Financing Activities: Definition & Examples

Instructor: Wendy Frasch

Wendy currently teaches college Business classes and has a master's degree in Organizational Management/Project Management.

This lesson provides an explanation of what a banker is looking for, and the thought process, when attempting to determine whether to extend credit to a small business. It identifies and explains the Five C's of credit which is the foundation for securing a loan.

Secure Bank Financing

As a small business grows, it may become necessary to secure external financing, meaning financing from a bank. Which bank should an owner choose and what will the banker be looking for in terms of granting credit are both legitimate questions for a business owner to have. It seems logical that an owner would begin his/her search for money (financing) with the same bank that provides the business's checking account. This makes sense as the business owner and banker have most likely already established a business relationship.

So what is a banker thinking? The banker has three main priorities:

1) How will the bank recoup the principal (before interest) amount of the loan?

2) How much income will the loan provide for the bank in the form of interest and fees associated with a loan?

3) How can the banker help the borrower be successful and in turn become a larger customer?

The banker's main priority is to protect the bank while still maintaining a relationship with the borrower.

Five C's of Credit

A banker is going to look at five main points to answer the three questions above. These are identified as the Five C's or foundation of securing a loan.

The first key point is to determine a borrower's character. Character in this case is demonstrated through a credit report. The banker may choose to look at only one or all three reporting agencies. Transunion, Equifax and Experian are the primary reporting agencies across the United States and world. A credit report tells the banker whether historically the borrower (owner) has paid on time. In other words, is this person credit-worthy?

The second key point is capacity - what is the borrower's capacity or ability to repay? This is typically demonstrated through the business's financial reports and tax returns but is ultimately a reflection of proven cash flows. For example, a construction contractor earns several hundred thousand dollars a year. However, being a smart entrepreneur he utilizes all the allowable tax credits. Therefore, his taxes show a completely different picture with an annual net of $35,000. If this contractor is seeking a loan of $350,000, would the banker be likely to make such a loan?

The third key point is capital - for new businesses, a bank is highly interested in the amount of cash (capital) the borrower (owner) himself is willing to invest. An owner not willing to invest in himself is very unlikely to convince a bank to invest in him. An owner can use his savings, retirement, contributions from family and friends, even credit cards as capital, although retirement and credit cards are not recommended.

The fourth key point is collateral - or secondary source of repayment. If cash flow becomes unavailable the bank will want something tangible of equal or greater value which can be offered if the loan cannot be repaid, for example: machinery, building, land and equipment.

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