The Five C’s of Lending

 

There are Five C’s of Credit that all business owners should know when they are ready to request financing for their business.  Those Five C’s are:

Cash Flow
Collateral
Capital
Character
Conditions

Every business owner should know where they stand on all Five C’s and use them to help in the preparation of questions and concerns you may get on your business when you apply for your next equipment finance.

CASH FLOW

Does your business generate enough cash flow to replay the loan you are requesting? Your historical and projected cash flow will both be reviewed during the cash flow analysis and will be compared to your projected debt service requirements.  Every bank completes their cash flow and debt service coverage ratios a little different, but here is a general formula you can use:

Cash Flow Coverage=    
Net income after taxes + depreciation + interest + rent – distributions
Proposed debt obligation + CPLTD (current portion long term debt) from prior year + rent + interest

Most lenders will look at the past two to three years of your financial statements or tax returns and the most recent financial statement on your business depending on where you are in your fiscal year.  While projected cash flow is important, the lender will usually put more weight into the historical cash flow of the business and make sure it is sufficient to support the requested debt.  Projected cash flows usually show higher figures than historical performance because of the expected growth of the company.  Because of this, your lender will review these with some skepticism.  You should be prepared to defend your future cash flow projections with information that would give your lender data to show these figures are accurate, such as signed contracts or backlog information.  A typical cash flow coverage should be 1.2 or higher to meet most lender’s guidelines.  This means the company is expected to generate at least $1.20 of cash flow for each dollar of debt service. 

COLLATERAL

Collateral is important to a lender as it is the secondary source of repayment of the loan.  If the company is unable to generate sufficient cash flow to repay the loan, the lender will get the collateral and liquidate it using the funds to pay off the loan.  Many lenders want the collateral to be equal to or higher than the amount of financing provided.  Some banks may ask for additional collateral on top of the equipment they are financing in order to overcome financial or credit issues.  Many banks are only interested in financing collateral types that they can easily liquidate such as accounts receivable, inventory, equipment and real estate.  Most lenders will only use a percentage of the value of the equipment or collateral on the financing.  For example, on average a bank will generally give a business 80% of the value of their accounts receivable, 50% against their inventory, 80% against equipment and 75% against real estate.  Each bank will waiver on these percentages a little based on their historical experience in other liquidation scenarios against each asset class.  Keep in mind there are costs to liquidating (appraisals, shipping, legal expenses) or collecting (bad debt customers) on these assets and the percentages will reflect these costs also.  Most lenders will look at comparable assets to verify the true value of the asset.

 

CAPITAL

Lenders like to see the owner(s) of the company to have sufficient equity in the company.  Capital is important for two reasons:  1) It gives the company a cushion to withstand a blip in the company’s ability to generate cash flow.  If the company has a tough quarter or becomes unprofitable for any reason, having enough capital to weather the storm is important.  Without capital, the company could run out of cash and be forced into bankruptcy.  2)  Lenders like to see owners have “skin in the game.”  This shows the bank the owner will be motivated to stick by the company and work hard to turn the company around should anything go wrong. There is no exact number for having enough capital.  Many banks will look at the owner’s investment into the company relative to their total net worth.  Most banks will also run a debt to equity ratio which shows how much debt the company has compared to the equity in the business.  Most lenders want to see a debt to equity ratio no higher than 2 to 3 times. 

CONDITIONS

The overall environment the business is operating in can affect the lender’s decision.  The lender will assess the conditions surrounding your company and its industry to determine the key risks facing your company and how well you can mitigate those risks.  Here are some examples of things your lender will consider:

  • Competition- how do you differentiate from your competition?  What keeps your customers working with you versus going to your competition?
  • Customers- Do you have any significant customer concentrations?  If so, how do you protect these customer relationships?  What are you doing to diversify your revenue base?  Are any of your major customers having financial issues? 
  • Supply risks- What are your relationships with your key suppliers?  Is there any risk of disruptions from them?
  • Industry issues- Are there any economic or political factors affecting your company?  What trends are emerging in your industry?

Be prepared to discuss what you see as the primary threats to your business and what you are doing to mitigate those risks and protect your company.  Make sure the lender understands the drivers of your business.  These could be just as important as your company’s financial profile.

CHARACTER

I would argue that Character is the most important of the Five C’s.  It is important for lenders to know who they are working with; are the owners and management of the company honorable people when it comes to meeting their obligations?  Character can not approve your financing by itself, but it can make a lender turn you away by itself.

Character is tough to “grade” because it is an intangible asset.  It really comes down to the lender’s “gut feeling” about you and your business.  Your lender will get a good read on this based on your personal credit bureau report and how you handle other debt obligations.  The lender can pull business reports on your pay history and will also communicate with your current and former bankers and suppliers to find out how you have handled your arrangements in the past.  The lender may talk with your customers or past business partners.  How you handle yourself with the lender during the application process also plays a big role.  Most lenders will only work with people they can trust; in good times and in bad times.  The lender wants to know that if things go wrong, you will do whatever you can to honor your commitment to them. 

Take the Five C’s and make sure you are ready to present to your lender on behalf of your company when the time comes for you to apply for financing.  Being prepared and having your Five C’s in line will help your process go quicker and smoother.  You can also use these Five C’s as a management tool to aid you in running your company.

Visit my profile on Linked in:  Carrie Radloff

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