In 2019, the small business credit survey reported 43 percent of small businesses applied for a business loan. Overall, 36 percent of those that applied were denied at least some of their funding due to poor credit. Most small business owners cannot personally fund their entire venture, placing great importance on small business loans. Lenders use five pillars of credit in order to determine an applicant’s creditworthiness and understanding each one can help you maximize your chances of successfully securing funding for your business. 

What Are the 5 Cs of Credit? 

The 5 Cs of credit is a system used by lenders to determine the risk of an applicant. If the lender feels the small business owner is likely to default on a loan or be unable to pay it back, it would be very risky to lend them money. Therefore, the borrower would be denied part or all of their requested funding. If the borrower is deemed creditworthy, they are considered low risk and will secure a loan. 

The 5 Cs of credit are as follows: 

  • Character
  • Capacity or Cash Flow
  • Capital
  • Conditions
  • Collateral

Small businesses, in particular, should pay close attention to these five pillars of credit because loan accessibility is vital to supporting growth and overall financial health. 

1. Character

Character relates to the trustworthiness of the applicant. Of course, lenders want to lend to people who are able to follow through with their commitment to pay the money back. Unfortunately, a completed loan application with the vow of the prospective borrower alone is not enough to give lenders peace of mind. In order to determine whether an applicant is low risk based on character, lenders look at the following: 

  • Work experience, to confirm a consistent source of income
  • References, to get an idea of reputation and whether it is positive or negative
  • Past interactions with lenders, including previous applications and their status
  • Credit history 

To improve your character in the eyes of lenders, prioritize making payments on time, every time. Additionally, banks tightly associate character with positive relationships, which is why reputation is something they investigate. If you’re just beginning to build character, begin with your local bank or credit union. These smaller branches allow you to build personalized relationships with individual bankers and lenders, which elevates trust. This can help you secure a smaller loan, allowing you to build a positive history that can help earn greater funding down the road. 

2. Capacity or Cash Flow

Capacity or cash flow refers to a prospective borrower’s ability to pay back borrowed money. Similar to character, banks are less likely to extend a loan to a high-risk business owner because there is a greater chance they won’t get their money back. When measuring an applicant’s capacity, lenders look at the following factors:

  • Business debt 
  • Cash flow statements 
  • The owner’s credit score from their credit report
  • Repayment history of previous loans

To improve your capacity, be diligent about assessing your business’s financial health through regular cash flow calculations. This will provide valuable information that can help balance your debt-to-income ratio. If you need better insight into your business’s cash flow, use a small business bank account that integrates with your bookkeeping tools to make it easy to understand your company’s performance. Aim to use no more than 30 percent of any open lines of credit, and make sure any outstanding debt is less than 40 percent of your business’s income. If you have less debt and more cash flowing into your business, lenders will feel more confident extending you a small business loan. 

3. Capital

Capital relates to the amount of money the owner personally invested in their small business. Banks are more likely to provide a loan to small business owners who have invested their own money. This shows that the bank isn’t the only one at risk of losing money. It makes a bold statement that the business owner believes in the venture, has the vote of confidence from other stakeholders (in the case of a partnership where there are multiple owners or investors), and has some level of personal funding to support their startup business. Potential lenders look for the amount of money the applicant and any investors have placed into the business. 

To improve your capital, aim to fund at least 20 percent of the startup costs for your small business with your personal savings. Be diligent about keeping records of any personal investments made to show to future lenders. Integrating your bookkeeping with other financing tools, like accounting software or mobile banking, can help keep these records organized and easy to find. 

4. Conditions

Conditions refer to the state of your business — is it thriving and expanding or falling flat? The current state of your business correlates to what you’ll be using the funds for, so be explicit and transparent about your spending plans. A cash flow statement can help you map this out. 

When assessing an applicant’s conditions, a lender may look into the following:

  • How the requested money will be used 
  • Current economic conditions
  • Current trends and projections for your particular industry

Lenders care about the above factors because it helps them determine how risky the investment is. Banks don’t want you and your small business to fail. In fact, it’s the opposite. They want to lend you money under the best economic and industry conditions possible so that you can succeed and have the means to repay the loan. 

You can overcome challenges related to conditions by intentionally applying for loans during economically sound times. This is when your business is most likely to see success, minimizing risk. Healthier economic conditions pave the way for strong business capacity and cash flow, helping improve your creditworthiness. 

5. Collateral

Collateral is the last of the five Cs and refers to assets used to guarantee a loan. Often, collateral serves as a backup source of payment, should the borrower fail to repay a loan. Guaranteeing a loan is another way lenders work to minimize risk on their end; having collateral incentivizes the borrower to make consistent and timely payments. The following is acceptable collateral:

  • Hard assets, like real estate or equipment that belongs to the business
  • Working capital, including inventory
  • Personal assets belonging to the business owner 

In terms of assets, you can help protect yourself by making a well-informed decision regarding the structure of your small business. Certain business structures, such as an LLC or limited liability company, may offer better protection for your business and personal assets. Be proactive about putting a thoughtful legal entity in place to minimize risk prior to applying for any loans.