Mr Shakti Singh has been running his printing and packaging business successfully for a couple of years and now, he wants to expand. Thus, he wishes to apply for a loan. Being a meticulous person, he does not want his loan application to be rejected due to lack of homework. So, when he asked around, many of his friends told him that credit score is the only parameter on which loans are approved and rejected. Well, this is not the case. While credit score is an important factor, there are other factors too which are considered while judging an applicant's eligibility. Therefore, it is important for loan seekers like Mr Singh to value not just credit score but also their entire creditworthiness that is calculated by the 5 Cs – Character, Collateral, Capacity, Capital, and Conditions. If your 5Cs are in good shape, there is a high probability that your application being accepted. Let us learn more about them.
The 5Cs of Credit
By character, lenders mean your financial character. They want to know if you are a trustworthy borrower and have a good reputation as a business owner. They want to ascertain that you do your business dealings in a fair and responsible manner. Lenders assess the character by analysing the credit history of both your business and personal credits, by investigating your market reputation and by verifying from sources and references. Checking the credit history will reveal all instances of delays and defaults in repayment. Therefore, as a loan applicant, you should settle any pending debts and review your credit report to rectify any anomalies before applying.
Collateral is any valuable asset like home, jewellery, car, etc. that can be pledged as security. Lenders can seize and sell the asset in case of defaults. Since collateral reduces the risk for the lender, putting an asset on the line will get you better terms from them. However, you also stand a chance of losing the asset if you fail to repay the loan.
Capacity signifies a person’s ability to repay the loan. It is determined by the cash flow of the business. Lenders check if you are in good financial health, you are not already saddled with debt, and can afford to repay a loan without defaulting. It is assessed by checking your business’s cash flow statements and projections, bank statements, Debt Service Coverage Ratio (DSCR) and Debt-to-Income ratio (DTI). These documents not only tell the lenders about the current cash flow but also the future capacity of business. So, to make sure you have good ‘capacity’, increase your revenue, collect receivables, and lower your expenses before applying.
Capital is the monetary worth of your business – the money you have invested in your firm (in purchasing office space, machines, inventory, etc.) and the amount you are seeking to invest. Huge monetary investments mean bigger possibility of getting the loan repaid as it establishes the owner’s intent and commitment towards the growth of the business. Lenders check your history of investments and what dividends have they paid. You need to explain to lenders about your recent investments that helped you earn profits and how with a financial push will help take it further. Keep a comprehensible and convincing business plan ready as well.
There are some terms and conditions levied on a loan and they might change vis-à-vis any changes in the economy. These conditions are measures taken by lenders to minimise their chances of losing money like sometimes there are restrictions on the use of the loan amount. As a borrower, you must be on the same page as the lender about them. Always apply for a loan when the cash flow is decent and business is booming to get better terms as financial institutions are hesitant about lending to risk-prone industries and businesses that may raise red flags.
- Revenue statements:
Revenue is the amount of money generated by the sale of goods and services. If it is more than the cost of production, the company is making profits. Lenders check your income statements or profit-loss statements to see the size of revenue generated, how it is being used, and if you save enough to repay loans. Keep revenue statements of the past two calendar years ready when you decide to apply for loans.
- Years of Operation:
Since many business ideas do not turn into successful ventures, lenders trust borrowers who have spent a long time in business. It shows that the business model has the potential for growth and can withstand seasonal dips. New entrepreneurs may have to wait for a little longer to get the desired loan options and better loan terms.
- Business Balance Sheet:
Balance sheet provides a gist of your business’s financial health to lenders. They learn about the assets you own and what debts you owe. This document is used to ascertain that your business has enough assets to cover the liabilities and the profits earned will make repayment a smooth process.
Understanding the requirements of the lender not only maximises your chances of securing a loan but also helps you get the desired amount at better terms. Though every lender evaluates the loan application differently, the above-mentioned points are the standard parameters and focussing on improving these factors will boost your creditworthiness. While it is, difficult to have a stellar rating in every parameter but if Mr Singh and other entrepreneurs like him can manage to be exceptional in some aspects and satisfactory in others, they stand a good chance of establishing themselves as credible borrowers.