The 5 Cs of Credit
A bank is not a charitable institution. It is in business to make (not lose) money. Consequently, when a bank lends money, it wants to ensure that it will be paid back.
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A bank is not a charitable institution. It is in business to make (not lose) money. Consequently, when a bank lends money, it wants to ensure that it will be paid back. To maximize the possibility of being paid back, the bank wants to make sure that there is sufficient assurance that a person can pay back a loan and that he or she has met such obligations before. According to the Small Business Administration, here are the 5 Cs that banks use to evaluate potential loans.
Capacity to repay is the most critical of the 5 factors. The prospective lender will want to know exactly how you intend to repay the loan. The lender will consider the cash flow from the business, the timing of the repayment, and the probability of successful repayment of the loan. Payment history on existing credit relationships—personal and commercial—is considered an indicator of future payment performance. Prospective lenders also will want to know about your contingent sources of repayment.
Capital is the money you personally have invested in the business and is an indication of how much you have at risk should the business fail. Prospective lenders and investors will expect you to have contributed from your own assets and to have undertaken personal financial risk to establish the business before asking them to commit any funding. If you have a significant personal investment in the business, you are more likely to do everything in your power to make the business successful.
Collateral or “guarantees” are additional forms of security you can provide the lender. If for some reason, the business cannot repay its bank loan, the bank wants to know there is a second source of repayment. Assets such as equipment, buildings, accounts-receivable, and, in some cases, inventory are considered possible sources of repayment if they are sold by the bank for cash. Both business and personal assets can be sources of collateral for a loan. A guarantee, on the other hand, is just that: Someone else signs a guarantee document promising to repay the loan if you can’t. Some lenders may require such a guarantee in addition to collateral as security for a loan.
Conditions focus on the intended purpose of the loan. Will the money be used for working capital, additional equipment, or inventory? The lender will also consider the local economic climate and conditions both within your industry and in other industries that could affect your business.
Character is the general impression you make on the potential lender or investor. The lender will form a subjective opinion about whether you are sufficiently trustworthy to repay the loan or generate a return on funds invested in your company. The lender will review your educational background and experience in business and in your industry. The quality of your references and the background and experience of your employees will also be taken into consideration.
Source: Small Business Administration (www.sba.gov).