Small business owners looking for a loan need to understand the way their creditworthiness is evaluated to put their best foot forward—understanding the 5 C’s of Credit can help. As a general rule, there are three questions for which lenders need the answers:

1. Can you repay a loan?
2. Will you repay a loan?
3. What will you do if something unexpected happens?

Lenders might not ask them this way, but today I’d like to share with you the 5 metrics many lenders use to judge your answers. 

Generally speaking, lenders are pretty risk averse (although some have a higher risk tolerance than others). I remember an economics class I attended many years ago where the instructor made it a point to make sure we understood the test questions, and the answers, before a big test. Our grade depended on how well we answered the questions, not simply if we got the answers right. He wanted us to be prepared and learn.

It might be a stretch to compare my economics class with applying for a small business loan, but understanding what the banker (or any other lender) is looking for and judging your loan application against might make it easier to answer the questions well and get your loan application approved.

What are the 5 C’s of credit and why are they important?

The 5 C’s are the handful of metrics lenders have used for years to evaluate a potential borrower. They predate the predominantly data-driven digital world we live in today, but will give you insight into how and why lenders make the decisions they make—the 5 C’s include Character, Credit Score, Capacity, Capital, and Collateral.

The 5 C’s

Character, or C #1, is an important part of how a lender may size you up. 20 years ago I could sit in front of my banker and get a few thousand dollars based on my reputation with him and whether or not he liked my particular loan purpose. That type of small business lending doesn’t happen much anymore, but that doesn’t mean your character isn’t part of the equation.

I once spoke with a community banker friend who said, “If they have a good management team and have some of the other factors in place, we can make a case to the lending board that the business is a good candidate for a loan.”

That doesn’t mean the more tangible metrics don’t matter. She also said, “Of course there is a credit threshold we won’t go below, but we want to make sure we’re doing the best we can for all the small businesses in our community.”

In other words, your character alone won’t get you the loan. Remember, it’s data that drives loan decisions, but your character matters where the rubber hits the road.

I know C #2, your personal credit score, doesn’t really say much about how your business meets its financial obligations, but it does say something about you. Most lenders use your personal score as the gatekeeping metric to determine if they will even consider your loan application at all. Not all lenders adhere to the same credit thresholds, but the better your personal score, the more options you’ll likely have.

Basically, lenders are trying to determine what you will likely do in the future based upon what you’ve done in the past, and your personal credit history, along with your business credit profile, will help them evaluate that. They’re assuming if you have a strong credit history, you’ll likely continue to meet your financial obligations in the future. In fact, the longer the history the better.

In today’s economy (including when the economic challenges associated with the pandemic end), it’s probably safe to say that credit challenges experienced during the current financial crisis will be looked at differently than a chronic credit problem that pre-dates coronavirus. In other words, if your credit history took a hit this year, you may still be able to secure a small business loan if the other metrics look good and your credit history before 2020 otherwise looks good.

Capacity is C #3. No lender is interested in offering a loan to a business that doesn’t have the ability to repay. This C focuses on your annual revenue and your cash flow. This is how they try to determine whether or not you can repay a loan.

Even if you have great credit and a character above reproach, if you don’t have the revenue and cash flow to make periodic payments, your loan application will not be approved. That’s why idea-stage and early-stage startups have such a hard time. If you don’t have revenue that demonstrates the ability to make loan payments, you aren’t going to successfully apply for a loan.

C #4 is capital. I grew up in what I like to call a small business family. I started my career working in my father’s business. My dad sometimes complained, “If I had that, I wouldn’t need a loan from the bank,” after a conversation with his banker. He was complaining about the cash on hand his banker expected him to have before he would approve a loan.

The banker wanted, among other things, to make sure he had enough skin in the game that made it harder for him to walk away should something unexpected happen. They were looking for some kind of tangible assurance that he would still be able to make his periodic loan payments if he somehow got broadsided. A healthy cash flow, and maybe even some capital set aside for a rainy day, tells a lender that you aren’t looking for a last-ditch bailout loan to keep your business alive for a few months. Remember, lenders don’t like risk.

