In the good old days that ended in the fourth quarter of 2008, financial forecasting was a lot easier, particularly as far as company debt was concerned. Financial statement footnotes or loan documents disclosed debt repayment schedules. I entered those into my spreadsheet model. If more cash was needed, I increased the amount of debt (provided it was not excessive, i.e. in excess of the company’s line of credit) and adjusted the payment schedule accordingly. After all, friendly bankers were more than willing to lend.
NOT ANYMORE!
Projecting debt is a whole new and much riskier ballgame today. Most businesses’ credit quality has deteriorated, and bank lending is as tight as it has ever been in my experience.
I wish I could give you lots of specific advice about how to handle tight credit, but there are so many variables to consider that I just cannot. All I can say is: be very careful what you put in those spreadsheet cells for future debt!
Here is a partial list of questions to ask – as always, email me those I have missed.
1. Can the business adequately service existing debt – pay annual interest with a margin of safety, principal due within a year with a margin of safety, and meet all of its loan covenants? (Covenants are conditions attached to a loan, such as that the current ratio be greater than, say 2 or interest coverage be greater than 1.5.) Violation could lead to default, meaning the bank could call the loan.
2. What would happen if the company defaulted? Consider pessimistic scenarios (say significant sales or margin declines) that could cause that. How probable is that? What could the company do: cut officer compensation, lay off employees, stretch payables, etc. … short of liquidating?
3. Do the owners have sufficient personal resources to (1) guarantee the loans or (2) loan the business money to tide it over?
4. Even healthy businesses might need capital to grow…but will banks finance that? If not, what other sources of funds are available, and at what cost? Will growth have to be deferred until the credit crisis ends? (Who knows when that will be
Come to think of it, I can give one specific piece of advice…increase the company-specific equity risk premium component of the cost of capital to reflect increased risk of not being able to obtain financing…but by how much is case-specific.