Deciding if and when business financing is right for your business can be a tough decision. And on top of that, there are many types of credit options to choose from. According to a recent Wells Fargo study of small business owners and their use of credit, many small business owners have a limited understanding of what it takes to be approved for credit and how to best use credit options.
To help you understand how lenders will evaluate your credit application, we’ve identified five critical components known as the 5 C’s of credit: credit history, capacity, capital, collateral and conditions. Lenders can accept or deny requests based on these business credit requirements, so it’s important you understand each one. Here’s a breakdown of the five C’s, as well as some tips on how to make your credit application more attractive.
A strong credit history is critical to obtaining financing, as lenders want to see that you have an established financial track record, along with evidence that you can pay back a loan. A credit history will show a lender who you have previously borrowed from, how much you borrowed, if you carried reasonable balances and if you made payments as agreed. To manage your credit responsibly, it’s important to make payments on time. With bank credit cards or lines of credit, keep your balances low relative to the credit limits. And last, set up dedicated business accounts, as lenders will want to see how you handle both your business and personal finances separately and responsibly.
Before extending financing, a lender will want to ensure the business has the ability to repay a loan and meet payment obligations. Profitability and cash flow are essential components of demonstrating that your business has the capacity to handle new credit. A business must have enough positive cash flow to meet both short-term and long-term commitments, and a lender will carefully assess the cash flow of a business to gauge the probability of repayment.
When a lender sees the owner invest money in the business, it shows that the business owner is committed to succeeding. What’s more, a business owner with assets that can be converted into cash in case of a sudden downturn in revenue will be better able to operate his or her business and repay debt. A lender wants to see that the assets of the business sufficiently exceed its liabilities, and understand how quickly and easily those assets can be turned into cash.
There are several internal and external factors, beyond your financial situation, that may affect the ability of a business to repay a loan. For example, on the external side, if a major recession is anticipated that could adversely impact your business, lenders might factor this probability into their decision. On the internal side, conditions include the borrower’s business experience and knowledge. In some cases, business references and education are personal factors that can impact conditions. Both internal and external conditions can be important indicators of a business’ ability to survive and thrive, and therefore its ability to repay its credit obligations.
Collateral, when it’s required, can be used as a secondary source of repayment to a lender in case of default. You may be able to qualify for a small loan — typically less than $50,000 — without collateral if you have a healthy credit history and financial statements. However, if you need to put up collateral to secure a lender’s investment, it’s important to document your assets. These can include real estate, equipment or in some instances, savings and deposits.
With a better understanding of the five C’s of credit, you’ll have a good sense of what it takes to get credit-ready and some of the fundamental steps to help get you there.
Brandon Meredith is the Wells Fargo small business leader in Idaho.