Hello,

Quick Scenario:

1. Cash basis client providing monthly unaudited modified cash basis financial statements.
2. Quarterly Reviewed modified cash basis of accounts financial statements are provided. Statements are review by an external public accounting firm.
3. Client will not, or is not, required to submit accrual financial statements. This is not an option.
4. Reconciliation of Operating Expenses per the Financial Statements to cash disbursements per the Bank Statement yield a variance of less than 2% (acceptable).
5. Prior fiscal periods have resulted in losses per the Financial Statements. Current fiscal period is positive.
6. Periodic reviews of the client have not yielded any material negative issues that warrant action.

I am looking for some cash-basis or modified cash-basis loan covenants. While the client's current position does not warrant immediate concern, it would be beneficial to have modified loan covenants that are more tailored to this form of accounting. Accrual basis covenants, currently in place, are causing confusion and disagreement over calculation/interpretation. Can anyone help, or point me in a specific direction?

Thanks!

Jtown:

I don’t think that there is a lot of difference between the actual verbiage of the financial loan covenants for a customer that uses cash or modified cash than from one that uses accrual financing. If anything the actual ratios could be adjusted down or up to be tailored for your customer.

I think that the first thing that needs to be looked at is what it is that is being financed, and require submission of financial information and financial covenants that you can live with. For example, in the last few years I have seen a push away from open LOCs and towards ABL financing. By making advances subject to a borrowing base calculation and tying availability to actual transactions a lot of the risk associated with the financial condition and performance of the borrower is mitigated. If business slows down so does your amount outstanding as less receivables are within formula.

If this customer has always provided cash basis statements, there must have been a baseline of performance and condition established at the beginning that was found to be sufficient to merit the credit. In this case, I would think that subsequent financial covenants would build up on that initial writeup.

For example, the initial writeup might have required a certain level of tangible net worth, liquidity, and debt service coverage. The crux of the matter is looking at how those were originally calculated and incorporating those formulas into the actual covenants. It is good form to include the actual formula in the actual covenant so that there are no interpretation problems later on.

I am also confused about your mention of ” Accrual basis covenants, currently in place,….”. If the customer is keeping the books on a cash basis there is no reason to request them to meet a certain level of liquidity or asset turnover that would require the inclusion of receivables or payables into the equation. I think that the best way to take a look at their conversion would be to ask for an aging of accounts receivable. They must have some way of tracking receivables if they sell on terms.

Without the actual covenants that are causing you trouble to look over, I would have to repeat that the best way to approach this is to look back at the numbers presented in the original writeup, and build from how they were originally computed.

Also if you work for a regulated lender {bank or S&L}, keep in mind that the more complicated or frequent the covenants, the more work for whomever is in charge of portfolio management.

Good luck

Thanks for the comments. This account is inherited. It is my belief they may have provided accrual financial statements at time of funding, but are not required to going forward. I cannot determine that assumption based on limited information. If this is true, someone erred.

Typical ratios are not possible to an accurate basis as not all balances are accounted for on a Balance Sheet. Certain accounts like A/P, A/R, and Accrued Expenses, are not reported. It is difficult to accurately quantify these balances without detailed anlaysis. Therefore, debt ratios can be skewed based on limited reported information.

We will keep searching for closure to this item ASAP given the professionalism and performance of this client to date. Thanks again.