Every lender uses a set of guidelines when screening applicants for a loan. By understanding this decision making process, borrowers will know exactly what to expect and how to prepare in order to start the loan application process.
This article is the third part in a series that helps explain the 5 C’s of credit. These are the standards often used by lenders to determine whether a potential borrower is a strong candidate for a loan. The 5 C’s are: Character, Capital, Capacity, Collateral and Conditions.
Capacity
Capacity, one of the most important of all five factors, is how the borrower will pay back a loan. Capacity includes the ability to pay current financial commitments, repay any new debt, provide for replacement allowances, make payments for family living and maintain reserves for adversity.
Cash Flow
One key factor in determining whether an applicant has the capacity for the loan is sufficient cash flow into the business. Because cash flow is crucial to business survival, having cash on hand shows lenders how much cash will be available to make potential loan payments. In a positive cash flow, there should still be money left over to handle principal payments after family living expenses and taxes are taken out of net income.
Past Financial Records
Lenders use past tax records to see how an applicant has managed finances historically. Looking back 3-5 years gives the lender an idea of how the applicant responded during market highs and lows. Since tax records do not show every detail, lenders might also use income statements, balance sheets and cash flow statements to analyze repayment capacity in more depth. Every lending institution has its own way of calculating repayment capacity from these financial statements and records. A good tool to use is Capital Debt Repayment Capacity (CDRC). Your lender can help you calculate your CDRC.
Future Plans
When meeting with a loan officer, it is very beneficial to an applicant to be aware of all expenses the business incurs. Being informed on all aspects of the business shows the loan officer that there is a solid plan in place for finances. The plan makes a borrower a more reliable candidate if they are able to productively manage and organize the business to be profitable as well as showing they are capable to repay the loan.
If you have past financial success, a well thought out strategy with solutions to most possible situations and an understanding of capacity, your loan officer will see that you are capable of supporting a loan for your business.
Randy Pace is a Vice President with FCS Financial in West Plains, Mo.
