Institutional debt can fund expansion, equipment purchases or a major acquisition, but lenders will examine far more than the amount requested. They require proof that your firm knows what it is capable of borrowing, is a provider of dependable accounting data and is capable of repaying despite more difficult conditions. Answering these questions in advance of your meeting with your potential lender will speed up the process of underwriting and make sure you will not receive too demanding terms.
Clarifying Total Debt Capacity
First, try to figure out the amount of debt the company can afford in accordance with the recurrent flow of cash. Evaluate all the existing borrowings, credits, credit facilities and any other liabilities, and next compare the annual sum of payments against cash generated through the operations on the basis of the lender’s debt service ratio formula.
For instance, the company earning $600,000 annually will have difficulties financing debt service of $550,000 each year regardless of its recent growth. Make sure that there will be some money left aside for taxes, replacement of equipment and unexpected costs. Find out in advance from your potential lenders how to adjust their earnings.
Reconciling Working Capital Fluctuations
Document why receivables, inventory and payables move from month to month. The standard working capital formula provides a starting point, but lenders will also examine collection periods, inventory turnover and supplier payment terms.
Even a seasonal distributor could seem flush with cash in March and short on it in September due to preparing for peak season. Give him monthly information on this trend over at least the last two years. If you have cash tied up, try ways of increasing your working capital such as fast invoicing or better collection methods. Clarify any odd numbers before the lender questions them.
Securing Formal Financial Assurances
Determine what type of financial examination you need and arrange it. In-house accounting might work for a smaller deal, but bigger deals usually require an outside examination or audit. Business owners who need accountants, auditors and tax specialists can discuss audit and assurance services before entering formal underwriting.
External audits provide an objective assessment of financial statements, helping lenders evaluate the accuracy of reported figures and the company’s financial position. Independent financial audits and assurance services can strengthen confidence among creditors and other stakeholders.
Ensure revenue recognition, inventory valuation and expense classification are consistent through time. Reconcile the balance sheet to underlying schedules and reconcile any old transactions that no one understands anymore. This independent verification will make the lender more confident about the figures and help management to detect reporting problems before they become an obstacle to the deal.
Stress-Testing Repayment Scenarios
Prepare a few scenarios rather than just basing yourself on the annual budget. A good negative scenario could be where revenue is down 10%, collection from customers is delayed by 15 days and interest expense is up two percentage points. Compute cash flow and loan repayments based on each of these assumptions.
The analysis will reveal the breaking point where the borrower would be unable to fulfill a covenant or need additional liquidity. For example, the manufacturer could still be profitable after sales decline but have cash flow problems due to the inability to cut back inventory levels. Develop a realistic response strategy that could involve delaying discretionary expenses, cutting back planned capital expenditures or utilizing an available facility.
Presenting a Bulletproof Credit Package
Structure the credit package so the underwriter sees the deal clearly without assembling documents from multiple emails. The package should include three years of financial statements, recent interim financial results, cash flow projections, debt schedules and fund use information. Also include a brief description of ownership, management and key sources of income.
Be upfront about areas of weakness. If one customer accounts for 35% of sales, provide information on how long the contract is in place, renewal history and steps to diversify. Reconcile your projections against historical performance and show what assumptions have been made regarding growth. Clearly label all schedules, make sure reporting periods are consistent and confirm totals reconcile among all documents.
Finalizing Terms for Long-Term Stability
Examine all terms of the agreement, including covenants, reporting requirements, fees, collateral and prepayment provisions. A more favorable interest rate might come with increased restrictions limiting future financing or dividend payments. Estimate the cost of unused line fees, arrangement fees and possible interest rate changes over the term of the facility.
Look at covenant definition in depth. There could be a big difference in calculations of earnings or debt service by two banks, resulting in vastly different degrees of flexibility from the same figures. Look for sufficient cushion to allow seasonal fluctuations without constantly seeking waivers. Find out who is responsible for the covenant monitoring, when the certificates are due and what will happen in case of technical violation. The agreement should provide for financing of the business plan for a few years ahead, not just the next transaction.
The consistency of institutional borrowing can only be achieved when all the documents in the credit file tell one and the same story from cash flow to covenant capacity. Prior to filing, appoint someone to check all the numbers against their sources and make sure that the downside scenario still provides for loan repayment under new terms.
