Sunday, October 26, 2008

Businesses need to take fresh look at loan papers

With all the news about trouble on Wall Street and the banking crisis, many entrepreneurs are scrambling to figure out how it all affects their banking relationships.

The economy has been slowing down for the past year. Since the third quarter of 2007, there has been a slowdown in the demand for loans from small business owners as they become more cautious. The National Federation of Independent Business reports that this drop in demand has resulted not so much in a credit crunch for small business as it has in a softening of demand for loans for expansion and growth.

However, banks are coming under increasing scrutiny by federal regulators. This is going to lead to some changes in the relationship between small businesses and their banks. Owners must prepare for the fact that their loans will be getting increased scrutiny.

Every business loan from a bank has covenants. The bank may require that insurance and tax payments be kept current, while at the same time it may put limits on things such as distributing profits or taking on more debt without approval from the bank.

Covenants also may define minimal financial performance expected from the business. These typically define minimal financial ratios for the liquidity of the business, debt ratios, minimal cash flow requirements, and the necessity of meeting certain profitability ratios.

Read the fine print

Many entrepreneurs pay little attention to these covenants after they close the loan. When times are good this may not become a serious issue. But in times like these, any loans that are out of compliance with stated financial covenants can be "set aside" by the regulators. The bank will be required to set aside additional reserves to cover these loans.

The result is that the bank no longer makes money on these loans. If this happens, banks may be forced to call in these loans, demanding immediate payment of all principal owed by the business. This can happen even if the business has never been late or missed a single loan payment.

Business owners who have bank loans should read all covenants carefully. Make sure that they are in compliance with all actions required in the covenants, for example, keeping insurance policies current and not doing things that may be restricted, such as taking on additional debt.

Any financial covenants require constant monitoring. The entrepreneur or his accountant should calculate and review all required ratios every month. If any of these ratios fall below the bank requirements, swift action should be taken to get them into compliance.

In a recent survey of small businesses conducted by American Express, about one in five owners voiced a concern that the current economic crisis is putting their business at risk of failure. Don't put your business at risk by ignoring the covenants in your loans, especially during times like these.

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