Business Funding

Understanding the 5 Cs of Credit

Read Time: 5 min

You’re likely to come across the 5 Cs of credit when trying to learn how to get a small business loan. Obtaining funding to start or expand your business is a great way to acquire the cash necessary to meet your goals. The bank or credit lender you apply to will complete a credit analysis to determine the risk lending you capital. This analysis will include many factors, which you can easily remember as the 5 Cs of credit. It’s important to understand how lenders will evaluate your business before applying. Knowing what the 5 Cs of credit are and how they relate to you will help you put yourself in the best possible position to receive business funding. In this blog, we will go in-depth about each of the 5 Cs of credit as well as why they’re important in your business loan journey. Let’s begin!

What are the 5 Cs of Credit?

Woman looking up the 5 Cs of credit

The 5 Cs of credit are the framework that many lenders will use to review small business loan candidates. Lenders use these characteristics to gauge how creditworthy you are as a potential borrower. The five Cs of credit are character, capacity, capital, collateral, and conditions.

When you apply for business funding, the lender will review each of the 5 Cs to determine your chances of default. Lenders intend to minimize the risk of this type of financial loss. Therefore, they use these criteria to determine whether or not to approve a business’s application. The weight of each C will vary by lender. Since there aren’t strict guidelines, you will find that certain lenders place more value on one aspect than another.

Lenders look at both qualitative and quantitative aspects when they are evaluating a borrower based on the five Cs of credit. A lender’s review may include credit reports, income statements, credit scores, and other relevant documents. They will review both your business and personal financial history in their evaluation of the 5 Cs of credit. Let’s dive deeper into each of these characteristics and how a lender may evaluate them.

1. Character

The first of the 5 Cs of credit is character. This characteristic actually refers to a borrower’s credit history. To a lender, your character is your track record for paying back debts. Your credit history appears on a borrower’s credit report.

Experian, TransUnion, and Equifax are the three major credit bureaus that record the details of your history as a borrower. Lenders use these credit reports to see how much you’ve borrowed in the past and whether you paid your loans back on time. Accounts that have gone to collection and bankruptcies will show up on your credit report for anywhere from 7 to 10 years.

Lenders further use the information found on your credit report to calculate your credit score. For example, FICO reviews a person’s credit report and generates a credit score ranging from 300 to 850, based on what’s in the report. Lenders may look at your personal or business credit score, or both, depending on the type of loan you’re applying for.

Having a high credit score increases your chances of the lender deciding in your favor. Like other credit scores, FICO scores help lenders predict how likely you are to repay a loan. A lot of lenders also have a minimum credit score requirement that you must meet to be eligible for a loan.

For a business loan, lenders may also look at your background, industry knowledge, experience running a business, and other factors to evaluate your character.

2. Capacity/Cash Flow

Next up in the 5 Cs of credit is capacity or cash flow. This measures your ability to repay a loan by comparing your income against your recurring debts. This calculation is your debt-to-income (DTI) ratio.

You can calculate your DTI ratio by adding up all monthly debt payments and then dividing it by gross monthly income. As an applicant, the lower your DTI, the better your chances are of qualifying for a loan. Generally speaking, lenders tend to prefer you have a DTI of around 35% or less for new financing.

The lender will look at your business’s cash flow to verify that it can handle the expenses and debts comfortably. To do this, they may look at your monthly revenues, expenses, existing business debt, and business assets. Your financial documents such as business bank account statements, loan statements, and accounts payable can all demonstrate proof of your capacity.

3. Capital

Man using magnifying glass to look at one of the 5 Cs of credit - capital

The third C of the 5 Cs of credit is capital. Lenders want to see that you have skin in the game when it comes to your business. They’re more willing to lend money to business owners who demonstrate this. This means they will look at how much money a business owner or management team invests into the business.

Investing capital is important because it shows the lender your commitment to making your business successful. Not only that, but if you’re making a personal investment in the business, this also decreases the chances of the loan defaulting.

Lenders might also allow you to make a capital investment if they don’t feel you have a sufficient amount. For example, they may require a down payment to get approval on the loan.

4. Collateral

When you take out a home or car loan, you put up assets as collateral to obtain these loans. For example, if you default on a home loan, the lender will typically take the purchased home to recoup their losses.

With a business loan, you may also use assets to secure or guarantee the loan. If you’re running a retail store or restaurant, these assets could include real estate, equipment, inventory, and more.

5. Conditions

The last of the 5 Cs of credit is conditions. This means the condition of your business and whether it’s flourishing or not. Lenders will also look at what you’re planning to use the funds you’re borrowing for. Are you using the loan to buy additional equipment, make renovations, or pay for salaries during a downtime?

Other considerations may include the state of the economy, supplier/customer relations, and industry trends. These factors could affect your ability to pay back the loan.

Why the 5 Cs of Credit are Important

Having a strong foundation of the 5 Cs of credit will make you look better to lenders as you apply for funds. Understanding these characteristics does so much more than just help your chances of being approved for a business loan.

The 5 Cs of credit also affect the pricing and interest rate you receive on the loan. Having solid characteristics can help lower the interest rate on the loan. This will save your business thousands of dollars on interest so you can put more money towards your business.

To work on improving your 5 Cs of credit before applying for business loans, make sure you have a good understanding of your cash flow. Pay down existing business debt or look for ways to increase your revenue. Check your business and personal credit scores and your credit history to make sure they are accurate. For your collateral, take a look at your business assets and determine what their fair market value is. To solidify your character, make sure to have solid references and be able to demonstrate your experience and reputation.

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