The last newsletter on global credit provisions triggered some discussion about rules of thumb that bankers use, or used to use, to estimate and manage their problem loans. All of this was timely, as I had the good fortune to teach a three-day course in late August in Kenya to African bankers from Kenya, Malawi and Uganda on non-performing loan (NPL) workouts and approaches to debt management.
This newsletter does not duplicate what I just taught. Rather, it pulls some lessons from the banking side to offer advice to small business on how to develop needed financial accounting and reporting systems to demonstrate creditworthiness. Hence, the title of this newsletter edition, which is a pretentious take-off on Shakespeare and implies that the difference between accessing credit or being rejected may hinge on attention to the kind of detail that creditors use in their models and risk evaluation practices.
ABCs of Financial Accounting and Reporting Systems
As I write in my book Right-Sizing Strategic Financial Management for Small Business, understanding pressures faced by highly regulated financial institutions is important for a business to be able to access credit. While microenterprises may not be in a position to manage these challenges, small and mid-sized businesses often can. Doing so may be the difference between getting a loan and not getting a loan and/or benefitting from more favorable terms.
A starting point is for small business to try to structure their accounting and financial reporting systems in a way that meets internal and external needs by providing useful information:
- to management, for decision-making on resource allocation, product development, market entry and expansion, etc.;
- for external audiences like bankers, insurers and investors, who may be interested in offering financing in the form of credit, guarantees, hedges, and equity.
For the latter, this invites a discussion of loan covenants and how they work. Once understood, small business can work backward from various scenarios (loan amount, term, interest rate) and see how they fit into general credit risk assessment models. In effect, what small business would be doing is reverse engineering (to the extent possible) how financial institutions assess credit risk for a specific loan or borrower.
Of course, banks and other large financial institutions have models and systems to handle this at scale and on a dynamic basis subject to changing circumstances. What small business can do is model this at the high end, import internal financial information from company records, process the information based on covenants and other performance indicators, and generate results that can help the business determine how big a loan to request and for what time period. This would almost be like a mortgage calculator that households often use to determine how large a loan to request for a home purchase.
Overview of Loan Covenants
- Loan covenants and financial ratio monitoring are central tools used by banks to manage credit risk and identify deteriorating borrowers before loans become non-performing.
- Loan covenants are contractual conditions requiring borrowers to maintain specified financial or operational standards. They provide banks with rights to renegotiate, restructure, intensify monitoring, or accelerate repayment when borrowers breach agreed thresholds.
- Banks use covenants to impose financial discipline, limit excessive risk-taking, and provide early warning signals of credit stress. Covenants reduce moral hazard and discourage excessive leverage or risky borrower behavior.
- Financial ratios help banks assess liquidity, profitability, leverage, cash flow adequacy, operational efficiency, and debt servicing capacity. Once a loan is approved and disbursed, covenants help banks identify credit deterioration before payment defaults occur.
- Modern banking systems increasingly integrate covenant monitoring with probability of default (PD) models, IFRS 9 expected credit loss frameworks, stress testing, and watch list systems. Banks use covenant breaches as important triggers for watch list placement and heightened supervision.
Most Commonly Used Loan Covenants
The most commonly used covenants in loan agreements include:
- Debt Service Coverage Ratio (DSCR) covenants requiring minimum cash flow coverage of debt obligations;
- Leverage covenants limiting total debt relative to equity or EBITDA;
- Interest Coverage Ratio covenants requiring minimum earnings relative to interest expense;
- Liquidity covenants requiring minimum current ratio or cash balances;
- Loan-to-Value (LTV) covenants limiting borrowing relative to collateral value;
- Capital expenditure restrictions to limit excessive investment or acquisitions;
- Dividend restrictions preventing excessive shareholder payouts during periods of stress;
- Restrictions on additional borrowing and related-party transactions;
- Reporting covenants requiring periodic financial statements, audits, and operational reporting.
We can see from the graphic below some examples of the average ratios that apply. Small business can structure their planning and decision-making around performance that outperforms typical averages to enhance prospects for accessing external finance.
Of course, there are caveats. Each market, industry and sector has its norms or averages. Market conditions change, which will impact small business performance. Likewise, market and regulatory conditions change for lenders, which will influence resources they can make available and how they plan to structure their portfolios in the near term. However, the information provides a starting point for small business in developing comprehensive and useful financial accounting and reporting systems that address their internal and external needs.
The Bottom Line
The above provides basic guidance to small business on how to get started with some of the financial accounting and reporting information they need for decision-making and for external financing requests. Basic lessons for small business actions include:
- Fine-tune internal and tax statements and link with a more comprehensive FAS so that information can then align with better management decision-making and strategic planning.
- Structure and format FAS to align with external creditor/investor systems to enable better presentation of financial information when seeking financing, and to facilitate favorable decision-making by lenders and investors receiving requests for loans and investments.
- Establish a comprehensive list of relevant ratios by activity and monitor these on a continuous basis in relation to strategic or business plan targets.
- Approach external capital providers when ready for external finance. If rejected, seek answers about why the lending or investment request was refused.
- Ensure all information and systems have adequate cyber protection.
- Map out guidelines on backtesting to determine how valid the assumptions and premises are if any of the FAS or financial data used in strategic/business planning is subject to sensitivity or scenario analysis or models. Make adjustments as necessary once backtesting or ex-post validation has been done.
- Ensure the business has the personnel needed to manage the information and process. Outside advisors (like CPAs/chartered accountants) can be used to compensate for gaps and/or provide an “effective challenge” or second opinion.
- Commit to regular internal reporting and monitoring on a systematic and regular basis so that the business can be timely with decision-making about any adjustments that may be required by changes in the economy, the market, or internal company developments.
Final Note
Please feel free to suggest topics of interest that you and colleagues would like this newsletter to cover. (You can reach me on LinkedIn (https://www.linkedin.com/in/mike-borish-90a4321) or on my website: borish.com
Sharing with your colleagues and posting these can help stimulate the dialogue.
I’ll be back October 2 with my next one. Until then, have a good month.
#creditrisk #commerciallending #smallbusinessfinance #loancovenants