The 5 C’s of Credit: What Lenders Look For
Tricia has nearly two decades of experience in commercial and federal government lending. Her expertise is highlighted throughout small business loan content on Fit Small Business.
This article is part of a larger series on Business Financing.
Banks and lenders use the 5 C’s of credit analysis to determine a borrower’s risk and creditworthiness. Some create point systems for each category, while others consider the 5 C’s using their subjective judgment during the approval process. Although these characteristics are weighted differently from lender to lender, most use the same aspects to evaluate each category:
- 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 previous and current 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 evaluate your net worth and equity in comparison to your current debts 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 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.
Understanding the 5 C’s of credit and how they apply to a lender’s decision-making process will be helpful as you apply for a small business loan. The stronger your business looks as a borrower, the more likely it is to be approved for 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 personal credit scores is easy with a free service like that provided by Nav. If you use Bank of America for your business checking account, you can access your Dun & Bradstreet business credit score for free.
Character: Your Credit History & Background
When considering character, 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 such as payment history, liens, and credit utilization. Repayment history accounts for 35% of your personal credit score.
Beyond your credit, lenders may also look at your reputation, business or personal references, and how you’ve interacted with those references. For example, when applying for a Small Business Administration (SBA) loan, SBA Form 912 is required and helps the lender determine your eligibility based on reputation.
Capacity: Your Ability to Repay Debt
Capacity to repay debt is important since lenders want to ensure that your business has adequate cash flow to repay the new loan. Lenders generally will 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’ 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.
Calculating your DTI and DSCRs and reviewing your cash flow statements is an excellent way to measure and predict your borrowing capacity. Read our guide on the ways to solve cash flow problems if you need assistance.
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, 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 are as an individual or business. A lower ratio suggests you have minimal debts, so you’ll appear as a less risky borrower.
Additional ways that lenders evaluate capital include:
- Loan-to-value (LTV): This is a comparison of your loan amount to the appraised value of the asset you’re purchasing, such as a piece of equipment.
- 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
When evaluating your application, lenders want to understand the conditions that surround your business. Not every industry or business faces the same set of external conditions, so understanding the current market, the overall economic environment, and how the borrower looks to use the loan proceeds aids the lender in making a loan determination.
The conditions lenders consider for businesses include the:
- Current market
- Industry your business is in
- Current economic environment
- Interest rate of the loan
- Size of the loan
By evaluating these conditions, lenders 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 when collateral is required. However, if a lender doesn’t need collateral to support the transaction, it’ll 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.
Loans that are secured by collateral are considered less risky to the lender than unsecured loans. As a result, you’ll often receive better terms with secured loans—and it’ll be easier to qualify. Your business collateral can be inventory, equipment, accounts receivable, or any assets the lender can liquidate if you default on the loan. In some cases, a borrower’s home can serve as collateral and back the loan.
Before applying for a loan, read our guide on the loan requirements for small businesses. We included a checklist to help you ensure that your requirements are complete.
How To Improve Each C
The 5 C’s of credit are important for those applying for a loan and those who might consider applying for business financing in the future. Here are some ways that you can improve your standing within each of the 5 C’s of credit.
Character
Build your credit score and reputation: A good credit score for both the borrower and the business is incredibly helpful to show good character with managing money. To improve or maintain your credit scores and character you should
- Make your payments on time
- Avoid defaulting on your financial obligations
- Avoid bankruptcy
- Pay your taxes
- Prevent lawsuits
Capacity
Pay down your existing loans: 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.
Increase revenues: Another means of increasing your DSCR is by increasing your revenues. If you can show the lender that your projected revenues are increasing, this can help improve your capacity for borrowing.
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’ 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.
Bottom Line
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 these factors, how they’re weighted varies by lender and loan type. Ensuring that you pay your bills on time, have sufficient cash on hand to support repayment of debt, and have sufficient collateral to back your loan will help improve your chances of receiving the business loan you’re applying for.
