Visual representation of small business financial literacy - decorative

Module 4: Building Credit

What lenders look for

While every lender uses a different approach to assessing risk and determining creditworthiness, they still follow the same core strategies known as the Five C’s of Credit:

Capacity is the cash flow your business needs to show that you can pay off a loan or line of credit. Your financial statements and tax returns will serve as evidence.

Collateral is a form of security such as something you or your business owns – equipment, inventory, real estate, vehicles, etc. – that serves as a form of security should you be unable to pay the loan back. If you default, the lender can use your asset to help pay off the loan. This is not something lenders are eager to do since it can interfere with your ability to generate cash flow. But it can factor into the decision on a loan.

Credit history refers to the credit performance of the owner(s) and the business. Lenders evaluate information obtained from business and consumer credit bureaus and other reporting sources. Lenders consider your credit score, the number and type of inquiries, credit utilization and any past delinquency or adverse public records.

Conditions are qualitative and quantitative measures, such as how you will use the money, the local, industry and economic conditions, and the competition your business faces. These can all affect your ability to pay a loan or line of credit back.

Character refers to primarily qualitative measures such as your personal integrity, business reputation and references provided by your customers, vendors, past lenders and other business partners. Your social media reputation and online customer reviews can also be factored in along with your overall credit history.


Other things to consider

Nontraditional data, or alternative data, is not traditionally reported in a credit report. This can include payments for rent, utilities, phones and merchant accounts. As the credit market changes, some of these nontraditional items may be factored into your loan in the future. It’s not very common now, but you should be aware of it.  

Different lenders weigh all of the information gathered on your loan application differently. One vendor may use all the Five C’s of Credit to asset your creditworthiness as well as your personal credit and any collateral you have offered. Another creditor across town may consider the Five C’s to a lesser degree and focus more on your business credit, nontraditional credit data and conditions instead. Before you apply for a loan, you’ll want to do some initial research so that you can apply with a lender who most closely matches your credit situation.

Exercise #1: Comparing lender and loan options

Let’s look at how financing can be arranged and the impact your credit can have on the loan you apply for and receive.

Rosa and Albert have developed a new technology to automatically water plants. They have tested the devices with several customers but have yet to sell the technology to a paying customer.

To finance full production, they need a $100,000 loan. To help them, they meet with a Small Business Development Center (SBDC) counselor in their community who introduces them to two potential lenders: a local bank and a certified community development financial institution (CDFI). The bank works with the SBDC regularly, so there’s an existing relationship and a flexible set of products. The CDFI not only offers microloans but supports the business with technical assistance and training.

Option 1: Local Bank
Rosa and Albert visit the local bank first and learn that the bank can help in two ways:

  1. The bank will provide a business account with convenient terms and waive some fees by offering a bundled small business package that includes low-fee merchant services.
  2. The bank will provide a business credit card to help Albert establish a business credit history.

Unfortunately, the bank cannot offer the $100,000 loan because of Albert’s cash flow issues, his lack of collateral or someone who can guarantee his loan and his ability to demonstrate clearly that his business will be able to pay back the loan. His personal credit score has some blemishes, and he has no business credit score. Rosa doesn’t have a personal credit history.

Option 2: Online Lender
Leaving the bank disappointed, Rosa decides to contact an online company that advertises quick financing for businesses. She submits an application and receives an offer that she does not fully understand. Still, she is excited that she may be able to get a loan.

Before she completes the paperwork, she decides to speak with Albert. They call on a trusted adviser in their community who is happy to walk them through the terms of the loan. Their adviser explains the terms, which includes a $4,000 origination fee (4% of the loan amount of $100,000), a $10 monthly administrative fee to be submitted with payments, and payments of $20% of the company’s daily business receipts until the loan is paid for in full. Her adviser tells her this is not a good deal for the company, even though the lender would cover the entire cost of the loan. The repayment terms are not favorable and will be difficult to pay back.

Option 3: CDFI
He recommends that Albert and Rosa visit a local certified community development financial institution (CDFI). After working closely with a CDFI representative for three works, they learn that the CDFI will be able to provide $50,000 in expansion financing, but at a slightly higher interest rate than they were hoping for, in part because of their personal and business credit histories. The loan terms are $12% in interest over 60 months and a $150 refundable loan application fee if the loan is approved.

Each of these options carries a certain amount of risk to the business. The bank’s offer won’t help them finance production, but it will give them a starting point for establishing credit for the business. The second option will fund the loan in full, but with hefty upfront fees and a large payment based on business receipts, constraining cash flow. The final option won’t get them the total amount they need, but it is a start and can help them finance a reduced vision of their plans with an eye on expansion once sales pick up.