The five Cs of credit is an unofficial system that lenders, including First National Bank, use to determine the creditworthiness of a potential borrower and how likely the bank is to be repaid if it decides to make the loan. The five Cs takes into account the borrower’s character, as well as the capacity, capital and collateral of the business, and the conditions of the market or industry. This analysis helps us estimate the chance of loan default and the risk of financial loss for the bank.
The five Cs are somewhat subjective with no hard and fast formula for approval or rejection. Each financial institution places a different emphasis on the categories and has its own lending guidelines and protocols. Even though each bank will weigh these attributes differently, it’s important to understand the basics.
Personality and credibility still matter
One of the most important factors in securing a business loan is the applicant’s character. In other words, we want to form an opinion of the borrower’s general trustworthiness, integrity and personality. Our experience has taught us that if the business owner doesn’t have solid character, the business eventually will fail.
To evaluate character, we may review things like the applicant’s resume, educational background, employment record and professional accomplishments. Also crucial are references from suppliers, customers, lawyers and accountants to determine if the applicant is respectable and reliable.
As a community bank, we have a better opportunity to determine character because so many community members are well known to us. Even if we don’t personally know the applicant, it’s fair to say that we know someone the applicant knows and can reach out to that person for a candid response.
For small businesses or sole proprietorships, we may also review your individual credit reports and credit score. Just as in personal finance, a higher credit score often means a better chance of loan approval, and better rates and terms for a loan if it is approved.
Can the business repay the loan?
Capacity or cash flow measures the business’s ability to repay a loan. Our lenders will compare current income with recurring debts and evaluate the business’s debt-to-income ratio. Just like home financing, a lower debt-to-income ratio is favorable because it shows you have more capacity to repay your loan. If you are applying for a term loan, we will evaluate whether your cash flow is sufficient to service the loan over an extended period of time. If you’re applying for a short-term loan, we will evaluate whether the turnover of your current assets will repay your obligation. It’s important to note that banks rely on a combination of past performance and future cash flow projections when analyzing a loan request.
How much skin do you have in the game?
Capital is how much money the applicant has invested and committed to his/her business. If the business owner or management team have personally made an investment in the business it decreases the chance of default because they are naturally motivated to ensure the business performs at its best. Plus, banks typically will not take on 100% of the financial risk of a loan. We also may review whether the business is retaining an adequate amount of net income to support growth, and how the amount of capital compares to the amount of liabilities and debt.
What’s happening around you?
We must take into consideration how your business will be affected by economic and industry conditions. For example, is the industry stable, cyclical or entering a long-term decline? Are there barriers to entry in the industry that make it difficult to get started? Are there technological, environmental or political factors that will affect the business? Who and where are the business’s competitors? Does your business have any sustainable advantages over competitors? These factors are largely out of the borrower’s control; nevertheless, they must be considered to validate that the business is operating under favorable conditions. The more favorable the conditions, the higher likelihood that the borrower will repay the loan.
The backup source
Finally, we come to collateral. Collateral is anything that the borrower can pledge to secure the loan. If the borrower can’t repay the loan, the bank will seize the collateral as a backup source of income. Collateral can include real estate, equipment and machinery, accounts receivable and inventory, and in some cases, even the borrower’s personal home. A collateral-backed loan is also known as a secured loan and is considered to be less risky for the bank than an unsecured loan. Similar to capital, having some of your own assets invested in your business makes it more likely that you will fight for the success of your business and increases your chances of being approved for a loan.
Again, while every bank will weigh the 5 Cs differently, you will have the best chance of being approved for a business loan if you:
- Have a good to excellent credit rating for both your business and yourself
- Demonstrate your business will generate enough revenue to repay a loan
- Invest your own money in your business
- Prove that your business has a competitive advantage in the marketplace
- Secure the loan with business assets that can be sold to repay the loan if ever there was a default
At First National Bank, we’re committed to helping you grow your business whether you’re just starting out, or you’ve been in business for 30 years. Securing financing can seem daunting, but our experienced commercial lenders are invested in you. We work with you to assess your situation and answer all your questions. Learn more about the types of commercial financing we offer and then get in touch with one of our commercial lenders. You can also submit a business loan inquiry and one of our lenders will get back in touch with you!