Q: What is the best way to build a covenant around cash flow since borrowers don't prepare a UCA cash flow statement?
A: We suggest you use two covenants – a Financing Gap Ratio and a Business Profit Coverage Ratio – to assure that, if honored, the borrower will generate sufficient operating cash flow to service its interest bearing debt. If it honors both covenants and is still unable to meet debt service from operating cash flow, it means that profitable sales growth explains the deficit in operating cash flow and not any deterioration in balance sheet management or lack of sufficient profit remaining in the business to service debt.
The attached Credit Refresher on Covenants and the First Way Out explains the Financing Gap Ratio and Business Profit Coverage Ratio in detail. As you’ll note, both are simple concepts that are easy to understand. Briefly, the Financing Gap Ratio is the difference between operating assets, such as receivables, inventory, and payables and operating liabilities, such as payables and accrued expenses, divided by sales. If the ratio increases from one year to the next, it means that the Financing Gap has increased, which triggers a cash outflow from poor or deteriorating balance sheet management. And vice versa, if the Financing Gap Ratio decreases, it means that the company has reduced its Financing Gap by, for example, tightening control of accounts receivable days – a cash inflow.
Business Profit is Net Profit reduced by the sum of distributions and loans to owners or partners. The Business Profit Coverage Ratio is Business Profit plus interest expense divided by interest expenses and scheduled long-term debt repayment. So long as the Business Profit Coverage Ratio is greater than 1.00, it means that the borrower has sufficient profit (not cash flow) remaining in the business to properly service its debt.
Therefore, as the Credit Refresher points out, if a borrower honors both last year’s Financing Gap Ratio and a Business Profit Coverage Ratio of 1.00 or greater, it will generate sufficient operating cash flow to service its debt. The borrower has no need to understand UCA cash flow in order to achieve sufficient operating cash flow so long as it honors both covenants. As we noted above, sales growth could still cause insufficient operating cash flow if these two covenants were honored, but most lenders readily welcome providing financing to support profitable sales growth. An operating cash flow deficit in such circumstances is a positive event and a financing opportunity.
As a point of information, Shockproof! Training will conduct “Covenant Use in Controlling Cash Outflows” on August 10, 2022. This webinar addresses the use and application of the Financing Gap Ratio and the Business Profit Coverage Ratio in detail.
Q2:How do we best determine future cash flow if we don't receive projections?
A: The most practical approach is to use the last actual values for all the Business Drivers – sales growth, gross margin, SG&A%, A/R days, Inventory Days, A/P days, the Owner Payout Rate, and Fixed Asset Spending as % of Sales – as the default set of projection variables. If there is a compelling reason to change any of the last actual values based on your knowledge of the client and its marketplace, make the necessary adjustments and then run projections forward for one year.
This will provide a very rough estimate of cash flow from operations and fixed asset spending. You could then discuss your projections with the client and determine where and how its view of next year differs from the rough estimate you provided.
Course overview: Description and Analysis in the Credit Write-Up