When a business approaches a lending institution about debt financing, the lender conducts an evaluation of the borrower using a method known as the 5 C’s of Credit. Here is a quick explanation of each measurement.
Is the business considered trustworthy and do they have a good record of meeting their financial obligations? The things that a lender looks are to determine character are:
- Personal and business credit history
- Quality of references
- Experience in the business
- The impression you make on the lender or investor
Does the business have sufficient cash flow to make the principle and interest payments? The things that a lender looks are to determine capacity and cash flow are:
- Is your company able to repay the amount borrowed?
- How soon can you generate a positive cash flow?
- When will you show a profit?
- How large will the profit be?
- Can the profit be sustained?
Are the current economic conditions supportive of the business and is the business competitive in its industry? The things that a lender looks are to determine conditions are:
- Terms of loan:
- The intended purpose of loan
- How much are you requesting
- Length of the loan
Is there sufficient access to unencumbered collateral that can be seized in the event of non-payment? If the loan is not for an asset that can be easily repossessed by the lender and easily liquidated, the lender will require a secondary form of repayment in the form of additional pledged collateral. The things that a lender looks are to determine collateral are:
- A secondary source of repayment
- Third-party guarantee
- Tangible assets
- Accounts receivable
Generally, the lender would like to see that the business is well-capitalized in the form of owner equity, both so the owners are committed to the business’ success and so that the business is not taking on too much debt relative to its net worth. The things that a lender looks are to determine capital/contribution are:
- The money you have personally invested
- Your ability to save money and accumulate growth in owner’s equity
How does your business stack up with respect to the 5 “C’s”?