When your business needs financing, you’ll find that some of the best options require the most documentation. Why?

It all comes down to credit risk. Banks and other financial institutions need to gauge the risk associated with lending to your small business. 

Understand how lenders approach credit risk, and your business can improve its qualifications.

What is Credit Risk?

The term “credit risk” evaluates the risk of default; in other words, it tries to predict the possibility of losing money in the event a borrower fails to repay a loan or meet other contractual obligations. 

In simpler terms, it’s the chance that a borrower won’t pay back what they owe. Banks call this the “probability of default”.

The “riskier” a borrower, the more likely that they will default on a loan, line of credit, or other financial product. Here, we’ll refer to small business loans as a catch-all term for different types of business financing, as we explain what lenders look for.

Current State of Credit and How Credit Risk Fits In

Credit risk rose during the pandemic, and a combination of factors including supply chain problems, inflation, and high interest rates, helped keep it high. 

But that’s changing. The Federal Reserve cut interest rates in September 2024 in the first of several expected rate cuts. Inflation and supply change problems are easing. Delinquency rates are starting to hold steady, which is allowing lenders to loosen their underwriting standards. 

While credit standards are still higher than they were in 2021-2022, the fact that they are softening should help many businesses find it easier to access funding. 

Of course, businesses that are considered higher credit risk will still have a harder time accessing traditional financing, and high credit standards may push them toward less traditional financing. That’s why it’s important to build your credit profile.

How Lenders Make Money

Lenders primarily earn money from the interest and fees you pay on your loan. Sometimes, they also profit by selling your loan as a bond to other investors. 

While this process can be complex, what’s important to know is that loans always come at a cost, and the pricing of a loan is often closely tied to the credit quality of the borrower. 

Lenders get paid when you or your business, the borrower, repay your loan in full with interest and/or fees. Before they decide to lend money to your business, lenders need to assess whether your business is likely to pay back the loan. They do this through a credit risk assessment.

When it comes to debt financing (the type of funding we’re discussing), banks and even alternative lenders tend to be cautious. If their credit risk models indicate they could lose money on your loan, they’ll either charge more, or reject your application. 

How Lenders Assess and Manage Risk

Even with the best data and experts, credit risk management involves probability. Lenders consider several factors to assess a borrower’s chances of repaying debt.

Borrower qualifications

Lenders evaluate a borrower’s ability to pay and creditworthiness through:

• Personal credit and/or business credit ratings
• Business’s financial health (cash reserves, revenue, and assets)
• Time in business
• Industry

When assessing risk, there’s a rule of thumb called the “Five C’s”:

1. Character: The borrower’s credit history, often represented by their credit scores.
2. Capacity: The borrower’s ability to repay the debt based on income and other loans.
3. Capital: The borrower’s down payment or equity contribution.
4. Collateral: Assets that can serve as an alternative repayment source.
5. Conditions: The loan’s interest rate, repayment schedule, and other terms.

Lending terms and conditions

Lenders consider two main factors when making credit decisions:

1. The likelihood of full repayment
2. Reserves to cover credit losses

Lenders set loan conditions based on risk factors. Higher risk often means they must charge higher interest rates or take additional protections against default. Some ways lenders manage risk include:

• Interest rates: Higher rates for riskier borrowers
• Term length: Shorter payback periods for riskier loans
• Collateral requirements
• Loan amount adjustments
• Payment schedule frequency

New businesses often find it especially difficult to qualify for startup loans. Without an established credit history, lenders can’t easily assess the business as a borrower. New businesses may also lack strong financials (revenue, cash reserves, or collateral). To manage this risk, lenders often use risk-based pricing, which may mean smaller loans at higher interest rates.

This is one reason businesses with no credit or bad credit often only qualify for revenue-based financing, such as merchant cash advances or business cash advances. 

As you build your business and business credit history, you increase your options. This can lead to better loan terms.

