Running a business requires a lot of capital. Many companies need to apply for outside financing for one reason or another – be it keeping up with daily expenses, updating equipment or using it for something bigger, like expansion. Qualifying for a loan as a small business owner presents its own set of challenges, so how can you strengthen your chances for approval?
Small businesses seeking funding can improve their odds of receiving approval if they meet the qualifications that lenders have set in place. One method that many lenders use in assessing their applicants' creditworthiness, and thus the level of risk in lending to them, is the five C's of credit. This method evaluates these five factors:
- Character
- Capacity
- Capital
- Collateral
- Conditions
Knowing what the five C's of credit are, and how financing companies measure each, can give you a better understanding of how you can put your business in a stronger position for loan approvals.
The 5 C's defined
Lenders put themselves at a risk when they lend money to individuals and small businesses. Assessing the five C's of credit allows lenders to evaluate whether an applicant is worth that risk. Some lenders may also base the terms of the funding they provide on the information they get from evaluating the five C's.
Here's how lenders evaluate risk and qualifications through the 5 C's:
1. Character
Lenders look at an applicant's character to assess his or her trustworthiness and responsibility when it comes to handling debts and repayments. They want to determine if they can rely on you to make your repayments to them on time.
Lenders assess a loan applicant's character by looking at their credit history, which they can easily obtain through the credit bureaus (Equifax, Experian and TransUnion). Your credit report contains pertinent information about your financial track record and tells lenders whether you've been paying your debts on time, have a history of loan defaults or had any bankruptcies in the past 10 years. Credit reports also contain your credit score, which is a direct reflection of your creditworthiness. In some instances, lenders may reach out to your references to evaluate your reputation.
You can improve your character by paying bills on time. Missing even a single payment can result in a drop in your credit score. It's also helpful to check your credit reports for mistakes and inaccuracies every now and then. If you find errors, call the credit bureaus immediately.
2. Capacity
Whereas character assesses if an applicant would pay their loan back, capacity assesses whether or not they can. In this case, the financing company checks the business's financial statements to make sure the business has enough to make the payments should it get approval for the business loan.
When assessing the business's capacity, lenders look at your debt-to-income (DTI) ratio, which is a measurement of your business's monthly income versus debt payments. A low DTI ratio increases your chance of getting approval for the business loan. As a good rule of thumb, banks consider businesses with less than a 36% DTI ratio to be a good candidate. Lenders will also look at the business's debt, cash flow, bank statements and income stability.
Businesses can improve their capacity in two ways. One, they can reduce their debt so when the banks or alternative lenders evaluate their DTI ratio, they can prove they have enough financial resources to meet the required monthly payments for the new loan. Second, they can increase their cash flow by adding additional income streams to the business. Lenders recommend that companies apply for loans when they are able to show a stable income that can support their financial obligations.
3. Capital
Lenders assess capital to measure a business owner's financial dedication to his or her business. They do this by looking at how much personal investment the owner has put into the company.
Essentially, banks want to see what the business owner has to lose should the business fail. Lenders want to know how committed you are to ensuring that your business stays up and running. This is an indication that you are fully committed to seeing the success of your venture, and thus, will be responsible for making your repayments on time.
4. Collateral
Collateral are assets that business owners pledge to serve as security for the business loan they're applying for. It could be in the form of equipment, real estate, inventory, invoices or vehicles. Business owners with assets to present are more likely to get favorable terms in their business loans.
The collateral you pledge serves as the back up for banks if your business fails to make repayments each month. In other words, if you default on the business loan, lenders can seize the asset that you pledged to recoup their losses. Depending on the type of loan you're applying for, or the financing company you use, it may not be required to present collateral for the loan. However, the business may end up paying a higher interest rate as the bank's way to mitigate the risk associated with the lack of collateral.
5. Conditions
Conditions are the factors that contribute to the performance of your company. These may pertain to the current state of the economy or the survival rate of businesses like yours. In other words, banks want to assess anything that could affect your ability to repay your loan in the future. Even if you're able to make payments in the next few months, assessing the conditions allows lenders to factor in the different risks that could affect your repayments down the line.
Conditions also refer to how you plan on using the funding to advance your business. Lenders have to ensure that their money is going to be put to good use and that whatever your business plan is, the loan produces profits, because this will ultimately determine whether you can repay it or not.
Lenders evaluate the conditions of your industry by conducting their risk analysis of your business. They look at the industry your business is based in and compares how your business is doing in relation to competing companies. If you've received loans in the past, they may examine how you used those as well.
The best way to improve your chances here is to show the banks how you'll use the funds and that they will improve your company's bottom line. This could mean presenting a detailed business plan explaining every detail of how you'll turn your plans into profits.
Improving your business's financial foundation using the 5 C's of credit
As a small business owner, it's your responsibility to ensure that your business has enough capital to keep operating. To do so, you may need the help of loans. Whether you apply for one through banks, credit unions or other alternative lenders, there are certain criteria you have to meet for approval. Many lenders use the 5 C's to determine an applicant's eligibility for a loan. You should be proactive in using this method to evaluate your own business first, prior to applying for the loan.