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mayo 31, 2016

The 5 Cs of Credit: A Helpful Primer Before Applying for a Bank Loan

Charisse Conanan Johnson

Creator, Charisse Says

Summary

Banks have tightened their requirements for lending. Read on to learn what five factors may help you as you begin applying for a bank loan.

Over the years, many have predicted that large banks, regional banks and alternative lenders would approve more small-business loans. It was news that may have been encouraging for any small-business owner thinking about applying for a bank loan.

After much optimism, however, recent data reports that this percentage has not changed much. According to the Federal Reserve Board’s Senior Loan Officer Opinion Survey on Bank Lending Practices April report, lenders have slightly tightened their standards for small businesses (defined as businesses with less than $50 million in annual revenue over the past three quarters).

Yes, even though we are nine years past the start of the Great Recession, banks still have tightened standards for small businesses. Despite the tightening, some owners are flocking to traditional sources given the increased scrutiny to online lenders.

But is it possible for small-business owners to overcome the rejection hurdle that comes with applying for a bank loan, and better position their business’ chance of getting approved for a loan?

According to Ricardo Devallon, deputy director of New York City’s Business Solutions, the answer depends on which financial institution is evaluating you. Devallon asserts that “each bank, CDFI (Community Development Financial Institution), SBA lender or alternative financier has their own processes and lending standards.”

With the closing of community banks in recent years, which traditionally placed greater emphasis on relationships with borrowers in their underwriting processes, it is even more important for business owners to have a deep understanding of what banks are using to evaluate their loan applications.

The group that Devallon leads directly helps small-business owners navigate the plethora of financing options in the market. Instead of focusing on why most businesses get rejected by lending providers, Devallon focuses on the factors that lead to loan approvals. Amongst these factors are what's known as the “5 Cs of Credit”—a concept not unique to Devallon, and worthy of explanation as you begin applying for a bank loan:

Collateral

Most owners are familiar with collateral because it sometimes means that an owner pledges a personal asset, such as a home, to the lender with the agreement that it will be the repayment source in case one can't repay the loan. Business assets such as real estate, equipment and working capital (e.g., account receivables and inventory) may also be pledged as a security against default.

Capacity

Cited as one of the most important of the factors, capacity reflects whether a borrower can handle their debt payments, both on a retrospective and prospective basis. The lender also considers the cash flow from the business, the timing of the repayment and the probability of successful repayment of the loan.

Upon my interviews with many traditional banks, one key capacity metric is the debt service coverage ratio, defined as how much of a business’s operating income will cover a debt payment. A debt coverage ratio above 1.25 is considered “safe” amongst many traditional lenders.

Capital

When an owner invests his or her personal money in the business, banks view this shared interest as capital. It is important for banks to know how much the owner also has at risk, particularly if something goes wrong. Lenders may prefer when an owner has a meaningful amount of personal capital committed relative to the requested loan size. If an owner asks for a $200,000 loan, but only has $10,000 (or 5 percent) of personal capital committed, a lender may not be as welcoming.

Character

As one of the most subjective credit measures, character simply reflects a combination of your personal credit history, reputation, years of business experience and/or educational background. A personal credit score may have a significant impact on the approval process; lower credit scores are usually associated with denied applications or higher interest rates if approved on a loan application.

Conditions

Lenders often consider local economic conditions, the competitive environment and sector-specific conditions that may affect the business. In evaluating these “conditions,” lenders also examine how the loan proceeds will be used within the business, whether for working capital, additional equipment or inventory.

As a result, business owners may want to be aware of the specifics for each of the “5 Cs of Credit” factors of the particular institution they approach for financing. Remember, however, that many lenders are inherently risk-averse toward small businesses because these ventures may be considered in the early part of their business lifecycle. In the Harvard Business School report, “The State of Small Business Lending: Credit Access during the Recovery and How Technology May Change the Game," former Small Business Administration administrator Karen Gordon Mills points to the information asymmetry problem that can lead to problems with assessing creditworthiness.

With the closing of community banks in recent years, which traditionally placed greater emphasis on relationships with borrowers in their underwriting processes, it may be even more advisable for business owners to have an understanding of what banks are using to evaluate their loan applications.

But, armed with an understanding of the “5 Cs of Credit,” one may be able to better prepare as they begin applying for a bank loan and move forward in the loan approval process.

Read more articles on loans.

Photo: iStock

 

The information contained in this article is for generalized informational and educational purposes only and is not designed to substitute for, or replace, a professional opinion about any particular business or situation or judgment about the risks or appropriateness of any financial or business strategy or approach for any specific business or situation. THIS ARTICLE IS NOT A SUBSTITUTE FOR PROFESSIONAL ADVICE. The views and opinions expressed in authored articles on OPEN Forum represent the opinion of their author and do not necessarily represent the views, opinions and/or judgments of American Express Company or any of its affiliates, subsidiaries or divisions (including, without limitation, American Express OPEN). American Express makes no representation as to, and is not responsible for, the accuracy, timeliness, completeness or reliability of any opinion, advice or statement made in this article.

