Lenders such as Virginia Commercial Finance will use the 5 C’s of Credit as a framework to gather a more holistic view of the creditworthiness of a borrower. When looking at a potential borrower, lenders want to evaluate the risk of default. Using the 5 C’s, a lender can effectively measure the quality of the potential borrower and the loan. Through the 5 C’s of Credit, a lender examines a variety of factors before reaching a decision on whether to approve. As a business owner, you can increase your chances for loan approval by understanding the 5 C’s of credit.
At a glance, the 5 C’s of Credit represent:
- Character– broadly speaking, what type of person are you?
- Cash Flow- the cycle surrounding the amount of cash coming into and out of a business.
- Collateral- something you can pledge to back and secure a loan.
- Capital- the amount of your own money you have embedded in your business.
- Conditions- the market conditions of your industry.
Over the last 23 years, we’ve funded businesses experiencing both rapid growth and temporary losses. Through this experience VCF has become well versed at understanding Cash Flow, the 2nd C of Credit. Cash Flow is the lifeblood to every business! It indicates whether or not a company is generating enough cash to service debt and meet current obligations. Each business’ Cash Flow is specific to that business and changes based on the nature of the business and the current cycle the business is undergoing. As a business owner, you must first understand what Cash Flow is and how to measure it. Then apply this understanding to your specific business and determine if additional working capital may be needed to bridge any gaps.
So, What is Cash Flow, and How is it Measured?
Cash Flow is measured in a multitude of ways. Some lenders just look at your income statement to determine EBITDA (Earnings before Interest, Taxes, Depreciation and Amortization). VCF tends to look at total Cash Flow, and one very important indicator of Cash Flow to us is Free Cash Flow, also known as Operating Cash. This is the cash that exists before investment, purchasing of fixed assets, and other capital expenditures. Free Cash Flow is like a cushion; the amount of “extra” cash a company has. Free Cash Flow not only looks at your income statement, but also takes into consideration the changes in your balance sheet accounts. It more comprehensively determines if an entity is generating enough cash. Free Cash Flow largely services debt, typically the principle amortization of term debt. A company can also use Free Cash Flow to service new forms of financing, plan expansions, or make opportunistic inventory purchases.
How Does a Lender View My Cash Flow?
A lender must first pose the question, what is the business’s Cash Flow? What are the unique challenges to that business surrounding their Cash Flow? Once the lender fully grasps the Cash Flow cycle of an individual business (also known as the Cash Conversion Cycle), it is time to delve deeper to draw
conclusions. If your Cash Flow happens to be negative for the most recent period or two, the lender will want to know why, and when it is likely this trend will reverse. Using a highly-simplified example of a Manufacturing Firm, Cash Flow runs cyclically as follows:
Buy supplies from the vendor -> Create the product -> Customers buy the finished product on credit -> The vendors expect to be paid -> Finally, cash is collected from the customers.
Oftentimes, there may be gaps in your Cash Flow cycle. If you must wait to collect on your customers’ purchases, you may not have enough money to pay your vendors on time. Being able to demonstrate consistency in your business’ Cash Flow cycle is incredibly valuable when applying for a loan. This allows a lender to be more comfortable with your loan request because even if you do not have the money right now, they can predict when to expect it from you. This is important, because at the end of the day, Cash Flow is what pays back all loans.
What are the Cash Flow Benefits with VCF as my Working Capital Lender?
An asset based lender such as VCF can often provide financing in situations where Cash Flow is temporarily interrupted, because the loan is secured by the collateral. A company may be recovering from a downturn, a “bump in the road,” or have lost a major customer. They cannot meet their bills, and their existing line of credit is not providing enough liquidity to fund that recovery, or replace that customer. If a company’s Cash Flow is negative, is their story understandable? Do the other C’s of Credit come to bear weight that supports the loan request? Is the business owner willing to provide the lender the transparency they need to support them until they can get back to safer ground? Oftentimes, if a company can be provided with more Free Cash Flow, they can acquire new inventory, new employees, and other resources to service new customers, and eventually get back on their feet.
At VCF you don’t need to borrow more money than you require. On any given day, you can submit an advance request to draw on your Line of Credit (LOC) in the amount needed. As payment from your customers is received, your LOC is continuously paid down, increasing your availability to borrow more money as needed. If you realize you don’t need your full line of credit, there is no need to utilize the full line. Many companies, after they recover from a troubled point in time and return to previous levels of Cash Flow, do not need the additional flexibility, and can transfer back to a traditional bank LOC.
Alternatively, perhaps a company is healthy and simply wants to take advantage of an additional growth opportunity. Such a company has no problem paying their bills and meeting their obligations, but they do not have the extra means necessary to grow and expand. VCF offers greater cash availability for receivables and inventory than a traditional lender.
For example, a company may have $1,000,000 in receivables. A traditional lender generally gives no more than a 2:1 collateral loan, so the company would receive a maximum of $500,000. VCF typically advances around 80-85% against receivables, so VCF could provide up to $850,000. That would result in a potential $350,000 increase in cash availability.
VCF can often offer tremendous Cash Flow flexibility when compared with a traditional lender.
If you want to increase your business’s Cash Flow, consider asset based lending as the best option for you and your business. Take advantage of the opportunities you may miss by not securing the financing you need – contact VCF today at 804-897-1200.