Enterprise Bank & Trust

The Five Cs of Credit

November 1, 2016

Steve Albart, Enterprise Bank & Trust

It’s been said “It takes money to make money.” As a business owner, you might find yourself talking to a bank, a surety company or other provider to secure financing. Knowing what guidelines banks and other institutions utilize to determine if your business is creditworthy can help you achieve your goal.

Understanding the Five C’s of Credit

1. Character

2. Capacity

3. Capital

4. Collateral

5. Conditions

The Five C’s of Credit are the backbone of every credit decision made about your company. To help improve your chances of getting a loan it’s critical to understand what lenders look for and the type of information they will seek.

1. Character: A business’ reputation

This may be the most important of all the C's. The other four don't matter if the individual lacks sound Character and decision making skills. Businesses create a reputation in the business community regarding how bills are paid and problem situations are handled.

Often times, high-character companies are engaged in community philanthropy or involved with local trade associations. High-character companies do what's "right" and are setting examples of how to do business with others. Be sure to share any such involvement with your potential lender.

2. Capacity: Ability to comfortably make payments

Does your company have the Capacity to have credit? In short, do the gross revenues exceed all expenses in order to pay back the company's debts? Creditors want to make sure there is enough excess cash flow to repay all debts.

Bankers often use EBITDA (Earnings Before Interest Taxes, Depreciation and Amortization) to calculate cash flow for businesses. A healthy business will have annual cash flow over 1.20 times their annual debt service obligations.

3. Capital: Debt to net worth ratio

Capital represents the net worth or equity of a business. The equation to calculate the net worth of a business is "assets less liabilities equal net worth.” Another ratio that helps creditors make decisions on the creditworthiness of a business is the debt (liabilities) to net worth ratio.

Creditors like to see debts less than two times the net worth. The greater the net worth or Capital, the better a business' ability to obtain credit.

4. Collateral: Inventory, equipment, other

What Collateral does the business have to offer? Typically, creditors want to secure debts with Collateral such as accounts receivable, inventory, equipment, real estate, stock portfolio and personal residences. Each piece of collateral will have different advance rates depending on the creditor.

For example, banks typically lend up to 80% of the value on real estate or 70% on accounts receivable. A business will have greater access to credit when the collateral is more tangible and the loan to collateral value is a low percentage.

5. Conditions: Health of the business

Once the first four C's are reviewed, the last step is understanding the economic and intangible Conditions surrounding the business. Owners should take a proactive approach in keeping their creditors up to speed on business conditions within their industry as well as information regarding projections, backlog and management changes.

A creditor's decision on the conditions surrounding a business will be heavily influenced by the business owner. Providing information on the positive outlook of your business and the industry will be helpful.

Applying the principles of the 5 C’s to your business

These same principals can also be applied in your business every day regarding credit decisions on a new client. Unless your client pays COD, your business is extending credit. Although you may not be able to request financials, you can still apply many of these principles in your credit decisions. For example:

  • What is the customer’s history of making payment?
  • Does their business appear strong?
  • Is the industry doing well overall?
  • Do they have collateral?
  • Is the business involved in the community?

The Five C’s are the first step

The Five C's of Credit are basic concepts that establish the foundation of the creditworthiness of a business. All business owners are encouraged to sit down with their banker, CPA, and creditors to enhance each "C."

Find out where your business is strong and learn where you need improvement. Then put steps in place now so you can maximize the creditworthiness of your business to help ensure you get the money you need.

Enterprise Bank & Trust does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only. You should consult your own tax, legal, and accounting advisers before engaging in any transaction.


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