Happy Friday! Enjoy some banking humor. If only it was so easy to balance your books!
Have you ever had that brief experience where you started driving in the dark without your headlights on? It was dark and you couldn't see where you're going. Running your business without timely and accurate financial statements is just as risky as driving with your headlights off.
I was having lunch recently with a CPA that I share clients with. He and I were discussing the fact that some clients don't see the importance of providing financial statements that are timely and accurate. Here's why it's important:
1) Running an income statement and balance sheet on a quarterly basis doesn't give you the granularity you need. You need to know month to month what your cash requirements are going to be (receipts - disbursements) so you can order inventory or meet payroll. That's the reason for timeliness.
2) Accuracy is needed to tell you the real facts about your business. If financial reports are inaccurate, it could cause you to make incorrect decisions about moving the business forward. Financial reports are not intended to keep you in the dark.
3) Having timely, accurate reports allows you to make comparisons against your budget, same month last year or same period year to date against last year. Are there any trends (positive or negative) that are developing? Can you expand or are your financials giving you a warning that you may need to layoff people or contract the business?
4) Inaccurate reports lead to trouble. If accounts receivable or accounts payable are either overstated or understated, it could lead to a cash crunch or you could be missing opportunities to take purchasing discounts which would improve your profit margin.
Providing financial statements that are timely and accurate is a process. It takes time to build the process and it gets more difficult the larger the business gets. But, it's a process worth implementing for all the reasons I've mentioned.
How are you doing in this area? Are there ways I can help you improve?
You’ve got a loan request. How do you decide if you pursue traditional bank financing or an SBA (Small Business Administration) loan through your bank?
We’ve closed several SBA loans this year. One was a debt consolidation loan with working capital, one was a new location for an existing business and one was a commercial mortgage refinance.
Remember that the credit standards that a bank requires are no different in an SBA loan and a traditional bank loan. You still have to have the 5C’s covered. (character, cash flow, credit, collateral and conditions). The biggest difference to an SBA loan versus traditional bank financing is the term and in one case the equity requirement. I’ll talk more about that in a moment.
Here’s the pros and cons of SBA financing:
- An SBA loan has a fee of 2.75 to 3.5% of the SBA guaranteed amount charged by the bank to pay the SBA for their guarantee. For a $1 million SBA guaranteed portion (typically 75% of the loan amount), that can be $27,000-$35,000. SBA guarantees up to -90% of the loan amount under import/export programs.
- The SBA 7a program offers up to 10 year terms on any loan that includes working capital. In some cases, that can have a debt consolidation component, a business acquisition, or a line of credit.
- The SBA 7a program when financing real estate can go up to a 25 year amortization.
- In the case of the purchase of an owner occupied building, the SBA 504 program offers 90% financing. The owner is only required to put 10% down.
The longer terms of the SBA programs make the cash flow easier to qualify for because the payments are going to be lower than traditional bank financing. In the case of the 504 program, if you’re buying a building that costs $1 million, the normal equity requirement could be $200-250,000. With the SBA 504 program, it’s only $100,000.
Remember the credit requirements are going to be the same for the most part. The big differences are the longer terms. Pursue traditional bank financing when you can handle the higher payments and avoid paying the guaranty fee. When you don’t have enough of a down payment for that building purchase, consider the SBA 504 program.
How have you used SBA financing in your business? Please share your experience in the comments section below.
How do you know it's time to restructure your debt? When your cash flow has changed and your payments haven't, it may be time to restructure.
I'm working with several professional practices that are looking to restructure their debt. All the practices are in growth mode and/or need additional cash for that growth. Growth ALWAYS requires cash because the investment you make in the form of increased people and salaries or equipment purchases occurs before the cash from increased collections comes in. In this case, the investment doesn't pay for itself. You will have a decrease in profit which decreases your ability to pay back loans. During the time you're working "on" your business conduct a debt review.
1) Calculate your cash flow coverage ratio based on your last year's financial statement or tax return. Banks are comfortable lending in to a situation where cash flow is 125% or greater of loan payments. Be sure you understand how your bank calculates cash flow (before or after distributions). I had one client that tripped his covenant over distributions.
2) If you don't have 1.25 coverage, can you consolidate some debts and extend the amortization so that your payments are lower? For one client, we were able to refinance their debts, provide $165,000 in working capital and extend the amortization. They needed the working capital for additional marketing and were able to do this and keep their payments about the same.
3) Sometimes restructuring your debt can accomplish a rate reduction and lower your payments. At that point, you have the option of keeping the payment the same and decrease the amortization (pay it back faster) or lower the payment and give yourself room to take on additional debt.
