In the last year, huge numbers of loans were refinanced on the back of competition among lenders to sell money and attractive loan pricing. As a result, many CFOs have now refinanced, put their loan documents away and will revisit them in a few years when it’s time to renew. Unfortunately, it’s not that easy anymore; in particular in a sluggish and faltering economy, as your creditors keep a closer eye on all the covenants of your loan.
Once the loan has been restructured, renegotiated or replaced, now comes the harder part – ensuring that you stay within the covenants in the credit agreement. Unfortunately, it’s also not only financial ratios that you should monitor.
What could be more common covenants to watch?
– Financial ratios (debt service, fixed-charge coverage, debt to EBITDA, …)
– Covenant thresholds (debt/assets, cash flow, debt to equity,…)
– Disposal of assets and debt prepayment.
– Collateral transfers.
Why is it important and what are the implications?
To start with, a bank is entitled to charge fees and penalties for a covenant breach, whether or not it is a financial covenant – EVEN IF you’re current on all loan payments. This could be a one-off charge or higher interest payments over the life of the loan. Second, if customers or vendors hear that you’re in breach, they may become concerned about your creditworthiness and look for alternative back-up suppliers or withhold credit altogether. Third, your bank may reduce or freeze credit lines and refuse additional credit when cash is tighter.
If your business is not booming, any one of these could cause real harm to a company.
How can you reduce the likelihood of problems, even if you do breach a covenant?
1) Disclosure and communication with your bank: early and often.
– Discuss business plan changes in advance of implementation.
– Disclose adjustments to financial forecasts.
– Timely and clear financial reporting.
– Model different scenarios for future financial performance.
– No surprises. If in doubt, disclose a concern or business issues you are having. Banks can’t tolerate surprises and will respond much better to you saying “we foresee cash issues in three to four months if XYZ occurs,” rather than, “XYZ’s going to happen next week and we need more money.”
2) Monitor financial metrics to predict future cash needs.
3) Keep cash flowing – focus on early collecting receivables and reduce days sales outstanding.
4) Keep inventory turning.
5) Communicate early about larger customer orders or additional sales growth that may have additional cash requirements. Your lender may not be as excited as you about business growth if it’s going to stretch your cash flow.
A few additional thoughts…
Many companies may already be in breach of covenants and not be aware of it, while lenders may be more flexible if they have advance notice of possible breaches.
Be particularly mindful if your loan is now syndicated with multiple banks. In terms of communication and covenant issues, this heightens all the above points, because your bank may now need to seek advanced approval from all the other syndicated parties before agreeing to certain loan changes or extensions.
Whenever you communicate with your bank via email or in writing, consider the full audience that’s likely to review the message. In written communications, always be pre-emptive, prompt and professional.
