The 6 C’s of Business Credit
Regardless of where you seek funding – from a bank, a local development corporation or a relative – a prospective lender will review your creditworthiness. A complete and thoroughly documented loan request (including a business plan) will help the lender understand you and your business. The “6 C’s” are the basic components of credit analysis. They are described here to help you understand what the lender looks for.
1. Character – This is a highly subjective evaluation of the business owner’s personal history. Lenders must believe that a business owner is a reliable individual who can be depended on to repay the loan. Background characteristics such as personal credit history, education, and work experience are all factors in this business credit analysis. Character is the single most important factor considered by a reputable bank. Banks want to do business with people who are honest, ethical and fair.
2. Capacity – This is an evaluation of the company’s ability to repay the loan. The bank needs to know how you will repay the funds before it will approve your loan. Many banks will use a software tool to create a business credit report. The report generally analyzes five financial variables, which are representative of a company’s financial characteristics. These variables include:
1. Cash to Assets
2. EBITDA to Assets
3. Debt Service Coverage Ratio
4. Liabilities to Assets
5. Net Income to Assets
3. Capital – A company’s owner must have his own funds invested in the company before a financial institution will be willing to risk their investment. Capital is the owner’s personal investment in his/her business which could be lost if the business fails. The single most common reason that new businesses fail is undercapitalization. There is no fixed amount or percentage that the owner must be vested in his/her own company before he is eligible for a business loan. However, most lenders want to see at least 25% of a company’s funding coming from the owner.
4. Collateral – Machinery, accounts receivable, inventory, and other business assets that can be sold if a borrower fails to repay the loan are considered collateral. Since small items such as computers and office equipment are not typically considered collateral, in the case of most small business loans, the owner’s personal assets (such as his/her home or automobile) are required for the loan to be approved. When an owner of a small business uses his/her personal assets as a guarantee on a business loan, that means the lender can sell those personal items to satisfy any outstanding amount that is not repaid. Collateral is considered a “secondary” source of repayments-banks want cash to repay the loan, not sale of business assets.
5. Conditions – This is an overall evaluation of the general economic climate and the purpose of the loan. Economic conditions specific to the industry of the business applying for the loan as well as the overall state of the country’s economy factor heavily into a decision to approve a loan. Clearly, if a company is a thriving industry during a time of economic growth, there is more of a chance that the loan will be granted than if the industry is declining and the economy is uncertain. The purpose of the loan is an important factor. If a company plans to invest the loan into the business by acquiring assets or expanding its market, there is more of a chance of approval than if it plans to use the fund for more expenses. A tip-top business plan should be one that gives a comprehensive overview of your business’s past, present and projected affairs. Here are the key areas on which to focus your attention.
a. Executive summary – What is your business about, and why would a partner or investor be interested in it?
b. Who’s who – What are the qualifications of your key people running the business, and what are their core responsibilities?
c. Market analysis – Where does your business stand in its market? Honestly, how is the market faring?
d. Customer profile – Who buys what you sell? Do you know your target audience? How are your customers segregated?
e. Finances – How has your business fared for the past three to five years, and what are the forecasts that far ahead?
f. Cash flow – What level of funds do you have daily access to?
g. Contingency plans – If the market collapses or a key supplier or client goes under, what will you do?
h. Plans for change – If you apply for funding, how will it affect the business and what will the return be for an investor?
6. Confidence – A successful borrower instills confidence in the lender by addressing all the lender’s concerns on the other Five C’s. Their loan application sends the message that the company is professional, with an honest reputation, a good credit history, reasonable financial statements, good capitalization and adequate collateral. Following is a commercial loan checklist from a local Florida Bank:
1. 3 Years Personal Tax returns with all k-1’s and W-2s
2. 3 Years Business Tax Returns full schedules and K-1’s
3. Current Personal Financial Statements for principals and or guarantors
4. IRS Form 4506T for each borrower and guarantor
5. Entity Information (articles of incorporation)
6. Business Debt Schedule
7. 2 Month Bank Statements for the business
8. YTD Profit and Loss and Balance Sheet
9. Aging Report of payables and receivables
When applying for a small business loan, don’t forget the importance of personal relationships. Apply for a loan at a bank where you already have a positive business relationship. Also, try to meet with the person who will be evaluating your application, such as the bank’s lending officer, rather than the teller who handles your day-to-day banking transactions.
Keeping your financial house in order will not only let you know how the business is doing, it will also give you an idea when you might be entering the Danger Zone. “The Danger Zone is defined as the situation wherein the cash needs of a company far exceed the available cash.” Mills, Jerry L (2007). Avoiding The Danger Zone. Phoenix, AZ. Mills.
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