How a Bank Reviews a Small Business Loan Request and the 5 C's of Credit

Before you ever submit a formal loan request to your bank, chances are you've spent a lot of time preparing. First step will be deciding how much money you need, how you'll use these funds and what kind of loan best meets your needs. Having good answers to questions that most potential lenders ask will help you navigate the lending process with confidence. Next you'll want to gather all the documentation required for your loan application, like this list of what you need to apply for a TD Bank Small Business loan. Another step that can help you achieve a positive outcome for your loan request is understanding what lenders often look for in business loan candidates. So even if you don't need a loan immediately, developing the 5 C's of Credit can help prepare your business for success.

The 5 C's of Credit: What banks look for when they review your business loan request

  1. Character
    Trust that you'll repay debt based on documented experience

  2. Capacity
    Having enough cash on hand to repay a loan

  3. Capital
    Funds on hand for contingency, so loan repayment is more assured

  1. Conditions
    Economic or industry situations that may impact your ability to repay a loan

  2. Collateral
    Specific assets pledged in case you're unable to repay

Understanding the 5C's of credit

  1. Character: Character is your willingness to take on debt and commit to repayment on the agreed upon terms with other lenders. This information is often determined by a review of your Credit Bureau reports which can show both your business and personal credit history. If your business is newer, your personal credit history will be more heavily relied upon so it's important to periodically review your credit history for accuracy.

    Some for-profit organizations may promise quick credit repair solutions for an up-front fee. Keep in mind there are important steps you can take on your own, at no cost, by working directly with the credit bureau. Check out free resources on the National Foundation for Credit Counseling† for ways to help you repair your personal credit history.

  2. Capacity: Capacity is your ability to take on lending. Banks often use Global Debt Service Coverage Ratio (GDSCR) to assess your capacity for taking on debt, and each bank may have their own unique GDSR calculation methods. Generally speaking, GDSCR includes taking your business cash flow and dividing it by your annualized expenses and coming up with a ratio before considering a new loan request. If your ratio is more than one, this means your business is taking in more money than the money going to service the debt. A ratio of less one means your business is not taking enough cash and it may be time to restructure or pay-off debt.

    Some other things to consider regarding GDSCR calculations include:

    • Your business cash flow can include net income, depreciation, amortization and interest write offs
    • Your annualized expenses can include payments for existing obligations (principal and interest)
    • In times of economic uncertainty, you may find banks raising the GDSCR ratio to avoid higher risks of defaults. You can ask your banker what the typical ratio they would like to see from a borrower
    • To complete these calculations, you will need up-to-date financial statements and/or tax returns. If you do the calculations yourself, get a second review by your Banker or CPA
  3. Capital: The bank will evaluate the cash position of your company and your ability to liquidate other assets if it were necessary to support your loan obligation if your business hit a rough spot.

  4. Conditions: This tends to be a very industry specific analysis of the conditions that would encourage stability or pose a risk to repayment of your loan obligation. Having a well thought out business plan that identifies the risks and mitigations helps your bank understand your preparedness to address these challenges. For example, the TD Bank Small Business Covid-19 Survey found that 81% of businesses did not have a crisis plan prior to COVID-19 2020 shutdowns. While some businesses surveyed were able to pivot to meet these new challenges, more than 69% acknowledged the need to prioritize building stable financing and cash reserves and enhancing their business model flexibility to better prepare for future crises. Those businesses that were able to pivot pointed to virtual meetings/appointments, delivery-based customer fulfillment, eCommerce and online sales as key elements to meeting COVID-19 challenges.

  5. Collateral: Collateral refers specifically to what assets your business is willing to pledge in order to secure a loan. Small business owners are often asked to provide a personal guarantee in the event the business is unable to pay the loan. Most banks will require individuals with more than 10% ownership to provide a personal guarantee, so it's important that owners have updated tax statements and have reviewed their personal credit history at the time they want to seek business financing.

    You won't necessarily need to have top scores in all of the 5 C's but having the right balance will make you more competitive when a lender considers your application. Keep in mind, you're also a decision maker in the lending process. You're in charge of what kind of borrowing makes sense for your goals. This includes exploring lenders and the choices they offer, as well as preparation of your loan request keeping the 5 C's in mind.

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This article is based on information available in February 2021. It is for general informational purposes only. It is not intended to provide specific financial, investment, tax, legal, accounting, or other advice and should not be acted or relied upon without the advice of a professional advisor. A professional advisor will recommend action based on your personal circumstances and the most recent information available.

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