In the paragraphs, we present to you the 5 criteria for analyzing commercial loans.

You have refined your  business plan as well as prepared your financial forecasts carefully? Are your early startup years in the past and have you demonstrated that your business model works? You are now ready to move into second gear and want to meet with a lender to obtain a business loan. STOP! First of all, It is important to know the 5 most important criteria for analysis in the granting of commercial loans by a financial institution, what is called in lender jargon, the 5 “C”s of credit.

The 5 “C” assessment is a method used by lenders to determine the creditworthiness of businesses. This method weighs 5 company criteria and attempts to assess the risk of default. This blog will allow you to desecrate this type of analysis of your business plan, your forecasts and yourself. The 5 “Cs” are presented in order of importance.

1. Character

The first criterion is of course an analysis that focuses on you (honesty, transparency, experience, training, past successes, your strengths, etc.). The lender looks at the character of the manager and the company before anything else. The lender will ask themselves the question, do I trust the individual in front of me to grant them a loan? Will he repay the loan as agreed? In addition, the lender will look at the quality of the managers in place. Even in difficult times, a competent team of managers will know how to manage the company's activities well and will make the necessary decisions to maintain profitability.

2. Capacity

The second criterion is the ability to make your repayments (or the ability to meet debt service). In fact, there is often a misconception that the guarantees we offer are important. Well no, the commercial loan is authorized on a “cash flow” basis – moreover positive – and not on the guarantees that you offer. Therefore, it becomes important to demonstrate the profitability of your business. One of the most important foundations, and it is up to you to justify that your income as well as the quality of your cost management will allow you to generate profits in order to repay the debt when it comes due.

The lender will also analyze your past results and compare them with your financial forecasts. There is no need to demonstrate “Hockey Stick” type growth, because you will lose credibility. It is important to demonstrate to the lender a realistic repayment capacity. He must believe in your financial forecasts. In addition to your financial forecasts, bring your order backlog, your list of recurring customers, etc. In addition, demonstrate that you have a good command of managing your gross margin and your fixed costs.

3. Capital[1]

The third criterion of analysis is the capital of the company. More specifically, the lender is looking for a company with a solid capital (equity) structure. This is important to the lender for two reasons.

First, the company must have sufficient capital as a cushion to withstand any anomalies in the ability to generate “planned cash flows”. For example, if the company becomes unprofitable for any reason, it will start burning through cash to fund its operations. Financial institutions are never interested in lending money to finance a company's losses. A solid capital structure allows the lender to ensure that there is sufficient capital to weather a temporary storm.

Second, when it comes to capital, the financial institution is looking for business owners who have invested enough of their personal assets into their business, such that if things were to go wrong, the owner will be motivated to work with the financial institution during a recovery.

There is no precise measure of the desired capital structure. Generally, financial institutions prefer companies whose total debt to equity ratio is less than 3. Depending on the type of company, this ratio can vary.

4. Collateral
The collateral is made up of guarantees (accounts receivable, inventory, equipment, building, etc.) that you offer to your lender and are elements of risk mitigation for the latter. The lender will only very rarely finance assets up to 100%[2] of their fair market value. Risk sharing between the lender and the company is therefore necessary.

The financial institution is interested in the guarantee as a secondary source of repayment of the loan in the event of realization of the guarantees. In addition, the financial institution may require an evaluation of certain of your assets, normally for real estate financing. Keep in mind that you will be responsible for the cost of third parties in valuing the assets, and remember to factor in the time required to complete the required valuation.

Finally, the type of guarantees is all the more important, because in a liquidation scenario, goodwill, amounts paid in advance, investments, etc., will not be considered significant, because they generate little or no liquidity.

5. Conditions
The final analysis criterion relates to market conditions and loan conditions.

Market conditions

The lender will assess the general conditions surrounding your business and its industry to determine the main risks and how the business is going about mitigating them. Even if historical financial performance is strong, the lender wants to ensure the future viability of your business. Here are some risk elements that the lender can take into account in its analysis:

The competitive landscape: Who are your competitors? How do you differentiate yourself from the competition? Does your business have access to capital compared to your competitors? How are identified risks mitigated? What are the risks of seeing your customers go to the competition?

The nature of your relationships with your customers: Does one of your customers represent more than 10% of your turnover? If so, how do you protect your relationship with this client? What is the company doing to diversify its sources of revenue? How long is the relationship with your customer? Are some clients subject to financial duress? Is the business sufficiently capitalized to withstand any significant write-down of a bad debt?

Supply risks: Is the company subject to supply disruptions from a key supplier? How the company is able to mitigate this risk. What is the nature of the relationship with its key suppliers?

Industry issues: Are there any macroeconomic or political factors that could affect the business? Could the passage of pending legislation harm the industry or the economy?

The important thing to remember is that the lender will need your help to identify and understand these key risks and how you are able to mitigate them. Be prepared to speak out about the main threats and demonstrate that you are comfortable managing these risks and how you protect your business.

Credit conditions

Now that your loan is approved, make sure you understand all the conditions included in the loan contract. For example, the lender can restrict your salary conditions, your dividend payments, the purchase of equipment without its agreement, etc. The lender also requires meeting certain financial ratios, including debt, debt service coverage, etc. If certain conditions or requirements are not satisfactory for you and your business, it is best to discuss them with your lender and see about renegotiating the clauses that do not satisfy you. It is important to maintain your freedom of action.

We hope this article has helped you understand how your lender analyzes your financing request. With a better understanding of how your lender evaluates your application, you will be better prepared. Do not hesitate to use these 5 “Cs” as a strategic management tool, because it will allow your business to grow, flourish and propel itself ahead of the competition.

If you would like to share your thoughts on this article, simply reply to this post or email us at info@6dt.ca . We look forward to reading your comments.

[1] Some financial institutions analyze collateral before capital.

[2] Leasing can finance up to 100% of the acquired asset.