SME Lending – The 5Cs of Credit
Business Finance Professionals are uniquely positioned to help SMEs secure the business loans they need because they have the insights, knowledge and experience to understand the lending process. Further, because they are once removed, they can consider things from the lender’s perspective and rationally position their client’s application to maximise the chances of loan approvals.
The 5Cs of Credit is a tried and tested system that lenders use to assess a SMEs creditworthiness – their ability to pay back a loan. The five areas of evaluation that can impact on lender’s decisions are: -
Character
Collateral
Capacity
Capital
Conditions
By working with their clients across these five areas, Business Finance Professionals can add tremendous value to SMEs, not only with their lending needs but also in their general business operations.
1. Character
Character covers your SME client’s integrity, standing and overall willingness to make good on their debts. In answering the fundamental question - ‘Will they pay the money back?’, lenders seek to work with reputable and trustworthy SMEs. And, in order to evaluate these attributes, lenders will analyse the following: -
Credit Reports and Scores
These tell the story of credit history – the SME’s past ability to pay off debts on time. Further, lenders will look at the credit history of both the SME and the personal reports and scores of SME owners.
Some SMEs don’t know of their credit report or what their credit score is. And your role as a Business Finance Professional can be simply to help them access and review these reports. From there you can assist your SME clients by working with them to understand their credit report (so errors can be corrected, and anomalies and negatives can be more readily explained) as well as raise their overall credit score before they apply for a loan.
Business Tenure
Longevity in business is an indicator of the SME’s stability and likelihood to be successful and cover loan repayments. Again, it may be useful to look past the current business to demonstrate the collective management experience and combined business expertise of the personnel within the SME.
SME Owners
Character can also cover the personal attributes and background of the individual owners of a SME. This may involve interviews or reference checks by the lender. Being personable and professional when dealing with lenders can go a long way to demonstrating strength of character. After all, lenders are people too!
2. Collateral
SMEs that offer assets as security for loans (collateral) provide lenders with higher levels of comfort. It not only means that lenders will be able to recoup some of the debt in the event the SME defaults on loan repayments, but it also demonstrates confidence, by the SME, in their ability to service the debt.
All lending and finance situations are different when it comes to collateral. Some lenders will be happy for specific assets to be offered as collateral, others will only accept a general asset offer (meaning they can go after any assets, of the SME, in the case of a default). And others may even request a personal guarantee, holding the business owners individually responsible.
When it comes to collateral, your role as a Business Finance Professional can be to work with your SME clients to determine the following:
What’s Available?
Whether it is property, equipment, investments or vehicles, it’s important to carefully assess assets and their current value so you know what could be offered as collateral. SMEs should track their assets and depreciation so, at any point in time, they know their worth.
Comfort Levels
Because of the different approaches to collateral by lenders, it’s important that your SME client understands the implications and is comfortable with how they can put up collateral to secure a loan. If a personal guarantee is going to create family concerns, it may not be appropriate.
The Best Lender
Part of the expertise you build as a Business Finance Professional is understanding the different requirements that lenders have in respect to Collateral. Shopping around can maximise the results from the lending process whilst giving your SME client the comfort and confidence that the loan is best structured for them.
3. Capacity
Capacity refers to the SME’s financial ability to repay the loan. It is related to the cash flow position of the SME. Even though lenders may have assessed the SME’s historical willingness and track record for paying off debt, they also want to know SMEs have the current cash flow to afford a loan.
Lenders may analyse SMEs bank statements, cash flow statements, cash flow projections and relevant financial ratios to determine capacity.
Assisting your SME clients in demonstrating cash flow and capacity can include:-
Paying Down Existing Debt
Taking out more debt before paying off past debts can be an indication an SME is ‘chasing its tail’. Cash flow used to service other debts is obviously taken into account on new loan applications. Even where SMEs have ticked the character and capacity boxes, lenders can be reticent where the SME has existing debts in place.
DSCR and DTI
One of the key financial ratios lenders look at in relation to capacity is the Debt Service Coverage Ratio (DSCR). This measures the relationship between SME’s debt and income.
A high ratio is good as it indicates more cash to invest in the SME. DSCR can be improved by increasing net operating income, decreasing net operating expenses as well as paying off existing debt.
The other ratio, Debt to Income (DTI), measures the relationship between the SME’s owners’ personal debt and income. Again this is improved by increasing personal income and paying off debts.
Accounting Software
Implementing and using accounting software not only assists your SME client to produce the statements, historical reports and calculate the financial ratios lenders require, but it also demonstrates, to lenders, an organised and financially responsible business.
Some lenders even insist that accounting software is used for a set amount of time before they will approve a loan.
4. Capital
In reference to SME lending, capital refers to the amount of money the SME owners have personally invested in the business. Lenders equate high levels of capital investment to a commitment in the SME and its future viability. When a new loan is taken on, SME owners who have personally invested in the business, are much more likely to pay off debts and continue to see the business succeed. SMEs with no or limited capital need to rely more heavily on the other 4Cs.
In assessing capital, lenders take a dual view. They want to know how much owners’ capital is invested and how that money has been invested. As such, the way Business Finance Professionals can work with their SME clients in this space include:-
Increasing the Owner’s Capital
As an adjunct to borrowing or as an alternative, encouraging SME owners to reinvest in their business not only helps with SME growth and the owners’ long-term prosperity, it will also make future finance applications easier.
Demonstrating Investment Acumen
As part of the borrowing application, lenders want to know exactly how the funding will be used. Where funds have been invested wisely and astutely by the SME previously, this is an indication of good business practice and quality investing acumen. Assisting your SME clients to demonstrate to lenders how borrowed funds will increase the business cash flow is one of the main ways to secure a business loan.
5. Conditions
For SME lending, conditions refer to the factors that impact on the ability to repay the loan. Lenders consider the amount of the loan, the applicable interest rate, level of principal repayment, payment frequency, the state of the economy, the industry the SME operates in and the SME competitive environment. It, therefore, looks at both the loan conditions and the economic conditions.
Whilst it is difficult to influence conditions, Business Finance Professionals can assist their SME clients in the following ways.
The Business Plan
Whether it is for purchasing inventory or equipment, hiring staff, increasing cash flow or business expansion; the purpose for a lending request should align to strategies and goals within the SME’s business plan. If the loan application is accompanied by a well-documented Business Plan that communicates what the funds will be used for and what the desired outcomes are, the more likely the loan conditions will be favourable.
Lines of Credit
Business Finance Professionals don’t have to only work with SME clients at points in time when they need funding and finance. When your SME clients’ businesses are booming, it may be a great time to establish a line of credit. The conditions will be more conducive to securing a funding source; one without a requirement to drawdown and start to repay. However, in the future, when cash is needed (and possibly conditions are not so conducive), the facility is in place for the SME to utilise.
Expertise
As part of a loan application, you and your SME client will have the chance to ‘state your case’ and demonstrate expertise. When conditions are poor, the ability to show how you are approaching things differently and will prosper while others are failing gives lenders confidence and faith in the SME’s capability.
Not all lenders assess the 5Cs the same way. Some will place more emphasis on character and conditions, whilst others will use computer-generated algorithms to concentrate on collateral, capacity and capital. Researching and understanding the nuances between different lenders can help you master the 5Cs and assist your SME clients in securing appropriate lending.
In conjunction with industry experts, elevateB has developed a self-paced, online, interactive Business Finance Certification. This program will provide you with the knowledge and skills required to become a successful Business Finance Professional and work in the SME space. In addition, it provides strategies and soft skills to assist you to better market and deliver your existing and new-found client offerings.
For more information on the Business Finance Certification, click here.