The Five Cs of Credit: Why Some Loans Get Approved and Others Do Not

The Five Cs of Credit: Why Some Loans Get Approved and Others Do Not

This article originally appeared in Live Oak Bank’s Accounting and Tax Resource Center.

A bank’s decision to lend money to a borrower is not based on rocket science. It’s a decision based on a few founding principles. To better understand how they decide who is approved and who isn’t–and why–let’s look through the lens of the lender.

At the core of any loan process is a credit analysis, which is used to determine the risk associated with making the loan and the likelihood that the loan will be repaid. In business financing, it is not just a matter of evaluating the business, but also evaluating the person(s) associated with its ownership and operations. Most credit analyses use five categories to evaluate the risk of a loan: Character, capital, conditions, collateral and cash flow. These are known as the five Cs.

Documents such as personal tax returns, personal financial statement (PFS), resumes, business tax returns, interim profit and loss statements, balance sheets on businesses and business plans help paint the picture of a borrowers five Cs. Here’s what those categories mean and why you should pay attention before you seek financing for your accounting or tax firm:


Character: Can we trust you?

Your aggregate traits define your character. Through each interaction you have with a lender, the bank is evaluating and determining your honesty and integrity. The lender needs to feel confident that applicants have the background, education, industry knowledge and experience required to operate the business in question. This all amasses to answer the question of whether or not you can be trusted to run the business successfully and ultimately, pay back the loan.

All business owners have a personal financial history that can help paint a picture of their (likely) future behavior. There are many factors that influence loan approvals, and personal finances and credit can have a significant impact on your ability to borrow money for business purposes. A lender will examine personal credit reports and PFSs of the borrowers and guarantors associated with the loan.

Your credit report is your track record of prior debt repayment. Your credit report compiles your debt story in one place and reveals how successful you have been at paying that debt back in the past. Balances, credit limits and payment history are reported from your credit cards, student loans, mortgages, car loans or other lines of credit. Payment history is one of the largest factors in your credit score. It is wise to check your reports before talking to a lender. If there are any delinquencies, be prepared to explain them to the financing institution.

Scores are based primarily on the following: Payment history, revolving credit availability, age of accounts, collections, personal bankruptcies and liens and judgments.


Capital: What is your investment?

When asking to borrow money from a lender, it is only natural that they question the personal investment–or capital–you plan to make or have already made in the business. Contributing your assets shows that you are willing to take a personal risk for the sake of your business. It shows that you have ‘skin in the game.’ The amount needed varies depending on the size, use and type of loan you are requesting.

To assess your personal financial position, the lender will request a PFS. This is simply a summary of your assets (things of value that you own), liabilities, debts or obligations. From these numbers, you are then able to calculate your net worth, which equals assets minus liabilities. Depending on the lender and the type of loan, a positive net worth may not be a requirement to qualify for the loan.

Your PFS is also another indicator of your financial responsibility. The types of assets and liabilities that you accumulate begin to reflect long-term planning behaviors or short-term spending behaviors. Accumulating credit card debt even in smaller amounts can appear as a less favorable type of spending behavior than larger student debt balances used to invest in your education or a reasonable mortgage for a house. Savings is also important, as it shows the lender that you are living within your means. There is no silver bullet, and at every stage of your life, your PFS will be looked at differently.

Consider these two questions about your PFS: 1.) Does your PFS align with your past and current job positions? 2.) Does your PFS reflect a history of responsibility when it comes to managing your personal finances?


Conditions: What is happening?

This C represents the lender getting a grasp on what the money can be used for and the health of the industry. There are several things that factor into how the lender evaluates the industry’s conditions at any given moment in time. The overall premise is that they’re gaining a perspective on what the loan will be used for, what will be taking place, the status of the business, and the status of the profession and marketplace economy. Lenders like to see positive trends and strong business plans with a thoughtful plan for growth and continuity.

Common reasons for accounting and tax financing may include: Buying an existing firm, expansion and renovations, working capital, refinancing and commercial real estate costs.


Collateral: What if you don’t pay it back?

A lender is not just interested in what happens if everything goes well. They also must consider the worst-case scenario. For instance, what happens if the borrower chooses not to pay back the loaned money?

Collateral helps solve this problem by acting as a secondary source of repayment. A lender will consider the value of the business’ assets and the personal assets of the guarantors as potential collateral for the loan. Collateral also acts as a psychological motivator, as people tend to get more resourceful when they have something to lose. Collateral is an important consideration, but its significance varies based on the type of loan. A lender will be able to explain the types of collateral needed for your specific loan.


Cash flow: How will you pay it back?

Ultimately to approve the loan, the lender wants to get comfortable with how your firm will be able to successfully repay the loan. In business financing, there is a different paradigm in evaluating repayment ability than in consumer financing. With business loans, the repayment ability is coming from the performance of the business being evaluated. This capacity to repay comes from the business’s cash flow. This is the amount of cash available after ordinary business expenses have been paid. The business should have sufficient income to support its business expenses and debts comfortably while also providing principals’ salaries sufficient to support personal expenses and debts. Cash flow management is an imperative skill for any small business owner.



  • Revenue:The amount of money generated from business sales and activity. This is also referred to as income, sales, or “the top line.”
  • Cost of goods sold (COGS):Cost of the materials to perform the services you deliver and the goods you sell. This is the primary variable or direct expense for the business because it varies directly with sales volume.
  • Gross profit:Money available for the company to meet its overhead and other general expenses.
  • Operating expenses:General expenses of the business not directly associated with a sale. This can also be known as overhead costs or indirect expenses.
  • Net income:The resultant dollar amount after all other expenses have been subtracted from the gross profit.
  • Net operating income (NOI):A simplistic measure of the company’s available cash flow. NOI is calculated by add-backs to net income.
  • Margin:Ratios created to translate dollar amounts into percentages to express efficiency.
  • Debt service:Total dollar amount owed for principal and interest payments on debt.


Common add-backs

  • Compensation of current owner(s)
  • Interest
  • Depreciation
  • Amortization
  • One-time expenses and/or labor normalization
  • Rent (if purchasing the business’ real estate)


Final thoughts

Remember, these five Cs—character, capital, conditions, collateral and cash flow—are the pillars of a typical credit analysis. These five areas help the lender evaluate the accounting and tax firm owner and the business to better understand the risk of making the loan and the likelihood that the loan will be successfully repaid.


To speak with one of Live Oak Bank’s dedicated accounting and tax team members, contact Taylor King or Shannon Hay.  To learn more about Live Oak Bank, visit the website.