Funding Your Business: The Five Cs of Business Credit

In the approval process for business loans, lenders use the “five Cs of credit” as their standard for credit analysis.

If you want to improve your chances of getting a business loan, you need to satisfy the requirements in these five areas: Capacity, Capital, Character, Collateral, and Conditions.

Let’s take a closer look at these five Cs.

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1. Capacity

In rating a business’s capacity to repay a loan, lenders generally evaluate the company’s Cash Flow Statement for at least two years. Startups, on the other hand, need to prepare a projection of their cash flow for the first year. An evaluation of cash flow statements will reveal whether your business generally has enough cash to repay its loans.

In addition to your cash flow statement, your lender will want to know what personal sources of income that you could use to make payments, such as checking and savings accounts or even your spouse’s income.

2. Character

In deciding whether to approve your loan application, bankers will assess your “character.” This has a little less to do with your personal integrity than it does to your credit score and creditworthiness.

More than one-third of small businesses whose loan applications were denied or did not receive all of the funding requested resulted from a less-than-desirable credit score. Two factors that greatly affect your credit score are an existing high level of debt and having an insufficient credit history.

Lenders use your personal and your business credit scores as a measure of your ability and willingness to pay back a loan. Before you apply for a business loan, examine your personal and business credit scores.

Lenders also view your past credit history as a barometer of future financial success. From the viewpoint of a lender, a low credit score equates to high risk. Consumer credit scores are based on a mathematical model, which estimates the risk of someone going ninety days late on a payment during a two-year period. FICO scores range from 350 to 850. Lenders view scores above 750 favorably.

Business credit scores are connected to your company’s EIN (Employer Identification Number). Banks use credit scores from different reporting agencies, such as Dun and Bradstreet (D&B), Experian, and Equifax.

The models used for business credit scores predict the chances that your business will run ninety days late within a year. Some scoring systems will also forecast the possibility of your business encountering a financial catastrophe.

The D&B score is called the PAYDEX score. They base their score on how promptly you have paid your vendors over the last two years. PAYDEX scores range from 0 to 100. Anything above 80 is a great rating.

Some credit risk scores use a blended system, which evaluates both your personal and business credit history. For example, SBA uses the FICO SBSS score as a basis for approving all SBA 7(a) loans. FICO SBSS scores range from 0 to 300. Loans are rejected for any score below 160.

Many other factors are used in developing a credit score. These include the number of years in business, company assets, revenue, and cash flow. The best way to improve your credit score is to pay your bills on time.

In determining how much credit that a bank will extend to your business, they will check whether you have maintained a minimum daily balance of $10,000 for the last 90 days. Banks will also look at frequency of deposits and the age of your account.

Some of the factors that credit agencies and banks use are within your control. Others are not. In some cases, credit ratings take into consideration your industry and general economic conditions. You can’t control external financial considerations, so only focus on those components that you can influence.

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Based on the information in your financial documents, a lender will also make a number of critical calculations to ascertain the health of your company. These assessments include: Debt-to-Income; Debt Service Coverage Ratio (DSCR); and Debt Ratio.

Debt-to-Income. One of the measures banks use to assess the ability of a business to repay their loan is debt-to-income (DTI) or sales ratio. DTI describes a relationship between what a company owes versus its revenue. A rule of thumb is that your DTI should not be higher than 45 percent. So an $85,000 monthly debt divided by a $290,000 monthly income equals a 29.3 DTI Ratio.

Debt Service Coverage Ratio. DTI and Debt Service Coverage Ratio (DSCR) are similar but not the same. The DSCR is usually (but not always) calculated over a year. It compares your net operating income to your debt service for a specified period of time.

Debt Service. Your annual debt service covers all of your payments on your loans for company vehicles, real estate, and shop equipment. This includes both the principal and the interest for all outstanding loans. In many cases, debt service will be listed as an expense on your income statement, which makes it easy for a lender to identify it.

To calculate the DSCR, divide your annual Net Operating Income by your annual Debt Service payments. Your operating income equals your revenues minus Cost of Goods Sold and Shop and Administrative Expenses. As a rule of thumb, the minimum DSCR value required for a bank to approve a loan is typically 1.25 or 125 percent.

Debt Ratio. Your debt ratio compares your total debts (liabilities) to total assets, and a lender can calculate this using your balance sheet. For example, if your liabilities are $200,000 and your assets are $450,000, your debt ratio is 44.4 percent

3. Capital

Banks may also check the amount of money that you personally have invested in your business.

Lenders generally believe that if you personally have “skin in the game,” you’ll be more likely to repay the loan. As a rule of thumb, banks like to see that the owner’s personal investment in their business is at least 25 percent.

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4. Collateral

When starting a business, one of your worst options for financing is a bank loan. You take a big risk when you take out a loan—the reason being that you commit to paying the loan back on a schedule.

Collateral is an asset that you (as a borrower) pledge as security to obtain a loan. When you default on a loan, the bank can seize the assets that you used as collateral to recover their losses.

To secure a business loan, you can use the following assets:

  • Commercial property;
  • Vehicles;
  • Shop tools and equipment;
  • Inventory;
  • Accounts receivables;
  • Cash; and/or
  • Personal property
5. Conditions

You can control some factors of your business destiny. Other factors are beyond your control.

In approving your loan application, banks will take into consideration many of those conditions that you cannot control. These include the effect of inflation on the economy. Many predict that we could be heading into a recession in 2022. Lenders will also evaluate the conditions within your specific market and your competitive environment.

In addressing these conditions, your business plan should expound upon the opportunities available, as well as the numbers of competitors and the threats that they pose to your shop. Your plan should also include your sales and marketing strategy and how you would respond to an economic downturn.

