The 5 C’s of Credit: A Beginner’s Guide

The 5 C’s are used by lenders to evaluate potential risk when determining a borrower’s creditworthiness and ability to repay a loan. Each lender has their methods of valuing each category and uses their judgment during the approval process before extending financing.

Key Takeaways

The 5 C’s act as a decisioning model to assist with determining financing eligibility.
There are various methods to improve upon each C to increase your chances of approval.
Evaluation of the 5 C’s is not a regulated requirement, but rather general categories of consideration for lenders.

The 5 C’s of credit are as follows:

Character: This demonstrates your reliability and creditworthiness as a borrower. Lenders take into account whether your business has a good track record of repayment and an overall reputation. Factors considered include credit score, business history, references, and previous debt obligations.
Capacity: This determines your ability to repay debt based on your available resources. When extending financing opportunities, lenders will want to ensure you have enough cash flow to meet repayment expectations or cover any losses in the event of default.
Capital: Lenders evaluate your net worth and equity in comparison to your current debts to gauge your access to capital. Depending on the amount of money you’ve invested in your business, lenders may consider your current capital involvement, as it reduces the risk of default.
Conditions: Current economic conditions can impact business operations, and lenders will evaluate how viable the market your business resides in is. Alongside analyzing market trends, lenders will also want to know how the loan proceeds will be used.
Collateral: This represents how the loan will be secured. Whether it be via business or personal assets, collateral is required by a lender in some cases where the loan needs a backup source of repayment in the event of default.

Both your personal and business credit scores often play an important role in a lender’s evaluation of your overall creditworthiness. Staying on top of your personal credit scores is easy with a free service, and we recommend you check out Nav for that. If you use Bank of America for business checking, you can access your Dun & Bradstreet business credit score for free; visit Bank of America.

Character: Your Credit History & Background

The character of a borrower paints a picture of a lender regarding their business’s reputation and credit history. When evaluating your character, lenders will take business financials, credit scores, and references into consideration.

This allows them to see your repayment reliability and analyze the likelihood that you’ll able to repay your loans on time and in full. Overall, lenders are valuing your borrowing reputation—inclusive of current and prior debt obligations—and business transaction history.

When considering character, lenders analyze your personal and business credit scores, as they reflect your borrowing history. These scores are also a part of both your personal and business credit reports, which show factors such as payment history, liens, and credit utilization. Repayment history accounts for 35% of your personal credit score.

Capacity: Your Resources & Ability to Repay Debt

Lenders will want to ensure you have the resources available to repay your debt obligations. They’ll evaluate your current capacity and take your cash flow, net worth, and assets into consideration. Lenders will generally evaluate your capacity through these three measurements:

Debt-to-income ratio (DTI): This is a measurement used for individuals that evaluates the percentage of your monthly debt obligations and your monthly gross income. The lower your DTI ratio, the more willing a lender will be to lend you money.
Debt Service Coverage Ratio (DSCR): This measures your business’s ability to repay debt by dividing your net operating income by your total debt and interest payments. Lenders generally use this to evaluate your capacity because it shows if your business is generating enough income to pay its debt.
Level of excess cash flow: Lenders use your financial statements, such as a cash flow statement, to analyze the level of excess funds available to repay any debt obligations.

Read our guide on the ways to solve cash flow problems if you need assistance.

Capital: What You Owe vs What You Own

Borrowers who have contributed capital to their businesses are less likely to be subject to default, given their personal investment in the business. Since this helps to mitigate risk, lenders consider capital injections when determining rates and terms of financing options that may be presented to you.

Keep in mind that there are a few valuation calculations they use to measure capital. These include:

Debt–to–net worth (or debt–to–equity): Lenders will want to know if your current debts outweigh your total net worth. Net worth is the total value of all financial assets, minus current liabilities. To calculate net worth, add your total owned assets (including investments) and subtract any outstanding debt obligations.
Loan-to-value (LTV):LTV calculations are used by lenders to compare the appraised value of the asset you’re purchasing (e.g., real estate, equipment, etc.) to your requested loan amount.
Down payment percentage: The amount of money you’re bringing as a down payment can be calculated as a percentage if you divide it by the total loan amount—typically, you can expect a lender to require a down payment equal to 20% of the purchase price.

Conditions: Market, Economic, Industry & Other Factors

Lenders will evaluate the various conditions in which your business operates. This includes the economic environment, market trends, industry factors, or other external conditions that can impact your business. Understanding the current fit of your business within these factors and how loan proceeds will be used allows lenders to make an educated decision as to how you’ll fare in various economic conditions.