Over the years, many have predicted that large banks, regional banks and alternative lenders would approve more small-business loans. It was news that may have been encouraging for any small-business owner thinking about applying for a bank loan.

After much optimism, however, recent data reports that this percentage has not changed much. According to the Federal Reserve Board’s Senior Loan Officer Opinion Survey on Bank Lending Practices April report, lenders have slightly tightened their standards for small businesses (defined as businesses with less than $50 million in annual revenue over the past three quarters).

Yes, even though we are nine years past the start of the Great Recession, banks still have tightened standards for small businesses. Despite the tightening, some owners are flocking to traditional sources given the increased scrutiny to online lenders.

But is it possible for small-business owners to overcome the rejection hurdle that comes with applying for a bank loan, and better position their business’ chance of getting approved for a loan?

According to Ricardo Devallon, deputy director of New York City’s Business Solutions, the answer depends on which financial institution is evaluating you. Devallon asserts that “each bank, CDFI (Community Development Financial Institution), SBA lender or alternative financier has their own processes and lending standards.”

With the closing of community banks in recent years, which traditionally placed greater emphasis on relationships with borrowers in their underwriting processes, it is even more important for business owners to have a deep understanding of what banks are using to evaluate their loan applications.

The group that Devallon leads directly helps small-business owners navigate the plethora of financing options in the market. Instead of focusing on why most businesses get rejected by lending providers, Devallon focuses on the factors that lead to loan approvals. Amongst these factors are what's known as the “5 Cs of Credit”—a concept not unique to Devallon, and worthy of explanation as you begin applying for a bank loan:

Collateral

Most owners are familiar with collateral because it sometimes means that an owner pledges a personal asset, such as a home, to the lender with the agreement that it will be the repayment source in case one can't repay the loan. Business assets such as real estate, equipment and working capital (e.g., account receivables and inventory) may also be pledged as a security against default.

Capacity

Cited as one of the most important of the factors, capacity reflects whether a borrower can handle their debt payments, both on a retrospective and prospective basis. The lender also considers the cash flow from the business, the timing of the repayment and the probability of successful repayment of the loan.

Upon my interviews with many traditional banks, one key capacity metric is the debt service coverage ratio, defined as how much of a business’s operating income will cover a debt payment. A debt coverage ratio above 1.25 is considered “safe” amongst many traditional lenders.

Capital

When an owner invests his or her personal money in the business, banks view this shared interest as capital. It is important for banks to know how much the owner also has at risk, particularly if something goes wrong. Lenders may prefer when an owner has a meaningful amount of personal capital committed relative to the requested loan size. If an owner asks for a $200,000 loan, but only has $10,000 (or 5 percent) of personal capital committed, a lender may not be as welcoming.

Character

As one of the most subjective credit measures, character simply reflects a combination of your personal credit history, reputation, years of business experience and/or educational background. A personal credit score may have a significant impact on the approval process; lower credit scores are usually associated with denied applications or higher interest rates if approved on a loan application.

Conditions

Lenders often consider local economic conditions, the competitive environment and sector-specific conditions that may affect the business. In evaluating these “conditions,” lenders also examine how the loan proceeds will be used within the business, whether for working capital, additional equipment or inventory.

As a result, business owners may want to be aware of the specifics for each of the “5 Cs of Credit” factors of the particular institution they approach for financing. Remember, however, that many lenders are inherently risk-averse toward small businesses because these ventures may be considered in the early part of their business lifecycle. In the Harvard Business School report, “The State of Small Business Lending: Credit Access during the Recovery and How Technology May Change the Game," former Small Business Administration administrator Karen Gordon Mills points to the information asymmetry problem that can lead to problems with assessing creditworthiness.

With the closing of community banks in recent years, which traditionally placed greater emphasis on relationships with borrowers in their underwriting processes, it may be even more advisable for business owners to have an understanding of what banks are using to evaluate their loan applications.

But, armed with an understanding of the “5 Cs of Credit,” one may be able to better prepare as they begin applying for a bank loan and move forward in the loan approval process.

Read more articles on loans.

Photo: iStock

 

The information contained in this article is for generalized informational and educational purposes only and is not designed to substitute for, or replace, a professional opinion about any particular business or situation or judgment about the risks or appropriateness of any financial or business strategy or approach for any specific business or situation. THIS ARTICLE IS NOT A SUBSTITUTE FOR PROFESSIONAL ADVICE. The views and opinions expressed in authored articles on OPEN Forum represent the opinion of their author and do not necessarily represent the views, opinions and/or judgments of American Express Company or any of its affiliates, subsidiaries or divisions (including, without limitation, American Express OPEN). American Express makes no representation as to, and is not responsible for, the accuracy, timeliness, completeness or reliability of any opinion, advice or statement made in this article.