Credit analysis by a lender is used to determine the risk associated with making a small business loan. Regardless of the type of financing needed, a bank or lending institution will be interested in both your business and personal financials. Credit analysis is governed by the “5 C's of credit:” character, capacity, condition, capital and collateral.
Character
Lenders need to know the borrower and guarantors are honest and have integrity. Additionally, the lender needs to be confident the applicant has the background, education, industry knowledge and experience required to successfully operate the business. Lending institutions may require a certain amount of management and/or ownership experience. They will also ask about your licensing and whether or not you have a criminal record.
As history is the best predictor of the future, a lender will examine the personal credit of all borrowers and guarantors involved in the loan. Sound business and personal credits are a must. Check both reports before calling your lender; if there are any delinquencies, be prepared to explain. The lender may be able to make exceptions for low credit scores.
Capacity (cash flow)
The lender wants to know that your business is able to repay the loan. The business should have sufficient cash flow to support its business expenses and debts comfortably while also providing principals’ salaries sufficient to support personal expenses and debts. Examining the payment history of current loans and expenses is an indicator of the borrower’s reliability to make loan payments.
Condition
The lender will need to understand the condition of the business, the industry, and the economy, which is why it is important to work with a lender who understands your industry. The lender will want to know if the current conditions of the business will continue, improve or deteriorate. Furthermore, the lender will want to know how the loan proceeds will be used- working capital, renovations, additional equipment, etc.
Capital
Your lender will ask what personal investment you plan to make in the business. Not only does injecting capital decrease the chance of default, but contributing personal assets also indicates that you are willing to take a personal risk for the sake of your business; it shows that you have ‘skin in the game.’
Collateral
A lender will consider the value of the business’ assets and the personal assets of the guarantors as a secondary source of repayment. Collateral is an important consideration, but its significance varies depending on the type of loan. A lender will be able to explain the types of collateral needed for your loan.
The five components that make up a credit analysis help the lender understand the owner and the business and determine credit worthiness. By knowing each of the “5 C's,” you will have a better understanding of what is needed and how to prepare for the small business loan application process.
