Tag Archives: credit score

5 C's of Credit

The 5 C’s of Credit: 
What Do They Mean To Your Small Business Loan?

One of the most common questions among small business owners seeking financing is: “What will the bank look for from me and my business?” While every bank has its own unique criteria, many use some variation of the five C’s of credit when making credit decisions. Broadly speaking, they are:

  • Character
  • Cash flow
  • Collateral
  • Capitalization
  • Conditions

Let’s take a look at each of these ingredients and review how they may impact your funding request. Review each category, and see how you stack up.

Character ― Your willingness to pay back your loan

What is the character of the management of the company? What is your payment history and patterns in other loans you have taken? What is management’s reputation in the industry and the community?

Bankers want to lend their money to those who have impeccable credentials and references. The way you treat your employees and customers, the way you take responsibility, your timeliness in fulfilling your obligations are all parts of the character question.

This is really about you and your personal leadership. How you conduct both your business and personal life gives the lender a clue about how you are likely to handle leadership as a CEO. It’s a banker’s responsibility to look at the downside of making a loan. Your character immediately comes into play if there is a business crisis, for example. As small business owners, our personal stamp on everything that affects our companies is essential. Because the bank may not know you, your credit score tells the lender how you will pay your business loan. Many times, banks do not even differentiate between us and our businesses. A poor personal credit score is enough information for a lender to outright decline a business loan. In a commercial lender’s eyes, there is no differentiation between handling personal obligations and business obligations. They are one and the same.

Cash Flow ― Your capacity to pay back your loan

What is your company’s borrowing history and track record of repayment? How much debt can your company handle? Will you be able to honor the obligation and repay the debt? There are numerous financial benchmarks, such as debt and liquidity ratios, that investors evaluate before advancing funds. Become familiar with the expected pattern in your industry. Some industries can take a higher debt load; others may operate with less liquidity. As a conservative guideline, you should have $2 of income (business and personal) for every $1 of debt.

Collateral ― How lenders get paid if the business fails

While cash flow will nearly always be the primary source of repayment of a loan, bankers look at what they call the secondary source of repayment. Collateral represents assets that the company pledges as an alternate repayment source for the loan. Most collateral is in the form of hard assets, such as real estate and office or manufacturing equipment. Alternatively, your accounts receivable and inventory can be pledged as collateral. Generally, lenders will want a 1:1 ratio, or $1 of collateral for every $1 you borrow. Bankers typically discount an asset and lend on that basis. So for every $1 of collateral, the bank will lend anywhere from 70 percent to 85 percent of the value depending on whether it is fair market value or liquidation value.

The collateral issue is a bigger challenge for service businesses, as they have fewer hard assets to pledge. Until your business is proven, you’re nearly always going to pledge collateral. If it doesn’t come from your business, the bank will look to your personal assets. This clearly has its risks; you don’t want to be in a situation in which you can lose your house because a business loan has turned sour. If you want to be borrowing from banks or other lenders, you need to think long and hard about how you’ll handle this collateral question.

Capitalization ― How much money have you put into the business?

How well-capitalized is your company? How much money have you invested in the business? Has your business grown? Have you reinvested the profits, or paid yourself a bigger salary? Investors often want to see that you have a financial commitment and that you have put yourself at risk in the company. Both your company’s financial statements and your personal credit are keys to the capital question. If the company is operating with a negative net worth, for example, will you be prepared to add more of your own money? How far will your personal resources support both you and the business as it is growing?

Conditions ― SWOT: What are the Strengths, Weaknesses, Opportunities and Threats that affect your business?

What are the current economic conditions and how is your company affected? If your business is sensitive to economic downturns, for example, the bank wants a comfort level that you’re managing productivity and expenses. What are the trends for your industry, and how does your company fit within them? Are there any economic or political hot potatoes that could negatively impact the growth of your business? (I wrote at length on SWOT analysis in my January blog.)

Keep in mind that in evaluating the five C’s of credit, investors don’t give equal weight to each area. Lenders are cautious. One weak area could offset all the other strengths you show. For example, if your industry is sensitive to economic swings, your company may have difficulty getting a loan during an economic downturn ― even if all other factors are strong. And if you’re not perceived as a person of character and integrity, there’s little likelihood you’ll receive a loan, no matter how good your financial statements may be. As you can see, lenders evaluate your company as a total package, which is often more than the sum of the parts. The biggest element, however, will always be you.

For more information about the five C’s of credit and/or B2B CFO, visit b2bcfo.com.

Business Credit Score

Protect Your Business Credit Score, Improve Business Policies

Most people know that how you manage your personal finances directly impacts your credit, but many don’t realize that proper management of your business financials is significant for protecting your company credit standing and ultimately a company’s growth and success. Just as a poor credit score can make it difficult for you to get a home or auto loan, it can influence the decision on a business loan or even the opportunity to lease office space. Maintaining a good credit score can be difficult for startups and small businesses that rely on payment for products or services.

Fortunately, there are ways to protect your company’s credit. At the core of it all, companies need to focus on receiving payments on time and keeping a reasonable amount of cash on hand to cover expenses. Enlisting staff support and making them aware of how to handle billing and payment inquiries and proper collection procedures can have a direct and positive impact on the company’s credit scores.

Create and enforce business policies

If you don’t have internal policies in place already, consider developing specific business practices that promote prompt and timely payments from your customers or vendors. Work with staff members and even key customers to eliminate issues in your organization that may adversely impact cash flow, including limiting the way your business takes payments.

When customers are consistently paying late or not paying altogether, consider automating the identification of delinquent accounts based on a formula of the customer’s credit rating, payment histories and buying patterns. This will allow you to manage the company’s accounts receivable investment more effectively.

In difficult situations, credit lines and payments can be worked out collaboratively with the customer to achieve the objectives of both parties. This may require creativity on the part of the credit manager and use of security, documentary and other credit management tools. Credit policy should be a tool used to expand company revenues as well as the customer relationship.

Provide proper training

Provide training across all departments that interact with clients or customers to ensure understanding of your company’s policies and objectives. Ensure all members of your organization provide a consistent message to the outside world, and anyone working in a customer service role knows how to answer questions about payment, deduction, dispute or credit-related problem. This can help eliminate payment delays by a customer waiting on callbacks and emails from the accounts receivable department.

When to start collecting

Use a credit and payment scoring model that triggers workflow actions. The scores should reflect credit risk and industry payment data, as well as your own experience with a customer to estimate a time for your company to begin collection action.

Be sure that collection performance goals are written down and that your staff are held accountable for their results. The goals should be in sync with those that drive senior levels of management but focus on more targeted metrics to draw team concentration to what’s important.

Partnering with outside agencies

Don’t shy from using collection outsourcing companies or agencies. While they will charge for their services, the alternative may be lower collection rates, higher borrowing and bad debt write-offs. This prioritization must be by employee as well, as some are better suited for volume collections as opposed to complex collections.

If your business is experiencing an unacceptably high level of bad debt, perhaps your credit processes are inadequate to the task. Another possibility is credit insurance, although a credit insurer will also require that you implement effective credit controls and policies. If you have tried improving your business with the steps suggested above, you may find it more beneficial to try turnkey solutions, including credit and collection outsourcing or even factoring.

For more information about how to improve your credit score and your chances at attaining a business loan, visit fswfunding.com.