The ABCs Behind the 5C's of Credit

If you’ve ever applied for a sizable loan from a lender, chances are you were asked a lot of questions and for a lot of financial details. Some customers wonder why lenders spend so much time learning about their business and their personal situation. Bottom line, lenders are assessing loan risk using the 5C’s of credit: character, capacity, capital, collateral, and conditions.

In our recent podcast and webinar with Oak Street Funding’s Director of Underwriting, Rob Roach, we discussed what those five C's mean and how they affect cash-flow-based businesses looking for financing. It’s great information to know and understand if you’re looking for a loan.

→ Watch Now: Deep Dive Into the 5C's: Understanding Credit

Character

In lending, character is all about how you and your business have performed in the past and how that can help predict future behavior. If you’ve shown responsibility with credit, applying for loans wisely and paying them back on time for example, that is character evidence you’re likely to pay back a future loan.

Some people ask how important a business owner’s personal credit history is when applying for a business loan. It depends somewhat on the size of the business and the size of the loan. The owner’s personal credit history is especially important when the business has only one or two partners or principals.

→ Download the 5C's Cheat Sheet

Do leaders at a company provide the breadth of expertise to ensure that the business will continue to thrive? The lender needs to know that the cash flow – the collateral for these kinds of loans – will continue and the loan will be repaid.

So, how can a business owner with a limited credit history build trust with lenders? One of the best ways is to start building relationships with lenders early, before financing is needed. Network at conferences and other business events. Find a lender that has products and services that fit your business needs. And give those lenders that fit a chance to get to know you and your company and character before it’s time do business.

Capacity

Capacity is a simple question, “What is your firm’s ability to repay the loan?” Our assessment of capacity is based looking at the funded debt to EBITDA ratio (debt load compared to earnings) and the borrower’s ability to cover payments on that debt with earnings. Beyond those financial benchmarks, many lenders will weave in character, i.e., what is the borrower’s personal ability to back up the loan if the business isn’t as successful as expected?

Lenders assess capacity by reviewing the potential borrower’s financial statements. Underwriters review how much leverage the business currently has and how much it will have after the loan.

If the borrower is seeking a loan for an acquisition, lenders also look at the financial statements of the target company. They’re trying to ascertain how much debt the borrower will be taking on from the acquired company and whether there will be adequate earnings to cover the debt service on all of it.

Borrowers sometimes wonder what the best strategies are to improve their debt-to-income ratio. The first is the most obvious: increase earnings and improve cash flow. Be careful what expenses are being run through the business. The second is to borrow prudently. Don’t overleverage the business so you’ll be able to borrow when you really need to.

Capital

The third C of credit is capital, represented by the equity the borrower has in the business or the cash they’re bringing to the loan closing. Usually, the more skin the borrower has in the game, the more the lender is able to loan and the better the terms are for the borrower.

How much capital does the lender expect? In some instances, the lender could be satisfied with the equity the owner has in the business, especially if the loan is for a first acquisition. Sometimes, a lender will expect a down payment. For working capital loans, there may not be an expectation of a down payment.

Lenders will consider how much capital a potential borrower has retained in the business. They are looking at how much the owner takes out of the business every year. Are they leaving anything behind to help fuel growth? Are they committed to a long-term strategy of improving the business? All these factors play into the lender’s assessment of capital.

Collateral

Traditional banks see collateral as fixed assets (real estate, buildings, equipment, etc.) Being a cash flow lender, Oak Street Funding looks at collateral as the value of your firm, the value of the recurring cash flows you have year in and year out. It’s why looking at financial statements for us is so important.

We recognize that cash flow can go away or diminish quickly, and too much debt can eat into healthy cash flow. Our approach allows us to make more and potentially larger loans to RIAs, CPAs, and independent insurance agents than banks that rely on traditional sources of collateral can manage.

→ Download the 5C's Cheat Sheet

Conditions

The final C of credit, conditions, refers to things happening in and around your business that affect its success. How long have you been in business? How’s your industry as a whole doing? Is it growing? Stagnant? Declining? How does the size of your business compare to averages in your industry? What is the regulatory environment for your industry like – is it favorable or not? Is the general economy doing well? What are you doing in your business that makes yours better than others? What is the overall credit and banking market like?

It can be a challenge to answer those questions, which is why at Oak Street Funding it’s so important to have a relationship with every client. We recognize that each client is unique and their situation – their conditions – are one-of-a-kind. We take the time to understand our client's business situation and how local and global forces affect them, so we can best serve their needs.