What lenders look at
The 5 Cs of credit, in plain language
Banks and credit unions have weighed small business loans the same basic way for decades. The “5 Cs of credit” are capacity, character, capital, collateral and credit. Here is what each one means, why a lender asks about it, and what to have ready.
01
Capacity
Can the business afford the payments?
Capacity is the business's ability to repay the loan out of its own cash flow. A lender starts here because cash flow is the first way a loan is expected to be repaid. If the business can't carry the payments in a normal month, the rest of the application rarely matters.
To judge it, the lender looks at what the business brings in, what it costs to run, and what it already pays on existing debt, then adds the payment on the new loan. They want to see enough left over to cover all of it with room to spare, because sales dip, costs rise and customers pay late. Bankers usually measure this with a debt service coverage ratio.
An established business shows capacity through its financial statements. A startup shows it through projections, and the lender will test every assumption behind them.
What helps
- Year-end financial statements that show a profit after all expenses
- Room in the numbers for every loan payment, old and new
- For a startup, a realistic forecast you can explain line by line
Related terms: Cash flow · Monthly revenue · Existing debt payments
02
Character
Will you do what you say?
Character is the lender's judgement of you as a borrower and as the person running the business. In a small business the owner and the business are hard to separate, so the lender wants to know whether you are trustworthy, capable and committed.
Experience counts heavily. A lender is more comfortable when the people running the business have done this kind of work before, ideally in the same industry. If you haven't, a partner, manager or advisor who has can fill the gap.
How you present yourself matters as well. Complete, consistent paperwork, a clear explanation of your own numbers, and being upfront about anything that went wrong all build trust quickly. References and any history you have with the lender help too.
What helps
- Relevant experience, or a partner, manager or advisor who brings it
- Complete, consistent paperwork with no surprises
- The ability to explain your own numbers in plain terms
- A straight answer ready for anything that went wrong in the past
Related terms: Industry experience
03
Capital
How much of your own money is in it?
Capital is the money you put into the deal yourself, often called your equity, down payment or cash injection. Lenders rarely finance the full cost of a project. Your own money shows commitment, and it means the lender isn't carrying all of the risk.
Lenders expect that money to be in a bank account before they advance anything, not money you hope to raise later. Money you've already spent may or may not count, so ask your lender before you spend it. A loan from family or a personal line of credit usually doesn't count, because it's still debt.
Capital also includes what you and the business have built up over time. A healthy net worth tells the lender there is a cushion if the business has a slow stretch.
What helps
- Your down payment set aside in a bank account, untouched
- A clear record of where that money came from
- A personal net worth statement ready to hand over
Related terms: Equity / down payment · Personal net worth
04
Collateral
What backs the loan if things go wrong?
Collateral is the security behind a loan: assets the lender can take and sell to get its money back if the business can't repay. Bankers call it the second way out. Cash flow is the first way a loan gets repaid; collateral answers the uncomfortable question of what happens if the business fails.
The asset being financed is usually the main security, such as the equipment, vehicle or building the loan pays for. Lenders often also take a general security agreement over the business's other assets, like inventory, receivables and equipment. They favour tangible assets that are easy to value and sell, and they usually count them at less than full value, because a forced sale rarely gets top price.
In a small business, the owner's own assets are often part of the second way out too. That's why lenders so often ask owners to sign a personal guarantee, which makes you personally responsible for the loan if the business can't pay it.
What helps
- A list of what the business owns, with current values
- Current values for your home and other major personal assets
- A clear answer on whether you, and any partners, will sign a personal guarantee
Related terms: Business tangible net worth · Personal net worth
05
Credit
How have you paid what you owed before?
Credit is your track record of repaying what you've borrowed. Before making a small business loan, a lender will almost always check your personal credit with a credit bureau such as Equifax or TransUnion, along with the business's own credit file if it has one. For a small or new business there is usually little business history to go on, so the owner's personal record carries most of the weight, even when the business is incorporated.
The report lists the loans, credit cards and lines of credit in your name: what you owe, your limits, and whether each payment was made on time. Lenders read it as a predictor. Someone who has kept past payment agreements is likely to keep the next one. Late payments, accounts sent to collections, or a bankruptcy or consumer proposal suggest more risk.
Your credit score sums this up in one number, but lenders look behind it too: how recent any problems were, how much of your available credit you are using, and whether you have enough history to judge. If there is a blemish, explaining it upfront is far better than letting the lender find it.
What helps
- Payments made on time, every time
- Credit card and line of credit balances kept well below their limits
- Your credit report from Equifax and TransUnion checked for errors
- A short explanation ready for any past problem on your report
Related terms: Credit score
How to prepare your business for a loan · Loan terms in plain language