Do you know how your bank looks at your business?

Are you one of their “good” customers or are you on the bubble, at risk of having your loan facilities cut back or withdrawn altogether?

The answers to these questions are more important than ever, as banks tighten up their lending requirements in response to the recent financial crisis and “freeze up” of credit markets. Your banker isn’t your enemy – they hate nasty surprises as much as you do. You’ll benefit greatly if you learn to understand how your bank looks at your business – this will help ensure you always put your business’ best foot forward.

Simply put, banks care about 2 things:

1. Can your business afford to repay your loans plus interest as they become due?
2. Can you provide adequate security for your loan(s)?

Its not enough to be able to meet just one of these requirements – you need to meet both in order to qualify for financing.

To measure your ability to meet the first test, banks rely on 3 main financial ratios – interest coverage, debt service coverage, and Debt-to-Tangible Net Worth.

Interest coverage is calculated as your EBIT (earnings before interest and taxes) divided by your interest expense. This measures whether your business generates sufficient income to pay your projected interest expense. Banks typically require an interest coverage ratio of at least 2.

Debt service coverage is calculated as your net cash from operations divided by your interest expense plus the portion of your long term debt due within the next year. This is a measure of whether your business generates sufficient cash flow to repay debt and interest as it becomes due. To obtain financing, you need to have debt service coverage of at least 1.25.

Debt-to-Tangible Net Worth is a measure of the risk of your business and is calculated as you would expect – Your total debts divided by your “tangible net worth” (“TNW”). When determining whether you have adequate security to support your loan, banks often require your business to have and to maintain a certain level of TNW. The definition of what constitutes TNW varies from bank to bank, but it generally means retained earnings plus any loans from shareholders that have been subordinated to the bank (this means that the loan can’t be repaid without the bank’s permission). To qualify for a bank loan, you need to have a Debt-to-TNW ratio of less than 2.5:1.

A bank may also require that your business maintain a certain level of working capital which is generally defined as your current assets (cash, accounts receivable, inventory, etc.) less your current liabilities (i.e. accounts payable, bank lines of credit, etc.) . This may be a specific dollar amount, or a specific current ratio (ie. current assets divided by current liabilities). We are aware that certain Canadian banks currently require a current ration of at least 1.25:1.

Your specific lending requirements are typically buried deep in the wording of your loan agreement. Too many people don’t pay attention to these covenants before they sign their loan agreements – They sign the agreement then tuck itaway in their desk drawer and forget about it.

This is a major mistake. It assumes that failing to live up to these requirements doesn’t carry significant potential repercussions.

Today, if your business is in breach of its covenants, you’re probably in a very tough spot – with your bank loan and operating lines subject to a repayment demand from your bank, or facing a requirement to inject additional capital into your business – funds that you might not have readily available. Even worse, they may reassign your account to special loans which is really code for “You need to take your business elsewhere and SOON!”. Worst of all, given the current financial turmoil, you likely won’t have new banks lined up, just waiting for the chance to fight for your business.

The bottom line here is – you need to pull out those loan agreements and figure out where you stand. Don’t wait until your year end numbers are in and you have no opportunity to deal with covenants you haven’t met. At that point, all you have to look forward to is a difficult discussion with your bank manager. If you act now, it might not be too late to for you to fix things before year end by focusing your efforts on the specific activities that drive your business.

If you’re not sure whether you currently meet your bank covenants or whether you’re on track to meet them at year end – we can help. Contact us at compass@macgillivray.com to arrange a no-risk consultation today. If you have any questions, please feel free to  post them below – we’ll do our best to answer them.