Updated June 26th, 2019
There are a variety of variables that lenders look at when determining credit worthiness for small business lending. Typically, they can be classified into the 5 C’s of credit: character, capacity, capital, collateral, and conditions. In this blog post by The Commercial Finance Group, the best factoring company, we’ll examine these five C’s of credit and then take a look at what we use to determine credit worthiness — what we consider to be the 2 C’s of credit. Contact us today to get started!
THE 5 C’S OF CREDIT
Character is a combination of subjective measures and objective data gleaned from your past. Some believe that “character” is the most important of the five “Cs”. CFG is one of those believers. Character is a function of a borrower’s background, education, industry knowledge, reputation and past experience running a successful business. Some objective measures are: 1) past track record; 2) results of background checks; 3) repayment history from previous borrowings and 4) work ethic/drive. Within the “character” attribute, another vital component is person’s ability and willingness to honestly and effectively communicate with all stakeholders.
Capacity is your ability to pay back the loan for which you are applying. In the banking world, this is measured by the cash flow your company generates relative to its debt obligations due. Banks tend to look at two ratios to determine capacity; 1) a Fixed Charge ratio and 2) a Debt/EBITDA ratio. EBITDA is short for “Earnings Before Interest, Taxes, Depreciation and Amortization”. Though not a true measure of cash flow, EBITDA is a good proxy and widely used. If this is a new term for you, you might ask your accountant or CPA to help explain its importance. The Fixed Charge ratio is EBITDA divided by Fixed Charges. Fixed Charges are the sum of interest payments, current year debt obligations and sometimes maintenance capital expenditures. The ratio the bank is looking for is at least 1.25X. The higher this ratio, the more debt you can borrow. In terms of Debt/EBITDA, this is a general measure of how long it would take the company to repay its debt if all operating income (EBITDA) were devoted to debt repayment. Though this is a bit unrealistic, it is a measure they look at. Banks typically like to see a Debt/EBITDA ratio of 3.0X or less. Besides these ratios, a bank is also evaluating the stability of your EBITDA. The more volatile your EBITDA, the less they will lend. It is also important to note, that if you are a fast growing company, your cash flow (EBITDA) will be less than a slow growth company, generally speaking. This is because fast growth companies incur costs before these costs can be turned into revenues. Think of when you hire an additional sales person. You have to pay their salary and benefits beginning day one, and yet they may not make a sale for 3 months. So, you are carrying the cost without any corresponding revenue increase. That will lower your EBITDA in the short term. Another thing to note, is that both of these ratios are “backward looking”; they give you no benefit for future growth or future sales. So, as we say, banks tend to look out of the “rearview mirror”. We, at CFG, tend to look out of the “windshield”. While the past is important, we also understand that there is “no future in the past”.
The most straight-forward of the five C’s of credit is capital. Capital is the amount of equity you have in the business. This is measured by taking total business assets and subtracting all business liabilities. Another way to look at it, it shows how much “skin in the game” you have. Here, the bank is looking at another ratio, generally Total Liabilities / Total Equity and they like to see this ratio be 4.0x or less. The higher the number, the less “skin” you have in the game, and that makes a bank nervous. You also have to remember, you are the owner and as such, you have all the upside in the business. The bank has no upside in your business, they only have downside risk as they are capped at what they can make by the interest rate they charge. Said another way, the bank will only make what they charge in interst regardless if you make $100,000 or $1 million. As such, they are going to structure how much they will lend to you based on the risk to them of “losing” money. They are focus solely on protecting themselves in the event of a downside situation. You, on the other hand, are focused on the upside. So, you need to understand, as a business owner, you have a totally different mindset than the bank.
What types of collateral you have and how much you have play into the small business lending decision. Collateral is important because this is what the lender can take possession of and sell in the event you can not pay back the loan. Generally speaking, the more liquid the collateral, the more you can borrow against it. Also, as your assets grow, your borrowing capacity grows. So, a fast growing company can generally borrow more from an asset based lender than a bank because a bank focuses on EBITDA while an asset based lender, like the Commercial Finance Group, focuses on your assets. Another big difference between a bank and asset based lenders lke CFG, is that the bank will want you to use your personal assets (your house) as collateral for your business loan, in addition to taking all business assets. Asset based lenders like CFG do not require you to pledge your personal assets in order to get a business loan. CFG believes that you should keep your business assets separate from your personal assets. Remember, per the SBA, one in seven small business fail. You don’t want to loose your house if the business fails.
Conditions play a major role in how much you can borrow. But what conditions? These are mainly macro issues and include, the current stage of our economic cycle, the stability of that cycle, the state of your particular industry, the competitiveness of your industry, and the regulatory and political environment. The best thing a borrower can do is to be aware of these conditions and to have plans to deall with them should they change. Conditions are another subjective piece to the complicated puzzle of small business lending and though you can’t control them, you should be aware of them.
WHAT MATTERS TO THE COMMERCIAL FINANCE GROUP
Above are the 5 C’s most traditional lenders, such as banks, use to make their lending decisions. Credit score is also another C that is used for determining small business loans. For The Commercial Finance Group, we’ve narrowed it down to two C’s: character and collateral. Character is probably the most important to CFG. A person of good character can lead and drive a business and knows how to deal with obstacles when they occur. And in a small business, obstacles will occur. We also take a hard look at your collateral, specifically your accounts receivable and inventory. For a growing business, these assets will provide the borrower with more access to capital than a lender who is focused on EBITDA. And since we have over 44 years of evaluating collateral, CFG is your best bet when it comes to financing your growing business. So, if you are interested in either an asset-based loan, or a factoring solution, pleased contact us.
Factoring is where you sell your accounts receivable to a factoring company, such as The Commercial Financial Group. The factoring company evaluates the credit quality of your accounts receivable, performs the credit analysis on your customers, and collects the payments when due. In asset-based lending, in addition to evaluating your accounts receivable, we will also look at the quality of your inventory and how quickly it turns. Slow moving inventory is an enemy to a lender. Slow inventory can become stale, which can result in a write-off or fire sales. The type of inventory as also matters, whether it is raw materials, work in process, or finished goods. Very few lenders will lend against work in process, as finished goods and raw materials are generally more easily turned into cash.
The Commercial Finance Group primarily lends to small to medium sized businesses that are considered non-bankable by other lending institutions. These businesses are generally new, have weak cash flows which limits their “capacity”, have a weak capital base, or may be in an out of favor industry. While these are reasons for a bank not to lend, they do not prevent CFG from providing you a loan. We view our small business lending services — factoring and ABL loans — as a crucial step to get you on over the bridge to bankability. When you partner with us, you can be guaranteed that we deem your business a good fit for what we offer. We’re not into gouging your small business just for the sake of making a dime. We partner with those small businesses and start ups we believe we can help by providing them a solution to meet their cash flow needs and working capital needs. Our mission is to help, not hinder, your small business growth.
If you’re interested in factoring or ABL loans, give The Commercial Finance Group a call today to get started!