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Commercial Lending 101: The Five C's of Credit

Charity Kuehn,

September 05, 2013

Building Your Business


The bullet points below are what an individual or business will need to present to the bank to demonstrate their performance of “The 5 C’s”

1) Character – Character is mainly how the business and the principals of the business (owners) have performed on their previous debt obligations. Basically, have the owners handled their financial commitments for the business (and personally) in the past and paid back their loans? Other factors evaluated in reviewing character of a borrower include, how interested do they seem in the success of the business? Are they experienced in and knowledgeable of their industry? Does management seem sufficient for the present size of the business and do they have the capability to manage as it grows? Below are some tools that the bank may use to review and verify that the borrower has quality character:

  • Personal and business credit reports
  • Resume of owners
  • Current standing on monies already borrowed with bank
  • Performance of deposit accounts/bank statements
  • Personal Financial Statement
  • A written business plan that includes financial projections, opportunities and risks, and who or what the competition is in their industry

2) Capacity (Cash Flow/Debt Service) – Capacity or what most bankers call it, cash flow, is the ability of the company to repay debt. Can the company really generate enough “cash flow” to pay back the debt requested? In today’s lending environment loan officers are also evaluating, what the “global” cash flow is. This includes the company’s ability to repay all loans to the company and any other related companies (for example, real estate holding companies related to the operating company, and not just the requested loan). Capacity can also be referred to as the Primary Source of Repayment. Typically, “debt service” is calculated by taking net income (profit after taxes), and adding back depreciation and interest expense which is then divided by annual principal and interest payments of all debt for the company. Typically, a bank will want to see a debt service coverage ratio of 1.2x or greater. Anything less doesn’t leave the bank or the business much room for error if they have something come up unexpectedly in their business that affects performance, a.k.a. cash flow! See the example of how a debt service coverage ratio is calculated:

For the bank to evaluate cash flow/debt service the following are usually requested from the borrower:

  • 3 years historical financials (Profit & Loss and Balance Sheet)/interim financials,
    and/or projections
  • 3 years business tax returns
  • Rent rolls for leased property
  • Personal Financial Statement of the guarantors

3) Collateral – Collateral is considered a “back door” in those cases when unforeseen problems arise that would diminish capacity, which is the ability to repay debt. Collateral is the safeguard but it is not the primary repayment source. For a bank, the understanding of the monetary value of the collateral is very important. The collateral is something that is checked or reviewed throughout the life of the loan to ensure the collateral maintains its value. Often if a business owner has personal assets that have quantifiable value they may be asked to pledge them as collateral as well to “shore” up a deficient or “upside down” collateral position in the business. Collateral is also referred to as the Secondary Source of Repayment. When analyzing a new loan request, the loan officer examines cash flow first as repaying the loan, not collateral. The collateral though may enhance the credit by giving the bank more security and reduce the risk in making the loan knowing that if something does arise in the business and cash flow is affected, there is value in the collateral that can be liquidated to repay the loan. Below are examples of how banks evaluate and value collateral:

  • Appraisals on property
  • Equipment listing and depreciation schedules
  • Statement on marketable security accounts

4) Capital – Capital is the ability to sustain a downturn in the economy and also establishes the commitment of the owner to the business. A low capital position of a business raises questions by the bank as to if the owner is “bleeding” the company for personal gain or if there is a downward trend in the company and how the business is operated. Cash is “King” right now for an established or new business owner looking for financing. If the business owner cannot put up 20%-30% capital it will be difficult for that individual to secure traditional financing. In the bank's view, if the owner isn’t willing to put up their own capital, why should the bank put their capital at risk in making the loan? There are a number of ways for business owners to raise capital:

  • Owner’s capital (cash injected by borrower)
  • Retained earnings of the business
  • Capital raises by private investors
  • Grants and other government sponsored programs that allow for lower levels of capital by borrowers to be eligible for financing such as the SBA or USDA financing programs that support small businesses and agricultural businesses

5) Conditions – Evaluating current economic conditions at the time a loan is requested is the final part of the task to determine what the feasibility of approving a loan request. Are there specific economic conditions or downturns that would directly affect the capacity of the loan? For example, prior to 2013 there was an immense amount of downward pressure on commercial real estate. We had experienced a recession; recovery has been slow, leaving our economy and businesses stressed. If a developer was looking to refinance or build, they had to be able to show capacity in the leases that they already had in place or had secured. If they could not clearly and definitively demonstrate cash flow from the rents of their lease tenants as well as show excellent character through their own personal financial statement and value in the collateral, the bank is not going to be interested in offering financing.

So there you have it. I hope that this will be helpful to you as you look to approach your bank for financing. I think some of the most important aspects for a business owner looking to get financing include: know your business, know your financials and demonstrate your passion for it. You won’t know everything that is going to take place in the future, but if you understand your industry and the financial aspect of your business, you will be able to navigate through a rough period much easier.

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Hi Mandy. Many thanks for this comprehensive and informative blog entry. I've often wondered about the origin of the 5 C's of Credit. Do you happen to know the history of the concept?

Hi James, thanks so much for your post and your interest in the article. I'm not sure that we can point to a particular person or point in time as the exact origin of the 5 C's. Rather, over time, they became the accepted foundation of loan underwriting.

hi,thanks 4 dis great info,it has helped a great deal

The origin of 5 c's is not known, accepted. Is there anybody that has added other C's or invented other alphabets?

Thanks for your post, Mufutau. Actually yes, recently added a 6th C in their business advice content.

6. Confidence – A successful borrower instills confidence in the lender by addressing all of the lender’s concerns on the other Five C’s. Their loan application sends the message that the company is professional, with an honest reputation, a good credit history, reasonable financial statements, good capitalization and adequate collateral.

When applying for a small business loan, don’t forget the importance of personal relationships. Apply for a loan at a bank where you already have a positive business relationship. Also, make an attempt to meet with the person who will be evaluating your application, such as the bank’s lending officer, rather than the teller who handles your day-to-day banking transactions. If the potential customer hasn't established a relationship with the financial institution, starting a checking account will do so.

This blog article is for informational purposes only, and is not an advertisement for a product or service. The accuracy and completeness is not guaranteed and does not constitute legal or tax advice. Please consult with your own tax, legal, and financial advisors.