This article is part of a larger series on Business Financing.
Most lenders incorporate the 5 C’s of credit to understand how likely you’re to repay your debt. The five C’s of credit are:
- Character: This measures your reliability and trustworthiness as a borrower. Generally, lenders will evaluate your credit score, credit history, and how you’ve handled your debt obligations.
- Capacity: This considers your level of cash flow and measures your ability to repay your debt. Banks and lenders are looking to see if potential borrowers have enough cash to pay back what they borrow.
- Capital: Lenders look at your level of debt and use your net worth and equity to gauge your access to capital. The more equity and less overall debt you have, the better.
- Conditions: Lenders factor in the current economic condition of the industry in which a business operates as well as how the borrower intends to use the money. They also want to know how a borrower plans on using loan proceeds.
- Collateral: This is defined as the business and personal assets you can pledge to back the loan. For loans that don’t require collateral, such as an unsecured loan, the other four characteristics will have a higher level of importance.
Knowing each of the five C’s of credit and how they apply to a lender’s decision-making process will be helpful as you consider or apply for a loan. The stronger you look as a borrower, the more likely your business will get a loan. 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 credit scores is easy with a free service like that provided by Nav.
How Lenders Use the 5 C’s of Credit
Banks and lenders use the five C’s of credit to determine a borrower’s risk and creditworthiness. Some lenders create point systems for each category, while others consider the 5 C’s of credit using their judgment during the approval process. Although these characteristics are weighted differently from lender to lender, most use the same aspects to evaluate each category.
Lenders use information, such as your credit history, DTI ratio, DSCR, cash flow statements, equity, industry factors, and personal assets to qualify businesses for SBA loans or individuals for personal loans. Small business owners looking to apply for an SBA loan, individuals applying for a traditional loan, credit card applicants, and those that want to maintain good creditworthiness should keep the five C’s of credit in mind.
Character: Your History & Background
Lenders are generally risk-averse and hesitant to lend money to borrowers with poor credit history or reputation. When banks and lenders consider character and the five C’s of credit, they look at your personal and business credit history, and they might also look at your reputation.
Lenders analyze both your personal and business credit scores as they’re a reflection of your borrowing history. These scores are also a part of both your personal and business credit reports, which show factors like payment history, liens, and credit utilization. 35% of your personal credit score is based on repayment history.
Beyond your credit, lenders may also look at your reputation, business or personal references, and how you’ve interacted with those references. SBA Form 912 is required for all SBA loans and helps determine a borrower’s eligibility based on reputation.
Capacity: Your Ability to Repay Debt
Capacity to repay debt is important since lenders want to make their money back, plus some interest. Lenders generally will evaluate your capacity through these three measurements:
- Debt-to-income (DTI) ratio: 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 business cash flow statements, to analyze the level of excess funds available to repay any debt obligations.
Monitoring your DTI, DSCR, and cash flow statements are an excellent way to master your borrowing capacity.
Capital: What You Owe vs What You Own
Debt to net worth (or debt to equity) is one ratio used to measure capital for both individuals and businesses. Net worth is defined as the value of all non-financial and financial assets. To calculate your net worth as an individual or business, subtract your total liabilities (what you owe) from your total assets (what you own), including your investments. Your debt to net worth shows how financially stable you’re as an individual or business. A lower ratio suggests you have minimal debts, and you’ll appear as a less risky borrower.
Some other ways banks may look at the capital you’re investing are:
- Loan-to-value (LTV): This is a comparison of your loan amount to the appraised value of the asset you’re purchasing (e.g., a home).
- 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—typical down payments are around 20%.
Conditions: Market, Economic, Industry & Other Factors
Lenders want to understand the conditions that surround a potential borrower. Given not every industry or business faces the same set of conditions, learning about the overall economic environment and how the borrower looks to use their funds after approval helps. The conditions banks and lenders consider for individuals versus businesses are:
- Individuals: How a borrower plans on using the funds, economic factors, interest rate, and the size of the loan
- Businesses: Market, the business’s industry, economic environment, interest rate, and the size of the loan.
“On the business side, conditions are typically the things within your industry that are outside of your control. They include industry trends, inflation, tax cuts or increases, and cost of shipping, transportation, and freight. When banks look at the conditions they ask, ‘What are the trends of the economy?’, ‘Are people buying more or borrowing less?’, ‘What’s happening in the market?’, and ‘Are the trends in your industry increasing or decreasing?’
“We are not necessarily making this judgment ourselves, but instead, we use a third party, such as an industry analyst, to pull a report that shows trends and projections. This report tells us where your company fits in that industry as a whole.”
—Gary Gomulinski, Executive Vice President, Alpine Bank
These conditions allow banks and lenders to ensure that risks are identified and mitigated. While it can be challenging to identify each lender’s process, they often compare how you’re doing relative to your competition.
Collateral: Available Assets for the Lender
Lenders will always take collateral into consideration for secured loans where it’s necessary. However, if a lender or creditor doesn’t require collateral to support the transaction, they will likely value other characteristics more and require other offsetting factors. They may require a higher credit score, better cash flow, lower leverage, a lower loan amount, or a higher interest rate to offset a lack of collateral.
Loans that are secured by collateral are considered less risky than unsecured loans. As a result, you’ll often find better terms with secured loans, and it’ll be easier to qualify. Your business collateral can be inventory, equipment, accounts receivable, and any assets your lender can liquidate if you default on the transaction. A borrower’s home can also serve as collateral and back the loan.
How to Improve Each C
The five C’s are important for those applying for a loan and those who might consider applying in the future. Improving and mastering the 5 C’s of credit analysis will help you immeasurably. Here are some ways that you can improve your standing with each of the 5 C’s of credit:
- Character—Build your credit score & reputation: A good credit score for both the borrower and the business is incredibly helpful to show good character with managing money. Some things that go into your credit scores include timely payments, avoiding defaults on your obligations, avoiding bankruptcy, preventing lawsuits, and paying your taxes.
- Capacity—Pay down your existing loans: By focusing on reducing your debts, you can lower your debt-to-income ratio and increase your DSCR. This will improve your capacity to repay any future lending obligations.
- Capital—Use some of your own cash: Individuals should monitor their levels of personal debt. Business owners can invest some of their personal equity into their business 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.
- Conditions—Plan carefully: 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 doesn’t hurt to utilize 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: If you can’t provide enough collateral, consider an unsecured business loan. Before getting an unsecured loan, make sure 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.
The five C’s of credit are character, capacity, capital, conditions, and collateral. An analysis of these factors helps lenders determine if you’re a reliable borrower. Although most lenders consider all of these factors, how they are weighted varies. Ensuring that you pay your bills on time, have sufficient cash on hand to support repayment of debt, and have the collateral to support what you wish to borrow will help prove a strong case to any borrower that you’re qualified for funding.