The last C, collateral, could be different depending on the type of lender and the type of financing. Traditional lenders like banks, credit unions, and the SBA, consider assets like real estate or equipment good collateral. Other lenders might consider your Accounts Receivable, your credit card receipts, or unspecified business assets as security for the loan. Although these things might not be called collateral, they tend to serve the same purpose, so maybe the last C could be “security,” but that doesn’t start with C.

Most lenders, even traditional lenders, will also expect a personal guarantee with every small business loan. Over the years I’ve heard many business owners complain about it, but there’s no getting away from it with many small business lenders.

Understanding your credit score based on the 5 C’s

Fortunately, when a lender considers your loan application he or she is looking at more than just your credit score. Think of the 5 C’s in the same way you would the way there are two announcers calling a basketball game. One of the announcers gives the play-by-play and the other offers the color commentary. The color commentary makes the play-by-play easier to understand.

The 5 C’s do the same thing regarding your credit score and the evaluation of your credit worthiness. Of course, depending on the lender, there will be lenders that won’t consider your loan application if your personal score is below their acceptable threshold, but the 5 C’s give a more complete picture of your business when your credit is being evaluated for a small business loan.

How to use the 5 C’s to improve your credit

Understanding the 5 C’s helps you too. If you know what lenders are looking for you can evaluate your business’ creditworthiness for yourself and fill in any gaps you find before you approach a lender to apply for a loan. Here’s a list of some actionable ways you can look at your loan application to help you build a stronger application. Although some lenders might not require all this information, there’s still value to going through this exercise to help you prepare for your conversation with a loan officer (regardless of the lender).

• C #1, Character: Be prepared to talk about your credentials. How long have you been in the industry (in addition to how old your business may be). If you have a lot of experience in the field, even if it’s not as a business owner, it can help. And, if you don’t have a business plan, you might consider creating one. Even if your lender doesn’t require it, being able to succinctly articulate your plan will give you confidence and exude credibility. Creating a business plan will also help you create a strategic vision for your business.
• C #2, Credit Score: You should know what your credit score is before you ever talk to a lender. There are literally dozens of ways to access your score for free, Nav happens to be one of them. Most traditional lenders are looking for scores in the 700s, though they will sometimes go as low as 680. The SBA wants to see a score no lower than around 650 and some online lenders will work with you if you have a score of 600 or better. There are even lenders who will work with you if you have a score as low as 500, but the lower your score the fewer options you may have, the higher the interest rate you’ll likely pay, and the more restrictive terms you’ll need to meet. If you know your score before you apply, you can look for the type of financing you will more likely be approved for and take the steps needed to improve your score.
• C #3, Capacity: Granted, you may not be able to change what your revenues are or what your cash flow looks like overnight, but you can make sure your accounting house is in order and that a potential lender has access to all the information they may need to make a loan decision. Be prepared to give a lender digital access to review your accounting records and allow data verification if it’s offered. This not only helps your lender review your information, it makes the process much more streamlined for you as well.
• C #4, Capital: Stay on top of your cash flow. Poor cash flow management will not only make it more difficult to get a small business loan, it could ring the death knell for your business. Lenders are looking for a healthy stream of cash flowing into your business every month from multiple sources. If you are overly dependent on one or two customers it could potentially hurt your business loan application. 
• C #5, Collateral: A truly “unsecured” business loan doesn’t really exist today, although there are lenders that don’t require specific collateral to secure a loan. Even though a general lien on business assets and a personal guarantee might be distasteful to some business owners, this type of financing allows businesses that don’t have assets that would be considered as collateral to still acquire a loan. If you have assets that do, you can prepare a detailed list before you apply to streamline the process. Regardless of whether or not you have collateral or the type of loan you choose, you will likely need to sign a personal guarantee—so be prepared.

Now that you have a better understanding of how a lender might interpret your creditworthiness and your loan application, you can take the steps needed to get your loan application on the top of the pile. That being said, there is no guarantee that you’ll get approved for the loan you’re looking for, but it will make it easier to apply and will hopefully improve the odds of success.