The Five Cs of Credit: What Are Lenders Looking For?

The 5 Cs of credit is a system that many lenders and other funding providers use to determine how creditworthy a borrower is. It’s not a universal system, meaning not everybody uses it. But it’s used by enough lenders that you’ll definitely want to familiarize yourself with it.

What are the 5 Cs of credit used for? Well, by assessing these 5 specific aspects of a borrower’s financial profile and details of the loan they’re applying for, lenders essentially try to reduce the level of risk they take when lending.

Keep in mind, though, that not all lending institutions are focused on the same characteristics – banks may be more concerned with making sure borrowers have assets to secure their loans, while alternative lenders will often focus more on revenue and credit scores. It really depends on the lender you work with.

But before we get into the specifics – what are the 5 Cs of credit? How do lenders use them? And why are the 5 Cs of credit important for business owners to know?

Here is where you’ll find all of the answers!

Why are the 5 Cs of credit important?

The 5 Cs of credit – also known as the 5 Cs of credit analysis – are important for every business owner to know about for one very simple reason: lenders care about them (including those in the Become online business lending marketplace!). And the info that’s important for lenders to know is going to also be important for potential borrowers. So, if you want to be ready for the day when you want or need to take a loan, you should learn about the 5 Cs of credit analysis.

Regardless of how you or anyone else might feel about the fairness or value of using the 5 Cs of credit as a way to gauge a borrower’s creditworthiness, that’s precisely what lenders do. But educating yourself on the basics of what the 5 Cs of credit are is just the start. To truly prepare for the loan approval process you’ll also need to learn how lenders actually use the 5 Cs.

Knowing, understanding, and improving the 5 Cs of credit can help you prove your business’s creditworthiness to lenders and potentially increase your business loan approval odds.

The bottom line: If you plan on ever applying for business loans or any other type of business funding, you’ll want to make sure you have your bases covered when it comes to the 5 Cs of credit.

What are the 5 Cs of credit?

The 5 Cs of credit analysis are:

1. Character
2. Capacity
3. Capital
4. Collateral
5. Conditions

1. Character

What lenders look for: When assessing credit character, lenders will look at your credit history. They’ll want to see if you’ve borrowed money, how much it was, if you paid it back on time, if you’ve filed for bankruptcy, and so on. In essence, they want to know if you have a good track record of paying your debts on time, in full, and on a consistent basis.

Quick fact: According to a 2019 small business credit survey, more than one-third (36%) of small business credit denials were due to a low credit score. This illustrates the importance of having strong character, as the 5 Cs of credit defines it.

How lenders analyze it: To analyze your credit character, lenders will look at your personal and your business credit scores and histories, including payment history and credit utilization. They may also look into your reputation by reaching out to references to see how you’ve interacted with them on a personal and business level.

How to improve character: First and foremost, make your payments on time. If you’re behind on paying off your debts, you’ll appear a riskier borrower to lenders. Secondly, foster a relationship with your lender – whether your bank or an alternative lender. Generating good rapport can help you get better terms for your loan. That might mean taking a loan now with less-than-perfect terms and using that as a way to build a good reputation with that lender.

Note: Due to the current circumstances regarding the coronavirus pandemic, federal law now gives every American the right to access their credit reports through the major credit bureaus for free once a week. You can check your credit reports for free by visiting AnnualCreditReport.com.

2. Capacity

What lenders look for: Before lending you money, lenders want to see that your cash flow will be enough to cover future payments. In other words, when they look at your credit capacity, lenders are checking your ability to pay back the loan.

How lenders analyze it: To assess your credit capacity lenders will refer to several measurements including your debt-to-income ratio, your debt service coverage ratio, and your excess cash flow. The stability of your income may also come into question (seasonal businesses may find this factor problematic).

How to improve capacity: There are two general ways to improve your credit capacity. First, reduce your debt. That means paying off most of your debt so you can demonstrate that you have enough financial resources to pay off the new loan you’re applying for. Second, increase your cash flow. Even if you can’t reduce your debts right away, you can find ways to cut back on your costs and retain more of your gross profit.

Note: There are important differences between good debt and bad debt. In fact, having no debt at all can be a sign to lenders that you’re not confident in the ability of your business to earn enough to pay back its debts. It may seem paradoxical, but being in some amount debt can actually help you get approved for a loan – as long as it’s not too much!

3. Capital

What lenders look for: In assessing your creditworthiness, lenders will want to see how much money you’ve invested in your business along with your business’s net worth. Both of those factors will indicate that you’ve “got skin in the game” and that you’re not such a risky investment.

How lenders analyze it: For this factor in the 5 Cs of credit analysis, lenders will look at how much money you’ve invested in your business, the valuable business assets you have (equipment, real estate, etc.), and the ratio of debt to equity. If you’ve invested more, have more valuable assets, and have a low ratio of debt to equity, then your business has got step three of the 5 Cs of credit analysis covered.

How to improve capital: Keep detailed records of all personal investments you make and have made in your business. Invest more, if possible. It may also be a good idea to speak with a financial advisor about whether or not to refinance your business loans.

4. Collateral

What lenders look for: Collateral can come in the form of business equipment, commercial vehicles, inventory, real estate, accounts receivable, and even a borrower’s home. The bottom line: Lenders want to know what valuable assets your business can use to repay the loan if you fail to make repayments and move into default.

How lenders analyze it: Lenders will analyze your credit collateral by evaluating what valuable assets you have, how much they’re worth, their depreciation rates, and so on. Putting collateral down as security on a loan will often result in better rates, loan terms, repayment amounts and schedules, and so on.

How to improve collateral: Consider the advantages and disadvantages of purchasing versus leasing business equipment. If you’re leasing, you can’t use that equipment or vehicle as collateral. Additionally, in order to protect your personal assets from seizure in the event that you can’t repay your business loans, you can register your business under certain entity types and be safe from that risk (such as LLCs or a corporation).

Note: If you don’t have valuable assets to use as collateral, or if you don’t want to put your valuable assets down as security, then you’ll want to apply for unsecured business loans. Keep in mind, though, that lenders may still take your collateral into consideration when evaluating your creditworthiness – even for an unsecured loan.

5. Conditions

What lenders look for: Conditions refer to the external factors which can impact your ability to repay a loan. For instance, lenders will usually take into account the current state of the economy at large (and for your industry, in particular), survival rates for your business type, the size of the loan you’re applying for, the interest rates, how you intend on using the funds, and so on.

How lenders analyze it: To analyze conditions, lenders will take a close look at economic trends, how your main competitors are doing, what sort of issues are predominant in your industry, and how sound your proposed usage of the funds is in their opinion.

How to improve conditions: There’s an old saying “you can’t control the way the wind blows, but you can control the way you set your sails”. In other words, nobody can control conditions, but we can prepare ourselves and/or react effectively. One piece of advice you may have heard from us before is to apply for a business line of credit even if you don’t ‘need’ it. It’s a great way to provide your business with a financial safety net and help build up your credit at the same time.

Note: While the current pandemic has created an unprecedented set of conditions, lockdowns will eventually be lifted. Now is the time to prepare your business to reopen after coronavirus shutdowns expire.

Now you C me…

Character, capacity, capital, collateral, and conditions. Why are the 5 Cs of credit important? Now you know!

These factors are what lenders use to gauge your creditworthiness, but make no mistake. It’s also important for the financial health and stability of your business to check the 5 Cs of credit analysis on your own from time to time. Whether for lenders or for yourself, use this guide to help you strengthen your business’s 5 Cs of credit!