Businesses that have borrowings from Banks – Line of Credit, Equipment lines, have to conform to Loan covenants (or ratios) that will track the business’s performance It is important to agree only to appropriate loan covenants and subsequent monitoring when obtaining and utilizing Bank credit.
Do this proactively by;-
- During negotiations test the relevant covenants on your current and forecasted financial statements.
- Develop a set of suitable covenants and negotiate with the bank. Assess the covenants not only on your current situation, but on your forecast for the next 12 months to 3 years as well. Take care to account for your business cycle needs – may be expansion, contraction and equity issues. Watch out for restrictive covenants and trigger events.
- Monitor your covenants – monthly when preparing your financials and also forecast it for the next 6 months. Do a stress test – change revenues up or down variable and fixed costs up or down and see what happens to these ratios. Determine your margin for violation and work out what activity will breach them- eg: sales drops, variable cost rising, receivables/inventory levels changing.
- Talk to your bank frequently about your business and the “numbers”. This way you can and should, alert the bank on any possible problems that may arise. This will foster a good relationship and an understanding that you are on top of your business. Banks hate surprises.
- If there is possibility of a breach in the future, and it should only be in the future if you are monitoring properly, talk to your Banker about options that are available and penalty clauses that will be triggered.