The 5 C's of Credit: What They Mean to Your Business

Businesses face any number of financial challenges. Often, it's as simple as needing financing to grow and stay competitive, expand business operations, purchase assets such as new equipment or a commercial building, or even consolidate and restructure business debts.
One of the most common questions among small business owners seeking financing: "What will the bank be looking for from me and my business?"

While each lending situation is unique, many lenders utilize some variation of evaluating the five Cs of credit when making credit decisions: 

 1. Character:

• What is the character of the management of the company?
• What is management's reputation in the industry and the community?

Investors want to put their money with those who have impeccable credentials and references. The way you treat your employees and customers, the way you take responsibility, your timeliness in fulfilling your obligations — these are all part of the character question.

This is really about “you” and your personal leadership. How you lead yourself and conduct both your business and personal life gives the lender a clue about how you are likely to handle leadership as a CEO. Your character immediately comes into play if there is a business crisis, for example.

As small business owners, you place your personal stamp on everything that affects your company. Often, banks do not even differentiate between “you” and “your businesses." This is one of the reasons why the credit scoring process evolved, with a large component being your personal credit history.

2. Capacity:

• What is your company's borrowing history and track record of repayment?
• How much debt can your company handle?
• Will you be able to honor the obligation and repay the debt?

There are numerous financial benchmarks, such as debt and liquidity ratios, that lenders evaluate before advancing funds. You should become familiar with the expected pattern in your industry. Some industries can take a higher debt load; others may operate with less liquidity.

3. Capital:

• How well capitalized is your company?
• How much money have you invested in the business?

Lenders often want to see that you have a financial commitment and that you have put yourself at risk in the company. 

Both your company's financial statements and your personal credit are keys to the capital question.  If the company is operating with a negative net worth, for example, will you be prepared to add more of your own money? How far will your personal resources support both you and the business as it is growing?

If the company has not yet made profits, this may be offset by an excellent customer list and payment history. All of these issues intertwine, and you want to ensure that the lender perceives the business as solid.

4. Conditions:

• What are the current economic conditions and how does your company fit in?
• What are the trends for your industry, and how does your company fit within them?
• Are there any economic or political “hot potatoes” that could negatively impact the growth of your business?

If your business is sensitive to economic downturns, for example, the bank wants a comfort level that you're managing productivity and expenses.
 

5. Collateral:

·         Primary Source of Repayment

·         Secondary Source of Repayment

Business cash flow will nearly always be the primary source of repayment of a loan. Lenders also look at what they call the secondary source of repayment such as business assets and the strength and financial support of guarantors.

Collateral represents assets that the company pledges as an alternate repayment source for the loan. Most collateral is in the form of hard assets, such as real estate, business assets or equipment. Alternatively, your accounts receivable and inventory can be pledged as collateral. The collateral issue is a bigger challenge for service businesses, as they have fewer hard assets to pledge.

Until your business is proven, you're nearly always going to pledge collateral. If it doesn't come from your business, the bank will look to your personal assets.

Keep in mind that when evaluating the 5 Cs of credit, lenders do not place equal weight to each area. Lenders are cautious, and one weak area could offset all the other strengths you show.

Debra Murphy is Vice President and Relationship Manager at Union Bank. She works with small to medium sized business in the Inland Empire and tailors financial products and services to help businesses grow, expand, and get to the next level.

Get in Balance with Your Balance Sheet

Business owners often say they want to have a cash reserve, collect on receivables sooner, pay down accounts payable, and pay off credit cards. Does this sound familiar? If so, then my question is: Why does everyone spend so much time obsessing over the Profit and Loss, aka P&L?

Don’t get me wrong. I too spend much of my time analyzing my company’s P&L. I compare my prior year’s earnings with this year’s earnings. I make sure my budget-to-actual is in line. I compare my earnings and direct expenses with my company’s projections. However, if I truly want to know how my business is doing, I spend time with my balance sheet.

I believe the answer to my first question, why so many business owners only spend time with the P&L, is that they don’t know how to interpret the story of the balance sheet.

A balance sheet is a record of company assets and liabilities. Assets are what your company owns. Liabilities are what your company owes. Equity is what your company has.

3 Ways to Spend Time with Your Balance Sheet

 1. Evaluate your company’s liquidity. How quickly can you turn your company’s assets into cash? Current assets (CA) determine liquidity. Current assets are made up of cash, accounts receivable, and inventory. Cash is the most liquid and inventory is the least.

Take the sum total of your current liabilities (CL) combined with current payments on long-term debt. Current liabilities include accounts payable, credit cards, payroll payable, taxes payable, etc. Calculate your current obligations on long-term debt for the month (car notes, mortgage, and equipment finance loans) and add to your current liabilities.

Now that you know how much you have in current assets and how much you owe in current liabilities, divide current assets by current liabilities. Coverage of assets to liabilities should be at least 1.25. Example: Current Assets = $1,000 Current Liabilities = $460. CA/CL = 2.17. If assets to liabilities is less than 1, there could be a cash-flow problem.

Basically, if a company generates more liquid assets than operational costs, it can give the excess to the shareholders/owners. At some point in the future, the company may end its operations. It will pay off all liabilities and what remains is tangible shareholder/owner value. This is the return on invested capital/sweat equity generated by the company’s operations.

This step also identifies if the company can fund its own growth, or if debt will need to be issued to the company to support growth.

2. Determine whether liquid assets are increasing or decreasing. How about your payables? From one month to the next review the change in cash, accounts receivables, inventory, payables and credit cards.



**Note: The chart above is a very basic analysis, but hopefully you can start thinking about the relationships between accounts.

3. Employ tactics to control cash. Going back to the first sentence of this article—businesses want to have a cash reserve, collect on receivables sooner, pay down AP, and hopefully pay off the credit cards. Are these goals attainable? Yes! Let’s start with the need to have a cash reserve.

As a business owner, what are you doing to control cash? Is there a budget in place to control expenses? Are expenses realistic? For example, you don’t lease a luxury auto that the company cannot afford. Is the company collecting AR in a timely manner to pay for operational costs? Do you maintain credit card debt and have a plan in place to pay off the debt? Do you separate expenses for your life from your business? If you answered yes to any of the above questions, you are on your way to having a cash reserve and getting in balance with your balance sheet.

Beth Bockenhauer started her career with five years of military service. She then worked for ten years as a small business owner, and holds a Bachelor of Science degree in accounting. Beth has worked in public accounting for the past seven years. Her company, Beth Bockenhauer, CPA is dedicated to helping business owners establish beneficial financial systems and processes, and to wisely manage growth as well as budgets.