Understanding the 4 Cs of Credit
There are many reasons a small business might need a loan—from supporting a product launch, financing new equipment or real estate purchases, refinancing existing loans and everything in between.
Though the loan process can seem daunting for some business owners, BankCherokee provides support to businesses navigating the loan application process from seasoned lending experts like Roger Hamilton, senior vice president of commercial loans. Hamilton and the team at BankCherokee are available to help borrowers determine the best financing options for their businesses.
Hamilton advises businesses hoping to secure any type of loan to do their homework first. “Some of the things we look for are a solid track record of cash flow for an established business, credible financial projections for a new or young business, and adequate collateral to secure the loan,” he explained. “In cases where cash flow or collateral are lacking, the bank can look to the U.S. Small Business Administration (SBA) to guaranty a percentage of the small business loan.”
Borrowers can prepare for the loan application process by better understanding the 4 Cs of Credit:
This refers primarily to the personal credit history and money management skills of the individual owner(s) of the business. An important factor in a small business loan is personal credit score—a score lower than 680 is less likely to be approved. Other factors that impact loan approvals include late payments, delinquent accounts and past personal credit challenges where loan obligations were unable to be met.
“New businesses don’t have a history of acceptable credit,” Hamilton added. “So in those cases, we look particularly closely at Character.”
The capacity to repay a loan from cash flow is critical. Even with a strong personal credit score, lenders must be confident that the small business has the ability to generate enough revenue and cash flow to make the loan payments. Businesses that don’t have a proven track record of profits and cash flow pose a greater risk for banks. In those cases, a business plan supported by realistic financial projections is often required.
For business acquisition loans, copies of financial statements for the acquired company must be accompanied by realistic financial projections that reflect strategic changes the buyer will make. “Once again, we look for a business that has shown positive historical cash flow, or a business plan with financial projections that make a strong case for anticipated future cash flow,” Hamilton said.
Capital is also referred to as net worth or equity, and it is the difference between the assets and liabilities of the business. Oftentimes, capital is evaluated based on a ratio of total liabilities to capital. Typically, the lower this ratio is, the lower the risk is to the bank. The acceptable level of capital ratio for a small business varies by industry types, but a general rule of thumb is a capital ratio of no more than three to one.
Collateral is the property or assets a business pledges in order to secure a loan. Collateral is critical to the lender, as it helps the bank get paid if the business is not successful or unable to meet the payment plan. Additionally, banks want wise decisions to be made with their money that are beneficial to the business. That is more likely to happen when collateral is pledged and personal guarantees are provided.
Based on the type and purpose, loans can be secured with a variety of collateral types, including business assets (primarily accounts receivable and inventory), equipment, vehicles and real estate. It is also very common for banks to require personal guarantees from owners of the small business with an ownership interest greater than 20 percent. How much the bank is willing to lend against each collateral type is based on what the assets might be worth in a forced sale scenario.
While understanding the 4 Cs of Credit can prepare small business owners for the loan application process, Hamilton emphasized that an acceptable loan request doesn’t necessarily have to be strong in all four Cs.
BankCherokee has several funding options available for businesses in need of loans, including lines of credit, equipment/vehicle loans, real estate loans, and business acquisition loans. Additionally, BankCherokee is an SBA Preferred Lender, offering a variety of specialty loans for small businesses through these programs. For more information, contact Roger Hamilton today.