If you're going to restructure your debt, have a goal in mind. The most common ones are:
- Lower rate to acheive a lower payment
- Lower rate to pay the loan off faster
- Consolidate existing loans and lower your payment to take on additional debt for working capital or equipment purchases
Have your restructured your debt lately? Share your experience in the comments section below.
How much time do you spend with your balance sheet? Do you look at changes in liquidity and leverage from year to year? Are you monitoring changes in your collection period on accounts receivable and inventory turns?
In giving a presentation to a group of business owners yesterday, I was surprised at how little time they spent with their balance sheet compared to how much a bank spends with it. Banks measure trends in profitability, activity, leverage and liquidity (I call this PALL). Three of the four items are balance sheet measurements. Only 1 is an income statement.
I have a client that I worked with recently in the fast food business. He has several locations and is considering expanding. His profitability has been negative for the past two years but improving. He’s doing a good job of turning his inventory. The problem for him was his liquidity was below normal. He showed a book overdraft on his 2013 tax return (a red flag for the bank) and was only 3% of assets in 2012. A normal percentage is about 12%. Further his leverage was within industry standards if you include intangible assets (goodwill for the store purchases). However, since a bank can’t lend against intangible assets, the bank typically subtracts intangibles in underwriting leaving a leverage ratio of 3.3 to 1. This is about double of what industry standard is.
Given the lack of profitability combined with a book overdraft and high leverage compared to the industry standard, I had the uncomfortable circumstance of telling this client that he’s not bankable for the expansion plans he has at this time.
To be bank ready means that you’re not only profitable, but you have spent time with your balance sheet checking any changes in liquidity, leverage and asset quality (stale receivables or inventory). Only one measurement pertains to the income statement (profitability). Three pertain to the balance sheet. So, spend a little more time there.
How do you manage your balance sheet? Please comment and share your best practices.
Have you ever had the experience where you were trying to hit a deadline? Everything seemed to be falling into place, when out of nowhere something significant came up that delayed the entire process. You missed your deadline and paid the price for it.
This is actually happening to one of my clients right now. He has a very successful business. We have a term sheet from the lender with a favorable rate and terms. The lender has all items required except for “interim financials statements."
I have another client who is having significant operating issues and is in the Special Assets Department of the bank. His commitment letter states that he is to provide financial statements monthly to the bank. He hasn’t been able to deliver on that requirement due to the reduction in staff and the complexity of his business. However, he is not helping his case with his banker by continued delays in reporting.
Whether you know it or not, your bank(er) is forming an opinion about your firm on how timely you are in providing financial statements to the bank and whether they are accurate and complete. Bankers are looking for a balance of sales, operations and financial management in determining how bankable your company is. Financial reporting falls under the financial management piece. It’s a subjective call when your banker starts feeling uncomfortable about your loan based on your financial statements. However, when you’re slow that’s a heads up to your banker that something is wrong.
Here’s a few things to help you be sure your financial reporting is on track:
- Make sure you understand the legal and ethical standards and requirements for accounting and financial reporting.
- Drafting a financial report yourself takes a lot of accounting know how. Know when you ask for help from your CPA.
- Your financial reports have to comply with all current rules and regulations. The legal exposure of businesses has expanded and the amount of changes in account and financial reporting standards has increased.
Don’t let your lack of financial statements hold you back. I would encourage you to engage your CPA or hire someone to staff this important aspect of your business.
All the business owner clients I talk to are looking for any small sign of economic improvement. Unfortunately, after the reports from the first quarter, economic forecasters will leave us hanging with more lackluster results.
Severe winter weather and a record inventory build drove down GDP for the first quarter 2014 to a negative 1% annualized rate. To add insult to injury, corporate profits in the business sector fared even more poorly as pre-tax profits fell 9.8%/33.9% annualized. Records of corporate profits go back to 1947, and this quarter was seventh worst on record of the 268 quarters reported.
Even after weather and inventory problems, corporations took another hit in the form of increased taxes. At the beginning of 2014, several tax breaks on business depreciation expired and as a result taxes as a percentage of profits increased 3.5%. As a result of this increased tax, after tax profits fell 13.7% for the quarter/44.6% annualized. This was fourth largest decrease since 1947 and among the 1.5% worst.
So, what do we do? The economics is pretty simple, but the devil is always in the details. Tax revenue that flows out of the private sector and in to the public sector decreases productivity which decreases employment. For the economy to thrive, we need less money flowing in tax payments to the government. Those funds should be invested in jobs, technology and capital equipment. If we want a healthy economy, we should figure out a way to tax businesses less and give them the funds they need to invest and increase economic output and productivity.
