Every business owner knows that success isn't just about revenue — it's also about how you manage and understand your finances. While the saying "Cash is King" is a well-known mantra in the business world, it's vital to dive deep into the nuances of your company's financial commitments, particularly when it comes to debt agreement reviews.

Debt agreements often contain boiler-plate language and terms, but these terms/requirements can vary significantly between financial institutions and between types of debt.  Understanding the type of debt available to you and the key items to consider when reviewing your debt agreements will enable you to make the best possible decisions for your business.

The Importance of Debt Agreement Reviews

A debt agreement isn't merely a piece of paper signed and stored away. It memorializes your business's promises and its commitments. Being versed in the specific terms and conditions of your agreements equips you with the knowledge to make decisions that are both strategic and in harmony with your business's financial goals.

Think of it like this: You wouldn't set off on a cross-country drive without first ensuring your vehicle is in top shape. Similarly, steering your business without a clear understanding of your debt obligations might lead you into unforeseen financial terrain. Regular debt agreement reviews can help you minimize surprises and anticipate potential pitfalls before they escalate, ensuring smooth financial operations.

Types of Debt Agreements

Business operations come with diverse financial needs, which can best be met through various types of debt agreements:

Term Loans: These are often long-term loans with set repayment plans, ideal for significant investments like real estate or machinery.

Lines of Credit (LOC): These flexible sources of funds can be drawn upon as needed, making LOCs perfect for meeting short-term capital needs.

Equipment Financing: These loans are designed for purchasing business-specific equipment. The equipment purchased is held as collateral against the debt so this type of debt can often have a lower, fixed interest rate than an unsecured debt.

Shareholder Loans: These are funds loaned to the business by its owners or shareholders. These types of loans should be formalized in a signed agreement that outlines the terms, including an interest rate that is reasonable based on market rates. Not formalizing or abiding by the terms of shareholder loans poses a risk of the Internal Revenue Service.

Lease Agreements: These contracts allow businesses to use assets (like machinery or premises) without the hefty price tag of purchasing them. While not technically a "debt agreement," these agreements include future obligations of the business. Therefore, these commitments should be included when analyzing future cash flows.

The implementation of the Accounting Standards Codification (ASC) 842 (the new lease standard) changed the presentation of leases in GAAP (Generally Accepted Accounting Principles) financial statements, so you also want to be aware of the impact of the lease agreements on the financial ratio covenants in other debt agreements.

Each of these agreements comes with its unique set of terms, covenants, and conditions. Understanding these intricacies can profoundly impact your financial strategy, affecting liquidity, solvency, and overall fiscal health.

Key Considerations for Debt Agreement Reviews:

With that in mind, let's explore some pivotal considerations for you to think about when reviewing your debt agreements:

1. Historical Comparisons

Review your current agreements against previous ones. Do you notice any significant shifts in covenants from the prior year? Be wary of unexplained tightening of covenants — it might signal underlying issues.  Always know that you can go back to your banker and ask for an explanation of the reason for any changes.

2. Stay Ahead of Changes

Are there any new accounting standards or operational changes on the horizon? Consider their potential impact on existing covenants. For instance, a new lease standard or substantial distributions could significantly alter your financial landscape.

Ensure that you are incorporating those significant transactions into your monthly budget and projecting the impact they will have on your financial ratios.  You don't want to make a significant distribution during the year only to find out at the end of the year that the distribution threw the company out of compliance with the debt covenants with the bank!

3. Learn from the Past

Historical performance can be a great teacher. Reflect on how your company fared with covenants in the past. If you've historically teetered close to breaching them, use those lessons to exercise caution and shape future strategies.

Discuss with your banker whether alternative financial ratios might be better for your company. Below is a list of some of the more common financial ratios and restrictions included in bank debt agreements.

