The financial crisis caused many lending institutions to clamp down on providing loans to businesses. There was no hidden agenda to denying loan applications because they have an incentive to loan money to businesses: this is how they make money. However, these institutions only want to lend money to a business that can repay to loan on time and in full. This is standard practice even before the U.S. economy went south.
Typically, lending institutions use an analysis system to determine the creditworthiness of the business. Similar to the standard used on individual borrowers, the system consists of five criteria that helps lenders determine overall risk potential in approving a loan. These crucial elements are: capacity, character, capital, collateral and conditions.
Understanding what is known as the five Cs is important if you want to be approved for a loan. You might not be in the market for a business loan right now. However, you will want to follow these fundamental principles to make sure you maintain good business credit.
Capacity refers to the ability of your business to repay a loan in a timely fashion. Typically, the lending institution will review the financial history of your business. This helps them determine whether they will approve your loan application. Therefore, it is vital that your business has a pristine repayment history.
Every business has projections; historical information is based on facts and is used to support your ability. Unless you have good historical information, the lender views your declaration of repaying the loan as simply a plan. In addition, the lender also assesses how much debt your business can handle and whether the requested amount is justified by your cash flow.
The income that your business generates versus operational costs determines if it truly has the capacity to repay a loan under lender terms. Lenders may look at a two or three year period for the analysis.
Payment history is another component used to evaluate your business’s capacity. This refers to the timeliness of payments you made on previous loans. Commercial credit rating companies usually provide this information to lenders.
Having contingent sources for repayment may increase your business’s chance of being approved. With additional sources of income, lenders know that you have other means to make loan payments if for some reason the business income does not come through. These sources could be personal assets or a spouse’s income outside the business.
Lending institutions want to know that they are approving loans for a reputable and trustworthy business. Additionally, they want to know that you are an industry expert. Therefore, your character – as a principle within the firm and the business’s reputation – is of vital importance when you approach a lender for funding.
Expect some lenders to also review your personal credit history, so it is imperative that you also maintain a strong personal credit score. Some lenders align personal habits with business practices. If you have a habit of maxing out credit cards and minimizing payments, lenders will assume this is how you run your business.
Before applying for a business loan, make sure any personal debts that could have a negative affect are settled. Lenders may also review your education and relevant work experience as part of analyzing your business for credit approval.
Undercapitalization is the most common reason many new businesses fail. However, why should a lending institution invest in your business if you have not done the same? Most lenders will scrutinize all financial investments made by you and/or business partners. Your level of financial investment is evidence that you have a stake in wanting the business to succeed. Having this type of track record demonstrates that you are dedicated enough to invest personal resources.
To the lender, capital represents your personal investment that could be lost if the business fails. Lending institutions will not fund 100 percent of your business venture. While there is no fixed amount that lenders expect to see, most find that having at least 25 percent of personal resources invested shows a sign of good faith and belief in the business.
Historically, the most important criterion for obtaining a business loan is having good collateral. This can be any tangible asset such as equipment, real estate or even purchase orders. If you have orders coming in, lenders will view these as something you can fulfill and use the proceeds to pay back the loan.
Inventory, machinery and accounts receivable are also considered collateral. Lenders know that they can sell these items if you fail to repay the loan. Assets generally not considered valid collateral include used equipment, computers or an old company truck. Valuations of these items do not present substantial money that a lender could receive as payment or if you default on the loan. Other than business collateral, lenders may consider your home, a stock portfolio or 401(k) plan.
For small business loans, your personal assets are required before the loan is approved. Use of your personal assets gives lenders the right to sell those items to satisfy outstanding loan balances that are not repaid. In all cases, collateral is considered a secondary repayment source. Given a choice, lenders would prefer cash to repay the loan, not personal or business assets.
In general, conditions present an overall evaluation of the general economic climate in which your business operates. Not only does this include the economic conditions that are specific to your industry, but also the country’s overall economic state is important. This is why so many businesses had a difficult time getting approved for a loan for several years following the Great Recession. Even businesses that had good historical records were considered risky loans because of the level of economic uncertainty.
In a good economic climate, lending institutions rely heavily on economic factors. Thriving during an economic growth period is a clear sign that the business will be granted.
Lending institutions also want to know how the money will be used as part of their conditions evaluation. If you plan to make an investment of acquiring assets or expanding your market base, there is a good chance that the loan will be approved. However, if you need the loan to cover operational expenses, you have an equal chance of being denied.
This evaluation element includes factors such as:
Current industry trends are also of great concern, which is why certain lenders only approve loans for certain industries. Before applying, make sure you are targeting lenders that will view your loan favorably.
Start with the lending institution where you have current business and/or personal accounts. If they are reluctant to lend, look at a few others. Just as you would want a second or third opinion on a medical diagnosis, do not limit yourself to the approval/disapproval of one lender.
Keep in mind, however, that shopping around with different lenders may require different criteria. What is acceptable with one bank might be looked upon negatively by another. Bottom line: do your homework and find the best lender suitable to your business and purpose for the loan.
Building and maintaining good business credit extends beyond being approved for a loan. You will have other financial resources at your disposal that keeps your business afloat if turbulent times hit. You can respond and adapt quickly to market demands. Good credit gives your business a financial cushion to increase operational capacity without cutting off your cash flow.
Staying ahead in highly competitive markets is easier with a good business credit profile. Your business will reap huge dividends in more ways than one.
