The Five Cs of Financing: How Lenders Evaluate Entrepreneurs for Small Business Loans

For small business owners, obtaining a loan can be a vital step in realizing their growth and expansion goals.

But before funding any loan, lenders will assess entrepreneurs’ overall risk and their ability to pay it back in a process called underwriting. A helpful guide for entrepreneurs to know is known as the five "C"s of financing: Character, Capacity, Collateral, Cash Flow, and Capital. Understanding these factors and taking appropriate steps can significantly improve your chances of qualifying for a small business loan.

Please note: This isn’t a comprehensive guide to evaluating your loan readiness and each lender has their own specific processes. Rather, this guide hopes to equip you with general knowledge to improve your chances of obtaining a loan. Always speak to a financial professional before signing any loan. 

No. 1: Cash Flow

A cash flow analysis helps lenders evaluate your business's ability to generate sufficient cash for loan repayment. For startups, cash flow projections are based on sales and revenue forecasts. This analysis involves evaluating such factors as average ticket sales per customer, charge per hour, collection times on accounts receivables, costs of goods, industry mark-ups, operating expenses, marketing, and advertising costs.

For existing businesses, cash flow is based on historical performance and projections. Traditional Cash Flow — which is calculated by adding net profit, depreciation expense, interest expense, and amortization expense — should ideally cover loan payments by about 1.25x.

No. 2: Character 

Lenders want to see a demonstrated desire and ability to repay debts. Personal credit reports are typically pulled for each business owner with a 20% or more stake in the company. It’s important to review your credit report from major bureaus like Equifax, Experian, and TransUnion to identify and correct any issues with your personal credit, such as collections, past-due payments, or bankruptcies.

To strengthen your character profile, consider paying off any outstanding debts or paying as agreed for about 12-18 months. A bankruptcy on your record may not necessarily disqualify you, but any federal debts in bankruptcy could impact your loan eligibility. Additionally, ensure you have no unpaid back taxes, as this can be a major red flag for lenders. Click here to learn more about building your business credit.

No. 3: Capacity 

Capacity refers to your ability to achieve business performance, and it’s especially important for startup businesses i.e. businesses under two years old. Lenders often require the resumes of each owner actively involved in the business, along with the resumes of two critical employees. These resumes should highlight relevant skills, education, training, and franchise-specific expertise that contribute to the business's success.

For startup businesses, specific industry experience is often a key requirement when seeking financing. Demonstrating your capacity to grow a successful business, handle its operations, and build toward the future will enhance your chances of obtaining a loan.

No. 4: Collateral 

Collateral serves as security for a loan and provides a safety net for lenders. A good goal is to provide sufficient collateral to cover 100% of the loan amount, ensuring that the liquidation value of the assets can pay back the loan if needed. Different types of collateral are assigned a percentage value, known as the advance formula, which determines their liquidation value.

Lenders have different collateral requirements for their loan products, so make sure to ask your lender before getting too deep into the process. You can also involve non-owners who can pledge collateral on your behalf. If you plan to do that, make sure to discuss that with your lender to see what information they’ll need. 

No. 5: Capital

Capital refers to the cash or assets that owners contribute to the business. Lenders assess the debt-to-equity ratio (referred to as leverage), which varies depending on the loan amount, business type, and industry. Startups with loan amounts of $100,000 or less might have higher debt-to-equity ratios, while larger loans typically require a lower ratio.

Having sufficient capital and a healthy debt-to-equity ratio can demonstrate your commitment to the business's success and improve your loan eligibility.

Conclusion

By understanding and addressing the five "C"s of financing, small business owners can present a compelling case to lenders and secure the financing they need to fuel business growth and success.

Demonstrating a solid character, capacity, collateral, cash flow, and sufficient capital greatly increases the chances of qualifying for the loan your business deserves.

If you have questions about your business’s loan readiness, please reach out to us at info@altcap.org or call (833) 549-2890.