Master the 5 C’s of Credit

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While a “C” average may feel middle-of-the-road on an academic scale, nailing the five C’s of credit is the key to getting funding from banks and other financial institutions.

The five C’s, or characteristics, of credit — character, capacity, capital, conditions and collateral — are a framework used by many traditional lenders to evaluate potential borrowers.

However, there aren’t any strict guidelines — different lenders may place more value on certain attributes. Online lenders also use proprietary algorithms to determine a borrower’s creditworthiness by analyzing finances and other data, such as social media accounts.

The key to small-business success is focusing on things you can control, says Brad Farris, a business advisor with Anchor Advisors in Chicago. “The five C’s are one of those things that just are — banks believe in them, so we have to deal with it,” he says.

We’ve rounded up the five characteristics and some tips for putting your best foot forward.

Five C’s of credit

1. Character
2. Capacity/Cash flow
3. Capital
4. Conditions
5. Collateral

 

1. Character

What it is: A lender’s opinion of a borrower’s general trustworthiness, credibility and personality.

Why it matters: Banks want to lend to people who are responsible and keep commitments.

How it’s assessed: From credentials, references, reputation and interaction with lenders.

How to master it: “Character is something you can control and promote, but only if you have a bank that cares about relationships,” Farris says. If you have a local or community bank, work to build a relationship. Farris recommends sharing good news about your business with your banker to help build that relationship and asking if she wants to be added to your company’s newsletter. “Make yourself someone they want to lend to,” he says.

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2. Capacity/Cash flow

What it is: Your ability to repay the loan.

Why it matters: A business must generate enough cash flow to repay the loan. Loans are a form of debt, and they must be repaid in full.

How it’s assessed: From financial metrics and benchmarks (debt and liquidity ratios, cash flow statements), credit score, borrowing and repayment history.

How to master it: Some online lenders may be more open to helping you finance immediate cash flow gaps. If you’re focusing on local banks, pay down previous debt before you apply. Also, calculate your cash flow to understand your starting point before heading to the bank.

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3. Capital

What it is: The amount of money invested by the business owner or management team.

Why it matters: Banks are more willing to lend to those who have invested some of their own money into the venture. Most lenders are not willing to take on 100% of the financial risk, so it helps borrowers to have some “skin in the game.”

How it’s assessed: From the amount of money the borrower or management team has invested in the business.

How to master it: Nearly 60% of small-business owners use personal savings to start their business, according to the Small Business Administration. So put some of your own resources into the mix. There are other ways, however, to acquire startup funding if you don’t want to take on all the risk yourself.

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4. Conditions

What it is: How the business will use the loan and how that could be affected by economic or industry factors.

Why it matters: To ensure that loans are repaid, banks want to lend to businesses operating under favorable conditions. They want to identify risks and protect themselves accordingly.

How it’s assessed: From a review of the competitive landscape, supplier and customer relationships, and macroeconomic and industry-specific issues to ensure that risks are identified and mitigated.

How to master it: You can’t control the economy, but you can plan. Although it might seem counterintuitive, apply for a line of credit when your business is strong. “Banks will always be happiest to loan you money when you don’t need it,” Farris says. If conditions worsen, they may reduce the credit line or take it away, he adds, but at least you have some cushion for a while if things go south.

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5. Collateral

What it is: Assets that can be pledged as security.

Why it matters: Collateral acts a backup source if the borrower cannot repay a loan.

How it’s assessed: From hard assets such as real estate and equipment; working capital, such as accounts receivable and inventory; and a borrower’s home that also can be counted as collateral.

How to master it: Picking the right business structure can help protect your personal assets from being used as collateral if you’re sued or if a lender is trying to collect. Making your company a legal entity will help you mitigate the risk.

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Updated April 28, 2017.

Jackie Zimmermann is a staff writer at NerdWallet, a personal finance website. Email: jzimmermann@nerdwallet.com. Twitter: @jackie_zm.