Industry Insights

With the ongoing banking crisis and the country’s overall economic woes, many companies are trying to understand how their financing needs will be affected.  Banks are under heavy scrutiny from federal regulators and this will lead to some changes in banking relationships.  Credit markets are tight and any company with external financing should be prepared for its lender to take a thorough look at existing financing agreements.

Understanding where your company stands with its financing agreements is key to preparing for these changes.  Financing agreements can vary widely by financial institution, but most loans have some level of debt covenants.  A debt covenant is a clause included in the financing agreement to protect the lender.  These covenants can range from minimum insurance coverage and limits on distributions of the company’s earnings to restrictions on changes in management of the company.

Many financing agreements include financial covenants.  Financial covenants are typically measured using the company’s financial statement information.  Failed financial covenants can give lenders the right to call the loans.

Financial covenants vary widely between lenders and set minimum financial performance thresholds.  Some common examples include:

1. Debt service charge – earnings before interest and depreciation divided by annual debt service requirements
2. Funded debt to EBITDA – total interest bearing debt divided by earnings before interest, taxes, depreciation and amortization
3. Debt ratio – total debt divided by total assets
4. Debt-to-equity – total debt divided by total equity
5. Minimum net worth – sets a minimum level the company’s equity can reach (management should pay particular attention to how net worth is defined in each lender’s agreement)
6. Interest coverage – earnings before interest and taxes divided by interest expense

Focus on financial covenants regularly but do not forget to monitor nonfinancial covenants.  A lapse in insurance coverage or disposing of certain assets can lead to default of nonfinancial covenants.

Management should go beyond simply reporting what the lender requires, though, and check compliance with debt covenants monthly.  Monitoring covenants in the interim can give management time to adjust operations and ensure compliance by required reporting periods.  These adjustments could include monitoring discretionary spending, evaluating the need for additional capital from shareholders or cleaning up the balance sheet by repaying shareholder loans.

It is common to pay little attention to these covenants once an agreement is signed.  This may not be a problem during prosperous times, but during an economic slowdown it may become harder to meet these requirements.  Bank regulators will take a closer look at your loan if you do not meet these covenants.  This could mean halting further borrowings or requiring immediate payment of all outstanding borrowings.  Failed covenants at a company’s year end also could require all related debt to be classified as a current liability.

So management can efficiently monitor financing issues, the company should create a summary document listing details and specific calculations of all covenants related to outstanding financing agreements.  Monthly financial results should be compared to these covenants for compliance.  This will allow management to determine how much margin the company has to maintain compliance.  Management  also should continually update internal forecasts for reported results and compare the forecasted figures to the covenant requirements.  Should issues emerge, management can make adjustments to planned operations or consider alternative sources of capital for financing operations.

Another key step to preparing for lean times is maintaining a relationship with your lender.  The better your lender understands your business and management team, the easier it will be to work through difficulties your company may face.  Should you face hard times, be proactive by taking a plan of action to your lender.  Demonstrate to them you are aware of the issues at hand and are prepared to survive tough times.