My Business Loan Covenants Are Out of Compliance – Now What?

The potential for a larger financial storm than many private business owners are expecting may occur during the next several months if you are not proactive. And it could be personal. For those of you who have business loans outstanding, end of year financial statements and covenant compliance certifications are generally due to your lenders within 120 days after your fiscal year end. For many of you that is April 30. The current state of your company’s results and outlook is more important than ever. If you don’t plan now you may need to be ready for significant change to your loan deal and in some cases banking relationship. Under most circumstances, most banks are not going to give waivers for missing their deadline for supplying financial statements and covenant certifications.

Since October, there have been a significant number of seminars and panel discussions around the subject of credit and lending. I would venture a guess it is the number one topic for seminars right now, and rightly so. It is very important for business owners to get started on understanding where you are right now if you haven’t done so already. Sponsors of these events are targeting their customers and constituents who need to know how to face this situation. The number one message from the speakers, bankers and panelists I heard was “communicate, communicate, communicate”. This is all well and good if you have a positive relationship with your banker and you are in full compliance with your agreements, but if not I say “hold on a minute”. You need to do some work first. If you are out of compliance and/or won’t be able to meet the terms of your loan agreement, you must have a credible written short-term strategic plan to discuss with your banker. There may be little they can do for you if you don’t. But don’t wait for the due date or for them to find out. You need to talk with them as early as possible.

So, what should you do to prepare? First, understand your current ratios and covenant positions. If you don’t know much about that part of the business, familiarize yourself. Understand where you are now. Do the math (have your financial staff do it for you). If you are in compliance with all of your agreed ratios and covenants you are fine. If not you need to start getting into compliance now. If you won’t be able to be in compliance by year end, your plan must be in enough detail to get you there in a very short period of time. “Technical defaults” are enough to get you in trouble. Address them.

As a business advisor and member of the Board of Directors of the RI EDC’s Small Business Loan Fund Corp. I evaluate companies’ credit-worthiness on a fairly frequent basis. I’m not a banker, I’m an operating guy. A business owner. I do review the ratios, historical income statements, balance sheets and cash flow statements. Once I have an idea of how your company has operated and performed historically, the most important part of my review is to understand how you are going to spend the money and how it relates to where you plan to take your company. If that is not clear, I’m not comfortable. If you want your banker to help you there are several things you must do now.

· Lenders and investors hate surprises. The horse is already out of the barn, so now you must show tangible evidence you are being proactive. You must show you have recognized you have a problem and are doing something about it.

· You must re-earn your credibility. That’s right, re-earn. Your plans must match your projections. Deviations must be explained completely and coherently. Be confident in your understanding of the numbers. By being up front with your banker, you are adding to your credibility. The best way back to credibility is to “under promise and over deliver”… always.

· Your financial statements must be timely. I’m talking about operating statements, the ones you should be using on a monthly basis to help guide your company, not tax statements. If you can’t get your operating financial statements to the bank on time, it will be an automatic red flag, and potentially an opportunity for the bank to renegotiate your agreement, or worse.

· Any covenant violations should be addressed in detail. Reasons why you are out of compliance, what you have done to address it (and results) so far and any additional action plans to be implemented. Although it is prudent to have intermediate and long term plans, the banks are only interested in short term results right now.

· Spotlight your management team, including key advisors and consultants. Next to history, bankers (and investors) want to know who is doing the work. Having people on board who they trust, have been in this situation before and successfully brought a company back to good standing, add significantly to risk reduction and company credibility.

· Make sure your financial team is credible. Do you have a bookkeeper when you need a controller? Make the change and make sure that controller is good. I’ve seen many owners call their bookkeepers controllers. They are not the same. Your BAG Advisor and CPA are both good advisors to use to help find that resource. You won’t regret it. This step will take out risk, help make your banker more comfortable and will also help you as you grow.

· As the leader and owner of your company you should already be cutting costs. If personal costs are in your company, take them out first. Bankers don’t want to see your personal mortgages, utility bills, family car loans and tuition payments in your company’s expenses. After personal expenses, right-size the business. This point really hurts but is necessary.

· Articulate your market, competitive position and marketing plan. Again, make sure the projections hang together with your financial statements. Make sure any growth is real.

· Highlight the tactics you are using to execute your plan. Especially the tactics already implemented and any tangible results.

