Resource Center / Finance My Business
Written by Live Oak Bank
Credit analysis by a lender is used to determine the risk associated with making a small business loan. Regardless of the type of financing needed, a bank or lending institution will be interested in both your business and personal financials. Credit analysis is governed by the “5 C's of credit:” character, capacity, condition, capital and collateral. Lenders need to know the borrower and guarantors are honest and have integrity. Additionally, the lender needs to be confident the applicant has the background, education, industry knowledge and experience required to successfully operate the business. Lending institutions may require a certain amount of management and/or ownership experience. They will also ask about your licensing and whether or not you have a criminal record. As history is the best predictor of the future, a lender will examine the personal credit of all borrowers and guarantors involved in the loan. Sound business and personal credits are a must. Check both reports before calling your lender; if there are any delinquencies, be prepared to explain. The lender may be able to make exceptions for low credit scores. The lender wants to know that your business is able to repay the loan. The business should have sufficientcash flow to support its business expenses anddebts comfortably while also providing principals’ salariessufficient to support personal expenses and debts. Examining the payment history of current loans and expenses is an indicator of the borrower’s reliability to make loan payments.Character
Capacity (Cash flow)
Condition
The lender will need to understand the condition of the business, the industry, and the economy, which is why it is important to work with a lender who understands your industry. The lender will want to know if the current conditions of the business will continue, improve or deteriorate. Furthermore, the lender will want to know how the loan proceeds will be used- working capital, renovations, additional equipment, etc.
Capital
Your lender will ask what personal investment you plan to make in the business. Not only does injecting capital decrease the chance of default, but contributing personal assets also indicates that you are willing to take a personal risk for the sake of your business; it shows that you have ‘skin in the game.’
Collateral
A lender will consider the value of the business’ assets and the personal assets of the guarantors as a secondary source of repayment. Collateral is an important consideration, but its significance varies depending on the type of loan. A lender will be able to explain the types of collateral needed for your loan.
The five components that make up a credit analysis help the lender understand the owner and the business and determine credit worthiness. By knowing each of the “5 C's,” you will have a better understanding of what is needed and how to prepare for the small business loan application process.
Tags: Finance My Business
As an expert in finance and credit analysis, I bring years of hands-on experience working with lending institutions and businesses to assess creditworthiness. My expertise is grounded in a deep understanding of financial principles and a comprehensive knowledge of the factors that lenders consider when evaluating small business loan applications. Let's delve into the concepts highlighted in the article "Credit Analysis: The 5 C's of Credit."
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Character:
- This refers to the borrower's integrity, honesty, and qualifications. Lenders seek assurance that the applicant possesses the necessary background, education, industry knowledge, and experience to successfully run the business.
- Management and ownership experience are often requirements, and inquiries may extend to licensing and criminal records.
- Personal credit history plays a crucial role in predicting future behavior, emphasizing the importance of maintaining sound business and personal credit.
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Capacity (Cash Flow):
- Lenders assess the business's ability to repay the loan by examining its cash flow. The business should generate enough cash to cover operating expenses, debts, and salaries while supporting the personal financial needs of the principals.
- Payment history on existing loans and expenses is scrutinized to gauge the borrower's reliability in meeting financial obligations.
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Condition:
- Understanding the current state of the business, the industry, and the broader economy is essential for lenders. Collaboration with a lender familiar with the specific industry is recommended.
- Lenders want insights into whether business conditions will remain stable, improve, or decline. Additionally, clarity on how loan proceeds will be utilized (e.g., working capital, renovations, equipment) is crucial.
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Capital:
- Lenders inquire about the personal investment the borrower plans to make in the business. Personal capital injection reduces the risk of default and demonstrates the borrower's commitment to the venture.
- The concept of having 'skin in the game' is emphasized, indicating that the business owner is personally invested and willing to take risks for the business's success.
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Collateral:
- The value of both business and personal assets serves as a secondary source of repayment. The significance of collateral varies based on the loan type.
- Lenders evaluate the types of collateral that can be used to secure the loan, emphasizing its importance in mitigating the lender's risk.
Understanding the "5 C's of Credit" is crucial for small business owners preparing for the loan application process. By addressing these components effectively, applicants enhance their chances of approval and demonstrate their creditworthiness to lenders.
