Cr-r-r-unch: Time to put a financing contingency plan in place

The Era of Global Financial Instability. Mortgage Meltdown Contagion. Central Banks Pumping Billions into World Financial System. Despite the wringing of hands and gnashing of teeth, the reality is certainly not as dire as the headlines suggest. The Canadian and global capital markets still have plenty of cash on hand — although it may not be dispensed quite as liberally as it has been in the past five years.

By Clark McKeown, CA, CIRP, CFE

When it comes time to renew loans, increasingly, companies are discovering that lenders are offering fewer dollars at a higher cost and with more covenants. The high-flying deals of investment banks have dropped to less heady levels. The chartered banks are returning to more conservative lending practices and the availability of funds is tightening. 

While the banks still offer competitive interest rates, they are more hesitant today to lend to certain industry sectors — such as lumber, auto, agriculture and tourism — that are sensitive to fluctuations in the dollar, commodity swings and offshore competition. As well, the type of financing they offer may not be the most appropriate for a company’s particular needs.

Not having the right financing arrangements in place for a business can make borrowing unnecessarily expensive. It might restrict access to working capital or funds for growth or unexpected events. To ensure that a business can access the funds it needs, when it needs them, at an affordable price, a company should have a comprehensive financing strategy. Here are the principal components.

Anticipate financing needs

Although a company may be satisfied with its current financing arrangements, it shouldn’t assume that when the agreement comes up for renewal it will be able to obtain the same amount of funds at the same rate. Accessing capital is likely to be more challenging in the months and years to come and, if a company runs out of time, it may have to source alternative financing at a significantly higher rate of interest.

Establishing a new relationship with a lender can take up to six months, so a company shouldn’t wait until existing financing agreements approach the expiry date. Financing should be a continuing discussion among the members of the management team.

Prepare a long-term budget

Look ahead at least one to two years when the business may need to acquire additional funds or to renew financing agreements. Prepare a detailed budget analyzing capital requirements and evaluate and quantify borrowings to meet those needs.

Revisit the company’s capital structure and assess whether the company has the best form of financing to meet its requirements. Does short-term financing correspond with current liabilities and working capital needs? Does long-term debt match long-term assets?

The management team should anticipate slow cash periods, budget for the organization’s longer term cash needs, plan for capital improvements, and establish appropriate strategies. If the team needs guidance during this process, a corporate finance advisor can be a valuable resource to provide knowledgeable support.

Explore options

While a company may have an established relationship with a traditional lender, over the past decade many new lenders have emerged in the marketplace that may better suit a company’s needs. To protect a company from the risk of a future cash crisis and to find the right fit with a lender, it is recommended that a company identify prospective sources of additional financing, such as the following, and determine what they may be able to offer.

1. Senior secured debt. Typically offered by Schedule A banks, includes cash flow loans based on a multiple of EBITDA (earnings before interest, taxes, depreciation and amortization), asset-based loans, secured-term loans and secured operating lines of credit. These lenders require predictable, positive cash flow and solid security backed by strict compliance with covenants. They also offer the least expensive loans, with interest rates typically ranging from 7 to 10 per cent.

2. Asset-based loans. These loans, available to companies with saleable assets, can be used for working capital, acquisitions, growth capital and letters of credit. They are typically structured as a revolving line of credit or term debt with terms of two to five years. An ABL lender will provide capital based on a certain percentage of the value of the asset. This could be 70-90 per cent of accounts receivable, 65-80 per cent for equipment or 50-60 per cent for inventory. ABLs generally charge interest of 8-15 per cent and, since they require frequent audits, also have additional fees. However, they can also advance more capital than senior secured lenders and can be more flexible with companies in transition or with cyclical needs.

3. Second-secured debt is offered by a variety of lenders, including groups within traditional lending institutions. The debt is generally structured as a junior lien behind the senior lender on all of a borrower’s assets. Where hard assets can’t support the amount of the second lien, the lender may advance funds based on enterprise value that also reflects the equity in the business. In essence, second secured lenders blend assets and cash flow to determine a loan amount. Generally, the price a company will pay for this capital is 10-15 per cent, or prime plus 600-900 basis points, on an annualized basis. There are also closing costs of about 2-3 per cent.

4. Mezzanine financing is typically based on cash flow and is used for acquisitions, leveraged buyouts, new product lines, or new distribution channels or plant expansion. Mezzanine financing usually includes subordinated convertible debt and yield based on preferred shares. These lenders charge interest of 15-20 per cent or more, depending upon the market availability of capital.  Warrants or options to buy common stock or equity are sometimes included in the deal.

5. Private equity investors are usually interested in growth companies with a positive history. Along with injecting capital, they take some ownership of the business and often want some control. This type of investment is used to finance current or capital assets, plant expansion, introduction of product lines, research and development, acquisitions, restructuring or management and leveraged buyouts. Sources of private equity include angels, venture capital firms, institutional investors, and others. These investors generally strive for target returns of at least 20 per cent and charge financing fees of 5 per cent or more.

