What Are The 5 Cs Of Credit?

The 5 Cs of Credit is a system designed to help lenders decide whether or not they want to give you a small business loan.

In this article, we’ll walk you through the loan process from the lender’s perspective, helping you understand what they’re looking for and how to increase your chances of being approved for a business loan.

Read on to learn more about the 5 Cs of Credit.

What Are The 5 Cs Of Credit?

The 5 Cs of Credit is a system that lenders use to evaluate your business’s creditworthiness and ability to repay a loan. Before making a decision, lenders look specifically at these five characteristics:

1. Character – The borrower’s reputation and perceived trustworthiness.
2. Capacity – The borrower’s ability to repay the loan.
3. Capital – How much money the borrower has put toward the investment.
4. Collateral – What assets the borrower has to offer as insurance in the event of a default.
5. Conditions – The conditions of the loan the borrower is seeking, as well as the current state of the economy in general.

In this post, we’ll explain everything you need to know about these 5 Cs, including why these traits matter, how lenders evaluate each trait, and how to boost your business’s 5 Cs so you can secure a business loan.

Character

Character refers to a business’s reputation and trustworthiness. Also sometimes called “credit history,” character often translates to how faithful you’ve been in paying off past debts on time.

Why Character Matters

For lenders, it all comes down to the question: “Will I get my money back?”

Lenders want to work with responsible, organized businesses that are likely to make their repayments on time.

How Lenders Evaluate Character

When evaluating character, lenders look at:

• Credit report
• Credit scores
• Personal qualities
• References

To analyze your credit history, lenders will often view your credit report and credit score. Lenders take both your business credit score and your personal credit score into consideration.

They tend to look at how long you’ve been in business as well. The longer you’ve been in business, the more stable you appear. For lenders, this again means less risk and increased likelihood that your business will be successful enough to cover loan repayments.

Sometimes, lenders also take a literal approach to the word “character” and analyze your attributes as a business owner.

They may conduct a personal interview or require references (some even go so far as looking at Yelp reviews of your business). Many online lenders make phone consultations a part of their application processes so that they can help you with any questions about the application while also getting a feel for you and your company.

How To Improve Character

If you’re looking to impress lenders with your personality or improve the character of your business, there are a few ways to do so. Here are four tips for boosting character:

Capacity

Capacity is your business’s ability to pay back the loan. Also sometimes called “cash flow,” capacity is directly related to how much cash your business has available for loan use.

Why Capacity Matters

Not only do lenders want to see that you have a history of paying your loans on time, they also need to see that you actually have the cash to do so. They must look at your financial health to ensure that you can afford a loan in the first place, and then use this information to see how large of a loan amount they can offer you.

How Lenders Evaluate Capacity

Lenders may use the following tools to determine your business’s capacity to afford a loan:

• Cash flow statements
• Cash flow projections
• Bank statements
• Debt service coverage ratio (DSCR)
• Debt-to-income ratio (DTI)

Most lenders require you to provide cash flow statements and bank statements when you apply for a loan. They also may require a cash flow projection to get an idea of what your cash flow will most likely look like in the future.

Some lenders may depend on more concrete measures of financial health, like debt service coverage ratios (DSCR) and debt-to-income ratios (DTI). The debt service coverage ratio measures the relationship between your business’s debt and income, while the debt-to-income ratio measures the relationship between your personal debt and income as the business owner.

Both of these ratios are used to determine the health of your business’s cash flow and demonstrate how much extra cash you have available for a loan. Ideally, lenders look for a DSCR of 1.25 or higher and a DTI ratio of 36% or lower.

How To Improve Capacity

The following are four tips for maximizing your business’s capacity; following these steps will demonstrate that your business can handle a loan and may also increase the size of the loan that you can realistically afford to make payments on.

Capital

Capital refers to how much money you (or you and your business partners) have invested in your company.

Why Capital Matters

In lenders’ eyes, the more money you personally have invested in your business, the less likely you are to default on your loans. Lenders see capital investments as a sign that you take your business seriously and have something to lose if the business goes under.

It makes sense — if you have money personally invested in your business, you are much more likely to do everything you can to make that business succeed — which for lenders, translates into doing everything you can to pay your loans off.

