Starting a small business may seem like an impossible dream if you’re not sure how you’ll get the financing needed to get started. In the past, when I advised hopeful small business owners, helping them apply for micro loans, I would challenge them to think about their applications from the perspective of the lender. Whether you are borrowing from a bank, credit union, or micro-financing organization, simply put, your lender wants to get paid back. (Getting paid back is how they’re able to provide more loans to other borrowers.)
So how does a lender evaluate whether you are likely to pay back the loan or not? Many small business lenders use “the 5 Cs” to help them analyze the application and decide if they will approve the loan. These factors indicate the level of risk and frequently inform each other. Here they are:
- Collateral is something of value that you authorize the lender to take in case you cannot pay back the loan. For an auto loan, the lender can repossess your car if you miss payments. Small business loan collateral can be equipment, inventory (usually discounted heavily) or other tangible assets. (For example, a list of your clients may be quite valuable to someone considering buying your business, but not valuable to your lender.) In addition, some lenders may require guarantee, or another person agrees to pay the loan if you cannot.
- Capital is your net worth. Determine your net worth by adding together everything you own (car, home, cash, etc.) minus everything you owe. Your net worth gives the lender an indication of personal resources that you may be able to access if your business goes through a rough patch.
- Capacity is a measure that compares your total debts and expenses to your total income. When this debt-to-income-ratio is low it means that you have plenty of income to cover your expenses.
- Conditions are outside circumstances that may affect your business and your ability to repay the loan, such as the local economy, industry trends, the local market, and competition. Typically these factors are out of your control, but you can address them by understanding them and considering how your business will respond to them.
- Character is an assessment of how likely you to repay, based on your history of paying back debt and how much experience you have in your business’ industry. Especially if this is a new business, your character may be equated with your credit score. Micro-lenders often base decisions heavily on character, relying on their relationship with the borrower.
Ideally, your financial statements demonstrate a realistic picture of how your business income and expenses will generate a profit and meet the demands of the 5 Cs. Similarly, your business plan will support your loan application if it clearly and concisely explains and supports the estimates and assumptions of your financials and takes the 5 Cs into consideration. If you’re considering applying for a small business loan, think like a lender.
By Julie Mauchenheimer, Development Specialist