Need a loan? Here’s how lenders rate your business – Inside INdiana Business

Business owners considering financing options often wonder how lenders decide if their business qualifies for a loan. Homebuyers know that mortgage lenders look at credit scores and income-to-debt ratios when making decisions, but the process isn’t as straightforward when it comes to business financing options. . The basics come down to what is called the five Cs of credit.

When a business owner applies for a loan, the lender compares the financial health of the business to a set of established standards. These standards and the factors measured vary by lender, but most can be categorized into the five Cs of credit: capacity, character, collateral, principal and terms.

Ability refers to the level of debt that a company can support. Lenders assess whether the borrower can repay the loan without harming the company’s profitability. To determine this, a lender traditionally looks at the cash flow to EBITDA ratio. EBITDA is an abbreviation for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is common for lenders to offer companies credit based on a multiple of EBITDA.

Character also comes into play. While a loan is about money and credit, the deal is between people. Lenders take the time to get to know the customers to ensure that the business, owners and management team are a good fit for the institution. Beyond personal, lenders look at homeowner’s credit reports to help paint a picture of the potential borrower’s financial character. This rating provides insight into a borrower’s reliability and likelihood of repaying the loan.

Collateral refers to the assets that a borrower pledges to the lender to secure the loan. In the event of default by the borrower, the lender can take these assets in repayment of the loan. A lender may order a business valuation. This number represents the value of the business, similar to the appraisal of a residential property or a house. Traditional commercial lenders appraise property and assets, such as equipment or inventory. Professional services firms may have cash flow and/or future commissions valued as collateral.

Capital the ratios are reviewed to ensure that the loan does not place the loan in an over-indebtedness position. The process examines the capital available to the company. This gives lenders an estimate of how much the borrower is setting aside to finance the asset or purchase and ensures a strong cash position after the loan closes. Some lenders have down payment restrictions that borrowers are required to follow.

Conditions are the specifics of the loan and the factors that can influence it. Lenders will take into account macroeconomic and geopolitical factors that may hinder a borrower or affect loan terms. Today’s interest rates are a rapidly changing condition that many lenders are watching as they can impact portfolios.

To assess the five Cs of credit, lenders will ask for several types of documents during the loan process.

  • Financial statements for the last 2 to 3 years;
  • Corporate tax returns for the last 2 years;
  • Pro forma financial statements that forecast expected future revenues; and
  • Personal financial statements that establish the financial character of the stakeholders.

If you’re currently considering financing options for your business, a good first step is to have a conversation with potential lenders to understand how they make lending decisions and what factors they consider. Use this plan as a guide for the conversation.

Lenders are eager to lend to viable businesses. Understanding the factors used by lenders helps potential borrowers determine whether your business is likely to qualify and the loan amount you can expect to support business growth. A solid relationship with potential lenders long before you need capital is an important first step in making your goals a reality.

Alicia Chandler is President of Oak Street Funding, an Indianapolis-based company of First Financial Bank, which provides customized lending products and services for specialty industries, including CPAs, registered investment advisers and insurance agents nationwide.

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