Money Talk: Banking Covenants: Preparation is Key

The economy has changed, the banking industry has changed, and traditional relationships between companies and their banks have changed. As financial consultants to the printing industry, we see an up-swing in requests for help negotiating and/or meet bank covenants.

The recent economic recession has caused heavy regulatory scrutiny of bank loans making banks more cautious about lending money, even to their best customers. The situation has caused many printers to be denied financing or be forced to delay or cancel necessary capital expenditures. Some companies resorted to using lines of credit to buy needed equipment which hurts flexibility in cash flow. In addition, many banks required printers to reduce the upper limit on lines of credit, again losing much-needed cash flow in the process. Once the company used up cash reserves and credit, there may be little alternative to manage cash flow other than closing the doors.

Recently we see that the healthy banks want to lend money and create relationship with small businesses. They have cash and want to move it. Yet, these same banks are looking at customers more carefully. In many cases, the loans are (at least loosely) tied to performance. The measurements of performance and financial position used by banks are called the covenants. Covenants are the factors that serve as an early warning system to alert both the lender and the company that the business may not be headed in a positive direction.

Normally the lender has certain rights to change the terms, or even call the loan if these covenants are violated. At a minimum, it gives the lender an opportunity to have a candid discussion with the borrower about what has happened and what their plans are to rectify the situation. The covenants can help to keep a business focused on improving areas were a lender sees the most risk. From the lender’s perspective, this is a good thing because it should lead to an improved relationship with key business “partners”.

Below we highlight common bank covenants. These indicators could quickly change in a business that is beginning to experience difficulties.

Debt Equity Ratio:

• Debt (total liabilities) divided by Total Equity.

• The Debt to Equity Ratio shows how much the owners have at risk (Equity) as compared to the creditors (Total Liabilities).

• Depending on the type of business and the unique business situation, we generally see this ratio below 3:1 in covenants.

Debt Service or Debt Coverage Ratio:

• EBITDA divided by Total Principal and Interest Payments.

• EBITDA = Earnings before Interest, Taxes, Depreciation and Amortization. 

• Indicates how easy it is for a business to meet its debt obligations out of earnings.

• Generally, 1.4 to 1 and above considered good, 1.2 to 1 and below viewed as showing weakness.

Times Interest Earned: 

• EBITDA divided by Total Annual Interest Payments

• Similar to Debt Coverage Ratio, indicates a company’s ability to service its’ debt.

• Generally, above 2.5 : 1 is typically considered ok. Below that shows weakness.

Current Ratio:

• Current Ratio = Current Assets divided by Current Liabilities

• This is a ratio that takes a picture at a moment in time of your ability to pay back current liabilities with your current assets.

• Both Current Assets and Current Liabilities are amounts that are retrieved from your balance sheet.

• The average printer has a ratio of 1.4 to 1. If a bank uses the Current Ratio to measure its risk, it will typical use a ratio similar to the company’s present ratio, but not let it diminish. The lowest ratio we have ever seen as a covenant was 1.25: to 1, but higher ratio requirement should be expected.

When a bank is under pressure from the regulators, or the bank itself is unprofitable, they will be less lenient in overlooking covenant violations. If there are covenant violations, the loan can be called and/or the bank attempt to change the terms, like an interest rate increased. Trying to avoid such outcomes means that time should be spent communicating with the banks.

So how can a company successfully communicate with banks to get desired outcomes?

Increase Communication with Your Bank: Keeping your bank informed and updated. In most cases, the plans required by banks are plans that are necessary for company survival anyway. Be ready for them. Be sure to have income and expense projections that can be converted to analyze cash flow and determine if the cash flow is sufficient to service the debt and working capital. Have contingency plans in place in the event that original plans and sales projections are not realized. Pro-actively having these plans in place helps management think through scenarios and devise solutions that make sense. If the bank questions a falter, make sure the company is prepared with a reasonable solution.

Focus on the Operating Side of Your Company when Talking to the Banks: Showing them expense cutting, justifying any expenses that are made and demonstrating how long-term investments will increase future profits all helps.

Plan, Innovate, and Reorganize: If the current plan is not working, explore new ideas, show you can change with the times, and share your vision – and your success story -- with your bank.

Control Cash: If you have cash, keep it as cash, even if it means you get a smaller return on it in the short term.

Check the Financial Health of Your Bank: Visit the FDIC website (www.fdic.gov) for updates and resources on the banking industry, including FDIC’s List of Enforcement Actions to determine if your bank is undergoing enforcement activity. If you see (or suspect) that your bank is in financial distress, consider developing a new relationship with a more stable entity. Great disparities in service can exist between financially healthy banks and entities under strong scrutiny.

In short, plan, prepare and protect yourself. If necessary, get help.