“Prepare for the process – and bolster your loan chances — by developing a good understanding of key elements used by lenders to assess your borrowing position,” recommend K·Coe Isom advisors.
In particular, they advise careful review of loan covenants and loan consolidations in an effort to improve communication, strengthen borrowing position, and ease the negotiation process to secure a renewal:
- Know your loan covenants
Loan covenants require you to meet certain conditions as part of your borrowing agreement. Among them are possible restrictions on capital expenditures, or fixed-asset investments, placed on your business during the life of your loan. Covenants also typically stipulate working capital and equity levels, limits on distributions, current ratio measures, minimum debt service coverage and financial statement requirements.
Loan covenants are an important aspect of the lending relationship. Unfortunately, many business owners dismiss their importance. They may ignore covenant conditions or unknowingly violate them. Either way, that can create a serious problem in your lending relationship – something you don’t want during these tough times. Loan covenant violations can lead to an interest-rate increase of possibly 1-2 percent. A covenant breach can also activate a penalty interest clause, requiring additional monthly interest until the loan is back in compliance. At worst, a covenant violation can result in the lender calling the loan.
- Negotiate loan covenants, including working capital
Loan covenants can be negotiated with your lender. For example, you may have a sound business reason, such as a tax-planning purpose, to make an investment in your operation that exceeds the lender’s original restriction amount. If you ignore that covenant amount and proceed with the expenditure, you would violate that loan covenant. If, however, you explain your investment reason to your banker during the loan renewal process, you might negotiate a more favorable covenant for a higher investment allowance. Instead of an annual dollar limit on a capital expenditure, you might be able to spread an average annual amount over a three-year period.
Another covenant that can be negotiated is your working capital. This is the dollar-amount difference between current assets and current liabilities. Working capital can be negotiated in a loan covenant to provide a more consistent measure of liquidity available than the current ratio. Many times, the related party balances are modified in the working capital calculation and will favor the borrower.
Lenders will sometimes even drop certain loan covenants. For example, a typical loan covenant will address debt service coverage. This ratio compares earnings before income taxes, depreciation and amortization (EBITDA) to interest and long-term debt payments due within 12 months. Loan covenants often require this ratio to remain at a minimum of 1.25. But there is some variability in how the ratio is calculated and which debt payments are included. Make sure this covenant is as clear as possible to assure that everyone understands how it is to be measured.
This is a tough covenant for many agricultural businesses because of income variability. Since some banks will adjust interest rates depending on the strength of this ratio, it’s especially important to negotiate for favorable language and perhaps even include a sample calculation. Some K·Coe Isom clients have negotiated a lower ratio or even the removal of this covenant altogether.
- Monitor consolidated loans and potential for unintended consequences
Another area to keep an eye on are consolidated loans and their impact on farm program participation and partner liability.
With increasing credit difficulties and regulatory requirements, many lenders have moved toward more consolidated loan packages. These combine smaller loans into one large one. These loans are cross-collateralized across multiple related entities and associated with personal guarantees. They’re an effective way for banks to manage large, complex credits and the regulatory attention they attract.
But loan consolidations can create unintended consequences. Among them is their effect on government farm program participation. Such loans may violate capital contribution requirements for farm operations and may negatively affect farm program payments. The good news is that there are ways to properly structure a consolidated loan for farm program compliance.
Loan consolidation can bring an even greater concern than its farm program impact. An entity’s general partners who are involved in a loan consolidation could unknowingly become liable for the entire loan. For example, a general partner in a farming entity could have been liable for a $5 million line of credit for years with full knowledge. As part of a debt reorganization and consolidation, however, that partner could become fully but unknowingly liable for $15 million or more if the partnership loan is consolidated with the operating and land loans of other entities the partner may not own. The larger the entities, and the more consolidated their loan instruments, the more complex the risk for all parties – and the greater need to disclose and educate borrowers on their exposure.
K·Coe Isom recommends learning more about these borrowing conditions and how they affect your business. Further, work with a CPA firm to make sure your operation is in the strongest position it can be as you begin the process of renewing your loan.
Contact a K·Coe Isom advisor for guidance to assess and improve upon your borrowing position.
[Originally published in the High Plains Journal ‘Managing for Success’ column by K·Coe Isom, October 2018.]