What are the 5 Cs of Commercial Lending?
The 5 Cs are:
- Capacity (Cash Flow)
- Capital (Cash on Hand/Liquidity)
- Conditions (Loan Structure)
Note that Credit Score is not included, although we do pull a credit report on the owners/guarantors, and it can tell us how much they value timely repayment. The credit report is a result of past events and not a strong indicator of future events when it comes to business loans. Bad things can happen to good people that would result in a bad credit score, too, which may have nothing to do with the success of a business. For example, we see personal medical collections as one of the main reasons credit scores suffer. But this would probably have no bearing on the performance of the business, assuming the health issue didn’t cause the operations of the business to suffer.
The Lender’s Scorecard
The 5 Cs are the lender’s scorecard, so to speak. The primary fiduciary responsibility of the credit union is to protect the deposits of its members. It means not making loans that have little or no chance of being repaid. It doesn’t take too many defaulted loans to put a financial institution at risk as we saw on a grand scale with many credit unions and banks in 2008. The 5 Cs also give the lender a way to assess the likelihood that a loan will be repaid as agreed and allows the lender to price the loan appropriately for the risk it is taking.
The ‘C’ I look for above all others is Character. A borrower could have all the money in the world, but if they lack a moral compass everything could blow up in an instant. As a lender, I always want to know that when the going gets tough, the person sitting across from me will do everything in his or her power to make good on their debts. That, if a problem occurs, the borrower won’t take the easy way out. For this reason, we refer to credit references, credit reports, standing in the community, and payment history with our institution to assess the character of a borrower.
Everything Builds on Each Other
Another takeaway for members is that the ‘Cs’ do not work in a vacuum – they all build on each other to create a picture of a healthy or unhealthy business. Much like an artist wouldn’t use one color or brush stroke to paint a picture or a golfer one club to get around the course, the lender utilizes MANY tools to gain a clear understanding of the health of a business.
For example, I receive many phone calls where a borrower assumes if they have an 80 percent loan-to-value ratio on a piece of property, the loan should be made, no questions asked. What they may not understand is the lender doesn’t want to take that property back to repay the loan. The collateral is a secondary (or sometimes tertiary) source of repayment in case the cash flow of the business can’t repay the loan. It’s a way to reduce the risk to the institution in case the loan isn’t fully be repaid. What we need to know is how will the business repay the loan through its operations and what are the contingencies if this does not happen.
I also want to share with our business members that the 5 Cs aren’t just a lending tool. They are an excellent and often precise tool for a business owner to assess the health of their own business and can be used to help manage risk. You’ll notice that sales and profit are not included in the 5 Cs, but, Capacity (Cash-Flow) is. There is a difference, and your commercial lender should be able to explain that to you.
Improving Your 5 Cs
Improving the 5 Cs takes time and hard work above all else. There is no ‘silver bullet’ that will magically improve the health of a business. But, having said that, a financial institution may try to shore up one ‘C’ to overcome a shortfall in another. For instance, ECCU has a strong Small Business Administration (SBA) program. On certain loan applications, particularly start-up companies that might not be able to show the historical ‘C’apacity or ‘C’ollateral, the SBA option can provide ECCU with a 75% loan repayment guaranty. Adding this guaranty would strengthen the ‘C’onditions of the loan, which may offset the shortfall in the other areas.
What to Avoid and Embrace
Business owners should embrace their lender as a business advisor and be wary of the ones that hawk cheap money without providing value. The trustworthy lender will want to build a relationship with you and be able to point out potential pitfalls and offer suggestions. We can’t manage the business, nor do we want to, but we do have a wealth of best practice knowledge that is free to tap. Find a lender that is willing to have those conversations with you. Your business will benefit.
How We’re Different
The 5 Cs commercial lending model has been around for a number of years. We follow the same set of best practices as other reputable lenders. However, at ECCU, we pride ourselves on listening to the story that’s behind the numbers. Maybe a company had a bad year; most companies will have had one if they’ve been around long enough. But, if there is a good story behind the bad year, and an owner can show that processes and procedures have been implemented or improved, we can usually get behind that company. Improved practices can often help prevent repeat bad years.
What about Start-Ups?
Start-ups can be more difficult to finance because they usually lack in most if not all, of the 5 Cs. There is no historical data to support a reasonable assumption that the lender will be paid back. For this reason, most start-ups are self-financed or financed with the help of family and friends and sometimes Venture Capitalists or other investors. If a start-up owner approaches the credit union, he or she needs to come to the table with a well-designed business plan and an open mind. In most cases, a lender is going to be looking for additional cash flow. For example, outside employment of the owner or possibly a co-signor may be considered. Additional collateral, possibly a mortgage on the owner’s personal residence or an assignment of a brokerage account, may also be used. And finally, certain strenuous conditions (such as the SBA guaranty discussed above) may be instituted.
The lender is also going to be interested in how much personal cash the owner is investing into the new business. It’s also a typical sign of how much faith the owner has that the business will succeed. Depending on the business, a start-up owner should have saved at least 30%-50% of the cost to open the business doors and operate for the first year. This amount gives us comfort that the owner has made a strong personal investment in the success of the business.
A Trusted Advisor
I have seen virtually every situation in my 10 years of experience. I love working with our members and problem-solving. The most rewarding part of my job is finding solutions for you. Through active listening and in-depth conversations, my priority is to ensure your business grows. I want you to see me as your trusted advisor, now and into the future.
Learn more about ECCU’s Commercial Services Team.