How Lenders Evaluate Capital

When considering capital, lenders want to see:

• How much of the owner’s capital is invested in the business
• How the owner’s capital is invested

Lenders primarily look at the amount of owner’s capital invested in the business. Not only do they evaluate how much money you have invested in the business, they also check to see where you’ve invested that money. If they see that you’ve made smart investment decisions in the past, they can take comfort in knowing that you will most likely invest a new loan wisely.

How To Improve Capital

If you’re looking to present strong capital to a lender, here’s what you should do.

Collateral

Collateral is an asset (or assets) that are offered up as insurance against you paying back your loan fully and on time. If you default on your loan, lenders will seize the collateral in order to make up for their losses.

Why Collateral Matters

Much like owner’s capital, collateral means you have something to lose if you default on your loans. The hope for many lenders is that the collateral will encourage business owners to work hard to repay their loans.

However, if your business does go under, collateral assures lenders that they won’t lose all of their money if you default on a loan.

How Lenders Evaluate Collateral

Every lender has different requirements when it comes to collateral.

Some require specific assets to be offered up as collateral. Others require a blanket lien, meaning they have the right to go after your assets in case of a default. Others still require a personal guarantee, meaning you the business owner will be held responsible in the event of a default.

Some examples of collateral include:

• Property
• Vehicles
• Equipment
• Savings accounts

It’s important to carefully evaluate each lender’s policy and requirements regarding collateral. This way, you can know exactly what is expected of you. And, more importantly, you can decide if you’re comfortable with the required collateral or if you’d rather look for a different lender.

To learn more about collateral, read our article on the differences between secured and unsecured business loans.

How To Improve Small Business Collateral

Each lender has their own way of evaluating collateral, so there’s no one right way to improve your business’s collateral. However, by carefully researching potential lenders, you can work to present strong collateral that meets their standards. Here are a few tips to consider:

Conditions

Conditions are considered in two parts: the conditions of the loan and the conditions of the economy.

Why Conditions Matter

Conditions such as interest rate and principal play an important factor in whether or not you can afford a loan and how big that loan can be. Factors such as the economy and your business’s market can also play a role in how likely your business is to succeed and be able to repay a loan.

How Lenders Evaluate Conditions

When considering if the conditions are right to approve your loan, lenders consider:

• Interest rate
• Principal
• Economy
• Your business’s industry
• Your business’s competitors

The actual loan amount you are requesting is very important, but lenders will consider the principle, interest rate, and monthly payments to determine if you can feasibly take on that loan.

Lenders also carefully consider how you are planning on using the loan as the purpose of the loan can greatly affect whether your business will grow and profit from the investment.

The economy is also a huge consideration. If the economy is booming, businesses are more likely to flourish, meaning less risk for lenders. If the economy is taking a downturn, lenders may be more reluctant to lend money. When the economy is poor, lenders typically increase their minimum DSCR which means businesses have to have an incredibly strong cash flow in order to be approved.

Some lenders may look at your specific market and competitors to get an idea of how financially promising your business is. Certain lenders also have prohibited industry lists, meaning that they will not lend to businesses in specific high-risk industries. So before you apply, be sure that your business does not fall into that category.

How To Improve Conditions

You may not be able to control the economy, but you can control how strong your business and its loan application appear. Here are a few tips on how to put your best foot forward where conditions are concerned.

Final Thoughts On The 5 Cs Of Credit

The 5 Cs of Credit are how lenders can realistically evaluate how big of a risk you are. When it all boils down, lenders simply want to be certain that you will pay back your loan.

When it comes to loan applications, you don’t want to go in blind. Knowing what lenders are looking for and how they’re evaluating your application can be the key to securing the loan you need.

It’s important to note that not all lenders evaluate each C the same way. Some place more emphasis on character, while others care more about your capital. Carefully researching each lender’s requirements and following our tips to master each of the 5 Cs of Credit can greatly increase your chances of sealing the deal on a loan.

In the end, it all comes down to establishing yourself as a trustworthy, credible borrower who can set lenders’ minds at ease. Start mastering character, capacity, capital, collateral, and conditions to impress lenders and secure the loan you want.

Ready to take out a business loan? Read through our guide to the best business loans, the difference between personal and business loans for your business, and how to write a business loan proposal.

The 5 Cs Of Credit FAQs