by Richard Clarke

Leverage rules. That said, the lender needs to be sure to look at the true aggregate leverage of the entire enterprise. Here’s a useful how-to for community banks and larger banks making EBITDA loans. Lenders who accommodate borrowers with marginal leverage and cash flow are actually providing pseudo equity at a conventional rate and will fall victim to losses.

According to an old Indian fable, six blind men each describe an elephant quite differently depending on which part of the animal he happens to be touching. Lenders who do not consider the true aggregate leverage or cash flow of the entire enterprise are just like the blind man holding the elephant’s tail while declaring that “the elephant is very like a rope.” It makes no sense to view the corporate leverage of just one affiliate or the cash flow of one piece of real estate without knowing the total leverage of the entire organization or the aggregate cash flow of the combined entities.

Why Leverage Is Important

It is much easier to assess the future borrowing potential of a business enterprise if the lender is fully aware of the debt burdens borne by various affiliates. This concept flies in the face of the dogmatic approach to narrow cash flow lending, prevalent in the early 1990s but now quite discredited. Smart lenders support smart entrepreneurs who preserve unused borrowing capacity for either emergencies or opportunistic transactions. This capacity is measured by both aggregate leverage in relation to industry standards and the level of unused formula availability under secured borrowing arrangements. Conversely, many borrowers “pig out” at the debt buffet and move from one liquidity crisis to another. The old adage “For want of a shoe nail, a kingdom was lost” certainly applies here. These businesses have a high failure rate, are the prime causes of bank loan losses, and do not show the desired characteristic of developing into the type of stable long-term relationships that banks desire. Therefore, it is most appropriate for modern bankers to return leverage analysis to its prior prominence. In doing so, however, it is vital to look at the true aggregate leverage of the entire enterprise. Remember that corporate resources as well as your own loan proceeds will always flow to the location of greatest need. Upstreaming and downstreaming covenants are helpful, but if an entrepreneur has a cash emergency in a related company, most likely there will be a covenant violation not usually detected by the lender for some time. On a positive note, more solvent affiliates can and will support your borrowing entity in time of need.

How Do We Measure AggregateLeverage?

• Procure full consolidating financials for all consolidated entities as well as for unconsolidated affiliates (and ensure that your UCC filings are appropriate).

• Mark all assets to realistic market values if there is reason to believe there is material overstatement.

• Eliminate goodwill, especially if your borrower overpaid for the assets in question and is now losing money as a result.

• Do not accept net asset values for significant investments. Separate out the asset and debt components. If your borrower has a partial ownership interest, simply apportion the amounts accordingly.

Remember that even nonrecourse debt has to be repaid for the equity component to have value, so it is highly appropriate not to exclude any debt forms. This simple exercise could have prevented bank funding of the Enron disaster.

• Include all known liabilities, both direct and contingent, whether shown on the financial statements or not. Bankers who take the time to read audit footnotes will find a wealth of information in this regard.

• Do not include subordinated debt as equity unless there are absolutely no rights of acceleration, full and complete subordination, and no ongoing debt service, and the subordinated debt otherwise exhibits all the true characteristics of equity, not debt.

• Question all transactions that appear to create equity other than by way of real cash contributions or earnings substantiated by audit confirmation and/or tax returns. Creative accounting remains a problem

in spite of recent events and publicity. Remember that the receipt of financials is the starting point of your analysis, and officer value adjustments are always appropriate.

• Now comes the easy part. Simply aggregate the realistic asset and liability totals and perform the traditional leverage calculation of dividing total assets by total liabilities.

