If your business has a traditional line of credit with a bank, now is the time to pull out the loan documentation and read it carefully.
Many business owners sign loan documents without reading them before drawing money on them and before realizing what kind of covenants might be included. In today’s very tight credit climate, many banks throughout the U.S are starting to rigidly enforce loan covenants and finding loans in default without allowing periods to cure the default. As importantly, lines of credit that have been long standing are not being renewed as in previous years.
Business owners who rely heavily on their lines of credit need to know exactly what the covenants require, what financial ratios are required, and how close the business’s ratios are to those required in the loan agreement.
Many loan agreements allow the bank to reduce the maximum amount of the line without notice and immediately require the new overage paid down immediately.
Banks can also change the eligible collateral under borrowing base certificates without notice, which also has the effect of reducing the amount of money that can be borrowed on a line of credit.
Last week I met a borrower who was just informed that their $3.5 million line of credit was not going to be renewed because the borrower had a one-time unusual loss that forced one of their required liquidity ratios below what was required by the bank’s loan documents. In this borrower’s case, there was a requirement that the company maintain an EBITA-to-debt-service ratio of 1.25. The borrower has kept their ratio well over 2.0 for the 10 years the line of credit has been in place. The loan document required the borrower to submit a new borrowing base certificate each month. Quarterly, the bank computed the required ratios from financials submitted by the borrower. When the borrower’s EBITA-to-debt-service ratio fell to 1.23 (because of a one-time nonoperating loss), the bank informed the borrower they weren’t going to renew the line of credit. The bank notified the borrower on October 21, 2008; the line was set to mature and renew on November 1, 2008. Suddenly, the 30-year-old company that has over 2,500 employees has found itself scrambling to replace their line of credit in less than 3 days.
The borrower I am working with to replace the line of credit won’t be able to meet the November 1 deadline, but will likely be able to get a new line of credit in place from a commercial asset-based lender within three weeks. Fortunately, the borrower can handle not having access to their line of credit until it can be replaced by the end of the second or third week of November. The borrower’s cost will be a little higher than what they have been paying, but they will have access to the necessary working capital to continue to operate their business.
Many businesses will face similar surprises during the next year or two. It is imperative to know what your loan documents require, keep up with required financial ratios and reporting requirements, keep your business records up-to-date, and be prepared to move from a traditional bank lender to an asset-based lender or factoring company with short notice.