credit analysis

A Guide to The 5 C’s of Credit Analysis

Understanding the perspective of a lender is a helpful first step when you want to get approved for a loan for your small business. At the core of the loan process is a credit analysis to determine the risk associated with making the loan and the likelihood that the loan would be repaid. In business financing, it is not just a matter of evaluating the business, but also the person(s) associated with its ownership and operations. Most credit analyses use these five categories to evaluate the risk of a loan: character, capacity, condition, capital and collateral.

Character

Lenders need to know the borrower and guarantors are honest and have integrity. Additionally, the lender needs to feel confident that the applicant has the background, education, industry knowledge and experience required to successfully operate the business in question. Lending institutions may require a certain amount of management and/or ownership experience. During credit analysis the lender will also ask if the borrower has a criminal record. As history is the best predictor of the future, a lender will examine the personal credit of all borrowers and guarantors involved in the loan. Sound business and personal credits are a must. Check both reports before calling your lender, and be prepared to explain any delinquencies if they exist. The lender may be able to make exceptions for low credit scores.

Capacity (Cash Flow)

During credit analysis the lender will want to know that the borrower’s business can repay the loan. The business should have sufficient cash flow to support its business expenses and debts comfortably, while also providing principals’ salaries to support personal expenses and debts. Examining the payment history of current loans and expenses is an indicator of the borrower’s reliability to make loan payments in the future.

Condition

The lender will need to understand the condition of the business, the industry and the economy, which is why it is important to work with a lender who understands your industry. The lender will want to know if the current conditions of the business will continue, improve or deteriorate. They will also want to know how the loan proceeds will be used. Loan uses can include refinancing debt, obtaining working capital, financing a construction project, etc.

Capital

Lenders will ask what personal investment the borrower plans to make in the business. Many banks are more willing to lend to those who have invested some of their own money into the business. Not only does injecting capital decrease the chance of default, but contributing personal assets also indicates the willingness to take a personal risk for the sake of your business. In other words, it shows that you have “skin in the game.”

Collateral

A lender will consider the value of the business’ assets and the personal assets of the guarantors as a secondary source of repayment. Collateral is an important consideration, but its significance varies depending on the type of loan. A lender will be able to explain the types of collateral needed for your specific loan request.

The five components that make up a credit analysis help the lender understand the owner and the business and determine creditworthiness. By knowing each of the “Five C’s,” you will have a better understanding of what is needed and how to prepare for the loan application process.

We’re here to answer your questions. Contact one of our loan specialists and we’ll be in touch soon. In the meantime, you can also download our comprehensive guide that talks more about the 5 C’s of Credit.