Many banks have their lines of credit mature this time of year. Typically, 5 months after year end is plenty of time for your CPA to get your financial statements or tax returns prepared. You’re wondering if the bank will renew your line of credit or not. Before it matures, pull out your commitment letter or loan agreement and make sure you complied with all the loan covenants last year.
Loan covenant is one of those BankSpeak terms that bankers understand, but are confusing and sometimes forgotten by many business owners.
-A loan covenant is a mutual promise in writing made by the bank and the borrower to honor during the term of the loan.
-There are two types of loan covenants, financial and non-financial.
An example of a financial covenant is a cash flow covenant (cash flow/loan payments is greater than 1.25) or a leverage (debt to worth) covenant where you agree to keep less than $3 of debt for $1 of equity on your balance sheet at year end.
A non-financial covenant is no change in ownership or management without the bank’s consent.
If you break the covenant (intentionally or unintentionally) there’s another BankSpeak term called a loan covenant default. If you break your promise to the bank, they have the right to break their promise with you, meaning they stop lending and/or demand the balance.
If you have a covenant default, the bank can waive the default and provide you a loan covenant waiver letter. Just remember verbal agreements may not be binding. If the bank agrees to waive the covenant, get in writing. Your CPA may require it if your financial statements are reviewed or audited.
Before your bank comes calling take the time to review your line of credit agreement and be sure you’ve complied with any covenants in the fine print.
If something is too good to be true it usually is. Right? So, if you think you’re going to get a fixed rate from a bank and not pay anything for it, that would be too good to be true. Beware of the prepayment penalty.
I have a medical professional that is looking at options for buying a building. The lender is a big bank that is proposing two SBA options, the 7A and 504 programs. Big banks are willing to provide long term fixed rates because they have a lower cost of funds. Sometimes a bank can provide interest rate swaps through their capital markets department. An interest rate swap is where the bank and borrower swap cash flows (bank wants a floating rate and the borrower wants a fixed rate) and they use a third party to accomplish it. Even interest rate swaps have prepayment penalties. It's just referred to as a make whole provision.
The bank is offering a fixed rate of 5% for 20 years with the 504 and 4.75% for the same period thru the 7A program. Both are very attractive.
You have to know where to look in the commitment letter, but both options had a prepayment penalty of 2% in the first two years in option 1 and a three year prepayment penalty of 5% in year 1, 3% in year 2 and 1% in year 3 in option 2. The range of prepayment cost in both options is a low of $26,000 and a high of $120,000.
While it’s unlikely that interest rates would fall further, we have seen circumstances recently where interest rates moved against the commonly held view which triggered a significant number of refinances and in this case triggers the prepayment penalty.
If the fixed rate offer you have is attractive, go the extra mile to see if there’s a prepayment penalty in the fine print of the commitment letter. If you don’t see one, then ask your lender to be sure you don’t give them a good faith deposit only to be surprised when you sign loan documents.
Bankers are famous for using terms that business owners don’t understand. I know because I did it for years before I entered the consulting arena. Have you ever had that experience where your banker said something or put something in a term sheet or commitment letter that you didn’t understand? You didn’t want to appear stupid or maybe you just missed it. In any event, we’re going to talk about two small words that can have a big impact on the mortgage financing for your company building.
I have two clients I’m working with right now that are either buying or constructing a building for their professional practice. Both picked options that include an SBA guaranty or SBA bond (the 7a or 504 programs). In both letters there was a very attractive fixed interest rate, but the rate was subject to yield maintenance.
What is yield maintenance?
Simply put, yield maintenance is a kind of prepayment fee that borrowers pay to banks to reimburse them for the loss of interest resulting from the prepayment of a loan. When you and the bank enter in to the agreement, the bank assumes that you will continue the loan to the original maturity. If you have excess cash flow or rates drop dramatically, you will prepay the loan in part or in whole.
However, if you choose to pay the loan off, the yield maintenance kicks in and you pay a fee for loss of interest payments the bank suffers. Here’s how it works:
The formula for calculating yield maintenance is the present value of the remaining payments x interest rate –treasury rate.
For example, if present value of remaining payments is $600,000, the interest rate is 6% and the treasury rate is 3%, $600,000 x (6%-3%) 3% = $18,000
A lack of knowledge of the terms used in a bank term sheet or commitment letter can have significant consequences. If you don’t know what a term means seek the advice of an experience professional for help.