Entrepreneurs know that adequate cash flow is one of the primary elements of small business success. As a result, one of the most common questions our bankers get asked is, “What criteria do banks look at before issuing a loan?” Until now this process has remained somewhat of a mystery, but this post will shed light on the process behind analyzing creditworthiness.

The 5 Cs of Credit

When business bankers enter into loan discussions with potential borrowers, they often rely on a system referred to in the industry as “The 5 Cs of Credit” to evaluate the risk associated with the specific loans and borrowers. This approach helps gauge a borrower’s creditworthiness based on five key factors: character, capacity, capital, collateral and conditions.


There are a number of considerations that fall under the category of “character,” including:

  • Track record: The most critical factor is the borrower’s track record for repaying debt. If the borrower has a history of on-time payments and fully satisfied loans, he or she is more likely to be considered a good risk for the bank.
  • Background: A background that demonstrates responsible business management and the skills necessary to successfully operate and grow a business are looked on favorably in determining creditworthiness.
  • Legal situation: If the borrower is involved in legal disputes that could threaten his or her ability to repay a loan, this could hurt the chances of being approved. Similarly, past bankruptcies could cause the bank to decline the loan application.


Capacity refers to the borrowing organization’s ability to repay, based on a comparison of income against recurring debts. This characteristic helps the bank determine the borrower’s Debt-Service Coverage Ratio (DSCR). When considering capacity, the bank may also look at potential challenges to pinpoint any potential alterations to cash flow or liquidity. If a potential gap in revenue or situation exists in which cash will be needed to resolve the shortfall, the bank look for reassurances of the borrower’s ability to pay from reserves during that time period. Potential buyers should consider having early discussions related to seasonality with the bank to alleviate some hesitation.

In general, banks look at startups differently than established businesses that can demonstrate a history of proper management and profitability. When it comes to projections, startups should be able to accurately predict future revenue based on industry and market data as well as other factors; meanwhile, established businesses should be able to show evidence of solid long-term performance.


Borrowers with capital to invest in their businesses reduce the risk taken on by the bank, therefore improving the likelihood of securing a loan. Capital is what a borrower will need to rely on if the business grows or suffers downtimes. The guarantor’s net worth is also taken into account, as it can be an indication of the borrower’s ability to pay down its liabilities should the business fail to generate cash flow to pay its obligations.


Collateral is a borrower’s secondary source of repayment and includes assets like the building, equipment and inventory. The lender will want to determine if those assets are already pledged to other creditors before considering them as collateral for a loan. Should the borrower default on the loan, these are assets that could be liquidated for repayment. 


Conditions are factors like interest rates, loan covenants, the amount borrowed, borrower’s business, current and predicted future market conditions, regulations, environmental regulations and more. These all constitute factors that affect the bank’s willingness to lend.

How Are The 5 Cs Used?

No regulation requires banks to use the 5 Cs when underwriting loans, but every banker assesses creditworthiness based on some form of this method. Some may do a less in-depth review if he or she is very familiar with the business seeking the loan (its P&L statement, market, labor needs, etc.), and will undoubtedly do a much more comprehensive evaluation if the business is a startup. Despite different approaches to utilizing the 5 Cs, most bankers would agree that the most influential of the 5 Cs is capacity – the borrower’s overall ability to repay, as it’s the clearest indication of the level of risk the borrower represents to the bank.

How to Prepare for Your Loan Application

In addition to having knowledge of the 5 Cs, discussing your business needs and goals with your banker well in advance of actually applying for a loan has the potential to save you significant time and effort. When he or she understands your situation and the purpose of the loan you’re seeking, your banker is able to identify the most appropriate loan structure for both immediate and long-term business financing. He or she can also help you streamline the application process by providing a list of the information and documentation that must accompany your application.

Written by Dave Diedrich

Dave Diedrich is Vice President - Senior Business Banking Officer for Investors Community Bank. He works with local businesses in understanding their needs and provides options to meet the demands of their operations. He earned his bachelor’s degree from UW Green Bay and holds an MBA from Notre Dame. He has over 40 years of experience in banking, including 30 years in the commercial lending field.

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