What Lenders look for when approving a loan: The five C's of credit

A question I’m asked often is “How do you decide who to lend money to?” The answer for most lenders is pretty much the same: the Five C’s of Credit (although sometimes there’s 6 or 7, but let’s not worry about that).

We teach these five C’s to every lending underwriter (the person that decides whether or not to approve a loan) when they start working in lending. They are: Character, Capacity, Capital, Collateral, and Conditions. In this short article we’ll look at what each of these categories means, what lenders are looking for in them, and most importantly what borrowers can do to maximise their chances of being approved for a loan.

Character

Character is perhaps the most important of the Five C’s of Credit. It refers to the borrower's reputation and willingness to repay the loan. When assessing a borrower's character, lenders will consider factors such as their credit history, business experience, and references. Since the lender probably will not know you, your credit file and particularly any black marks, will be a key tool that the lender will use when assessing character. It’s not uncommon however for lenders to look deeper, reviewing your resume (if provided), LinkedIn profile, and more.

To give yourself the best chance of being approved when it comes to character, it’s essential to establish a strong credit history. This means avoiding black marks and building up a strong positive credit profile (by obtaining credit appropriately and by paying bills on time).

If you’re looking for funding for a new venture it’s also important to have a clear and well-documented business plan, as well as a solid track record of success in your industry. Remember, the lender wants to understand who they’re lending to, so the more comfort you can give them that you take your obligations seriously, the more likely they are to view your application favourably.

Capacity

Capacity refers to a borrower's ability to repay the loan. Lenders will look at a borrower's cash flow and expected income to determine their capacity. This includes analysing the borrower's financial statements (or projections), tax returns, and bank statements. Capacity may include some contingency, and the lender may need to make assumptions about anything that you don’t tell them, so don’t leave them guessing if you can help it.

When it comes to demonstrating capacity, it is important to have a clear understanding of your business's financials (or your business plan projections). You should have a solid understanding of your cash flow, profit margins, and expenses. Cash flow in the early days of a start-up business is particularly critical, a lender will want to know what you have to fall back on, or what contingency is available, if revenue doesn’t stary flowing as fast as you hope. It’s also important to make sure your projections are realistic and don’t miss key components (like remembering to pay yourself).

If you’re already trading then you should demonstrate your ability to manage your finances effectively, through strong financial reporting and management practices.

Capital

Capital refers to the amount of money a borrower has invested in their business. This includes the equity they have in their business and any personal assets they have pledged as collateral. Lenders will consider the amount of capital a borrower has when assessing their ability to repay the loan.

To get a big tick when it comes to capital, it is important to have a solid equity position in your business. This means investing your own money in your business, rather than relying solely on loans. Lenders often use the term ‘skin in the game’, we want to know that the borrower is not just shifting all the risk of their business venture on to the lenders.

When considering capital lenders may also consider potential capital, looking beyond the capital invested in the business and considering what other cash or assets you have available to you (including personal assets like property) that can be used to raise capital in tough times.

Collateral

Collateral refers to assets that a borrower pledges as security for the loan. Lenders will consider the realisable value of the collateral when assessing a borrower's ability to repay the loan. Common types of collateral include the equipment or assets you’re financing, inventory, and property. Sometimes other assets of the business (or a guarantor) can be considered as collateral (such as goodwill, intellectual property, or contracts) but only if those assets can be traded for value. It’s important to remember that what you paid for something may be very different to what it could be sold for.

To maximise your chances of being approved for a loan based on collateral, you’ll generally want to have assets in the business that can be used as security for the loan. Ideally, these assets should be of sufficient value to cover the loan amount, and they shouldn’t already be pledged as collateral for another lender. It can be very useful to have a detailed asset listing (with values), particularly if you’re looking to acquire a business, as this will help the lender assess their value. You should also check to make sure no other party has security over those assets (check the Personal Property Securities Register (PPSR)), and watch out for security interests from old loans that may have expired but not removed from the PPSR.

Conditions

Conditions refer to the overall economic and industry conditions that may impact the borrower's ability to repay the loan. Lenders will consider factors such as interest rates, market conditions, and competition in the industry.

Although you might think there’s nothing you can do to change the conditions, it’s important to help lenders understand the conditions that apply to your industry. If you’re starting a new venture then your business plan should cover off things like market conditions and if possible refer to independent sources of information. You should also be able to demonstrate your ability to adapt to changing market conditions and respond effectively to industry competition.

In Conclusion

Whilst the Five C’s of Credit might seem very much like something you only need to learn if you’re lending money, that couldn’t be further from the truth. Understanding how lenders assess loans can help you prepare a loan or business plan and set you up with the best possible chance of being approved by any lender. While different lenders will have different appetites for risk (banks typically being more risk averse than independents), they will all look at borrowers in pretty much the same way, and you want them to be picking up that big green ‘Approved’ stamp when they’re looking at you!

Phil chaplin the Chief Executive Officer of the CFI Finance Group, a specialist finance company servicing the franchise, accommodation, and fitness sectors as well as small businesses more broadly across Australia and New Zealand.

Phil has over 20 years’ experience in providing finance to businesses across Australia and New Zealand and has managed finance companies in the private and banking sectors, he is a former chair of the Equipment Finance division of AFIA.