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Debt Covenants

Loan Covenants – Challenges and Options to Consider

By Tom Bartos

A common concern with business loans is covenant compliance. Does my business loan have covenants and if so, what are the compliance requirements? Smaller loans under $100,000 may not require collateral, and are usually free of any covenants, but as businesses grow, so do their financing needs. Business owners looking to borrow over $500,000 can expect the loan agreement to contain some type of covenants or compliance requirements. The covenants typically are either financial, operating, reporting or restrictive in nature. Examples of each are maintaining a minimum cash flow to debt ratio (financial), carrying a minimum level of insurance (operating), submitting financial statements to the lender (reporting), and limiting dividends or payments to shareholders or owners (restrictive).

The covenants are in effect while the loan agreement is in place, and require compliance to be reported to the lender on a quarterly, semi-annual, or annual basis. They provide lenders certain financial and business protections in addition to their rights to the collateral, plus provide information regarding any possible adverse changes in the borrower’s financial condition. In other words, covenants provide an additional security blanket for the lender and serve as an early indicator of possible financial issues on the horizon.

Covenants are written as affirmative actions or negative requirements. Affirmative and negative covenants take on many forms. Affirmative covenants require the company to adhere to certain predefined promises, rules, or regulations. These covenants are written into the loan agreement for the benefit of the lenders, shareholders, and other stakeholders. Examples include requiring the company to maintain certain levels of insurance or paying all taxes on time. Negative covenants restrict a company from engaging in certain activities, such as restricting the payment of dividends to shareholders while the debt is outstanding, or purchasing an unrelated business.

 

What are Your Options?

A business owner has to live with the terms of the loan agreement while the loan is outstanding, therefore it is best to determine the company’s future or forecasted ability to comply with the covenants prior to the agreement’s execution. Forward looking projections are important to avoid a potential covenant default and an uncomfortable discussion with the lender at a later date. If a business owner is uncertain as to future compliance with any of the covenants prior to closing, the issue should be discussed and negotiated with the lender beforehand.

Another negotiating topic with the lender surrounding the covenants is the potential for avoiding or removing personal guarantees. Small businesses can have personal guarantees, if present in the agreement, removed after a period of covenant compliance, or avoid personal guarantees with tighter covenants.

 

 

Dealing with Compliance Challenges

If a business finds itself in a covenant violation, the borrow may have a cure period to rectify the violation, if it can be corrected. A cure period for covenant violations will be specified in the loan agreement. Not all covenant violations can be cured or can be cured within the time specified in the loan agreement, so it is best to proactively monitor covenant compliance throughout the year. As is the case with covenants, the ability and time frame to cure defaults can be negotiated into the loan agreement before it is finalized. In the unfortunate instance where a covenant default cannot be avoided, the borrower should notify the lender in accordance with the notice provisions in the loan agreement. The lender may grant a waiver, effectively stating that the lender will not take any actions as a result of the default for a period of time. If the lender does not grant a waiver, their actions can include increasing the interest rates, accelerating the maturity of the loan, or calling the loan to be due immediately.

When entering into loan negotiations with a lender, it is best to obtain advice and assistance from experienced advisers such as a CFO and a good corporate attorney who is experienced in negotiating bank transactions. These professionals will act as a team by adding value in the negotiations, helping everyone understand the various terms and conditions of the agreement, including the covenant provisions, and assist in the loan agreement’s ongoing compliance. Upfront planning, timely compliance, and having the right people and reporting systems in place can avoid covenant compliance issues in the future.

 

Tom is an Area President for FocusCFO based in Pittsburgh, PA.

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Forge and Finance

Forge and Finance

By Peter Geise

Recently I was asked to write a quarterly column on financial matters for Forge Magazine. As the name suggests, the magazine serves the forging industry, which is a $36.6B industry that is growing at a modest rate of 1.2% annually. Forging is big business in NE Ohio, where I live, with several companies like Sifco Industries, Wyman-Gordon Forgings, Wiseco, Dyson Corp., Wodin, Viking Forge, Solmet, Ohio Star Forge, Bula Forge, Ken Forging and Canton Drop Forge headquartered here. 

