Do you have your eye on a new excavator or vacuum truck to replace an over-the-hill model in your fleet? Are you outgrowing your current shop or office space? Is a friend in the industry ready to retire and offering you a golden opportunity to grow your business through acquisition? When it’s time to take your business to the next level, without having to open your wallet or ask family or friends for cash, business loans and credit lines are viable options.

While you’re looking at the next opportunity, the bank is looking at your credit worthiness and the risk associated with lending you money. According to Jerimiah Janssen, vice president of commercial banking at First Business Bank in Appleton, Wisconsin, each financial institution has its own way of making credit decisions, but many institutions rely on the five C’s of credit: character, capacity, capital, collateral and conditions. The five C’s pertain to both personal and business finances, which are closely linked for small businesses.

“If you want to borrow money to grow your business, the bank will look at you and the business together,” Janssen says.

Character

Character refers to the borrower’s credit history, which is represented in a credit report. A credit report lists an individual’s payment history, current debt, loans, and other financial obligations. Janssen says business owners should review their credit report before applying for a commercial loan or line of credit. That way, they can find and address any negative information in the credit report and fix any errors before the lender sees it. 

Through USA.gov/credit-reports, individuals are entitled to a free annual credit report from three credit reporting agencies: TransUnion, Experian and Equifax. You can request the reports one at a time or all at once. Business owners with excellent credit (740 or above) are considered a better risk by lenders, so Janssen recommends paying mortgages, student loans, car payments and other obligations on time. Watch your credit card spending, also.

“If you have a $5,000 limit and you’re at $4,900, that’s a high utilization of the credit card, and it’s going to report negatively compared with paying off the balance every month,” Janssen says.

In addition to reviewing personal finances, lenders will review business finances. Lenders determine the character of a business by its “accounts receivable aging” statement.

“What we’re looking at is how old is each account? Anything zero to 30 days is considered current. The further out it goes, the less likely you’re going to be paid on that. Anything over 90 days is aged,” Janssen says. “When you’re invoicing, make sure you’re following up, especially if things get out there longer than your terms. Just stay on top of that.”

Lenders will also review the accounts payable statement to see how well the business pays its vendors.

“Hopefully, you’re within 30 days of the agreed-upon terms. Anything other than that, we’re going to be asking some questions about why you didn’t pay this invoice,” Janssen says. 

Capacity

Capacity refers to the borrower’s ability to pay back the loan. A lender looks at the debt-to-income ratio, comparing how much money a business owes to how much money it earns. A lender also looks at a company’s EBITDA — earnings before interest, taxes, depreciation and amortization. EBITDA measures a company’s overall financial performance.

To improve their capacity in the eyes of a lender, Janssen says businesses should consider these questions: Have they prepared a business plan? Do they have a budget? Have they prepared a 13-month rolling cash flow?

By understanding their monthly cash flow, they can project the cash flow going forward, showing they have the capacity to repay a loan.

Capital

Capital refers to how much money borrowers have invested in the company and how much they are able to invest in this new opportunity. For example, when buying an asset like a new truck, equipment, or garage, a borrower will be asked to foot some of the bill. The more you finance yourself, the less risk the lender takes on, which can result in more favorable finance terms, Janssen says.

The amount of capital you’ll be asked to invest depends on many different factors, including the amount of the loan and the payback schedule. 

Collateral

Collateral refers to the assets you’re willing to pledge against the loan, in case of default. For example, if you take out a loan on a work truck, the lender places a lien on the truck as collateral. In the event of default, the lender may repossess the truck. 

“If we are short on collateral, the financial institution may ask for a mortgage on your personal residence or a second residence. It depends on the type of loan program they are using to structure the request,” Janssen says. 

Because they have so much to lose, borrowers should carefully assess the collateral they pledge.

Conditions

Conditions refer to the internal and external factors that affect a loan, including the current interest rate and current market conditions. 

“One thing we’re always looking at is: What is the purpose of the loan? Have you done any calculations as far as your return on investment?” Janssen says. “How quickly are you going to be paid back based on the investment you’re putting in?”

A lender will also want to see a pipeline of upcoming sales anticipated in the next couple of days or months. 

“That can give us an insight into how strong the company is and how strong the market is as well,” Janssen says.

Loan vs. line of credit 

In addition to term loans, businesses can apply for a line of credit. The nice thing about a line of credit is its fluidity, Janssen says. A line of credit has a preset borrowing limit that can be advanced on, repaid and advanced on again. A line of credit should be utilized to finance accounts receivable and inventory.

“Typically, a borrower should utilize a line of credit for any type of purchase that will be paid back within a year,” Janssen says.

On the other hand, a term loan works well for assets that will take longer than a year to repay. Term loans are designed for specific, one-off expenses like purchasing a new building, buying machinery, or acquiring another business. Borrowers receive a lump sum of capital that they need to repay at a specific interest rate over a specific time period. 

Business credit application process

When applying for business credit, a borrower will be asked to provide several documents:

• Last three years of personal tax returns
• A personal financial statement
• Last three years of company tax returns
• Last three years of company’s prepared financial statements
• Accounts receivable and accounts payable aging reports
• Budget
• Depreciation schedule; equipment, vehicle and machinery list

Additionally, a start-up may be asked for other documents, including a business plan, resume, or a list of skills and qualifications.

The right lender

Funding a business out-of-pocket has limitations, especially for start-ups and organizations ready to leap to the next level. Thus, working with a lender can open the door to opportunity. The right lender serves as a trusted adviser and a valuable resource. Lenders not only connect borrowers with financing but also with the people and other elements they need to move their business forward.

“When choosing a lender, ask some questions of the financial institution and determine if they are a good fit for you and your business. See if they have history and experience in financing businesses in your industry,” Janssen says.

Before approaching the lender for a business loan or line or credit, assess your company’s financial status based on the five C’s of credit. Owners who master them are more likely to secure the loans they desire to grow their business.