as straightforward when it comes to business financing options. The basics come down to what’s known as the Five Cs of credit.
When a business owner applies for a loan, the lender compares the company’s financial health to an established set of standards. Those standards and the factors measured vary by lender, but most can be categorized into the five Cs of Credit: capacity, character, collateral, capital, and conditions.
Capacity refers to the debt load a company can sustain. Lenders are evaluating if the borrower can repay the loan without hurting the profitability of the company. To determine this, a lender traditionally reviews cash flow/EBITDA ratio. EBITDA is an abbreviation for Earnings Before Interest, Taxes, Depreciation, and Amortization. It’s common for lenders to offer businesses credit based on a multiple of EBITDA.
Character also comes into play. While a loan is about cash and credit, the deal is being made between people. Lenders take the time to get to know clients to ensure the business, the owners and the leadership team are a good fit for the institution. Beyond the personal, lenders look at owner’s credit reports to help paint a picture of the potential borrower’s financial character. This evaluation gives insight into the trustworthiness of a borrower and the likelihood that they will repay the loan.
Collateral means the assets a borrower pledges to the lender to secure the loan. In case the borrower defaults, the lender can take those assets as repayment for the loan. A lender may order a business valuation. This number represents the business’s value, similar to an appraisal of a residential property or home. Traditional business lenders assess property and assets, such as equipment or inventory. Professional services companies may have cash flow and/or future commissions assessed as collateral.
Capital ratios are reviewed to be sure the loan does not put the borrow in an over leveraged position. The process looks at the equity the company has available. This gives lenders an estimate of how much the borrower is putting down to finance the assets or purchase and ensures a sound cash position post loan closing. Some lenders have down payment restrictions borrowers are required follow.
Conditions are the specifics of the loan and factors that may influence it. Lenders will consider the macroeconomic and geopolitical factors that may hinder a borrower or impact the terms of the loan. Today’s interest rates are a rapidly changing condition many lenders are monitoring as they may impact portfolios.
To assess the Five Cs of Credit, lenders will ask for several types of documents during the loan process.
- Financial statements for the past 2 to 3 years;
- Company tax returns for the past 2 years;
- Pro-forma financials that forecast the expected future revenue; and
- Personal financial statements that establish the financial character of stakeholders.
If you’re currently considering your company’s financing options, a sound first step is to have a conversation with potential lenders to understand how they make loan decisions, and which factors they consider. Use this outline as a guide for the conversation.
Lenders are eager to make loans to viable businesses. Understanding the factors lenders use helps potential borrowers to determine whether your company is likely to qualify and the loan size you can expect to support business growth. A strong relationship with potential lenders long before you need capital is an important first step to making your goals a reality.
Alicia Chandler is president of Indianapolis-based Oak Street Funding, a First Financial Bank company, with customized loan products and services for specialty lines of business including certified public accountants, registered investment advisors and insurance agents nationwide.