According to a recent Wells Fargo study, many small business owners have a limited understanding of what it takes to be approved for credit and how to best use credit options. To help you understand how lenders evaluate your credit application, we’ve identified five components known as the 5 C’s of credit: Credit history; Capacity; Capital; Collateral and Conditions. Lenders can accept or deny requests based on these business credit requirements, so it’s important you understand each one.
Credit history shows a lender who you have previously borrowed from, how much you borrowed, if you carried reasonable balances and if you made payments. To manage your credit responsibly, it’s important to make payments on time, and keep balances on bank credit cards or lines of credit low relative to the credit limits. You should also set up dedicated business accounts so lenders can see if you handle your business and personal finances separately and responsibly.
Before extending financing, a lender needs to ensure the business has the ability to repay a loan and meet payment obligations. Profitability and cash flow are essential components of demonstrating that your business can handle new credit. A business must also be able to show that it has enough positive cash flow to meet both short- and long-term commitments for a lender to gauge the probability of repayment.
A business owner with assets that can be converted into cash in case of a sudden downturn in revenue will be better able to operate his or her business and repay debt. A lender wants to see that the assets of the business sufficiently exceed its liabilities, and understand how quickly and easily those assets can be turned into cash.
There are several internal and external factors, beyond your financial situation, that may affect the ability of a business to repay a loan. On the external side, lenders might factor the probability of an anticipated recession into their decision. On the internal side, conditions could include the borrower’s business experience and knowledge. Internal and external conditions can be important indicators of a business’ ability to thrive, and therefore its ability to repay its credit obligations.
Collateral can be used as a secondary source of repayment in case of default. You may qualify for a small loan without collateral if you have a healthy credit history and financial statements. However, if you need to put up collateral to secure a lender’s investment, it’s important to document your assets. These can include real estate, equipment or in some instances, savings and deposits.
With a better understanding of the five C’s of credit, you’ll have a good sense of what it takes to get credit-ready and some of the fundamental steps to help get you there.
There are many resources available to help guide you through the credit process, including the Business Credit Center on WellsFargoWorks.com. This new, complimentary resource includes educational videos and articles that help demystify the business credit journey.
– Karina Gray is the Small Business Segments Manager for Wells Fargo Arizona. To reach her, call 602-378-1252 or KarinaGray@WellsFargo.com