Here are three things you can do to improve your qualifications:

1. Use a business bank account. All business revenue and business expenses should flow through your business bank account. 
2. Keep your bookkeeping up to date. Some lenders may require financial statements (such as an up to date profit and loss statement, or balance sheet, for example). Up to date books make it easier to provide these documents when requested. 
3. Establish business credit. Better credit translates to more financing options. 

Next, let’s explore how your business credit relates to credit risk.

Business Credit and Risk

Your business can have its own business credit reports and scores. Good business credit scores can help you qualify for a wider range of financing options. 

Although credit scoring models vary, there are some common factors the credit bureaus take into account when calculating your business credit scores. You should check each specific score breakdown separately, but for the purposes of understanding how business credit relates to lending risk, here is a general breakdown.

Top factors in business credit scores

1. Payment history

Does your business pay suppliers and business credit cards on time? Unlike personal credit, business credit can report how quickly your business makes payments, down to the day, using days beyond terms or DBT. Paying on time is crucial. 

Do what you can to avoid paying late, as delinquency can hurt your scores. On-time payments are the single most important factor in calculating credit scores. 

2. Age of credit history

An established business with a long credit history and a track record of timely payments will score higher than a brand new business with less than a year under its belt. Banks and other lenders look for stability, and an older credit history allows them to more accurately review a company’s ability to pay back loans. 

Commercial banks, which often give the best loans at the best rates, look for established businesses that have weathered market fluctuations, and many require at least two years. 

Lastly, note that the time in business refers to how long your business has officially been registered in one form or another; that’s why it’s so important that you register your business early (ideally right when you start it).

Read: A Checklist to Make Your Business Legit

3. Debt and debt usage

With personal credit, lenders and credit scoring models often consider credit utilization, and lenders may consider debt-to-income ratios. 

With business credit, lenders often review cash flow, and key metrics related to liabilities, such as a debt service coverage ratio. High debt indicates to lenders that your business may not be able to fund itself on its own cash flow alone. If you need to fund your business activities with outside sources, then will your business be able to pay back a new loan? 

Business credit scores may take into account your credit mix across loans, lines of credit, credit cards, tradelines, etc. to better assess your businesses’ liquidity and credit obligations. This matters because it helps lenders determine where they fall in your payment stack. If your business can’t make all its payments, do they get paid out first, second, third, etc.? Lenders will often look at UCC filings to see what collateral is already pledged and the adequacy of any collateral available to repay the loan. 

4. Public records

Public records are items recorded with the court such as UCC filings and other liens, bankruptcies, and judgments. 

5. Industry risk

Lenders often consider your business industry. The lower the level of risk for your industry, the easier it will be to secure certain types of financing. Keep in mind that certain industries and sectors are classified as higher risks than others. 

Specifically, if your business falls under real estate investing, auto sales, travel, transportation, money lending/collecting, or food and beverage, your business may be classified as high-risk. 

Note that what a lender considers a “high-risk” industry can also shift and change as other external factors include: for example, at the very beginning of pandemic shutdowns, financial services was seen as high-risk. However, this changed when the government stepped in and determined that banks were “essential.”

6. Company size

The number of employees and annual revenue can also help lenders understand the size of your business and the potential size of the loan.

Bottom Line on How Banks Assess Credit Risk

Understanding credit risk is key to improving your chances of getting a business loan. Here’s what to remember:

Credit risk is the chance a borrower won’t repay a loan. Lenders use this to decide whether to approve a loan to your business, and to set terms. As part of that decision-making process, lenders often look at:

• Personal and/or business credit scores
• Revenue and/or cash flow
• Time in business
• Industry

Lenders help manage risk exposure through:

• Interest rates
• Loan terms
• Collateral 
• Loan amounts
• Payment schedules

Building strong business credit can help your business get better loan terms. 

By understanding how lenders view risk, you can take steps to improve your business’s credit and risk profile. This can lead to better loan options and lower costs for your business in the long run.

How Nav Can Help

With Nav Prime, your business can build, manage, and leverage your business credit all in one place. With Nav Cash Flow Health, you can monitor and analyze your cash flow health across all your business accounts.