It is critical for business owners to understand how banks really analyze loan applications. You may have heard of the “The Five C’s of Credit” – Character, Capacity, Capital, Collateral, and Conditions – but these concepts are vague at best without context.
And as far as acronyms go, the “Five C’s” is a yawnfest of mediocrity. (The Five F’s, now that could be interesting.)
Nevertheless, when banks make a loan, their objective is to be paid back, plus the interest charged, full stop. This drives everything. The following questions (in order of importance) are what the bank really wants to know in order to get comfortable lending money to you and your business:
Who Are You?
This aligns with “Character.” It won’t really work in your favor, but it can work against you. The bank wants to know if you honor your obligations. Banks review credit reports, the media, the community, and other sources of information on you and your business.
If there is something in your past – a bankruptcy, an indictment, an ugly incident – banks will find it, usually at the most inopportune moment of the approval process. A past incident may or may not be an automatic disqualifier; regardless, it is usually best to get in front of it sooner than later.
Banks look very differently at having your Maserati repossessed because your beach house needed a second solarium, versus a 10+ year old bankruptcy due to medical debt, where best efforts were made to pay the creditors before ultimately filing to save your house.
Getting in front of a past incident allows you to tell your side of the story.
What Do You Make and What Do You Owe?
Small businesses are typically interwoven with their owner’s personal finances. DVI, or debt versus income, is an analysis banks perform in order to evaluate the ability of a business owner to service all debts, business and personal, based on all sources of income.
This metric aligns with “Capacity” and “Capital.” A low DVI shows more room for living expenses, saving, and absorption of earning disruptions. A DVI of 35% represents annual debt service requirements (not total debt) of $35,000 against total income of $100,000 and is the approximate outer limit of a bank’s comfort on this metric.
It is not unusual for some business owners – especially real estate investors – to show a higher DVI. This is typically caused by the George Harrison/Dave Matthews mashup, the “Taxman Two Step,” when taxable income is legally minimized while debt is sought on the basis of “actual” cash flow.
If you fall into this category, you may be able to demonstrate that the DVI metric is not relevant, so long as each asset services its own obligations, and there is sufficient excess cash flow for living expenses.
Who Are Your Customers?
This question speaks to “Capacity” and “Collateral.” Restaurants rely on individual customers with many choices as to where to eat. A contract manufacturer in the biotech space might have one large, financially sound customer accounting for 80% of revenue. The restaurant has a large customer base with low barrier to entry. The manufacturer has a concentrated customer base with high barrier to entry.
The ideal scenario for purposes of borrowing money is in between: a diverse customer base that is “sticky” in some way. For real estate investors, this could be a portfolio that includes a mix of residential, mom & pop commercial, and investment-grade commercial tenants.
Small businesses are often highly concentrated with a few customers. If this is the case, you need to mitigate the risk of losing these key customers. Long-term relationships and potential expenses the customer would incur to change suppliers, for example, are strong mitigants. A handful of high-potential, smaller clients is also a reasonable mitigant here.
What Do You Want?
Borrowers typically consider the terms and “Conditions” to be the most important of the C’s, as it includes the interest rate and monthly payment. From the banking perspective, however, the terms of the loan are only relevant once approved.
Plus, banking terms are largely commoditized. If you get approved for a bank loan, your rate and terms will be reasonably consistent with the market. Asking a bank for the “best rate” is like asking McDonald’s for the biggest hamburger.
Let the bank know that you know rates and terms will be consistent with the market: this will give you Credibility.