· If you are trying to form a new relationship, the reasons you are looking for a new bank need to be disclosed.

Once you have a credible plan, it is time to talk to your banker. Let them know where you are as early as you can. They will be better able to provide assistance if you have a plan than if you don’t. They most certainly will be more willing to work with you. Many bankers are working hard right now to reach out to their customers to prepare and to try to get an early warning if there are problems they aren’t aware of. Even if you are in compliance, talk with your banker early. They don’t want to have to concentrate on you right now (actually they would rather concentrate on helping you be successful). What I mean is they don’t want to worry you may be a problem. A key to remember here is you can’t hide from your banker. They will find out the truth.

Keep in mind that any violations to covenants or unacceptable ratios may trigger your bank to renegotiate your deal, or worse. So be prepared. I can assure you your relationship manager does not want to have that discussion with you but is obligated, in many cases by regulation. Only a few short years ago banks were very aggressive in their lending practices. Many didn’t price in risk and the spreads on many current deals don’t make sense in the current environment. Some are still more aggressive than others, but very few are offering deals anywhere near as aggressive.

So, what are the current requirements bankers are looking at to assess risk? Although risk factors are industry specific, the number one ratio criteria I heard for deciding a business’s credit-worthiness is debt coverage. Nothing new there, but perhaps the ratio is a bit tighter. All the banks I talked to require at least a 1.2:1 ratio, and several require 1.25:1 ratio. Generally, this ratio is calculated by dividing EBITDA less owner distributions divided by the current portion of long term debt plus interest. From the bank’s point of view, the higher the ratio, the less risk of default. Many banks will pass on lending to a company if that ratio is below the 1.2:1. Some high-risk industries such as construction, fishing, retail, consumer goods and auto dealerships may require significantly higher coverage ratios.

During my discussions with bankers, owner distributions were a frequent topic of concern. Many owners take out funds from the company as a matter of course. S Corps were cited the most in examples. These distributions are really not unlike public or private equity “professionally run” companies giving themselves excessive bonuses or “special dividends”. The net result is higher risk for the lenders, investors or bond-holders. In the current environment, banks are in a position to take on a more aggressive stance. As a small or mid-market business, you will now be expected to live by a higher standard to meet the measures you signed up for when you agreed to borrow funds. Distributions higher than the annual profit of the entity will raise a red flag. Banks are expecting owners to leave more cash in the business for growth, investment and emergencies. It may be safe to assume your banker won’t have much sympathy on your company if they deem those owner distributions excessive. Keep your ratio above 1.2:1.

Another ratio several banks use as a major indicator is the Leverage Ratio, a Balance Sheet measure. It is calculated by dividing total debt by tangible net worth. Tangible net worth is reduced by officer and owner loans and other intangibles. Bank consensus was that a 3x ratio was generally the max acceptable. As this ratio rises, additional covenants and guarantees are introduced.

Almost everyone I talked to suggested owner personal guarantees are part of most deals and always have been. All deals start with them in but are sometimes removed through negotiation, if the company has significant liquidity and low risk. Most articulated that the owner needed skin in the game and saw no reason to remove that dynamic. Likewise, the personal credit history of owners is always taken into consideration. Because of the dynamic between owners and their businesses, historically both have been found to be closely correlated.

In many cases you probably use one bank for all of your “go to” needs; deposits, checking, savings, credit line etc. Pattern changes such as running balances down significantly can be another red flag to the bank that all is not well. However, having all of your business with one bank is a positive and shows you have a commitment to your bank.

Although this article does not cover all of the variables in dealing with your banker, types of loans, credit lines, specific industries or factors specific to your situation, you should have a sense of what you may be looking at from a generic sense. I didn’t discuss size of banks and specific requirements because there are just too many and in some cases personal bias toward specific types of deals. Bottom line, communicate with your banker early and often, try very hard to keep your end of the deal and have a plan you can share to show short term improvements when you are unable to achieve acceptable ratios or covenant certifications. And most importantly, be prepared to have those discussions soon.

Tom Stocker is the Managing Director of Owner’s Edge, LLC (, a business advisory and consulting firm. He has over 30 years experience working with small and large companies in many industries.

Owner’s Edge, LLC’s core focus is on driving operational excellence. The firm specializes on growth, profitability and cash flow improvement, process and structure change, business recovery, financial restructuring. transition and exit planning.

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