Running a business requires a lot of capital. Many businesses have to seek outside funding for one reason or another, whether it’s to meet day-to-day expenses, update equipment, or use it for something more important like expansion. Qualifying for a loan as a small business owner comes with its own challenges, so how can you boost your chances of getting approved?
Small businesses looking for financing can improve their chances of getting approved if they meet the conditions that the lenders have in place. One method that many lenders use to assess the creditworthiness of their applicants, and therefore the level of risk in lending to them, is the Five Cs of Credit. This method evaluates these five factors:
- Capital city
- Terms & Conditions
Knowing the Five Cs of Credit and how finance companies measure them can give you a better understanding of how you can put your business in a stronger position for loan approvals.
The 5 Cs defined
Lenders put themselves at risk when lending money to individuals and small businesses. The Five C’s of Credit Assessment allows lenders to assess whether an applicant is worth that risk. Some lenders may also base the terms of the financing they provide on the information they get by evaluating the Five Cs.
Here’s how lenders assess risks and qualifications across the 5 Cs:
Lenders examine the character of an applicant to assess his reliability and responsibility when it comes to handling debts and repayments. They want to find out if they can count on you to make your repayments on time.
Lenders assess the character of a loan seeker by examining their credit history, which they can easily obtain from credit bureaus (Equifax, Experian, and TransUnion). Your credit report contains relevant information about your financial history and tells lenders whether you have paid your debts on time, have a history of defaults, or have filed for bankruptcy in the past 10 years. Credit reports also contain your credit score, which directly reflects your creditworthiness. In some cases, lenders may contact your references to assess your reputation.
You can improve your character by paying your bills on time. Missing even a single payment can lead to a drop in your credit score. It’s also helpful to check your credit reports for errors and inaccuracies from time to time. If you find any errors, call the credit bureaus immediately.
Whereas the character assesses whether an applicant would have repay their loan, the capacity assesses whether they can. In this case, the finance company checks the financial statements of the business to make sure that the business has enough to make the payments if it gets approval for the business loan.
When assessing the capacity of the business, lenders look at your debt-to-income ratio (DTI), which is a measure of your business’s monthly income relative to debt payments. A low DTI ratio increases your chances of getting business loan approval. Typically, banks consider companies with a DTI ratio below 36% to be a good candidate. Lenders will also look at the debt, cash flow, bank statements, and income stability of the business.
There are two ways that businesses can improve their capacity. First, they can reduce their debt. So when banks or alternative lenders assess their DTI ratio, they can prove that they have enough financial resources to meet the required monthly payments for the new loan. Second, they can increase their cash flow by adding additional income streams to the business. Lenders recommend that businesses apply for loans when they are able to show a stable income that can support their financial obligations.
Lenders assess capital to measure a business owner’s financial commitment to their business. They do this by looking at the personal investment the owner has made in the business.
Essentially, banks want to see what the business owner has to lose if the business goes bankrupt. Lenders want to know how committed you are to keeping your business up and running. This is an indication that you are fully committed to seeing your business succeed and, therefore, will be responsible for making your repayments on time.
Collateral is an asset that business owners agree to serve as collateral for the business loan they seek. It can be equipment, immovable, inventory, invoices or vehicles. Business owners with assets to present are more likely to get favorable terms in their business loans.
The collateral you pledge serves as a backup to the banks if your business fails to repay each month. In other words, if you don’t pay back the business loan, lenders can seize the asset you promised to recoup their losses. Depending on the type of loan you are applying for or the finance company you are using, it may not be necessary to present collateral for the loan. However, the company may end up paying a higher interest rate as a way for the bank to mitigate the risk associated with the lack of collateral.
Conditions are the factors that contribute to the performance of your business. These may relate to the current state of the economy or the survival rate of businesses like yours. In other words, banks want to assess anything that might affect your ability to repay your loan in the future. Even if you are able to make payments over the next few months, assessing the terms allows lenders to consider the various risks that could affect your long-term repayments.
Terms also refer to how you plan to use the funding to move your business forward. Lenders need to make sure that their money is put to good use and that whatever your business plan, the loan will produce a profit, as this will ultimately determine whether you can pay it back or not.
Lenders assess the conditions in your industry by performing their business risk analysis. They look at the industry in which your business is based and compare how your business is performing against competing companies. If you have received loans in the past, they can also look at how you used them.
The best way to improve your odds here is to show the banks how you will use the funds and how they will improve your business results. This could mean presenting a detailed business plan explaining every detail of how you will turn your plans into profits.
Improve the financial base of your business using the 5 Cs of credit
As a small business owner, it is your responsibility to make sure that your business has enough capital to keep operating. To do this, you might need the help of loans. Whether you apply for one through banks, credit unions or others alternative lenders, you must meet certain criteria to get your approval. Many lenders use the 5 C’s to determine an applicant’s eligibility for a loan. You must be proactive in using this method to first assess your own business, before applying for the loan.