Small business owners seeking financing regularly ask what a bank expects from them.
The “Five Cs of Good Credit” have long served as a guideline for businesses seeking funding, and the core principles still hold true today. Commercial lenders pay attention to the “Five Cs of Good Credit": character, capacity, conditions, capital and collateral. However, it's also just as important to be aware of the “Five Cs of Bad Credit": complacency, carelessness, communication, contingencies and competition.
Operating a small business isn’t easy, and the first C, character, illustrates a banker’s desire to know how you will react when times get tough. Lenders will assess your character, including traits such as honor and trustworthiness, to repay the loan. They want to know the character of your management experience and reputation. Lenders also will check your credentials, references and the experience of your employees.
Bankers also want to be reasonably sure of your ability to repay the loan. Determining your business’ capacity is an important component of overall credibility. They check for positive cash flow, timing of loan repayment, realistic profits for your business and the probability of your successfully repaying the loan. Your payment history — personal and business — is considered a strong indicator of your ability to pay. That's why it is very important to maintain a good personal credit history.
Conditions refers to the purpose of the loan and economic factors influencing your business. Your business plan needs to help a lender understand the industry, the impact of economic conditions and the future of your small business.
Lenders will try to make sure your company has adequate capital providing a cushion for potential losses. Capital considers the amount you have invested and the level of risk you share if the business should fail. Investors often want to see the level of your financial risk. If you have significant personal investment in the business, investors know you need to work tirelessly to make the business successful.
Collateral is a form of security that you provide the lender. If for some reason you cannot repay the loan, the bank wants a secondary source of repayment. Assets such as equipment, buildings, accounts receivable and sometimes inventory are possible sources of repayment. Both business and personal assets can be sources of collateral for commercial loans. Bankers prefer to have the loan repaid, rather than to sell the company’s assets.
Although the "Five Cs of Good Credit" have been used for many years, bankers need to also guard against the "Five Cs of Bad Credit."
Lenders now must guard against complacency. They can’t rely solely on personal guarantees or overemphasize past performance. Bankers can’t be complacent about the loan process just because your business has taken care of the past four loans or because you have a large net worth — they still need full documentation. Good lenders must maintain a healthy level of skepticism and realize good times are often followed by bad times.
Carelessness, another factor with bad credit, deals with improper documentation. Professional lenders ensure a lien is filed on time, statements are updated and appraisals are completed. They also make periodic checks of your loan documents. They need to know your business has an adequate level of equity in the company.
With communication, lenders must relay information about loan-to-value ratios and make sure the right people know when a problem exists. Bankers must communicate concerns, definitions and rules. Concerning contingencies, in the past, lenders have paid insufficient attention to downside risk.
Whether you’re considering pursuing funding from the Small Business Administration, traditional bank financing or approaching more investors, it's important to be prepared and develop a relationship with your commercial lender. Visit and communicate with your banker frequently. Keep them informed about opportunities for your business, but also challenges. Maintaining excellent communications with your banker about your business is very important for financing.
There are many opportunities to connect with lenders, including at the Great Lakes Lenders Conference. The conference, hosted Aug. 3-5 in Detroit, serves as a professional development conference for bankers and lenders. However, it's geared toward anyone who interacts with businesses looking to access SBA lending. More information about the conference can be found online.