  • Current Ratio: The current ratio measures a company's short-term liquidity by comparing its current assets to its current liabilities. A higher current ratio indicates better liquidity.
  • Quick Ratio (Acid-Test Ratio): Similar to the current ratio, but it excludes inventory from current assets. This ratio provides a more conservative measure of short-term liquidity.
  • Working Capital Ratio: This ratio assesses a company's ability to meet its short-term obligations by comparing current assets to current liabilities. It's similar to the current ratio but excludes non-cash items like prepaid expenses.
  • Debt to Equity Ratio: This ratio measures the proportion of a company's financing that comes from debt compared to equity. It's a measure of leverage and financial risk.
  • Leverage Ratio: This ratio assesses the borrower's overall debt levels in relation to its assets or equity. It helps lenders evaluate the borrower's ability to meet its financial obligations.
  • Interest Coverage Ratio: This ratio gauges the borrower's ability to cover interest expenses with its earnings before interest and taxes (EBIT). It reflects the company's capacity to service its debt.
  • Debt Service Coverage Ratio (DSCR): DSCR measures a company's ability to meet its debt obligations, including both principal and interest payments, based on its cash flow. DSCR is particularly important for project finance or real estate loans.
  • Fixed Charge Coverage Ratio: This ratio calculates a company's ability to cover fixed charges (such as interest, lease payments, and preferred dividends) with its earnings. It provides a more comprehensive view of financial obligations.
  • Loan-to-Value Ratio (LTV): Common in real estate lending, the LTV ratio assesses the relationship between the loan amount and the appraised value of the collateral property. It helps mitigate risk for lenders.
  • Asset Coverage Ratio: In the context of asset-based lending, this ratio measures the value of the collateral pledged against the loan compared to the loan amount. It ensures that the collateral provides adequate security for the loan.
  • Minimum Liquidity Requirements: Some agreements may specify minimum cash or cash equivalent balances that a borrower must maintain.
  • Capital Expenditure Limits: Lenders may restrict the amount a borrower can spend on capital expenditures without lender approval.
  • Dividend Restrictions: Some agreements may limit the payment of dividends to shareholders to ensure that cash is retained for debt service.
  • Restrictions on Additional Debt: Lenders may impose limits on the borrower's ability to take on additional debt or issue new securities.

4. Optimizing Debt Structure

Struggling with covenants? Realigning your debt, like subordinating shareholder debt to bank debt, can improve financial ratios and offer some breathing room. Or, consider the potential impact to your cash flow and financial statements of leasing equipment rather than purchasing it.

5. Broadening Financial Tools

If you're solely relying on a Line of Credit (LOC), it might be time to diversify. An equipment line, with its fixed interest rate, can be a more stable alternative to the variable rates of an LOC. Many lenders allow the company to pay for equipment throughout the year, using the LOC, and then grouping the equipment purchases into one primary equipment note to be termed out over 5 to 7 years.

6. Navigating Personal Guarantees

While the thought of personal guarantees might keep you up at night, they're often a standard part of the deal. However, if the opportunity arises, endeavor to eliminate them, reinforcing your business's financial autonomy. This can be an especially important step for a growing business who is looking to expand its ownership.

7. Banking on Relationships

Your relationship with your banker isn't just transactional — it's strategic. Nurturing this relationship during prosperous times can be invaluable when things get rocky. Consider drawing down on your LOC periodically, even if it's not a necessity. It's akin to flexing a muscle; it keeps the channel active and healthy.

Are you planning to or are you in the process of transitioning ownership of your company? Introduce the next generation of leaders to your banker and other key financial contacts. Familiarity can pave the way for smoother transitions.

In the dynamic world of business, your debt agreements are a roadmap to your financial journey. By understanding and leveraging them — and conducting regular debt agreement reviews — you're not only ensuring smoother financial operations but also laying the foundation for sustained growth and success.

Delap Can Help

Are you uncertain about the intricacies of your company's debt agreements or how they could affect your future strategies? Would you like assistance reviewing your debt agreements? At Delap, our business advisors specialize in reviewing and advising on debt agreements for businesses like yours. Together, we can optimize your financial strategy for sustainability and growth.

Reach out to us today, and let's ensure your business remains on the path to success.

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