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Company Vital Signs: Financial Ratios & Loan Covenants

March 5, 2020
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Pay attention to financial ratios and loan covenants, both actual and forecasted, for a complete assessment of your business’ financial health.

This has been mentioned before. It is one of the least discussed topics in SMB’s finance and many companies manage to continue operating and even thrive without paying attention to any of this. Sadly, many companies cease to exist, often due to lack of or poor planning with little or no attention to financial ratios and other balance sheet driven indicators.

Importance of Financial Ratios and Covenants

Many of these business failures can be prevented. Solid planning and budgeting and having financial ratios and lender imposed financial covenants as key ingredients in the planning and budgeting can make all the difference between growing a healthy organization and running the business into the ground.

Understanding Financial Covenants in Loan Agreements

When you read financial institutions loan agreements, you’ll notice a section titled “Financial Covenants and Ratios” which is generally a sub section of “Affirmative Covenants”, a section that lists some of the borrower’s obligations, such as:

  1. Submission of annual and interim financial statements to the lender.
  2. Maintaining an insurance policy with certain limits.
  3. Reporting existing and threatened litigation.
  4. Reporting material adverse changes in the borrower’s financial condition.
  5. Maintaining certain financial ratios computed per Financial Covenants definitions provided by the lender in the agreement.
  6. Other covenants that certain lenders require their borrowers to adhere to.

Compliance with Financial Covenants

Most companies I have worked with comply with the loan covenants, including the financial covenants. They simply maintain the requirements listed in the loan documents, submit their annual and interim financial statements to the lender and participate in periodic meetings called by their bankers where additional explanations are given by management to the banker.

The lender does the calculations after receiving the periodic financial statements and notifies the borrower if there are any issues with adherence to these covenants. Managements are usually given a certain time to correct these issues.

Monitoring Financial Strength

Lenders use their borrowers ’financial covenants to gauge the borrowers’ financial strength. If you observe a company’s key financial ratios over time you can clearly see the direction the company’s financial health is headed. Lenders do the same thing in their analyses of borrowers’ financial covenants calculations and how they compare from period to period and to other companies in the same industry.

Proactive Management of Financial Covenants

Although it seems the obvious thing to do, managements of many SMBs are hardly ever proactive in ensuring that there is planned compliance with the financial loan covenants. These financial covenants are generally a set of formulas based on common financial ratios or a combination of certain financial ratios. The result of the formulas specified in these financial covenants must not exceed certain values or must be greater than other values depending on the individual financial covenant.

Calculating Compliance

This can be calculated to determine whether or not the company complied with the requirements. The numbers needed are always found in the company’s balance sheet and income statement and can be used to calculate the financial covenants right after a period close. This is usually required quarterly and annually but should be calculated monthly in order for the company to increase visibility into its financial performance.

Since many SMBs don’t calculate (let alone forecast) their loan financial covenants they usually don’t know whether or not they are still in compliance at the end of each accounting period or at year-end.

Consequences of Not Monitoring Loan Financial Covenants

First, you may not realize that financial covenants’ results are slipping below your lender’s acceptable levels or are headed in that direction. Second, you may miss a chance to make corrections to your strategic and business plan, things that can help the financial covenants regain their expected levels. Worse yet, if your company does not comply with these covenants, the lender may force you to accelerate the loan payments or even foreclose on the company which could be devastating to shareholders, employees and also to suppliers and customers.

Prevention Through Planning

In addition to the actual accounting financial ratios and loan covenants which are very simple to calculate and keep track of, you should also forecast these same ratios and loan covenants, a relatively easy task if you employ a planning, budgeting and analysis application that automatically provides a periodic forecasted balance sheet, accurately and completely synchronized to the forecasted Income Statement and its underlying budget.

Intelligent Planning and Synchronized Financial Statements

In recent years a new technology has emerged that is capable by design to handle these challenges. With Intelligent Planning and synchronized financial statements one can perform analysis on forecasted data the same way actual data is analyzed. When the planning and budgeting software incorporates an analytics module one can generate visual depictions of all relevant financial ratios and financial debt covenants, compare with actual results for the same ratios and covenants and determine whether changes to the plan and budget must be made in order to reasonably ensure successful compliance with these financial covenants.

Benefits of Modern Financial Tools

Using such applications, SMBs can confidently monitor both their actual and forecasted financial ratios and loan covenants, in real time and with actual results replacing forecasted numbers as soon as a financial period is closed. With this approach, the CFO or VP of finance can predict with a much higher level of accuracy their company’s ability to comply with their lender’s financial covenants.

Moreover, forecasting these financial ratios and lender imposed financial covenants can alert management to changes in the financial health of their organization, ahead of time, allowing them to make informed decisions. Using multiple versions of the budget and “What If” features, they can look at different scenarios and immediately see how these forecasted ratios and loan covenants behave in each scenario. These tools, available to the CFO and the finance team today, have never been this powerful.

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.

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