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Will you Breach Your Loan Covenants?

How technology can help in forecasting your debt covenants compliance

Having debt while running a business is common; in fact, most companies are never able to grow on their own unless they acquire some kind of debt, such as a bank line of credit, a long-term business loan, or factoring of accounts receivable.  In larger organizations, issuing corporate bonds is another way to secure financing in addition to equity financing.  Small and medium size organizations are almost always dependent on a line of credit and/or long-term loans, generally secured by their accounts receivable and inventory as well as other assets.

These business loans and lines of credit come with covenants, which are conditions that must be met on a periodic basis in order to continue to use these forms of financing.  Breaching these loan covenants can have serious consequences to the business.  If not cured, a covenant breach can cause a loan to be called based on the typical acceleration clause built into the loan agreement.

Loan covenants define what the borrowing company must do (e.g., maintain an insurance policy with minimum required limits) or not do (e.g., borrow additional funds from another lender) as well as maintain minimum financial results, such as certain levels of cash flow, or meet key financial ratios.

When planning and budgeting for the future (e.g., next 12 months, 24 months, etc.), companies forecast and budget their revenues and costs associated with these revenues and other expenses required to run the business.  Unfortunately, most organizations, especially smaller companies, do not or are unable to forecast their balance sheets for several reasons mentioned in some of the earlier articles in this series:  Forecasting a Balance Sheet in a Spreadsheet World  and Why Financial Ratios Should be part of Your Budget and Forecasts.

With the inability to clearly forecast the balance sheet, much of the insight into the future financial health of the organization is lost.  Other than the obvious lack of cash flow (and cash balance) forecast, other very important attributes of the company future financial health are not available.  These are typically key financial ratios (e.g., debt to equity ratio, current ratio) and other indicators critical in assisting management in making important decisions.

It just happens that banks and other financial institutions use certain key financial ratios when implementing and enforcing these loan covenants, which are stipulated in the loan agreement.  These banks expect the covenants (measured through financial ratios) to be met as agreed by their borrowers.  Typical financial ratios that are used in defining loan covenants might be debt to equity ratio, Debt Service Coverage Ratio and possibly others.

Reporting these ratios after an accounting period has been closed is not difficult.  When you do that, you immediately know whether or not your loan covenants have been met.  Wouldn’t it be good (actually crucial) to know that in advance, perhaps 12 or 24 months in advance (or longer)?

The good news is that if you are able to accurately and completely forecast your balance sheet, you’ll be able to know whether or not your loan covenants will be met, in every period included in your budget.

Since it is nearly impossible to predict the future, it is important to note that all financial forecasts are highly dependent on assumptions (e.g., revenue growth during the budget period, forecasted costs during the same period, forecasted operating expenses, etc.).  However, if your planning and budgeting follows a specific logic and a set of business rules, using fair assumptions, your forecast will be accurate.  Moreover, having the right software tools is critical in consistently getting the desired output.

I have already referenced Budget Maestro with Analytics Maestro many times.  One of its greatest strengths is its ability to automatically provide a complete and accurate forecasted balance sheet (and its derived statement of cash flows), using the planning and budgeting data and without any user programming or formula work.

What this implies, especially when it relates to loan covenants, is that using the Analytics Maestro module (essential component of this software solution), one can have a visual display (as well as in tabular format) of all key ratios used to determine whether or not loan covenants have been met (for actual current and historical data) or are likely or not to be met in future periods covered by the plan or budget.

In Analytics Maestro, a set of charts (as well as tables if needed) can be set up to automatically display forecasted financial ratios and actual ratios achieved, using automatically applied formatting.  For example, using conditional formatting, you can easily display actual and future loan covenant breaches in red.  Formatting and using your own custom templates is only limited to the formatting options found in MS-Excel, the display application employed by Analytics Maestro, which is used only for reporting purposes, with no reliance on formulas, functions or macros.

It becomes obvious that by using Analytics Maestro, you can have any imaginable display or presentation of your actual and forecasted data, as provided by Budget Maestro.  This can include presentation quality financial statements that can be filtered by a reporting entity or any other desired dimension.  Financial ratios used in conjunction with loan covenants are just an example of what can be done with the software.

To continue our example, glancing at the Loan Covenants section you set up in Analytics Maestro will show all historic values, how close you were to breaching these covenants in the past or how high you are above the threshold and most importantly, where you are headed with meeting these covenants in the future.

Knowing where your financial statements are headed is essential to the decision making process.  It’s like knowing where the curves in the road are so you can properly anticipate when to steer your vehicle.  Conversely, not having this data ahead of time is like driving blind and risking your vehicle going off the road at the slightest turn.

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