Most companies need to borrow money from time to time in order to grow their business. They might need a loan to expand operations or purchase inventory to fulfill customer orders. Whatever the reason, they must first be approved for a loan by the lender before they may borrow. What can a business do to help ensure that they get approved? There are several factors to consider for the credit-worthiness of a company.
Five C’s of Credit
Let’s begin by reviewing the Five C’s of Credit that most banks use to make lending decisions. Understanding the Five C’s will help you recognize what it takes to increase your creditworthiness.
Character: The character of your company is somewhat of a subjective judgment made by the lender. It’s based on the owners, leaders, and management team of your company. Lenders look at the following:
- Personal credit histories of your company’s owners and the loan guarantors
- Tenure and success of your company’s leaders and management team
- Leadership succession plan of your company
Collateral: Collateral provides security to the lender in case your company is unable to repay the amount borrowed. Lenders assess the following:
- How well the collateral matches the loan request
- Type, value and performance of the collateral
- Current appraisals for long term assets being pledged for collateral
Cash Flow: Cash flow is an indicator of whether you can repay the loan. Lenders evaluate the following about your company’s cash flow:
- Consistency of recurring cash flow
- Explanations for insufficient cash flow or historical or recent losses
- Balance Sheet, Income Statement and Cash Flow Projections are a crucial requirement
Capital: Capital demonstrates your investment in and the prior performance of the company. Lenders determine the following:
- Current ownership equity in the company
- Plans, if any, to inject additional cash into the business
- Outside assets that can be pledged to strengthen the loan request
Conditions: Industry Conditions impact your company, although you may not have any control over them. These factors include:
- Positive or negative conditions of your industry
- Current economic conditions both global and local
- Current lending environment (How much risk is the lender willing to take?)
The Strength of Your Credit History
Your company’s credit history shows how well it has handled previous credit obligations. Lenders review it to determine whether:
- You have an established credit history
- You’ve been delinquent or defaulted on previous loans
- You have the ability to repay the principle and interest on the loan
Your company’s credit history can serve as a positive or negative reflection of your cash flow. Frequent delinquencies might indicate your company has experienced cash flow shortages in the past. The absence of delinquencies generally indicates you have sufficient cash flow to meet your credit obligations.
Being Prepared With Your Balance Sheet
When making a credit decision, lenders will review your financial statements including your balance sheet. Your balance sheet will help them assess two more of the 5 C’s of Credit: capital and collateral. Here are some tips for providing a quality balance sheet to lenders and being prepared to answer the questions you might be asked.
- Be prepared to explain material changes in assets or liabilities. Your balance sheet is a snapshot of your company’s financial position at a specific point in time. Expect a lender to ask you if there have been any material changes to your assets or liabilities since the balance sheet was prepared.
- Provide at least three years of balance sheets. Lenders will ask you for at least two years of balance sheets. Some may require three. Review your balance sheets for large changes in assets, liabilities, and equity before giving them to the lender. As always, make sure you know the numbers and they make sense!
- Know your debt to equity ratio. Lenders will evaluate your debt to equity ratio in comparison to industry averages. This ratio is simply your total liabilities divided by your book equity. Calculate it yourself and be prepared to explain why it’s either high or low compared to your industry.
Caring for Character and Conditions
We still have to account for two of the 5 C’s of Credit: character and conditions. Lenders will review the personal finances and credit ratings of the company’s owners when making a credit decision. Be sure your personal credit history is in order if you’re one of the company’s owners. The personal finances of owners are kept separate from the company’s finances but they are a reflection of how you may operate your business. Business accounts cannot be used to pay the personal expenses of owners.
As stated earlier, conditions of the industry may be outside the control of the company. However, lenders will want to know what your company is doing to deal with those conditions. Be prepared to explain how you’re accounting for economic or industry downturns.
Let VCF support your business on its desired path
By now it should be very clear how your company’s history impacts credit-worthiness. Your personal and company credit history, especially payment history, plays a big part in your credit risk rating. A positive or negative change in your income statement or in your assets, liabilities, and equity as shown on your balance sheet are other determining factors. Finally, past blending of owner and business finances could be detrimental to your loan approval. Therefore, it’s very important to understand the five C’s of Credit, so you can position your company in the best way possible to make it credit-worthy.
Looking for a financial partner that can help you evaluate the five C’s of Credit and thinks outside of the box? Contact VCF today at 804-897-1200 to learn more about our custom financing solutions, or check out our Prospective Borrower Application to get started now.