Today's topic is collateral, one of the 5 Cs of Credit that lenders use to determine their level of risk when offering a 504 loan, or any business loan. You may be thinking, "I've checked my credit reports and made sure my character hasn't been damaged. My business has good cash flow (capacity), and I've got plenty of skin in the game (capital). What more could a lender want?" Lenders do want more; they want collateral.
Collateral refers to the assets a borrower pledges to secure a loan. While cash flow is the primary source of loan repayment, collateral provides the lender with a secondary source of repayment if the cash flow is unavailable or interrupted.
An asset is a resource with economic value that a corporation or individual owns or controls with the expectation that it will provide future benefit. In other words, an asset is something that generates cash flow (and lenders love cash flow ). Assets increase the value of a company or benefit the company's operations, such as equipment, real estate, or investments.
Assets are classified as either current or fixed. Current means the asset will be consumed within one year, such as cash and inventory. Fixed assets are things that are expected to keep providing a benefit for more than a year, like heavy equipment or real estate.
Lenders prefer fixed assets because they retain their value and aren't easily consumed like inventory. In the 504 Loan Program the asset being purchased (e.g., buildings, land, or heavy equipment) is used as collateral on the loan. If the borrower defaults on the loan, the lender then becomes the owner of the assets. This is how collateral becomes a secondary source of loan repayment.
However, as we have mentioned before, lenders are not interested in operating your business or owning your assets. Therefore, lenders prefer assets that are easily liquidated for cash. Lenders always prefer a healthy cash flow to any collateral that is hard to sell.
Understanding collateral, and each of the 5 Cs of credit, is important when searching for business financing. Community Business Finance's knowledge of business lending and experience with the 504 Loan Program makes the process easier and faster.
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