Why should you care about Loan Covenants and Financial Ratios?
By Dan Taylor, EVP – Scott Valley Bank, Northern Region
Choosing a topic that will be of interest can be a daunting task. Before starting this article, I took a few minutes to review the past 18 issues of The Vault and was impressed with the breadth of the topics.
In January 2014, I authored an article focused on the importance of annual review of your company’s financial performance. I encourage you to review it again for reflection of how your company performed regarding projections and goals. An archive of all Vault articles is available at scottvalleybank.com under the Resource tab. This archive has grown to be a useful source of timely and informative subject matter. It is my hope that today’s topic is also one you will again refer to over time.
Have you wondered about loan covenants and financial ratios and how/why they are necessary? As your banker, we have no direct voice (nor do you want us to) in your company’s decisions and operations. Just as you expect us to run our bank properly, our expectation is that you manage your business properly. By implementing and jointly agreeing on certain financial covenants, important controls are put in place which protect the bank that is lending money into your business. These loan covenants, which are detailed in the Business Loan Agreement, provide the agreed upon expectations between your business and your bank. Thus, as long as your business is in compliance with the loan/financial covenants and loan payments are current, your business and the bank are both content and enjoy a mutually beneficial banking relationship.
These loan covenants play a critical role in the successful management of an on-going borrower/lender relationship. Loan covenants are designed to provide the boundaries in which the borrower has agreed to operate their business during the term of the loan. The loan covenants are designed as triggers to alert your business management, and the bank, that the level of credit risk could possibly be changing. These established loan covenants are definable, attainable and measurable with available financial information.
Loan covenants, which are included in the loan agreement, are designed to meet the following bank objectives:
- Full and accurate disclosure of information concerning the operation of the business
- Preservation of the borrower’s net worth and liquidity
- Maintain asset quality
- Continuance of the borrower’s existence and preservation of its business
- Maintenance of adequate cash flows to repay debt as structured
The two financial covenants that are the most prevalent are leverage and liquidity ratios. Though other financial ratios are also used, the Current Ratio and the Debt to Worth ratio covenants are the standard. As a note, each business industry has its own financial standards as to what is considered strong or weak. As a business owner, it is important that you have the business tools in place and the knowledge to determine the measurable standards in your particular industry.
The Current Ratio is calculated by dividing Current Assets (assets that can be turned to cash within one year such as accounts receivable and inventory) by Current Liabilities (liabilities due within one year). The Current Ratio measures how much money is available in current assets to pay current liabilities and sets the lower limit as to what the bank expects the business to maintain in liquid assets. It tests the “Solvency” of your business’s ability to pay its bills. For example, if your business’s Current Ratio is 1.50, it means there is $1.50 in current assets to pay for every $1.00 of current liabilities. This Current Ratio of 1.50 might be either a good or weak indicator depending on your business industry, but usually this would be considered a good Current Ratio.
The Debt-to-Worth ratio is calculated by dividing Total Liabilities by Equity. This ratio tests the “Safety” or riskiness of the business and sets the upper limit for total debt. For example, if your business’s Debt to Worth ratio is 1.50, it means that your creditors have put in $1.50 for every $1.00 the owners have put in. The primary reason that a higher ratio is riskier is that there is more debt, which equates to higher debt payments and possible strain on cash flow.
As a business owner, your goals and objectives are the same as those of your bank: for your business to be profitable and sustainable allowing you to take care of your family/personal needs, prepare for retirement and to meet the banks goal of wanting to be repaid as agreed. At Scott Valley Bank, we have the financial tools and knowledgeable Relationship Managers to assist you in your annual financial review to maximize profitability, financial ratio analysis and the long term, sustainable viability of your company. As we have stated in past articles, the Bank only does as well as your company does, so we are very interested in your success. We invite you to come in and meet our Relationship Managers to discuss your business.