The 5 Cs of Credit

March 9, 2023 Leah Driver

banker helping people

The 5 C’s of Credit for Small Business Owners

As a small business owner, seeking a business loan often signals a period of growth and expansion. While every lender has their own specific criteria to assess potential borrowers, there are 5 key areas used to judge your creditworthiness and determine your interest rate.

Capacity, character, capital, conditions, and collateral each carry their own value. In order to determine your strengths and liabilities within these 5 areas, we recommend consulting with your strategic banking partner to set yourself up for success.

Read on to learn more about these categories, how to assess your eligibility within each, and what you can do to position yourself for the best rates possible.

1. Capacity

After applying for a loan, lenders will evaluate your capacity and cash flow. Lenders will need to feel confident that you can repay the loan and will look at your revenue and expenses, as well as your repayment timing in your business plan.

While every lender is different, your debt-to-income ratio (DTI) will play a key role in loan approval and your interest rate. Your DTI is calculated as: your total monthly debts divided by your gross monthly income. Think of it like this: the lower your DTI, the more confident lenders will feel that you’ll be able to keep up with repayments.

How to Improve Your Capacity

The best ways to improve your capacity are also the most straightforward. The first way to improve your capacity is to increase your income and cash flow. While your cash flow doesn’t always have to come from your full-time job (consider freelance work or passive income), lenders will need to know that the inflow is consistent.

The second way to improve your capacity is by decreasing your debt and paying off any outstanding loans, which ultimately increases your capacity for loan repayment. While this strategy may require a little extra patience, it will definitely pay off in the long run.

2. Character

Your character is often considered by lenders to be the best indicator of whether this will be a successful relationship for both parties. They’ll evaluate your credit scores to assess your financial habits, look at your industry experience and background for strong indicators in your ability to operate and grow your business, and ask for personal and business references. Ultimately, lenders assess your credit to gain a full understanding of who you are.

How to Improve Your Character

Improving your character is all about cleaning up your side of the street and giving lenders a holistic picture of your credibility and commitment. Before applying, make sure your credit history is correct by contacting the credit bureaus about any discrepancies. If you have any delinquencies, there’s still hope—be prepared to explain and supplement your credit reports with reliable references and information to support your financial situation. While improving this area can be understandably daunting, working with a banking team that takes the time to know you, your business, and your goals can help alleviate some of the pressure.

3. Collateral

Lenders are well aware that sometimes, life happens. Conditions beyond your control may prevent you from making repayments. If that’s the case, lenders will want to ensure you have other assets that can be used instead. Loans secured with collateral are called secured loans or secured debt, as you’re guaranteeing that the loan can be repaid in some form. As a result, a secured loan may get you a lower interest rate.

How to Improve Your Collateral

Improving your collateral can be as simple as talking to your banking institution about your loan agreement and terms. However, it’s important to note that the types of assets that count as collateral can vary greatly depending on your lender.

4. Capital

The amount of capital you have allocated towards your business shows lenders whether you’ve got a fighting chance in the game. Capital refers to money, whether it’s your own or from investors, that you’ve already put towards your business. Your lenders want to feel that you’re invested in your success and serious about making it work. Additionally, the more capital you have, the less of a risk you pose for default or failure to pay back the loan.

How to Improve Your Capital

Think of the capital you’ve invested in your business as a down payment. Patience and a consistent savings plan is the most straightforward way to build your capital. If you’re on a timeline that’s far into the future, you may consider ensuring that your down payment savings yield growth by investment.

5. Conditions

Finally, lenders will evaluate whether or not there’s a market for your business. This is where creating a solid business plan comes into play. You’ll want to prove to lenders that you’ve assessed the economic conditions, your competitive advantage, demand for your service, the relationships that you have with other vendors… and show you still have a vision for success.

How to Improve Your Conditions

While external conditions such as the market and economy are beyond your control, you can prove that you have a thought-out, well-researched strategy for when things go awry. Showing that you have strong prospects and healthy financial projections can build confidence with your lender.

Which C is Most Important?

Each area carries its own value and should be taken seriously. However, character and capital are usually considered the most important for lenders. Additionally, not all lenders will assess your creditworthiness in the same way, making it crucial for small business owners to find an institution that will walk you through their process.

Consider Taking a Holistic Approach

At the end of the day, you will need to demonstrate credibility across the board to qualify for a business loan. Creditworthiness is often considered a holistic picture, as each area cannot support your business’ success on its own.

For example, let’s look at Janis, a wellness practitioner who is looking to open her own office in her small, Central Indiana hometown. She’s accumulated several, consistent streams of cash flow (capacity), has made several, solid personal investments into the business (capital), and has maintained a healthy credit score over the past few years (character).

However, her lenders are concerned that there isn’t a market in her hometown for wellness and tell Janis that the conditions aren’t looking favorable. Janis can improve her chances by consulting her trusted financial advisor and team of experts to create a business plan that shows a strong reason for incurring debt as well as a developing demand for wellness products and services in her county. Additionally, she can talk to her bank about including a rental property that she owns as collateral.

We’re Here As Your Strategic Partner

Assessing your credibility in the 5 C’s isn’t always the most straightforward. At Citizens State Bank, our Relationship Managers are here to understand your business goals and help you determine the path to success.

Request a financial assessment today to get started.

Request Your Financial Assessment

The views, information, or opinions expressed in this article are solely those of the author and do not necessarily represent the views of Citizens State Bank and its affiliates, and Citizens State Bank is not responsible for and does not verify the accuracy of any information contained in this article or items hyperlinked within. This is for informational purposes and is no way intended to provide legal advice.

Share This: