You always hear that you should develop a relationship with a bank and like all relationships you have to be conscious of the needs of the other party. At the early stage of the business, capital is a key requirement – so as well as basic banking needs some sort of debt financing may be needed such as working capital or asset finance.
If the bank lends it will want to make sure it gets its money back: It has shareholders and depositors, it’s accountable to the community and it needs to make margin and profit.
Typically before lending bankers go through the 5 Cs of Credit checklist: character, capital, capacity, collateral and conditions.
Character is simply who is the potential borrower and what is he all about? In considering a business loan for any purpose, the lender is going to assess the potential risk to the bank and its shareholders. The lender is going to review a variety of facts. Some of the facts are not going to be relevant to financial conditions. Banks consider everything-cash flow projections, marketing plans, the entire scope.
But the first C is Character. The lender considers the character of the company’s decision maker. Is he the owner? Is he the manager? Is he key personnel? What’s his background? Has he performed on his obligations in the past? That’s very important. If there has been credit problems are they up-front. Does the manager of this company have business skills? What’s is his depth of knowledge in this market? Is it going to be a cottage industry or hobby? That’s okay, but it will require different financing. There will be background searches on personal credit and evaluation of collateral. If there is a building or parcel of land involved, that will be researched as well. It’s due diligence on the bank’s part to determine any ongoing concerns.
The second C is Capacity. Capacity is ability to repay the loan. Lenders determine this in large part by analyzing statements to show a particular history of the company’s profitability and a pattern of cash flow. Other income not necessarily from the business can be taken into account.
The third C of credit is Capital. Is the company adequately capitalized? Where did the capital come from? Was it borrowed? Was it leveraged? Did it come from savings? Lenders look favorably at owners who have risked their own funds in the business. That’s a shared partnership. The lenders check to see that the capital is adequate to support the reoccurring operations and debt needs of the company. Is there a cushion of capital in case of hard times? When the economy hits hard times, does the business have the capacity to take care of its obligations without hampering cash flow? The business might have to come up with more equity or go to the bank and increase its facility there. Banks are not only mortgage lenders, they have lines of credit for cash flow needs, and they have term debt for equipment and other hard assets.
The fourth C is Collateral. It provides a secondary source of repayment in the event of a default. If a bank has to liquidate that asset, it’s a worst-case scenario for the bank. It’s looking to recapture as much of its depositors money as It can on the loan. So when collateral is being valued it will be margined; it will not be market value. A forced sale will have a lesser value. When banks take property as collateral, they want to make sure that they get a fair valuation, not excessive and not low, but a realistic evaluation of that asset.
Finally, the fifth C of credit is Conditions. When the lender considers loan requests, it also looks at conditions to place on the loan. Some ratios or covenances could be assigned to the loan. One could be a leverage ratio. A lender may restrict you from having x times debt for every euro of your capital. An excessive debt to capital ratio strains cash flow for debt service. Lenders also specify terms and conditions under which the loan will be offered. These conditions help the lender feel comfortable with future uncertainties and risks by setting standards of acceptable future performance by your company.