Additional Loan Requirements

If your business is a sole proprietorship or a partnership, each owner will likely need to provide personal financial statements in applying for a loan. What’s more, the owners may need to assume personal responsibility, in writing, for the loan. The reason is that sole proprietorships and partnerships are “pass-through entities.”

A pass-through entity is structured so that profits pass through the business to the individual owners. That way, the business does not incur income taxes; instead the owners do. The advantage is that you, as an owner, avoid double taxation. That’s why more than half of businesses are set up as pass-through entities.

Lenders often require owners of sole proprietorships and partnerships to provide personal financial information, such as social security numbers, assets (real estate, vehicles, etc.), mortgages, credit cards and tax returns. Your bank may not require this financial information for loans less than $50,000.

If your business is an LLC or corporations, your bank will likely require that you submit business tax returns for loans over $50,000.

Insurance Policies. To mitigate their risks in approving a loan to a new business, the bank may also require that the primary owners take out life insurance policies listing the bank as the beneficiary in the event of a death.

Tax Returns. To verify the accuracy of your financial documents, your lender will most likely require copies of your corporate tax returns. They will use the returns to ensure that there are no discrepancies with your financial records.

Receivables. Many sign shops require a 50 percent deposit upon placement of the order with the balance to be paid upon delivery of the graphics. That’s ideal because you don’t have to deal with receivables.

If you extend credit to your customers, your lender may insist on seeing an aging report. You can easily track your receivables using an Excel worksheet. The aging report allows you to classify receivables based on how long an account is outstanding.

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In formatting a worksheet, you need columns listing the invoice date and the due date agreed upon on the sales contract. With this information, you can organize receivables according to thirty, sixty, or ninety days overdue. Lenders will use this information to evaluate the financial health of your business.

When selling larger programs, payment terms are usually extended. That means that you will carry the amount due on your books, and this can complicate your bookkeeping and your life. Not only does it add to your liabilities, but you must also keep track of your receivables on an accounts receivable aging report and, in many cases, chase after your money. Collections are often a time-consuming and unenviable task. It takes persistence and tact. Very few people are good at it.

At the very least, you need to review your accounts receivable aging report monthly, if not sooner. Receivables are assets, which you can record on your balance sheet. They are valuable to your business, because you can turn them into cash. Once the receivable is paid, you list them as cash.

Sales History. Although it is not so important as cash flow, lenders often examine your sales history for the past two or three years. They will check for any trends of growth or decline.

UCC Liens. UCC is an acronym for Uniform Commercial Code, which is a set of laws accepted by all states covering commercial transactions. As part of a business loan, lenders may require that you agree to a UCC lien. The lien protects the lender in the event that the borrower defaults on the loan or files for bankruptcy.

The lien establishes priority in recovering payment for debts. The document is filed with the Secretary of State and covers a period of five years. The lender must refile the lien after it expires to reestablish their rights to priority.

If there are multiple UCC liens on your business, priority is determined based on the dates of filing. After you have completely repaid a loan, you should request that your lender notify the Secretary of State to terminate the lien.

Pro Forma Financials. In applying for a loan, the lender may request that you provide pro forma financial documents—income statements, balance sheets, and cash flow statements. Banks may request pro forma financials as evidence of your capacity to repay a loan.

As a business owner, a pro forma can help you make an educated decision when making an investment in your company. It is a projection of how your business will perform in the future. You can use pro forma financials to predict the financial impact on your shop, when making an investment in new equipment, opening a new location or hiring new employees.

In fact, pro forma financials are nothing more than a best guess. In making a business decision, you can compare projections of what might happen if you do make an investment to what might happen if you don’t.

Pro forma financials are only as good as the reliability of your inputs. As the saying goes: Garbage in, garbage out.

Financial projections are often suspect, because they are frequently used to paint a rosy picture. After all, the person creating the financials is trying to convince lenders that they should approve the loan application.

For this reason, when you submit pro forma financial statements, be prepared to support your assumptions as your lender scrutinizes your projections.

In making your projections, you may base them on a number of assumptions, such as “sales and fixed expenses will increase 15 percent annually” or “your Cost of Goods Sold (COGS) will remain a constant 20 percent of revenue.” Using these assumptions, you can make your calculations.

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Defaulting on Loans

During the pandemic, thousands of businesses defaulted on their loans. It doesn’t matter whether the loan is secured or unsecured, defaulting usually results in major repercussions for your shop. If you have a secured loan and cannot meet your financial obligations, your lending institutions can seize the assets that you put up as collateral.

Defaulting on a loan has other ramifications. For example, it usually damages your credit rating. This will hamper your ability to borrow money in the future.

In the case of an unsecured loan, you were not required to put up collateral. If your business is a sole proprietorship, your lender could come after your personal assets in order to recover their money.

On the other hand, if your shop is set up as an LLC (limited liability company), the owners are protected to some degree against defaults.

Difficulties in Paying Back Loans

If you find yourself in a financial hole, many shop owners secure a loan to solve the dilemma they are in. The mistake that they make is thinking that they can borrow their way out of debt.

If you are having problems paying back a loan, talk to your lender. They may be willing to propose a solution before you default. One possible solution is to request lower payments for a time until you are in a better financial position.

Rejecting Loan Applications

The primary reasons for loan rejections are insufficient collateral, poor credit rating and high expenses in relation to revenues.

To improve your chances of getting a loan, you can take the following steps: Create a business plan, provide sufficient collateral, improve your credit rating, reduce your shop and administrative expense, and increase revenues.

To get some more background about the different types of loans that you can apply for and receive to fund your business, check out my article “Lending a Helping Hand.”

—Jim Hingst