Knowing how bank covenants affect your trucking business is a critical consideration when choosing the right funding solution for your company. All businesses, no matter their size, will need to raise money at some point; this is particularly true in the trucking industry. A small business owner may have the ability to dip into his personal savings, or have resourceful friends that are able to lend the needed cash when required. Usually, however, truck company owners have to look to the banking system or alternative financial institutions for financing.
Covenants Protect the Interests of the Bank
Before a bank will lend you money it needs to be satisfied that your business is not in danger of becoming a credit risk and can sustain operations as it manages the debt payment. Normally, banks consider trucking businesses to be high risk, and therefore assign highly restrictive conditions to the loan. Every loan agreement made between a bank and a trucking company will carry some form of financial covenant to protect the interests of the Bank.
Covenants are a Set of Conditions in a Commercial Loan
A financial covenant is a set of conditions in a commercial loan that requires the borrower to fulfill certain conditions or which forbids certain actions. These conditions and forbiddances are either restrictive or protective in nature. Restrictive covenants will likely dictate limits, forcing the borrower not to exceed certain financial ratios or control certain activities such as limiting dividend payment options. On the other hand, protective covenants enforce certain actions that the borrower must comply with in order to safe guard the interests of the lender. These actions will define a strict payment schedule and will likely include obligations to maintain a minimum level of working capital, carrying specific insurances and more.
Understanding Covenants is Critically Important
At minimum, the bank will insist on analyzing your balance sheet and income statement on a regular basis. It could also involve more complex conditions such as requiring bank approval on all major financial decisions that you make. Understanding the terms of your loan agreement and the covenants that apply is critically important prior to committing your company’s future financial health to the control of your bank.
Covenants are Associated with Financial Benchmarks of your Business’ Performance
Loan covenants are generally associated with financial benchmarks of your business’ performance and are closely monitored by the bank to assure adherence. Covenants are tested monthly, quarterly, semiannually or annually, depending on the risk the lender associates with your business. It is important to note that at any time, the bank has to right to conduct spot checks and demand access to your financials.
Types of Benchmarks
Debt Service Coverage Ratio: This cash flow metric reflects a company’s ability to service its debt obligations. The ratio is a calculation of the company’s net cash flow during a specific period of time divided by the required debt payment during that same period. Banks are in the business practice of mitigating their own risk and therefore prefer a cushion when analyzing your company’s Debt Service Ratio. Normally a ratio of 1.2 or higher is required. This translates to your trucking company having $1.20 in net cash for every $1.00 of debt.
Debt-to-Equity Ratio: This benchmark (sometimes referred to as a Leverage Ratio) is a measure of your business’ total long term liabilities divided by common shareholder’s equity. If a company has long-term debt of $100,000 and shareholder's equity of $125,000, then the debt/equity ratio would be 100,000 divided by 125,000 = 0.80. It is important to realize that if the ratio is greater than 1, the majority of assets are financed through debt. If it is smaller than 1, assets are primarily financed through equity. Typically the data from the prior fiscal year is used in the calculation. Trucking is a highly capital intensive industry, and therefore tends to have relatively high debt-to-equity ratios. This higher ratio reflects an industry that typically depends on financing its growth with debt. However, it may also indicate a greater potential for financial distress if your company’s earnings do not exceed the cost of borrowed funds. Banks prefer to see a ratio ranging from 2.5:1 to 4.0:1 for trucking companies.
Working Capital: The measure of cash or liquid assets available for the day to day operation of your company. It is a calculation of current assets (cash reserves, accounts receivables and other assets that will convert to cash within 12 months) vs current liabilities (things that you will have to pay within 12 months). A minimum working capital covenant ensures that the borrower exercises prudent cash flow management. Banks require a ratio ranging between 1.2 and 2.0. If your working capital ratio is 1.2 this would mean that you will have $1.20 of available cash to pay for every $1.00 you have to pay out.
Borrowing Base Terms and Compliance
It is common for Banks to require a monthly certification process in order for your company to draw upon the line of credit, and alternatively to pay back principle payments. This is further control measures by the borrower to minimize the risk the Bank wants to assume. As an example; the Bank may establish a borrowing base formula that limits your company to draw up to a maximum of 80% of the business’ current Accounts Receivable. Generally, monthly monitoring of the Accounts Receivable is required to assess its aging status. Due to the aging of Accounts Receivable, trucking companies often find themselves with ineligible receivables which results in restricting access to funds. In this instance, the company now has a dilemma, needing to pay down the line of credit to meet the borrowing base without having the available funds to do so.
Thoroughly Understand the Implications Prior to Signing an Agreement
All aspects of a loan agreement with the Bank is intended to protect the interests of the lender. The language, terms, conditions and all covenants are designed to protect the Bank and minimize it’s risk. It is clearly understood that the Banks demand and wield the upper hand when your trucking business is in need of funding. It is, therefore highly recommended to request a copy of all loan documents well in advance, read and thoroughly understand the implications prior to signing an agreement.
It is important to consider all forms of funding solutions prior to signing a commercial loan agreement with a Bank. There are excellent alternative financial options available to meet your needs such as Invoice Factoring, Cash Advance on loads in transit, Asset Based Lending and more.
For more information about financial management and the benefits of invoice factoring, contact Accutrac Capital: 866 531-2615.