Managing loan covenants: what do you do ?

Home/Managing loan covenants: what do you do ?

Treso News

Managing loan covenants: what do you do ?

A new article based on our discussion between David Brault, Managing Partner of Objectif CASH, and Clément Letourneux, this time talking about managing loan covenants, another task the treasurer is responsible for.

Upholding loan covenants: vigilance is a must

Not meeting the objectives established when you sign onto the covenant in a loan contract can lead to early repayment or, at the very least, worse conditions on the loan. Financial institutions are particularly vigilant about their clients’ risk of insolvency, especially in the context of a leveraged buyout (LBO). To protect themselves, banks impose financial ratios on their clients in clauses called ‘covenants.’

However, in an already-difficult financial situation, not upholding those ratios can drag the company into a downward spiral. It can worsen the financing conditions for restructuring and, eventually, lead to bankruptcy.

So, you get the idea: tracking such covenants requires attention from both the company and its lenders.

The benefits of financial modelling

David Brault: What do you recommend then for handling this issue?

  • Modelling!

Clément Letourneux : ‘Upholding your covenants requires financial modelling and careful monitoring of financial indicators, which should be correlated with expected events, or unexpected events, that might influence performance so that you can correct the trajectory in due time.

To do this, you need to collect data from previous reporting periods from the various relevant departments. You must also be sure to work with fresh, up-to-date data.

Next, you must track your sales and balance sheet indicators with your DPO and DSO ratios so that you can evaluate different scenarios, taking into account the occurrence of various events. To do this, you use ‘what if’ scenarios, which allow you to identify potential breaking points. And thus anticipate what comes next!’

David Brault: Bankers often use a realistic worst-case scenario… How does it work within a company ?

  • Choose the right scenario

Clément Letourneux  : ‘Different departments can take different views. The director of a departments will be more focussed on budget so as to “comply” with set objectives, whereas the cash-flow management team will prefer to work with worst-case scenarios out of caution so that they can better communicate with banks… Indeed, banks are very informed about economic sectors or even the company itself; they might know more than we do! So, the treasurer would be well advised to provide reliable and up-to-date information. Banks like to see analysis and they are happy when a company has adopted good, reliable, recognised tools.’

What about waivers* ?

David Brault: And what happens if a covenant is breached?

Clément Letourneux : ‘If one of the covenants governing the company’s loan is at risk in the coming months, it is smart to warn the bank as soon as possible. Then, the company needs to ask for a waiver* and sign it before the closing of the reporting period. When a company negotiates before a problem arises, they have a better chance at achieving desirable results like adjusting a ratio that’s hard to maintain or replacing it with a new ratio. By modelling covenant requirements not just at three-month intervals, but also for the next year and future years, you can establish a controlled process: this helps you regain the bank’s trust if you’ve lost it because the bank needs to know the company’s future trajectory.

You need real cohesion between management auditing, the CFO, the CEO, and the cash-flow management team to analyse, understand, and explain internal shortcomings before going to discuss financing with banks. Only regular monthly analysis can give you a fine-tuned view of cash flow. That analysis should allow you to correct swings that occur throughout a month and act quickly, for example, by pushing back payments to suppliers.’

David Brault : So, to summarise, we should keep three words in mind to avoid breaching a covenant: VISIBILITY, REACTIVENESS, and FRESHNESS of data.

Are you interested in a financial modelling tool? Visit our page for Cash Modeling

Waiver* : In the event a covenant is breached, the borrower must write up a request for a waiver, which will expressly ask the bank to temporarily or permanently rescind a contract covenant. The request must be, at all costs, initiated by the borrower.

With the Cash Modeling solution, ACA offers fine-tuned management of contract covenants. Would you like to talk with us?  Leave your contact information