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What Are The Five C’s Of Credit?

Lenders look at several factors when determining creditworthiness for a small business loan and borrowers want to be prepared when approaching a bank for funding. 

To make sound underwriting decisions, lenders will approve borrowers based on a formula known as the Five Cs.

The 5 Cs: Character, Capacity, Capital, Collateral, and Conditions

The 5 Cs take into account several personal and business factors. These factors include character, capacity, capital, collateral, and conditions. 

Not all factors apply at all times. For example, an unsecured loan does not require the debtor to pledge collateral. 

In other cases, for a sufficiently well-capitalized business or one that has excess free cash flow, lenders may care less about personal character. It all depends on the circumstances. 

Character

While character lends itself to ideas about your personal morals or your standing in the community, lenders only care about one factor: your repayment history. For many business owners, particularly small business owners operating as sole proprietors, a personal credit history forms the core of a lender’s underwriting analysis. 

Personal Credit Score

Your personal credit score acts as an indicator of your level of responsibility in repaying debts. Three companies publish personal credit reports: Experian, TransUnion, and Equifax. You can access all three reports at no cost by visiting AnnualCreditReport

Related: Do SBA loans affect personal credit?

Also see: What is the minimum credit score needed for a business loan?

Capacity

This C indicates your ability to make loan payments. Business owners with high free cash flow or sole proprietors who have strong personal incomes will have greater capacity than those without. 

Calculating Your Debt-to-Income (DTI) Ratio

For small business owners and sole proprietors, the debt-to-income ratio occupies high importance in lending considerations. To calculate your own debt-to-income ratio, you can use the following calculation:

DTI = (Monthly Living Expenses + Existing Loan Payments + Credit Card Payments + Other Monthly Expenses) ÷ Pre-Tax Gross Monthly Income

Capital

Lenders will also take into account any existing capital you own. This C differs from collateral in that capital emphasizes assets which you could plausibly sell to make loan payments. Lenders will view debtors who possess significant existing capital more favorably than those without. Other forms of business capital include working capital such as inventory and accounts receivable. 

Your Personal Balance Sheet

As a loan applicant, your personal balance sheet plays a role in how favorably lending institutions view your credit worthiness. Having sizable assets to liquidate in an emergency and few liabilities can help play a role in loan eligibility. 

Collateral

The next C, collateral, focuses on assets which you pledge to secure a loan. These secured loans reduce the risk for the lender while also potentially reducing your effective interest rate. Lenders may require collateral for SBA loans, secured loans, and other types of credit products. You can read more about collateral in this article

Loan Collateral Requirements

One key point to keep in mind with collateral revolves around any existing debt which the proposed collateral currently secures. Any such debt will reduce the amount of the asset which you could pledge as collateral. 

Conditions

The last C, conditions, focuses on both micro and macro conditions. Lenders will want to understand in clear terms how you plan to use the funds. Additionally, lenders will also take into account the macroeconomic environment, including factors such as the state of the economy, market stability, and other high-level variables. 

Why Do Lenders Use the 5 Cs?

As a potential borrower, you act both as a source of a risk for a lender as well as a customer. Lending institutions will use the five Cs to better understand your level of trustworthiness as they build their capital risk models. Your credibility, industry trends, and your relationship to financial institutions all play a role in this calculation. 

Which of the 5 Cs Is Most Important?

Of the five Cs, your ability to service your debts most likely occupies the highest point of consideration for lenders. However, each factor will play a different role depending on the unique circumstances of your personal FICO score, net worth, and the success of your venture. Different lenders will also have different Cs that they emphasize in their underwriting decisions.

How to Determine Your Creditworthiness

One quick calculation to determine your creditworthiness, the debt service coverage ratio, stems from the following formula:

DSCR = EBITDA (Earnings before interest, taxes, depreciation, and amortization) ÷ (Interest + Principal)

This calculation actually comes from the world of corporate finance, but you can also apply it to your small business or sole proprietorship’s operating income.

Essentially, the formula considers how much cash flow a debtor brings in during a period against the current debt load. The higher a debtor’s EBITDA and the lower the existing debt level, the more favorable the debt service coverage ratio. 

You could also do this calculation with your personal income and debts such as a home mortgage or auto loan. In conjunction with the debt-to-income ratio, this formula can help both you and lending institutions make sound credit decisions. 

Other sources of debt in the denominator could include student loans as well as an existing small business loan. 

Improving Your Credit Profile for Business Loans

To improve your credit profile with the major credit bureaus and increase the likelihood that a lender will extend a business loan, consider implementing the following:

  • Reduce your existing debt burden by paying off credit card balances and student loans.
  • Decrease the amount of credit in your name by forgoing opening new credit cards or receiving new consumer loans. 
  • Increase your business revenue or personal income to create a more favorable debt-to-income ratio. 
  • Proactively identify credit problems such as identity theft or fraudulent activities in your name prior to applying for a business loan. 
  • Identify assets in your name with clear titles that can count as collateral for secured loans.

By taking these steps, you’ll have a greater chance of securing a loan at a favorable interest rate and with good terms.

Greg Bouhl

Greg Bouhl

Welcome! My name is Greg Bouhl, and I have over 21 years as an entrepreneur, educator, and business advisor, where I worked with over 1,600 entrepreneurs to help them start and grow their businesses.

As a small business advisor, I got fed up with clients finding inaccurate and outdated information when they were researching how to start a business online, so I launched StartingYourBusiness.com to be a trusted resource.

I'm constantly adding and revising this site, but if there is a question you have about starting a business or need help finding something, please ask!

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