The 5 C’s of Lending

Posted by Kevin  at June 17th, 2012

NOTE: Kevin originally wrote this article for Bloomberg Businessweek’s Business Exchange. Click here to read the original.

The 5 C’s of Business Lending

When you a apply for a business loan, the lender will examine the following five factors:

1. Capital – This is the combined amount of money and assets a business has available, and it also includes equity. Equity means the value of ownership interest in property. The lender calculates equity by determining the net difference of assets minus liabilities on a balance sheet.

For example, if Truck Co. A owns 4 trucks worth $100,000, but owes $150,000 for the same vehicles, then Truck Co. A would have negative equity. On the other hand, if Truck Co. B owns 4 trucks worth $100,000 and only owes $5,000, then Truck Co. B has positive equity. Of course, financial statements do not tell the lender the whole story. Therefore, the lender will also consider “practical capital” or “skin in the game”. “Skin in the game” means that the business owner will use his or her own money or assets to keep the business running. An owner who will fight to keep his or her business open shows a true commitment and is attractive to lenders.

2. Capacity – This is the ability of a business to repay monies borrowed. Capacity is closely associated with cash flow. To obtain a business’s capacity, the lender examines historical and projected cash flows to determine whether a business can repay the requested loan amount.Cash flow is king, and the lender looks at cash as the primary source of repayment. When painting a full picture of a business’s capacity to repay, the lender may consider secondary sources of repayment, such as any outside income, the borrower’s history of making loan payments on time, and credit scores.
3. Collateral – Collateral is a tangible piece of property pledged as security for repayment of a loan. The lender needs to prepare for the worst-case scenario—when the borrower cannot repay his or her loan—so the lender uses collateral as a secondary source of repayment.

The lender uses collateral to secure the loan, assuring the lender that it can recoup its money, if the borrower defaults. In the event of default, the lender sells the collateral and gets its money back.The lender will consider assets that the borrower already owns as collateral. Usually collateral will be tangible assets that can be easily liquidated (i.e., real estate, machinery, equipment, stock). To determine how much the collateral is worth, the lender will apply a discount to the market value of the collateral to account for depreciation and loss during sale.
4. Conditions – Before extending credit, the lender will take the conditions of the economy and market into account. The lender’s goal is repayment of the loan. The conditions of the market and economy will allow the lender to determine the future success of the business based on current conditions. For example, if a borrower wants a business loan to open a doughnut shop during a low-carb craze on a street where 6 other doughnut shops currently operate, and 3 other doughnut shops closed last month, then the borrower may not get the loan.The lender is also mindful of the fact that it doesn’t have a crystal ball. Therefore, the longer the term (the repayment period) of the loan, the riskier it is for the lender. When the lender has long-term experience with the borrower’s particular business, it recognizes when negative business cycles may occur (almost as good as a crystal ball!), and the lender can build its experience into the structure of the borrower’s loan.
5. Character – Character is the trustworthiness of The borrower a business owner. The lender will examine the borrower’s character along with his or her ability to succeed (remember “skin in the game”?). Think of the lender examining the borrower’s character as a job interview: If the borrower has the right education and relevant work experience, he or she is more likely to get the loan. Because a new business does not have a proven record of success, the lender will look to you, as a borrower and business owner, to show that you can succeed. A great attitude and constructive business plan will help assure the lender that you will both reach your goals—your business will succeed and the lender will get its money back.