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What are the 5 C’s of Credit?

How Banks Evaluate Their Borrowers

When applying for business financing, you know that your application goes through a review process. But have you ever wondered how, exactly, lenders evaluate applications for business lines of credit, commercial real estate transactions, receivable financing, and other loans? At Savoy Bank, we use the 5 C’s of Credit, a framework that is widely used among financial institutions to predict the risk of financial loss.

The 5 C’s of Credit encompass the following key characteristics of a borrower: Character, Capacity, Capital, Collateral and Conditions. Let’s take a closer look at how we evaluate you as a borrower when you seek business financing.

1. Character

When we’re considering making a business loan, we first need to ensure that you can be counted on to keep your commitment. A primary way we assess character is by looking into your history — specifically, your credit history.

Your credit history is a record of how you have managed credit in the past. Have you taken out a loan before? Did you make regular, timely payments? Did you ever declare bankruptcy? All of these factors are built into a credit report generated by credit bureaus and weigh heavily into your assessment.

Additionally, we may take into account your background, education, industry knowledge, and experience when considering a loan application.

2. Capacity

Capacity is the measurement of a borrower’s ability to repay a loan. If you’re a business owner, that means we will review your credit score, borrowing and repayment history, and key financial benchmarks and metrics.

Providing accurate cash flow statements is critical to demonstrate that your company generates enough income to meet its debt obligations. Your company’s capacity also can be calculated by comparing the number of debt obligations you have in relation to the expected monthly revenue.

One specific formula used to determine if your capacity is acceptable for the loan you’re seeking is your company’s Debt Service Coverage Ratio (DSCR). DSCR is a way to assess if there’s enough cash flow to pay your debt.

We calculate DSCR by dividing your annual net operating income (cash flow after all monthly expenses are paid) by the annual debt payment (i.e., the principal and interest that will be due over the course of a year). This gives a percentage value or DSCR ratio. For example, if your company has net operating income of $400,000 and an annual debt payment of $250,000, the DSCR is 1.6x.

If a DSCR is 1.0x, the loan would be a breakeven. If it were less than 1.0x, it means that the proposed debt structure would result in a net operating loss – not a good sign. We typically look for DSCR of 1.2x and higher.

3. Capital

We also evaluate how much of a personal investment you have made into your business. This is known as capital.

Investing your own money demonstrates your commitment to the business. This makes you a stronger applicant. From our perspective as the lender, the greater your personal investment into your business, the less likely you will be to default on the loan repayment. Adequate capital also signals that you may have funds you can tap into if cash flow gets tight.

4. Collateral

If you don’t have substantial capital, we may look to you to pledge assets to guarantee your loan. In the event you default on the loan, we could repossess the collateral to repay the loan.

Collateral is often the object for which you need financing, such as equipment, vehicles, or property. Your company’s accounts receivable and inventory may also be considered appropriate collateral. Loans backed by collateral, also called secured loans, are generally seen as lower risk. They usually have lower interest rates and better terms than other types of loans.

5. Conditions

Business owners are often most motivated to seek lending when their companies are struggling. But as lenders, our job is to identify and manage risks. This means that we prefer to loan money to companies that are operating under favorable conditions. In other words, seek financing when things are going well and before you desperately need it.

When we consider Conditions, we’re looking at outside factors that could potentially affect your company, such as economic and industry trends. We may also review the competitive landscape, supplier and customer relationships, and whether your company is growing or faltering.

Conditions also refers to how you intend to use the money. We’re more likely to approve your loan if it will be used for a specific purpose. 

Finally, conditions cover the terms of the loan, such as interest rates, loan period, and principal amount. Of the five Cs of Credit, Conditions is the most subjective.

Understanding the key factors that financial institutions like Savoy Bank use when considering whether you’re a suitable loan candidate is half of the battle of securing needed financing. By stepping into our shoes and understanding not only what key components we’re looking for, but also why they’re important, you’ll have the best chance to secure the financing you need to keep your small business growing.

Want to know how your company ranks when evaluated using the 5 C’s of Credit? Reach out to Savoy Bank’s friendly Success Team at (646) 775-4000 or here. We are here to help.

Mac Wilcox is the President and Chief Executive Officer of Savoy Bank, with more than 20 years of experience as a banking leader and entrepreneur.

Mac is a strong believer in small businesses and the power of local entrepreneurs to drive economic development and growth.

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