In my column, I’m hoping to provide some thoughts and tips to business owners, including how to evaluate and minimize risk, improve and manage cash flow, and how to add value. I also hope to hear from the Forge readers on topics they’d like me to cover.

Stay tuned!

Peter is an Area President for FocusCFO based out of Akron, OH.

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Richard Burns

Welcome Richard Burns

Welcome to the FocusCFO Team!

Richard has more than 30 years of executive management and leadership experience Management expertise in sales, marketing, operations, supply chain, technology, finance, strategic planning, organizational development and quality assurance. He has worked with thousands of customers across many industries including industrial, electrical, automotive, consumer and medical markets. Richard and his wife Donna live in Brecksville, Ohio.

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Professional Concepts Insurance Agency Testimonial

Professional Concepts Insurance Agency Testimonial

“PCIA believes in a laser focus on growth and opportunities.  Lesli Funk Matukaitis and FocusCFO have allowed our organization to focus “on the business.”   Every week, our CFO, from FocusCFO, spends a full day in our office strategizing and looking for unforeseen opportunities for financial growth at PCIA.  We enjoy our opportunity with FocusCFO and look forward to continuing our success.”

Michael Cosgrove, President of Professional Concepts Insurance Agency
February 2020

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Transparency of Profitability

Transparency of Profitability

By Mark Snyder

The pinnacle of profitability reporting is understanding your item and customer profitability metrics for organizations selling goods. We’ve seen many times that either the organization’s system cannot capture this data, or the way the system was deployed did not enable both an item and customer profitability view. Depending on the business, they may have either item profitability or customer profitability, but rarely do they have both.

Often an investment into a business analytics system are necessary in order to pull your organization’s data and parse out profitability by item and customer. You really need to understand the customer profitability view and then be able to do a deeper dive into the items that customer is buying, and which are profitable or not.

An organization was selling products through retailers to the end consumer. They were approached by a partner company to supply ingredients to the partner’s products in the same retail channel that were complementary and not competitive. The new industrial supply business would require minimal capital with some bulk load out capability expansion. On the face this looked like a great opportunity to increase the utilization of their manufacturing facilities and enable the industrial business to share in the plant and corporate overhead that was solely borne by the retail business. The organization was forward thinking and set up this business up as its own business unit and therefore leveraged their system to track profitability for these industrial customers and unique items separately from their core retail items.

What happened over time is a testament to the power of customer and item profitability. At the start of this new venture the gross profit margins and operating profit were comparable to the organization’s retail sales. But as time went on and the venture expanded to other partners, the gross profit of the industrial business began to erode, which was readily apparent via the separate industrial business item and customer profitability metrics.

Two things happened to the industrial business over the years. The partners expectations were constantly being raised with regards to quality and timeliness of supply. The requirements became so onerous that significant product rework and waste was created due to these ever-tightening specifications. Additionally, the partners treated the organization as merely a supplier and upon every contract renewal there were heated negotiations on price and ultimately concessions to maintain the industrial volume.

Finally, after many years of supplying product to their industrial partners the organization found that this business was becoming a significant drag to the organization’s profits and was a hindrance to their retail aspirations. If the profitability of the industrial business had been buried into the overall business, it would have taken a lot longer to find, diagnose and socialize the issue. Even with clarity into the industrial business profitability it was still a significant paradigm shift as whole teams had been built around this business therefore creating a lot of angst within the organization.

Ultimately the organization discontinued the industrial business and was able to sell parts of this business to another organization that was strategically focused on the industrial supply chain. This move freed up precious resources that allowed for expansion of their retail line as well as mergers and acquisitions to bolster their retail presence.

This positive outcome highlights the critical need for transparency into your customer as well at item profitability.

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