6. Sale-leaseback financing has become an increasingly popular form of reasonably-priced debt that enables business owners to raise capital without weighing down the balance sheet with long-term debt. These transactions may involve a business selling equipment to a leasing company, which takes ownership of the equipment and then leases it back to the business. In other cases, a company might sell property it currently occupies to an investor at a fair market value, which in turn provides the seller with a long-term lease of 10 to 25 years.

In order to minimize the cost of capital, it’s important to determine what sources and forms of capital are best suited to a company’s industry, requirements and goals. A corporate finance advisor can provide objective expertise with this assessment and also assist with developing a valuation or business plan, facilitate introductions to the most appropriate prospects and assist with negotiations.

Make a good impression

While each lender has its own lending standards, the following are common criteria most consider when evaluating borrowers.

Character — the reliability of the borrower — whether the company has met historical projections, there is positive feedback from investors and the business has a strong board with reasonable independence. 

Capital — how well the business is capitalized, how much the owner or management team has invested in the business and how much they have withdrawn. 

Capacity — the amount of debt the business can support and its ability to repay the loan. Lenders might check out the company’s borrowing track record and review debt-to-equity ratio and cash flow projections.  They will be cautious if a company’s performance fluctuates significantly from one year to another.

Conditions — the borrower’s current situation as well as the current economic condition and trends. Lenders want to know whether the business may be sensitive to an economic downturn, and whether the enterprise demonstrates an ability to effectively manage productivity, expenses and competition.

Collateral — the secondary sources of repayment the company has available in terms of unsecured collateral such as real estate, equipment, vehicles and net worth of the principals.

Before setting up formal presentations with lenders, request a preliminary meeting to ask for input and advice. When a company is in the stage of talking about a loan, the management team should arrive prepared with a detailed business/financial plan that includes at a minimum, the following:

• Five years of historical financial statements
• Projected financial statements for three years
• Well-supported assumptions for projections
• Current aging of accounts receivable and payable
• Recent inventory listing
• Summary of fixed assets and any recent valuations on buildings or equipment
• Summary of major contracts
• Schedule of debts and loan balances, payment and maturity schedules
• List of other available collateral

Lenders will expect to see an accurate portrayal of the business and its plans. Avoid unrealistic forecasts and don’t mask financial difficulties. Lenders want to know what challenges the company faces and how adeptly the management team deals with them.

When negotiating a loan, be cautious with covenants — ensure they allow sufficient flexibility in the event the business experiences periods of potential negative growth. If the company falls offside with covenants, it can be extremely challenging to access new capital.

Monitor EBITDA

Lenders often use EBIDTA to measure a company’s ability to service debt and to determine the amount they are willing to lend. If a company can demonstrate stable and growing EBITDA, it will have a better chance of securing a higher advance rate. Alternatively, if EBITDA is declining or fluctuating, the company may be considered a higher risk and lenders may respond with a lower advance rate and higher pricing.

Manage the balance sheet

Since lenders look to a company’s balance sheet to back their security, efforts to strengthen the balance sheet in the following key areas are likely to payoff in enhanced financing. 

Ability to fund short-term debt:  The current ratio (current assets/current liabilities) measures the ability of a business to meet it short-term obligations. If this ratio drops below 1:0, lenders will become concerned with the company’s ability to meet its current needs. The current ratio is also a common test for covenants, thus improving this ratio before approaching a lender is likely to generate better financing results.

Efficiency: The quality and turnover of inventory, accounts receivable and accounts payable are important indicators for lenders. They will be on the alert for receivables and payables past 90 days and slow moving and obsolescent inventory — thus it’s helpful to clean up problem accounts and liquidate obsolete inventory before approaching them. 

Leverage: The debt-to-equity ratio (total debt/net worth) demonstrates how a company is using debt and the extent to which it is leveraged. When profits dip, companies that are too debt reliant can quickly fall into trouble.  Anticipate slow periods by building detailed projections that look at not only “best case” but also “worst case” scenarios to ensure the company is prepared for future bumps in the road and can meet its debt financing needs. 

Conduct regular check-ups

Lenders want to know that a company is proactive and adaptable to changing conditions. 

A company can make its enterprise a more attractive financing prospect by conducting check-ups of the business on a regular basis to identify ways to enhance profitability and prepare for change. Look for opportunities, for example, to reduce overheads, balance negative cycles by expanding into compatible product offerings, create a more variable cost structure, and outsourcing for certain operations such as manufacturing and/or administration. Also, assess the profitability and vulnerability of customer and supplier relationships and look for ways to strengthen them.

After all, “crunch time” in the markets is really just another part of the business cycle for which companies should plan. And it’s a good reminder that a considered approach to developing a financing strategy will stand any company in good stead — no matter what the prevailing economic conditions.

Clark McKeown, CA, CIRP, CFE, (cmckeown@bdo.ca) is a partner with BDO Dunwoody LLP and a senior vice-president with BDO Dunwoody Limited. Clark oversees the transaction advisory services group in the Toronto region, which focuses on mergers and acquisitions and corporate finance services for solvent and insolvent companies.

Top