Module 6: The Five Cs of Credit | LISC Small Business

Although entrepreneurship is often touted as an arena of equal opportunity, there are major systemic barriers to realizing this ideal – one being access to capital. ICIC and LISC came together for an in-depth look at the small business financing industry and ways that business owners can use this knowledge to gain access to additional avenues of capital.

Foreign c’s of credit the second module in this chapter in this module we’ll go into a little more detail on the five buckets of information that lenders use to make a decision lenders evaluate loan applications based on their credit box and that credit box includes the five c’s it’s a system used by lenders to gauge credit worthiness of potential borrowers

The system weighs five characteristics of the borrower and conditions of the loan attempting to estimate the chance of default and consequently the risk of a financial loss to the lender so there you have a nice graphic of the five c’s of credit you can use that with your borrowers if it’s helpful and we’re going to start with capacity cash capacity so when

We’re talking about cash capacity we’re talking about debt service coverage the ability of a borrower to have enough cash in their situation to make the monthly loan payment so the applicant’s available cash after expenses is that greater than the monthly loan payment at least by a little lenders that i’ve worked with the cdfi lenders i’ve worked with are usually

Looking for about 125 percent coverage and that would mean that if the monthly loan payments a hundred dollars they’d like to see cash capacity of about 125 dollars per month and that way there’s a little cushion for the loan and in future modules will give you more help on calculating that there’s many many ways lenders calculate that and we’re going to present two

Here so it won’t be exhaustive but it will start to get you familiar with how that works and then you can refine it as you learn more about the lenders in your area so in determining cash capacity you may see a difference in your area between the mission-based lenders and the conventional and traditional lenders conventional lenders are more likely to use historic

Performance the past two or three years of historic profitability performance to determine whether there’s capacity for the loan that they’re analyzing and they like to rely on financial statements profit and loss and balance sheets these kind of more sophisticated documents that establish business owners can produce and they’re looking for the business to pay back

The loan if we hop over to what our mission-based lenders are willing to do they’re willing often to look at more recent history instead of going back two or three years to see capacity they might just look at the last six months they might be willing to look at bank statements instead of financial statements bank statements are much easier for our client base to

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Produce than the formal financial statements and they’re more likely to consider personal sources of repayment for young and startup businesses many of the clients we serve their business isn’t at a stage that can qualify for the cash all by itself so there are lenders out there and i’ve seen it both on the more conventional side and on the mission-based side they

Use this global cash analysis to determine cash capacity and what that means is you can see over there in the graphic they take all sources of personal income and all sources of business income and add them together subtract out personal expenses and business expenses and see what’s left over in order to determine the cash capacity because there’s potentially other

Sources of repayment that some lenders will look at such as the day job of the owner so maybe the owner still has a regular employment job while they start the business or run the business perhaps their spouse has income that can contribute to the cash capacity analysis maybe there’s other kinds of payments coming into the household that also contribute to the cash

Situation so that’s a quick intro to cash capacity question now our next c is character and i want to present this in two parts so part one is looking at the client’s credit history so for most people these days character means looking at the credit report and the credit history which we’ve talked about some and we will talk about more in future modules and it’s

Most likely going to be the personal or consumer credit report that is pulled a business has to be very well established to have a business credit report so when you’re working with clients always pull their personal credit report and take a look at it now lenders have lots of ways of using the credit report so that again there isn’t one approach but here are some

Ways that they do use it they’ll look at this thing called the fico score that’s the most kind of common credit score out there it’s the one that i know most cdfis use they’ll look at things like slow pays and collections and we’ll talk about that more they’ll look at the amount of credit used or available that means like how leveraged already is the borrower do

They have lots of loans showing up with a lot of you add up all the monthly payments it looks pretty extensive or is there current you know loan situation pretty lean and it looks like there’s room for additional debt to be taken on credit history is one of the most important elements of qualifying for a loan and it’s also one of the biggest barriers the clients

