How measuring your financial health the banker’s way can help you avoid trouble down the road
Many SMBs rely on bank financing, usually in the form of lines of credit (LOCs) and term loans, both of which are backed up by the borrower’s assets. With these LOCs and other loans come loan agreements, promissory notes, resolutions to borrow, personal guaranties and other documents.
Within the loan agreements are a set of covenants, some of which are financial. These are clearly defined in the agreements and measured periodically by the lender’s financial analysts to ensure compliance with the agreements.
Lenders pay close attention to these financial covenants, represented by a variety of financial ratios and other calculations, all obtained from actual financial statements submitted by the borrowers at specified intervals.
Some of the most popular financial covenants are:
- Working Capital: Must be no less than a certain amount (e.g., $12.3 MM at quarter end). Any lines of credit balances must be regarded as current liabilities for this calculation whether or not the LOC term is one year or longer.
- Debt to Tangible Net Worth Ratio: Here the lender is looking at how much more are total liabilities in relation to the tangible net worth, where in the banker’s view net worth or equity must exclude certain amounts such as intangible assets, receivables from related parties and other soft assets as defined in the agreement.
- Debt Service Coverage Ratio: Must be no less than a certain value (1.25 is very common) and is defined as the ratio of cash flow to the current portion of long-term debt (prior year’s principal payments on all loans) plus interest expense. Note that some lenders want to see cash paid for income tax used on both sides of the division line. This is designed to measure how well borrowers can comfortably service their debt.
These financial covenants are always more rigorous than common financial ratios. Banks put additional stress on each calculation to make certain the borrower’s financial health is still sufficient, enabling them to make all loan payments while operating and maybe even growing their business.
The banker’s version of the calculations is undoubtedly designed to indicate financial trouble, even before it is apparent using common ratio calculation methods. The lender must make certain that the company is not only financially sound at present time but will also remain so for the duration of its debt obligation.
For example: The popular Debt Service Coverage Ratio must assure the lender that the company is not using its line of credit to finance losses. Any prolonged period of losses will cause this ratio to severely deteriorate and eventually fail, triggering default.
Stay ahead of your lenders’ compliance verification
Since you must understand how these financial covenants are calculated, you should always monitor them internally, using the exact calculation methods your banker uses, with at least the calculation frequency specified in the business loan agreement.
For example: If a certain calculation will be verified by the lender quarterly, do your internal calculations monthly and see which direction the result is moving. For annual financial covenants such as the Debt Service Coverage Ratio, do a monthly or quarterly rolling calculation (using data from the trailing 12 months).
When borrowing your banker’s mindset you will be better equipped to detect trouble looming on the horizon; you will be better planning and forecasting; exploring new opportunities while staying conservative and you will be better equipped to provide senior management with data and insight based on proven analysis methods.
The actual calculations and documenting the results are very simple and the little time spent doing this is well worth it.
Here’s is an additional great benefit to applying these principles:
If your company uses an FP&A (Financial Planning and Analysis) solution that automatically generates a forecasted Balance Sheet, synchronized to the forecasted Income Statement (and the underlying budget), then all these “Banker’s” ratio calculations can be obtained and visually displayed for all future periods, throughout the duration of the budget. This has been covered in this blog in great detail: https://www.centage.com/financial-ratios-and-loan-covenants-your-companys-vital-signs/.
You will be able to clearly and visually chart all of your banker’s required ratios and see how close they are to the stipulated minimums and in which direction they are moving throughout the planning period. Different versions of the budget will produce different results, immediately visible when you switch versions. Changes to any budget version will instantly update the results and will help you arrive at a reasonable budget that can be further reviewed and approved.
Now you can be well ahead of your lender’s calculations and verification process and will have a lot more time to react to changes in the financial health of your organization.
What if your company is one of the lucky few with no traditional bank debt?
While there are no contractual reasons why you should maintain certain financial ratios, it is extremely prudent to follow lenders’ logic when evaluating your own company’s financial health and the various indicators that lenders always look for and analyze.
Putting a little (or much) stress on financial ratios and indicators and forecasting where that will lead the company when using planning and budgeting data in a next generation FP&A solution may prove very beneficial to the short and long-term financial outlook of the organization.
Best of all, thinking like your banker when evaluating your own company’s financial health will encourage you to put more emphasis on planning and reviewing the plan more frequently. Then, with use of analytics and applying the principles of a rolling forecast, you will have a clearer view of what lies ahead and many of the decisions made in response to actual results vs. plan will prove to be more valid and accurate.
Alan Hart, MBA, is Principal Consultant at Pacific Shine Group in Portland, Oregon, with responsibility for client business development and hands-on client project implementations. Prior to starting Pacific Shine Group, he worked in various executive accounting and finance positions with technology and growth companies. Notable is his 18 years in the hi-tech manufacturing industry where he served as Controller, Vice President of Finance and CFO of several privately as well as publicly held companies in the Hi-Tech industry, such as Hybrid Arts, Inc., Hamilton Bay Associates and Syncronys Software. In his role in management consulting, Alan has worked in diverse industries and with a variety of clients, including fortune 1000 companies such as Boeing, Delta Airlines, Intel, Wyndham Worldwide and others, as well as many mid-market organizations such as Guitar Center, Ducommun AeroStructures, Cypress Semiconductor, TriQuint Semiconductor and others.
Combining his skills and experience in engineering with deep understanding of technical accounting, he is able to assist small and medium-size manufacturing companies establish GAAP compliant accounting and reporting systems.