That being said, the overall condition of your business is also taken into account when evaluating your application, as your growth projections (both positive and negative) will help determine the terms of your loan.Some conditions lenders will consider when evaluating your eligibility for financing include the following:

Current market trends
Current economic environment
Industry-specific business needs
Intention of loan proceeds
Growth projections and stability
Current interest rates
Requested loan amount

By evaluating various conditions, lenders can make an approval decision based on potential risk and identify how a business fares in comparison to the competition. In mitigating these elements, lenders may be more willing to provide capital to fund your business.

Collateral: Available Assets to Secure a Loan

When a loan is subject to being secured, collateral is evaluated and determined by the lender to support the transaction. Generally, the collateral offered is the asset being acquired—whether it be a real estate property, piece of equipment, inventory, or any type of asset that can be liquidated.

While collateral isn’t always necessary to facilitate a loan, it helps mitigate the risks to the lender in the event of default. If you are unable to repay the loan, the lender can seize the asset and try to make up for the loss.

In turn, secured loans often have more favorable rates and terms and are typically easier to qualify for since they are deemed to have fewer risks. However, if a lender doesn’t need collateral to support the transaction, it will likely value other characteristics more, such as a higher credit score, better cash flow, lower leverage, a lower loan amount, or a higher interest rate to offset a lack of collateral.

Understanding the 5 C’s of credit and how they apply to a lender’s decision-making process will be helpful as you get a small business loan. The stronger your business looks as a borrower, the more likely it is to be approved for a loan. Before applying, read our guide on the loan requirements for small businesses.

How to Improve Each C

For businesses that may need to improve upon the various C’s, there are a few actionable items to help borrowers apply for business financing. Here are some ways that you can refine the 5 C’s:

Character

Work on building your credit history and reputation: Both personal and business creditworthiness will impact a lender’s decision, so you’ll need to demonstrate that you’re a responsible and trustworthy borrower. Good credit scores can go a long way, so should you need to improve yours, there are a few steps you can take:

Make your payments on time and in full
Avoid defaulting on your financial obligations
Manage your finances (invoices, payments to vendors, etc.)
Avoid bankruptcy
Pay your taxes
Prevent lawsuits
Monitor your credit reports

Capacity

Pay down your existing debts: By focusing on reducing your debts, you can lower your DTI ratio and increase your DSCR. This will improve your capacity to repay any future lending obligations and give you a better shot at obtaining financing.

Increase revenues:You can also increase your DSCR by demonstrating your ability to increase revenue. If lenders can see that you can positively impact your cash flow and keep up with growth, they’re more likely to extend financing opportunities.

Capital

Use some of your own cash: Individuals should monitor their levels of personal debt. Business owners can invest some of their personal equity in their businesses to help improve the business’s equity position. Individuals and business owners can use their capital as an indicator of the amount of financial leverage they have.

Consider the timing of your financing request: Capital availability can fluctuate over time, and it’s best to request financing when you’re in the best financial position you possibly can be. That said, depending on the needs of your business, consider the timing in which you need the funds. If you’re making a large purchase necessary to operate, you may need to act immediately. If you can wait until you have more capital resources, you may be able to delay your purchase and get more favorable financing later on.

Conditions

Plan carefully and be prepared: While you can’t control the economy or your industry, you can keep tabs on your competitors and adapt to changing business conditions as appropriate. It does not hurt to use outside resources such as SCORE or the Small Business Development Center (SBDC), both of whom counsel businesses and provide additional analysis and support.

Collateral

Consider what collateral you can pledge: Depending on the loan type, you should consider what assets you have that can act as collateral. If you can’t provide enough collateral, consider one of the best unsecured business loans. Before getting an unsecured loan, ensure you can pay it off in a reasonable amount of time. If not, create a financial plan and wait until you have enough collateral to support the loan.

Frequently Asked Questions (FAQs)

No, but having all five in good standing does significantly increase your chances of approval. Lenders will take a variety of factors into account when issuing a lending decision, and the 5 C’s are baseline points, not a requirement, to help them make that judgment.

A lender may request certain information that outlines these points, including business and personal financials, references, a business plan, and a credit score report.

The 5 C’s are tied to your business’s reputation and can impact your financing eligibility.

By actively improving your awareness of how your business operates around the 5 C’s, you can gain a track record through credibility and reliability and increase your chances of approval.

Bottom Line

The five C’s of credit are character, capacity, capital, conditions, and collateral. Lenders use these categories to evaluate the creditworthiness of a borrower and to mitigate the risk posed by a variety of factors.

Each is weighted differently depending on the lender, and they play an important part in obtaining financing options for your business and paint a picture for the lender regarding your overall reliability. By ensuring that you’re a worthwhile borrower who can make payments on time, has sufficient resources, and poses little risk, lenders are more likely to help you finance your business.

About the Author

Lauren McKinley