Recent economic conditions suggest that the economy has slowed considerably and some experts say that we have entered a recession. In times like these, banks are more likely to tighten up their credit requirements. The inevitable consequence is that business credit may be harder to come by.
Under these conditions, it is even more important that when business owners apply for credit, they understand what banks are looking for. They need to know and understand the four C’s of credit:
1.Capacity 3.Conditions
2. Warranty 4. Character
Let’s start with the first C, Capacity: the demonstrated ability to pay. Be clear! Banks are in the business of lending money. That is one of the main ways they make money. So, contrary to what it may seem, a bank wants to lend you money. In fact, banks need you as much as you need them. But with that being said, a bank must also feel confident that the business owner will be able to repay the debt. This really is the “meat and potatoes” of any loan.
Therefore, a bank will review a business owner’s financial statements to see if it can generate enough cash flow to cover both its current expenses and its new obligations.
Collateral is another C that speaks loudly to a bank. In my role as a commercial banker, it often amazes me how business owners often don’t appreciate the importance of collateral. Keep in mind that banks are security conscious; so having a guarantee helps the bank to feel more secure.
Also, having collateral can substantially reduce the cost of borrowing. Every business has guarantees, be it accounts receivable, inventory, equipment, etc. These are your assets; so use them to your advantage. When you sit down with a banker, be sure to discuss the guarantee.
The third C is Conditions. Banks also find it prudent to carefully observe current economic conditions when deciding to extend credit. They will look at the industry you are in and how it is affected by those conditions. A slower economy doesn’t mean a bank won’t lend you money; it simply means that they are more careful in their lending practices.
Another important factor is where your business is in its growth cycle. In general, banks want to see two years of business data before they will consider lending you money. Does your business not qualify yet? There are steps you can take to position yourself to be considered creditworthy. Talk to your banker and ask him or her to do a thorough financial reality check for your business. Use your banker as you would your accountant.
The fourth C is Character. JP Morgan, one of the most successful businessmen in the world, once said, “I’ll do business with anyone as long as they’re honest!” The key is to understand how a bank defines character.
Banks assesses his character by his past performances: how he handles his financial, business and personal affairs. Banks want to see that you understand how to run the company’s business. After all, would you extend credit to someone who has a history of late payments, non-payments, and defaults?
Remember that no matter how good your cash flow and cash position are, a bank will quickly turn you down if your credit history is mediocre. Clearly, then, a smart business owner will ensure that their business dealings also develop good character and integrity.
Finally, given the high cost of doing business in today’s global economy, the question is not if your business will need credit but when. Therefore, it is crucial that business owners fully understand what banks require in exchange for their loans.