Business Loan Decision: the 5 C’s:
Banks and other lenders all have their own methods of reaching a business loan decision. However they all use a version of the so-called 5 C’s of credit: Capacity, Capital, Conditions, Collateral and Character.
Each of these is really a component of risk, the key metric a lender uses to lend and price loan capital.
We’ll look at each in detail. What exactly will a lender look at when considering each of these factors?
The first is probably the most important: your business’s capacity to pay. The bank wants to know whether you can pay the loan back. Its assessment will include:
- Credit checks: expect the firm (and possibly your) credit score and credit history to be thoroughly scrutinized
- Cashflow: is there enough cash coming in from the business’s operations to cover the loan repayments? The bank would expect there to be significant buffer, excess cash over the required repayments, as well.
- Financial history: backing up the cash projections, how has the firm performed in the past? How reliable or believable are these projections? Are they realistic or over optimistic?
- Volatility of cashflows: Part of this cashflow assessment will also be an assessment of how volatile cashflows are. Lenders will expect there to be a greater cash buffer in competitive, cash volatile industries (bars and cafes for example) than in stable markets with known or contracted revenue streams (a cleaning company with long term cleaning contracts for example).
- Loan structure: the terms of any credit offered by a lender would also influence the attitude to risk. Conditions such as the term of the debt, repayment terms and interest rates (and hence profitability of any loan) will influence the bank’s assessment of its exposure.
The Capital assessment covers several areas.
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Firstly a lender will want to know that a borrower has significant capital tied up in their business. A significant investment in a business means they have ‘skin in the game’: they are incentivized to ensure the business does not go under.
Secondly, they will want to see similar ‘skin’ in the specific project for which the loan is to be used. How much is the owner putting in? Shared risk, ensuring a common incentive for success, between the borrower and lender is the aim.
And lastly, and related, a bank’s risk is lowered, over and above the shared incentives, if a bank is only putting up some of the cash. This is particularly the case when loans are to be used to buy equipment or premises that have a resale value (see later discussion about collateral).
This relates to two things: external, especially economic, conditions and the loan’s purpose.
Some purposes – working capital, a new venture, offshore investment etc – are inherently more risky than others such as fixed asset purchase or land acquisition. A bank will add this to its overall assessment of risk.
Economic conditions have, of course, been a very significant factor in loan assessment in recent years. Pre 2007/2008 economic conditions prevailed such that loans were readily available, with lenders willing to lend aggressively.
Post GFC, however, this reversed, with banks tightening lending criteria and being less willing to take on significant risk. This is only now starting to change, and so hopefully friendlier financing conditions will begin to prevail.
As has already been stated, the collateral backing of any loan is an important consideration too.
This can take the form of a fixed charge on specific assets – especially assets that are being purchased with the loan – or a so-called floating charge whereby all assets of a company become available first to the lender on default (more sophisticated charges or liens also exist).
The quality of any collateral offered is a key consideration. This means its value in relation to the loan – how much is it worth if the bank takes possession – and also its liquidity – how easily can that value be realized – are important.
(For more info on business loans without collateral click here.)
Character, the most ephemeral of the criteria, relates to how mainly to the bank’s trust in the business and associated individuals. The numbers may all stack up, but if a lender doesn’t trust a potential borrower they are unlikely to approve a loan.
Due to its nature there are no real objective tests to this. The bank will consider any previous history, especially credit history, a business has with the bank. Have they repaid previous loans? Any problems?
They will also review credit scores and reports, references and even criminal checks.
There may be other things a lender checks to assess a loan, but most are covered by these five criteria. Making sure your application scores strongly on each of these points will go a long way to determining its success or otherwise.
For more information about business loans click here.