by Dominic Karaba
In the literal sense, every business is “bankable,” but understanding what a bank is looking for from business owners is crucial for the relationship to be successful for both participants. Knowing what it means to be bankable will help you navigate the waters of applying for a loan and serve as a useful tool in preparing for what the banker is really evaluating to conclude “yes” or “not at this time.” For example, simply increasing revenue year over year doesn’t necessarily mean a business will get approved for financing, which can be shocking and confusing.
The five C’s of credit serve as the basic model that most banks use. They are character, capacity, collateral, capital and conditions. A banker will review all of these alongside one’s business model, so it is critical to understand the importance of each.
1) Character is one of the most difficult C’s to articulate because everyone has his or her own definition. Some banks may simply look at a credit score to determine one’s character, while others are looking at references in the community. Get a clear understanding of how far the bank is looking into this one, as it may make sense to provide references up front.
2) Capacity is arguably one of the most important C’s on this list. Capacity means cash flow or the ability to repay the loan. Business owners need to know their debt-to-income (DTI) ratio. Other key data to have on hand include fixed charge coverage ratio, cash flow coverage ratio, and EBITDA (earnings before interest, taxes, depreciation and amortization)-to-debt payments. Keep in mind that the banker will be operating under the general and logical premise that the business should be producing more than $1 in cash flow sufficient to service each dollar in debt. Most will want to see consistency for two to three years.
3) Collateral is what banks fall back on when there are impairments to cash flow (capacity). But the reliance on collateral is where the debate comes into play. Some may wonder why the bank wants to see income for an extended period of time if you have ample collateral. No question – collateral is a must, but the bank will have to take full responsibility of selling the collateral if the business gets into trouble and the bank has to take over. The bank will have to hire someone to sell it, which will cut into the sale, and there is also a stigma that goes with selling assets labeled “bank-owned.” One generally has to have some form of collateral to be bankable, but if a business is losing money, the strength of collateral alone will not make it bankable.
4) Capital tends to cause the most confusion. The essential question is: What percentage of assets does the business actually own when the dust settles and all liabilities are paid off? It is not unusual to find a business or business owner who distributes all earnings from the company, leaving very little strength to the balance sheet. The bank does not want to be the only player with “skin in the game” and will want to know that the company is committed as well.
5) Conditions refer to the economic climate. During the 2008 downturn, some business owners saw their covenants or loan terms change even with their companies doing well. This was an outcome of the economic climate. In conversations about financing, business owners should know how their industry is performing as a whole, not just how their company specifically is performing. They should also be aware of the broader economic environment.
The five C’s are an excellent guide to learning how to be a bankable customer and how business owners can lead a conversation with their banker about obtaining competitive financing.
Dominic Karaba is executive vice president of business banking at UMB Bank. He can be reached at firstname.lastname@example.org.
Submitted 8 years 170 days ago