Meeting Bank Covenants
Meeting Bank Covenants
By Alan Miklofsky, September 27, 2024
When a retail shoe store enterprise presents its financial reports to a bank or other financial institution, one of the key considerations is how extraordinary expenses are treated in the financial statements. Properly breaking out these items can significantly impact financial metrics that banks use to evaluate loan eligibility and compliance with covenants, such as the Debt Service Coverage Ratio (DSCR). This becomes even more critical during times of economic uncertainty, such as an anticipated recession, where financial scrutiny intensifies, and access to credit may tighten. Understanding how and why to separate these expenses is crucial for presenting a clear financial picture, meeting bank covenants, and weathering the challenges of an economic downturn.
What Are Extraordinary Expenses?
Extraordinary expenses are one-time, non-recurring costs that fall outside the ordinary course of business operations. For a retail shoe store, these could include costs such as:
Natural Disasters: Expenses related to damage and repair due to events like flooding, earthquakes, or wildfires.
Legal Settlements: Costs associated with lawsuits, settlements, or legal disputes.
Store Closures or Restructuring Costs: Expenses incurred due to the closure of underperforming locations or restructuring the business.
Significant Inventory Write-Downs: A large devaluation of inventory due to changing trends, market disruptions, or supply chain issues.
I have found many other Extraordinary Expenses for my Clients that are in addition to ones mentioned above.
Improves Financial Transparency
Aggregating extraordinary expenses with regular operating costs makes it difficult for banks to discern the true operating efficiency of the business. Breaking out these costs separately provides a clearer view of operational profitability, which is crucial for assessing the store’s ability to generate consistent cash flows.
Helps Meet Bank Covenants
Banks often set specific covenants that businesses must meet to remain in good standing for their loans. One of the most critical covenants is the Debt Service Coverage Ratio (DSCR), which measures a business’s ability to cover its debt obligations. If extraordinary expenses are included in operating expenses, the DSCR may appear lower than it actually is, potentially putting the business at risk of violating loan covenants.
Prevents Covenant Violations Due to Temporary Financial Distortions
Non-recurring expenses can cause temporary fluctuations in financial ratios, which might give an impression of poor financial health. By breaking out these expenses, the business can show that any temporary downturn is not reflective of its core profitability, thus preventing unintended covenant breaches.
Enhanced Scrutiny During Economic Downturns
During economic downturns or anticipated recessions, lenders become more cautious and scrutinize financial statements more intensely. By presenting a clearer financial picture through the separation of extraordinary expenses, the business can better withstand the increased scrutiny and demonstrate its ongoing financial viability.
Economic downturns, such as an anticipated recession, present a unique set of challenges for retail businesses, including shoe stores. During these periods, consumer spending typically declines, leading to reduced revenue. For retail shoe stores, which are highly dependent on discretionary spending, this can result in tighter margins, inventory build-ups, and a higher risk of operating losses.
In response to this environment, banks and other financial institutions tend to tighten lending standards, reduce credit lines, and impose stricter requirements on financial covenants. During such times, businesses are more likely to face:
Increased Scrutiny on Financial Statements: Lenders will closely analyze financial statements to assess the store’s cash flow stability and its ability to service debt during a downturn. Any anomalies or fluctuations caused by extraordinary expenses could raise red flags, prompting the lender to reconsider loan terms or reduce the credit line.
Higher DSCR Requirements: As a safeguard, banks may increase the DSCR requirement to ensure that businesses have a larger cushion to cover debt obligations. This means that the shoe store must generate significantly more cash flow relative to its debt service to remain in compliance.
Potential Reduction or Elimination of Credit Lines: If the store appears to be struggling to meet DSCR or other covenants due to extraordinary expenses that mask core profitability, banks may reduce credit availability or, in severe cases, call in the loan, putting the business at risk.
Improved Cash Flow Analysis
By separating extraordinary expenses from regular operating costs, the business can provide a more accurate representation of its operating cash flow. This helps in presenting a stronger case to banks that the business is still generating sufficient cash flow to cover its debt obligations, even if revenue has temporarily declined.
Better Alignment with DSCR Requirements
As mentioned earlier, breaking out extraordinary expenses can have a direct impact on the DSCR. Consider a scenario where the store incurs $100,000 in Extraordinary Expenses:
Without Breaking Out Extraordinary Expenses:
Net Operating Income (NOI): $500,000 (after including the $100,000 in expenses)
Total Debt Service: $450,000
DSCR: $500,000 / $450,000 = 1.11
In this case, the DSCR is 1.11, which might be too close to the threshold during a recessionary period, when banks may require a higher DSCR for added security.
With Breaking Out Extraordinary Expenses:
Adjusted Net Operating Income (NOI): $600,000 (excluding the $100,000 in expenses)
Total Debt Service: $450,000
DSCR: $600,000 / $450,000 = 1.33
A DSCR of 1.33 presents a stronger financial position, reassuring the bank that the business can comfortably service its debt despite economic challenges.
Ability to Negotiate Favorable Loan Terms
By clearly showing that extraordinary expenses are non-recurring and non-operational, the store’s management can negotiate for more favorable loan terms, even in a tighter credit market. Lenders may be more willing to extend credit or maintain current terms if they believe the underlying business is strong and these costs are unlikely to recur.
For a retail shoe store owner, failing to break out extraordinary expenses during an economic downturn could have several negative consequences:
Violation of Covenants: Lower DSCR due to the inclusion of extraordinary expenses can lead to covenant breaches, giving the bank the right to take action, such as demanding immediate repayment or restricting access to additional credit.
Increased Borrowing Costs: Lenders may raise interest rates or impose additional fees if they perceive a higher risk due to lower-than-expected cash flows.
Reduced Financial Flexibility: During a recession, liquidity is critical. Presenting a less-than-accurate financial picture can result in reduced credit lines, leaving the business with limited flexibility to manage cash flow fluctuations or invest in necessary inventory adjustments.
In an anticipated recessionary environment, breaking out extraordinary expenses is not just a best practice—it is a strategic imperative for retail shoe stores seeking to maintain financial stability and compliance with DSCR and other bank covenants. By enhancing transparency, isolating non-recurring costs, and presenting a clearer financial picture, shoe store owners can better navigate tighter credit conditions and safeguard their business’s long-term financial health. This proactive approach will allow the business to meet lender expectations, maintain access to capital, and successfully weather the economic challenges ahead.