RMA’s Annual Statement Studies provides excellent standards by which to assess your borrower’s leverage in comparison to others in the industry. (RMA numbers may not include all of the related entity debt or debt associated with balance sheet net investments.) Had Enron reported all debt relating to net investments or otherwise held by unconsolidated affiliates, the total result would have precluded any of the loan approvals that subsequently occurred.  If a privately held small business owns and operates its own production facilities, the real estate debt should be included in both the leverage calculation and the debt service analysis methodology discussed in the following section. Too many lenders continue to quote a borrower’s net worth in the abstract rather than viewing the correct amount in relation to known aggregate liabilities. Who needs a borrower with a $1million net worth and $600 million in assets, where a 1% drop in value would create a $5 million insolvency? The foregoing methodology not only establishes a better measure of true substance, but also offers the basis for one of the two most effective financial covenants, the leverage covenants.

Debt Service

Why is it important? Cash is the most liquid and fungible of all assets and regularly gets commingled in both large and small business entities. It is unwise to rely simply on a single debt-service covenant to protect the lender when, in fact, either multiple business entities or multiple properties are owned.  Just as the proceeds of additional borrowing can and will flow to the weakest link in the overall enterprise, internal cash flow also will be transferred, often to the detriment of the lender.  Therefore, it is essential for the lender both to understand the overall cash flow of any borrower and to apply covenants that trigger in the event of material problems in other affiliated nonborrowing companies. How do we measure aggregate cash flow? Just as in the preceding discussion on leverage, bank officers must not simply financial information provided by the borrower. Here, it is most important to “normalize” cash flow, especially in considering longer maturities.

Bank officers also should:

• Disregard specious arguments that frequent restructuring losses or other extraordinary charges are not cash flow elements.

• Not assume that extraordinary gains will continue.

• Not assume that all depreciation is true cash flow. There is usually a portion that must be reinvested as capital expenditures each year to preserve current earnings levels.

• Understand the debt-service requirements of other lenders providing either separate direct credit facilities or affiliated entities.

• Identify all other visible recurring cash requirements relating to all creditors, not just institutional lenders. Assume a reduction in future trade credit if there are either industry-or borrower-specific negatives. 

• Adjust real estate cash flows to reflect maturing abovemarket leases and current vacancy levels. Community bankers must look at earnings both before and after discretionary drawings to truly understand the cash-generation potential of their borrowers. It is clearly better to have a customer earning $10,000 per year and generating $200,000 in income for your guarantors/personal depositors rather than a company earning $50,000 but unable to pay a living wage to its owners. (Be a bit suspicious if They draw $300,000 per year and claim minimal personal assets.) It also is important for community bankers to adjust cash flows for significant future personal expenses such as multiple college tuitions, etc. Now, having applied the following concepts and having made other appropriate commonsense adjustments, simply aggregate all adjusted inflows as well as outflows and develop an overall cash flow coverage ratio. This number not only indicates the overall cash flow posture of the entire enterprise, but also provides an excellent basis for a comprehensive protective cash flow covenant.

Conclusion

For many years bankers have been using the phrase “my good customer.” The best way to know your customer and to ensure that this label is warranted is to assess true, global aggregate leverage and aggregate adjusted cash flow. These general concepts are equally important for money center bankers doing megabucks deals with public entities as they are for community bankers lending to small “mom and pop” businesses. Specialized focus has been offered where appropriate. Reasonably leveraged borrowers with good cash flow margins deserve senior debt support at conventional bank rates. Lenders who accommodate borrowers with marginal leverage and cash flow are really providing pseudo equity, either consciously or unconsciously, at conventional rates and will ultimately suffer loan losses well in excess of any monetary consideration received. There’s a lesson to be learned from the Indian fable about the blind men and the elephant, as recounted in a poem by John Godfrey Saxe:

And so these men of Indostan

Disputed loud and long,

Each in his own opinion

Exceeding stiff and strong,

Though each was partly in the right,

And all were in the wrong!

Postscript

Television’s “talking heads” as well as many financial analysts offering their analysis to the public could also engage in much more focus in the foregoing areas. The writer has often wondered how many really read audit footnotes as opposed to the apparent vast numbers of analysts who regurgitate company “pablum” verbatim.