The Good Kind of Debt: How Building Your Credit Can Help Grow Your Business

Tawnya & Scott Landis
Apr 21, 2023


Are you looking to grow your business and secure its financial future? The key might just lie in something that most people try to avoid: debt. But not just any kind of debt - the good kind of debt. By building your credit, you can unlock opportunities to secure loans and funding that can take your business to new heights.


Your financial power is partially determined by your credit. It enables you to procure items such as a car loan or a credit card based on your commitment to pay later. Enhancing your credit score is crucial to guarantee that you qualify for loans when you require them.


On the other hand, when launching a new business, many aspects like marketing materials, staffing, sales, and saving funds take precedence over your business credit. Nonetheless, maintaining your creditworthiness is essential to growing a successful company.


In this article, we'll explore how you can build your credit and use it to fuel your business's growth.


What is business credit?

Similar to personal credit, business credit reflects your business's financial risk to lenders, suppliers, and other vendors. This score enables them to evaluate your eligibility for financial credit. Your business's credit rating is a reflection of your company's reputation. When seeking small business financing or trade credit from lenders, they first often examine your business credit rating before engaging with you. This score uncovers any indications of your business's late payments or bankruptcy, which may affect your ability to establish future business relationships. Having a poor credit history can discourage prospective lenders or investors from partnering with your company because it poses a significant risk. Therefore, developing your business credit can position your business for long-term success.


Why is it important to build business credit?

Although your personal credit may be exceptional, it's not advisable to apply for a business loan under your name due to liability concerns. If your business were to face financial difficulties, your personal credit report could be negatively impacted if the loan couldn't be repaid. Additionally, in severe cases, creditors may seize your personal assets if the loan was in your name. To avoid this risk, it's advisable to establish business credit and apply for loans using your company's credit report.


Having strong business credit opens up a world of financial possibilities for your business. Lenders are more likely to approve loan requests when your business has a solid credit history, and they may even offer lower interest rates than if your credit is poor or nonexistent. This can enable your business to invest in new products or equipment that it might not have otherwise been able to afford.


Likewise, investors and partners may be more willing to work with your business if they see that your credit score is strong. This demonstrates that your business is trustworthy and dependable.


Good Credit vs. Bad Credit

To put it simply, having a good credit score indicates that you consistently make timely payments on all of your accounts until they are completely paid off. Conversely, having bad credit implies that you struggle to keep up with your obligations, either by failing to make at least the minimum payments or by missing payment deadlines.


What are the 5Cs of credit?

Lenders utilize the five Cs of credit to evaluate the creditworthiness of potential borrowers, taking into account five distinct characteristics of the borrower as well as the loan conditions. This approach aims to estimate the likelihood of default and the associated risk of financial loss for the lender. The five Cs of credit include character, capacity, capital, collateral, and conditions.


Character

A crucial factor in determining character is your credit history, which reveals all debts you have accumulated in the past 7 to 10 years. Lenders rely on your character to evaluate your capability to repay a loan. This information offers valuable insight into your ability to make timely payments and your credit mix.


As a small business owner seeking a loan, lenders may request access to your personal credit reports and communicate with your bank in order to verify how you handle your checking accounts and any existing loans. In addition, your personal credit history also directly impacts your character and consequently influences your ability to secure loans for your business.


Capacity

Your capacity to take on new debt is evaluated by measuring your ability to repay it in relation to your existing obligations. Your cash flow and debt-to-income ratio play a crucial role in this assessment.


When you apply for credit, lenders assess your debt-to-income ratio to determine how much you owe compared to how much you own. A lower debt-to-income ratio will make you a more attractive candidate for credit in the eyes of the bank. Moreover, other factors, such as job tenure and income stability, are also taken into consideration.


Capital

In assessing a borrower's creditworthiness, lenders take into account the borrower's capital level. For a business loan, capital comprises the owner's personal investment in the business, retained earnings, and other controlled assets.


Lenders prefer borrowers with higher capital levels as it indicates that the borrower has a greater stake in the business. When borrowers have invested their own funds, they are more likely to have a sense of ownership and be motivated to avoid defaulting on the loan. Banks quantify capital as a percentage of the total investment cost.


Collateral

Collateral provides lenders with a level of assurance that they can recover some of their funds in the event that the borrower defaults on the loan. Typically, the collateral is the same item that the borrower is seeking to purchase with the borrowed funds. For example, a car loan is secured by the car, and a mortgage is secured by the home.


Because of this added security, loans backed by collateral are often called secured loans or secured debt. Lenders view these types of loans as less risky, which results in them offering lower interest rates and more favorable terms compared to unsecured financing options.


Conditions

The term "conditions" encompasses both the specific terms of the loan and any external economic factors that may impact the borrower. When evaluating loan applications, business lenders take into account conditions such as the state of the economy, as well as the intended use of the funds, such as working capital, equipment acquisition, or business expansion. 


Conditions are generally evaluated using qualitative measures, making them the most subjective of the five Cs of credit. However, lenders also rely on quantitative metrics, such as interest rates, loan amount, and repayment terms, to assess the conditions of the loan.


Conclusion

Before extending credit to borrowers, lenders utilize the abovementioned criteria to assess their creditworthiness. If you wish to get a loan or make use of your credit, lenders take into account your credit history or character, capacity to settle payments in a timely manner, available collateral, capital, and prevailing market conditions to determine the most favorable credit terms.


It is important for you to be aware of these characteristics and how they impact your credit situation. By understanding these factors, you can work towards achieving your financial objectives while also improving your creditworthiness.


To better understand how credit works and how you can leverage it to grow your business, you can listen to my podcast. My guest, Adam Bednar, a successful corporate lender, shares his elaborate knowledge about building good credit and insights on how it can help to scale your business.