The Five Cs of Business Credit

 

Establishing credit for your business is essential for any new business as it allows you to separate your business credit from your personal and begin establishing a credit history. Meeting with a lender like Pillar Bank doesn’t have to be intimidating when you’re prepared.

Most lenders consider five areas when reviewing a credit / loan request. Prepare with an assessment of your strengths and weaknesses in each of these areas—Character, Capacity, Collateral, Commitment and Conditions. This will help improve your chances of having a productive meeting with your banker.

1.    Character:

Your banker will likely be evaluating the following related to your character:

  • Credit history and credit score (Know your Credit Score Blog). How dependable are you in paying your debt and managing your credit usage?
  • Background and ability to be a good owner, operator, and manager.
  • Training, knowledge, and direct experience in the business sector.
  • Transferable skills and experience from a similar business sector.
  • Financial competency. How capable are you of using financial information to make management decisions?
  • Record keeping. Do you understand the importance of record keeping and have a process in place?
  • Planning ability. Are your plans well thought out and logical?
  • Shortcomings and strengths. Do you have someone on your team to complement your strengths and weaknesses?
  • Understanding of your business and marketplace. Do you know the competitive landscape and how your business will differentiate itself?

2. Capacity:

Capacity is the ability to pay back the debt, replace the assets as they wear out, and provide money for living and expansion. Have you heard of the saying, “Cash is King?” A term your banker will often use is liquidity which means you’re able to meet ongoing debt payments, vendor commitments, and operating expenses.

You might also hear a business banker use the term, debt service coverage ratio. One way to think of it is the cash cushion after you have paid for everyone, covered all your expenses, and paid your loans. If that debt service coverage ratio is tight or close to 1:1, then there is not much cash on hand to pay for unexpected expenses and events or to respond favorably to new opportunities. Strong debt service coverage is important for a business owner as well. (It helps them sleep better at night.)

Working capital is another good term to know. It is the difference between current assets and current liabilities. Strong cost controls are critical. Too many business owners get caught up in tracking sales as their key metric. Your net profit is a more significant amount to focus on. Strive to get the most bang for your buck and remember that you can only spend that buck once.

The capacity to generate cash flow that exceeds expenses is the first way to pay back a business loan. What good debt service coverage ratio should business owners strive for?

Each bank determines what that number is for them. However, the standard industry figure is 1.25x. Another way to think about it is for every free dollar of cash to make a loan payment, there is an extra quarter for a cash cushion. Remember, “Cash is King.”

3. Collateral:

Collateral is also referred to as security and is the second way to pay off debt. Lenders do not want to be business operators, nor do they want to take control of collateral. However, if the cash flow fails as the primary way to pay down debt, bankers require a backup plan or tangible assets to be liquidated to repay the debt further.

Collateral is evaluated, in part, by the time and cost required to sell the asset should the bank need to foreclose to pay down unpaid debt. A familiar term when considering collateral is the advance rate, or discounted collateral. It is the value the bank will assign to the collateral based upon the bank liquidating the asset and paying down the principal on the remaining loan balance. The book value of the asset is reduced based upon this step.

A healthy and robust cash flow is always preferred to collateral as the primary way to pay down debt. What if there is no collateral or limited collateral? Is the loan going to be declined right off the bat? Not necessarily.

Another way to strengthen your loan request may be by partnering with another financial services program like the Small Business Association (SBA), a local microlender, or an economic development agency. Your lender will know these financial partners.

4. Commitment:

The level of financial and personal commitment to the business is also important to your lender. A financial commitment is the amount of money the owner invests in the business. Expecting 100% bank financing is not likely. Personal commitment to the business and paying back debt includes lifestyle choices. Controlling your personal spending to create savings and preserve personal liquidity in case of emergencies at home or the business is key.

Commitment in the form of personal cash contribution and personal guarantee is the third way to pay off debt. Personal guarantees show commitment. Why should the bank provide a loan if a borrower is unwilling to personally promise to pay back the debt by signing a personal guarantee?

It is strongly encouraged to get an advisor or business mentor to help you navigate all areas of your business as you get started. This will help ensure you set yourself up for success.

5. Conditions:

Conditions generally include markets, consumer trends, economic forecasts, and environmental or regulatory considerations. Analyzing and understanding the conditions a business faces is best documented in a business plan. Even if all the prior Cs of credit are strong, conditions may make it challenging for a lender to approve your loan. For example:

  • How accessible and secure is the market?
  • What is your competitive advantage?
  • Who are your key competitors?
  • What are the consumer trends that may affect the business? During COVID lock-downs, consumers bought goods but not services, which is reversing.
  • What is the local labor supply? Is there a steady flow of qualified employees?
  • What are the global and local economic strengths, weaknesses, opportunities, or threats?
  • What is the impact of supply chain disruptions or increased freight and shipping costs?
  • Are there environmental or regulatory restrictions?

A lender will evaluate whether a loan request is feasible, if the business is profitable, and whether the risks are acceptable. Good communication skills to express goals and objectives to your lender and explaining how your plan is feasible and profitable are essential.

Considering the current conditions affecting a business seems like a challenge. There are many variables to evaluate, and the conditions will differ for different companies. It can be a lot to think about and possibly even overwhelming if this is all new to you. Confidently prepare by thinking through the Five Cs of Credit. And don’t hesitate to reach out to your bank to discuss your options and answer your questions.

This article was written by Rick Bonlender who is V.P., Commercial Loan Officer with Pillar Bank, located in Baldwin, Balsam Lake, Chippewa Falls, Clear Lake, Plum City and Spring Valley, Wisconsin.

At Pillar Bank, we are a trusted local partner who is committed to providing guidance and resources for people in our communities to thrive. Reach out to our friendly staff by calling 715-684-3366, emailing https://www.pillar.bank/contact-us/, or visiting one of our locations in Baldwin, Balsam Lake, Clear Lake, Chippewa Falls, Plum City, and Spring Valley, Wisconsin.