The concept of borrowing money using collateral is called debt financing. Whenever a lender is considering financing a prospective client the very first hurdle that must be achieved is determining the borrower’s credit. It is important to provide ample information within and attached to a formal loan request that speaks to the potential credit question.
The concept of the five C’s of credit is based on the long standing reliance of creditors being able to successfully examine the risk involved in lending money to small businesses.
Here then are the Five Cs
- Collateral: This must be some form of liquid asset that could – in times of trouble, be instantly converted into cash to repay a loan. A loan is usually a percentage of this liquid asset. For example, a lender would finance 80% of a company’s accounts receivable. So what does the company have, which it owns free and clear, that has any value and can be borrowed against.
- Capital: The more capital the owners of the company have invested in their own company the greater their equity stake in the business. A lender likes to know a borrower will not simply walk away from the company. They want to see the owners have a lot to lose and therefore be careful with their decision making. This has the effect of lowering the risk.
- Character: All types of capital providers want to see who is going to execute the plan. What sort of history does the team have in their industry? Have they been successful in the past bringing their ideas to fruition? Does their personal credit show bad management of cash with tax liens and judgments? Unfortunately, individuals who show the willingness to walk away from obligations have a tougher time getting a loan.
- Capacity: The business model figures largely in the ability to repay a loan. With a term loan, the lender will determine within specified ratios if the business can maintain profitability while adding a new expense – the loan payment. With invoice factoring this actually does not apply, due to each funding event is based on an individual invoice that will be repaid by an account debtor. But generally speaking, how the loan will be repaid is critical to the decision to lend.
- Conditions: What is the intended use of funds? Knowing how much you are looking to borrow and what you need the capital for are important. The lender needs to see that you are competent enough to answer these questions. In your business plan show how you can overcome any potential obstacles. On a broader scale a lender might look to whether your particular industry, or agency that you are working with, are on the upswing or possibly winding down.
Credit is based on history and potential future. The earlier you control your credit history the better the chances are of breezing through the loan process. By keeping the 5 C’s in mind when making decisions that will grow a business you will insure access to working capital. Because the ability to access capital is the very lifeblood of any business.