That we serve face in terms of qualifying please watch the module 7 and 12 for more detailed information about credit reports their use and underwriting and how your clients might be able to improve credit i also want to strongly recommend you look at this organization called credit builders alliance it’s a non-profit organization that builds the capacity of their


Non-profit members to help clients build credit and enter the financial mainstream they have a wealth of information and training and services that you can participate in some of our mission-based lenders will look at this question of character more broadly around reputation does the borrower show a history of making all their rent payments on time their utility

Payments on time their insurance premiums or is their banking history show very few bounce checks they’ll broaden their scope beyond the credit report so i think that’s important to understand whether one of the lenders in your area will take that broader view they also might look at things like has the client completed a business planning course and have they

Written a business plan this can matter to certain lenders that there’s a there’s some training that’s happened for the business owner other things like is the customer reliable if you make appointments and ask them to complete things do they do it on time do they show up do they show stick-to-itiveness this is like the other side of that character question our

Third c is collateral which are assets pledged to guarantee the loan and a lender places a lean on asset so they have a legal right if they need to in in situations of default to go and collect the collateral and liquidate it or sell it so conventional lenders like secure assets such as equipment vehicles real estate things like that and the asset value often for

Conventional lenders has to be equal to the loan amount mission-based lenders might just take a blanket they call a ucc filing on all business assets i worked with the cdfi once they said yeah we’ve got 75 000 loans in our portfolio backed by a five thousand dollar car and they felt comfortable doing that because they knew people really want their cars desperately

And they don’t want to lose them so they actually thought that was a pretty secure way to secure their lawns some lenders also might require a personal guarantee which is a legal promise to repay credit issued to a business from personal sources which means that if the business goes belly up that the lender could come and perhaps take some of your personal assets

Or require you to personally pay back the loan out of other sources of income so our next c is capital and lenders want to see that business owners have invested in their own business that they have some skin in the game so there’s several ways this could look one is that they just have cash to invest in the project especially as projects get bigger like a real

Estate project for example i want to see you that the owner has a down payment to contribute to the project there are other ways this could look though that the owner has made previous investments in the business they’ve grandfathered in some assets from their personal side and committed them to the business or that they’ve reinvested profits from previous years

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Now reinvested profits show up on the balance sheet as retained earnings again we’ve talked about how many of the people we serve don’t have that document or don’t keep it accurately developed so they won’t be able to show that but for more established businesses that have a balance sheet retained earnings can be a sign that the business has been profitable in

The past and has reinvested those profits in the business so we’re on our final c conditions and these are factors that affect repayment and this can vary really broadly by lender it’s hard to know what conditions matter to a lender and some conditions are within a borrower’s control and some are not so what might some of these conditions be certainly the overall

Region of national economic conditions are we in a recession are we not out of a borrower’s control but that’s going to impact to some extent what a lender decides to say yes and no to what is the loan structure again remember the lender is trying to match what they see in the application to the products and conditions they have within their organization is the

Industry high or low risk you know do they already have a concentration of that industry in their portfolio or do they have some room to take on another loan in that industry organizations also risk rate their loans and they might find themselves too highly concentrated in high risk loans so they have to turn down your client because they’re looking for stronger

Deals again these are the types of conditions that a borrower doesn’t have any control over you know again the clarity of the application matters because i think you’re making a case that this is a strong business owner in a strong market in a strong economy everything about it is strong the more you can make that case the better and also what the business trends

Are can you show historically that there’s a growth in sales and or profits and remember each lender will have a different list of conditions and the best you can do is try to get to know your lenders and see which conditions matter most to them and see if you can help position your borrowers to fit this c so that completes our overview on the five c’s of credit

And i’ll see you in the next module that focuses solely on credit it’ll give you tremendous amount of information on how to analyze this really critical piece of the application process thank you

Transcribed from video
Module 6: The Five C's of Credit | LISC Small Business By Local Initiatives Support Corporation (LISC)