The 5 C’s of Credit

You have evaluated all the various ways of funding your business and have concluded that bank financing is the way to go.  Now you need to know how to get a bank loan.  Before you call your local banker, you should familiarize yourself with the 5 Cs of credit.  Loan applications are evaluated using the 5 Cs, along with other criteria, to determine the credit worthiness of a prospective borrower.  The better you understand these criteria, along with how well your business fulfills each criterion, will improve your chances of obtaining the financing your business needs to grow.

Character (or Credit History)

This is largely based on your FICO score.  FICO scores range from 300 to 850, with the higher the score indicating better credit risks.  Do you know your FICO score?  You need this information before you start speaking with someone at the bank. If you are speaking with someone at your current bank, then your banking history with that institution will also provide additional background for the bank to evaluate.  Applicants with lower FICO scores are good candidates for SBA financing which the bank will recommend assuming you are a candidate.  Also be prepared to complete a Personal Financial Statement where you list all the various assets you own, because you will be the guarantor on the loan.

Capacity

The bank will want to evaluate whether or not your business has the capacity or cash flow to repay the loan.  A general rule of thumb is a 1.25 debt coverage ratio.  To calculate your ratio, take your net income and add back any depreciation, amortization and tax payments to derive the cash available for debt coverage.  Most bankers will add back some amount of wages/distributions you pay yourself to the available cash amount and possibly other non-recurring items from the past.  Next, calculate your estimated annual debt payment amount using a calculator or spreadsheet software based on how much you want to borrow.  If the available cash amount, divided by the annual debt payment is 1.25 or greater, then you have the capacity to service your loan.  If not, then you need to figure out what changes need to be made to achieve a 1.25 debt coverage ratio.  Some financial projections may be required.

Collateral

Depending on the size of the loan, the bank may need collateral.  Collateral sources include accounts receivable and inventory.  If you are seeking more than $100K, then you will most likely need to identify some form of collateral that the bank can use to secure your requested loan.  If you are an existing business, you should know what your accounts receivable aging looks like.  For example, how many receivable dollars are greater than 90 days past due?  How quickly are you turning over inventory vs. your industry average?  This is information that the bank is going to want to evaluate.

Capital

Lenders are going to want to see that you, the borrower, have some skin in the game, so to speak.  They want to see that a borrower has equity in the business and will look at various ratios such as debt to equity to evaluate the prospective borrower’s leverage.  Typically, new businesses are not going to have substantial amounts of equity or invested capital; consequently lenders will look more to the borrower’s net worth to evaluate credit worthiness.

Conditions

This pertains to the overall environment within which you operate your business.  Are you looking for money to begin manufacturing VHS tapes?  More than likely, that would be viewed as being an unfavorable condition given the ever shrinking market for VHS tapes (though vinyl is making a comeback).  Do you have one customer that comprises 90% of your sales?  That level of customer concentration would be viewed as an unfavorable condition because the loss of that client could sink your business.  Banks have a preference for businesses that are in growing market segments/industries, with large client lists and well articulated value propositions.

Hopefully your take away is not “I can’t get a loan†but rather “I have some homework to do.† Many business owners I work with think that they have a money problem in that they cannot get access to the capital needed via conventional financing.  But in reality these business owners do not have a money problem.  What they have is an idea problem.  Business owners need to look at a wider range of possible capital sources and be more creative.  I will provide more information on increasing your creativity in future posts.  If you need help with pulling together a plan of attack for pursuing capital, please give me a call.  Let Profitwyse help you intelligently fuel your business’ growth.