THE 5 C’S OF LENDING

written by MO.com Subject Matter Resource Ilya Bodner

THE 5 C’S OF LENDING

Regardless of the type of financing you obtain for your small business, one constant remains true at all times—there will be interest. This is a rate charged for the use of money and commonly compounded continuously (every day of the year). Small business interest rates have a legal maximum, which can change as a result of inflation, or Federal Reserve policies. The 5 C’s of Lending help configure the rates and determine business credit, and vice versa.

The 5 C’s of lending for small business loans are Character, Cash Flow, Collateral, Capitalization and Conditions. The 5 C’s are the underlying principals behind lending.

1. Character

The basis here is the borrower’s credit report and his or her payment trends. Character gives an overall feel of how the borrower will treat the loan.

2. Cash Flow

There needs to be adequate cash flow available to repay the loan and allow the borrower to pay for all other small business expenses, including their personal needs. This is true whether calculating a business’s previous financial state or making projections for a small business expansion or a startup.

3. Collateral

These are the assets that the borrower offers to the lender to secure a small business loan in the event it is not repaid. The primary collateral will be the small business’s assets. If these are not sufficient, personal assets may be required as additional security.

4. Capitalization

This consists of the small business’s resources including fixed assets, retained earnings, and the owner’s equity. Funds borrowed from a source such as the seller of a small business do not improve the equity position of a borrower.

5. Conditions

This refers to the outside factors that will be considered, such as competition and trends of similar small businesses in the industry.

LINE OF CREDIT

For a small business, a line of credit is like having a loan on tap; you withdraw money as you need it, up to a certain limit set by your lender. If you know you will need some extra money over time to run or expand your business, a business line of credit may be the perfect solution.

A line of credit can be very useful—but at the same time can be extremely dangerous. Due to its flexibility, the payback amounts vary based on the amount taken out. Forecasting and estimating projected financials can be difficult. With a line of credit, the budgeting becomes a variable liability rather than fixed. Prior to taking the necessary funds from a line of credit consult with an expert to assure your business’s ability to pay back the debt. Relying on the hopes of future sales is not enough; many businesses suffer due to hope and optimism that don’t pan out. It is safe to assume that 2% of the loan amount will be the necessary minimum monthly payback payment.

Lenders typically reserve business line of credits for businesses that have a proven track record. Lines of credit may be secured or unsecured, usually requiring the business owner to pay a minimal annual fee to cover administration costs. Many owners prefer business lines of credit to loans.

There are additional advantages to opening a business line of credit. Business lines of credit typically offer lower interest rates than credit cards. They can also improve your cash-flow management, make it easier to initiate purchases that are too large for credit cards, provide a source of emergency funds, and offer the flexibility of repaying and borrowing again.