Besides bootstrapping, there are basically two ways to fund revenue growth in a business: take on debt or invite equity investors. In this blog post, we look at using debt to raise capital, and more specifically, what is required to qualify for a commercial loan.
All commercial lenders follow some standard underwriting principles and consider certain factors. This process is intended to build up a lender’s confidence that a business owner will repay the loan according to the loan provisions. In doing so, the lender generally considers what are known as the 5 Cs of credit.
The 5 Cs is a system used to gauge the credit worthiness of potential borrowers. Weighing these five borrower characteristics—character, capacity, capital, collateral, and conditions—is the lender’s way of estimating the chance of default and, consequently, the risk of a financial loss for the lender. Make no mistake about it, lenders want to loan money—that is how they grow their business—but they want to do it with some security. Borrowers can take steps to make their loan application more appealing to a lender by focusing on continuous improvement of their business in each of the five areas discussed below.
- Character (Credit)
To assess a business owner’s character (or credit worthiness) lenders may check credit history and credit score. A borrower can raise a credit score with some very simple internal controls and rules—making sure that all bills are paid on time and that any credit issues in the credit report are resolved and cleaned up well in advance of making an application for a loan.
Character involves more than just a good credit score. It also encompasses reliability, being someone who does what is promised and follows through on all commitments. Another thing an owner can do is inform the business’s banker about significant achievements in the business. This builds the business’ reputation.
A lender will measure the business’ capacity to repay the loan amount by evaluating the operational cash flow of the business. Poor management of accounts receivable could have a negative impact on the ability to qualify for a loan. Capacity to repay is also impacted by the amount of debt carried by the business. A high debt ratio puts the business in a more precarious position to repay its debts.
Other factors that could impact capacity include revenue history and revenue growth. Without a lengthy track record of recording sales and increasing those sales figures over time, the capacity to repay is less certain.
Capital is the amount of money that has been invested in the business that becomes operating funds. It is a measure of two things: the amount of money invested by the owner and how money is available to keep the business functioning. Lenders prefer to extend credit to borrowers who have invested their own money into the business, as this demonstrates proof of the borrower’s commitment to the business.
Borrowers with a large capital contribution in the business will find it easier to get loan approval because they present a lower risk of default. This works the same way as mortgage lending. Just as when buying a home, a borrower who has placed a down payment of 20% of the value of the asset can get better rates and terms for the loan, the business owner who has invested cash in the business is more likely to receive favorable terms.
Without making a personal cash investment in the business, an owner will find that getting loan approvals will be very challenging, if not impossible.
Collateral is usually an asset owned by the borrower that the lender will accept as security for the loan. Any real property, large equipment, or other assets can be used as collateral depending on the purpose of the loan. If the borrower defaults on the loan, the lender can seize the asset that was used as collateral.
Service businesses often have very few assets of this type. A related approach is “factoring” a business’ accounts receivable, which may be a viable option in some situations. Some service contracts may not be fulfilled for several months, delaying receipt of the cash payments from clients. For a fee that is some factor of the total receivables, an accounts receivables lender can take over collection of the receivables and provide cash to the business immediately. Of course, such costs should be taken into consideration when prices for services are negotiated.
The lender will consider various factors related to the borrower’s current situation and the specific conditions related to the loan application, including the purpose of the loan. Lenders will assess the need for the loan; obviously, raising funds to grow the business or to purchase a specific asset that will help the business grow will be more appealing to a lender than a loan to help bail out the business from losses, especially those stemming from poor decisions or lack of preparation for catastrophic events.
Other conditions might be related to the extent of the owner’s experience or how long the business has been in operation, its profitability and productivity. A lender also must consider the amount of the loan, the interest rate, and expected payment amounts, each of which will have an impact on the business.
To summarize, a business owner should consider how well the business’s history, financial standing, and operational success will appeal to the lender in each of the 5Cs before the need arises to take out a loan to fund growth. Being mindful of these commercial loan requirements can be a motivation in the way the business is managed. In fact, operating the business with the 5Cs in mind may be an excellent guide even for a business owner who has no intention of seeking a commercial loan.
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