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The Five C's of Lending

The "Five Cs" of Lending" are age-old principals that bank and lenders utilize to analyze any business loan application. The "Five Cs" are: * Character ...the borrower's integrity * Capacity ...the business' ability to repay ...

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The "Five Cs" of Lending" are age-old principals that bank and lenders utilize to analyze any business loan application. The "Five Cs" are:

* Character ...the borrower's integrity
* Capacity ...the business' ability to repay the loan
* Collateral ...assets to be pledged to secure the loan
* Capital ...the business' and principal's net worth
* Conditions which they are operating

While the analysis of these five factors is always integrated when making a lending decision, let's discuss each of these separately.

The most important factor to most lenders is the borrower's integrity, usually referred to as their willingness to repay the loan. A lender wants to know that they have a borrower that will repay the loan through "thick and thin". They seek the individual that treats their monthly loan payment as if it's a payment to the Internal Revenue Service.

Lenders use different methods to assess an applicant's character. The most common means are the use of personal and business reports, such as TRWs and D&Bs; (for the business). These reports provide a public view of the client and their business' financial history. Other methods include face-to-face meetings (what feeling did the lender obtain about this person), feedback from your creditors, and, finally, your personal references, usually provided by the applicant's branch bank representative, an accountant and/or lawyer.

A business' ability to repay the loan from its monthly cash flow is critical to the lender. They want to be shown documented proof (that is, tax returns or prepared financial statements) that the borrower can repay the loan, with an additional cushion for the unexpected. Capacity is usually measured with a Debt Service Coverage ratio which is calculated by taking "Net Income + Depreciation + Interest Expense" and dividing it by the Debt Service (monthly loan payment plus real estate taxes, if applicable). This ratio ("the DSC ratio") is usually expected to be 1.25 or higher to show solid evidence that the applicant can afford to make the monthly loan payment

This refers to the assets that the borrower and their business own that they are willing to pledge as security to back the loan. When the first two factors (Character and Capacity) are strong, there is usually less need for strong collateral. However, most small business lenders will insist upon strong collateral position to back their loans. These assets include your personal real estate (ie; a home and/or investment properties), business real estate and business' accounts receivable, inventory, and equipment. An applicant's interest in real estate is by far the most significant security that can be provided to a lender as collateral because the lender can secure the asset (through a lien) and readily assess its value (through an appraisal).

The borrower's net worth is defined by its capital. For a business, this is the value of their investment (initial business funding), outstanding shareholder loans and retained earnings. Personally, net worth is measured as the difference between personal assets and personal liabilities. A significantly positive net worth provides the lender assurance that the borrower will have sufficient additional assets to repay them in the event of a change in the business' capacity (to repay the loan).

The conditions that a business operates within are very important to the lending analysis. These include a review of the economy: Is it a local, national or global? and Is it in a growth mode, recession, etc.? The lender will also assess the state of the industry and any company-specific conditions that could impact the business' ability to repay the loan, such as a change in raw material prices, a strike by employees, or rising increasing rates.

The "Five Cs of Lending" are the basic core of every business loan decision. Every lender may place different emphasis on any one of these factors but they always assess each to make their decision on business loan applications.