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The 5 C's of Credit Analysis

The "Five C's" are the basic components of credit analysis. They are described here to help you understand what the lender looks for.

The 5C's Of Small Business Lending

1. Capacity

Capacity to repay is the most critical of the five factors, it is the primary source of repayment - cash. 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 or commercial- is considered an indicator of future payment performance. Potential lenders also will want to know about other possible sources of repayment.

2. Capital

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. Lenders typically like to see that you have invested some of your own capital into the venture that you have a little skin in the game. They may also want to see capital amounts that exceed the loan amount. It's not surprising then if a frustrated small business owner might think, If I had that, I wouldn't need a loan! Nevertheless, if a lender sees you invest some of your own cash into your venture, he or she may feel you're less likely to walk away if things get tough. Having some cash on hand for day-to-day needs and maybe even a little set aside for a rainy day also tells the lender that the business loan you're looking for isn't a last-ditch effort to keep your head above water for the next few months while your business falters.

3. Collateral

Collateral, or guarantees, are additional forms of security you can provide the lender. It is another way of making sure that the borrower is bearing some amount of risk with the bank. Banks believe that applicants who keep real estate or other assets as collateral are serious about repaying their loans. Banks would be willing to pay you a loan if you can put up an asset, that has a value more than or equal to the amount of the loan, as collateral.

4. Credit Score

Although this is listed as number two, it should probably be number one. It's pretty much a go-no-go measure for most traditional lenders, and although alternative lenders are willing to work with borrowers with credit scores as low as even 500 (on a case-by-case basis), they all have different credit score thresholds they won't go below. Whenever I talk to lenders, they uniformly suggest that credit score is really a measure of your willingness and commitment to meet your financial obligations. It's pretty cut and dried at most banks, but many alternative lenders understand there are myriad reasons why someone's credit score might be low. And, depending on the reason, may still be willing to work with you. Even though there are lenders that will work with small business owners with less than perfect credit, your credit score is critically important. For the smallest small businesses, your personal credit score is critically important. When meeting with a lender, you should know your score and be prepared to explain anything negative on your report. Give the lender a reason to look beyond the score.

5. Character

Character is the general impression you make on the prospective lender or investor. The lender will form a subjective opinion as to whether or not you are sufficiently trustworthy to repay the loan or generate a return on funds invested in your company. Your educational background and experience in business and in your industry will be considered. The quality of your references and the background and experience levels of your employees will also be reviewed.