With a growing, stronger economy, many small-business owners are looking for loans to expand their operations. An owner may need working capital to support the company’s growth, want to consolidate debts into one loan on more favorable terms, or purchase additional real estate and equipment. Regardless of why a small-business owner is looking for financing, lenders usually apply the same rules to assess the financial wherewithal of the business.
Financial institutions assess the quality of the potential loan by testing the “Five C’s” of credit. The “C’s” are: character, capacity, capital, conditions and collateral. As a business owner, here are the five areas to consider as you prepare to obtain financing and assess how you’re doing. Each is important.
Character typically shows a small-business owner’s willingness to repay the loan. Lenders collect three years of financial statements to see trends and behaviors that borrowers display. Typically, three years is a long enough period of time for a small business to encounter a hiccup, a difficulty, or other hard times. By looking at the borrower’s behavior during a difficulty, the lender will learn how the borrower reacted when he had his back up against the wall. Did he continue to pay the obligations? Did he short-sell his property or close a company or line of business? These can be indicators of the borrower’s character.
Capacity is the borrower’s ability to repay the debt. Lenders will study cash flow of the business because, in the end, cash flow pays the bills. Many lenders do not want to rely on liquidating collateral or ask guarantors for payment to pay the loan back. Financial institutions study the income and expenses and the flow of cash in and out to assess the viability of the company and its ability to repay all of its obligations.
Capital helps a lender to measure a small-business owner’s ability to withstand adversity. Usually when a borrower purchases real estate or equipment, the lender will ask for some down payment. Lenders want the borrower to have some “skin in the game.” In addition, growth is supported by liquidity and capital so a business doesn’t run out of cash before it reaches profitability at new stages of the business operations.
Conditions include adversity facing a business. Conditions essentially comprise the industry and market trends. A contributing factor to a small business’ success is the environment. Lenders look at trends in the borrower’s particular industry, the competition, and the feasibility of any greater success or slow-down in the economic conditions. These factors could affect the ability of the borrower to repay the loan.
Collateral is the equipment, real estate, accounts receivable or other business assets that secure the loan. The reason the lender wants collateral is to encourage the borrower to repay the loan. With the thought of losing collateral, some borrowers have an added incentive to continue making payments on loans. When there is a shortfall of collateral, lenders may ask guarantors to pledge their personal residences to provide additional collateral.
A financial institution will look at these five C’s of credit to assess the strength of proposed loans and the borrower’s ability to pay them back. Lenders have a saying that a good loan is the one that pays and pays and eventually pays off. If a small-business owner can prove their ability to pay the loan back and use the loan proceeds to drive the business to even greater success, then the economy improves, the communities grow, and the lenders are pleased!
aga merx is a vice president and SBA department manager for Bank of American Fork. A challenge in SBA lending is keeping updated on constant change in procedures and news from the SBA, so merx keeps up on changes and educates and coaches other loan officers. merx prefers not to capitalize her name.