We are a 90-person engineering firm organized as a "C" corporation. We recently had our annual meeting with our bank to review our financial statements and to arrange to renew our credit line. We’ve gone through this process routinely for several years with little difficultly and few questions asked. Well, not this time.
The ownership of our bank changed since last year. The bank is now insisting our principals and their spouses must individually guarantee any bank loans extended to our firm. Also, they have conditioned the ongoing availability of a credit line to our firm maintaining a debt-to-worth ratio of no more than 2 to 1; and a current ratio of not less than 2 to 1. We are expected to provide quarterly financial statements demonstrating that our ratios remain within these limits. What’s going on here, and what do these ratios imply?
A.L., New York
With new ownership your bank has evidently made some internal policy changes concerning its lending practices, or they may have spotted some negative trends in your firm’s financial performance that are making them nervous.
As a former banker, I can personally attest that banks go through cycles of being hot or cold when it comes to business loans. Frankly, I’m kind of surprised you have not been faced with a demand for personal guarantees before now. It’s a common practice for small- to mid-sized engineering or architectural firm principals—where the shareholders and management are one and the same—to be asked to stand behind bank loans to the firm.
Organized as you are as a corporation, without guarantees, the bank is limited to looking only to the firm to secure repayment of any money it might lend. By obtaining the guarantees of the principals, the bank has access to the personal worth and assets of the principals to fall back on in the event of a problem collecting from the firm.
As for the ratio requirements, these are often referred to as loan covenants. Or more simply stated, strings attached to the offer of extending you a loan commitment. Both ratios are from the firm’s balance sheet. The balance sheet reflects a snapshot of the mix and makeup of a firm’s assets, liabilities, and net worth as of the date of the balance sheet. Net worth is the excess of assets over and above liabilities.
The debt-to-worth ratio is found by dividing total liabilities by net worth. This particular ratio is considered a measure of the overall financial health of the organization. I’d suggest a debt-to-worth ratio of 2 to 1 or less as a good target for an A/E firm. As the debt-to-worth ratio gets higher, the firm is said to be more leveraged and therefore increasingly reliant on financing and creditors to support its operations. Safety margins are deemed to be eroding, and the firm’s creditors are becoming proportionately more at risk than the owners in the event of a default by the company on its obligations. This "leveraging" makes banks extremely nervous and incites them to demand personal guarantees, expect more collateral to secure debt, and charge higher rates of interest.
The current ratio is found by dividing current assets by current liabilities. Current assets are those assets which are cash, or will be converted into cash within the next 12 months. Some major categories of current assets found on a typical A/E firm balance sheet include cash, accounts receivable, and work in process. As you may have already figured out based on the definition of a current asset, current liabilities are those payment obligations the firm must meet within the same coming 12 months. The higher the current ratio, the more financial "liquidity" a firm is assumed to have.
Ideally, a firm should seek to maintain a current ratio of 2 to 1 or higher. At this rate, for every dollar of obligation coming due during the next 12 months, the firm can expect to have two dollars of cash available to service that debt. As the current ratio falls, the firm is more likely to experience difficulty finding the cash it needs to service its payments in a timely fashion.
While the request for personal guarantees and the ratio requirements demanded are not all that out of line with what many A/E firms experience in dealing with their banks, remember, all terms are negotiable. If you are not conversant in these matters, you should always have your firm’s outside accountants or attorney present any time you have meetings of this nature with your bank. They will help you point out your strengths and plead your case. If you cannot get the bank to back down from its demands for guarantees, at a minimum, have the bank spell out under what specific financial circumstances they would agree to forgo the requirement. You can then work on your financial position to bring the firm within a tolerable range the bank has pre-agreed would relieve you of having to guarantee firm debt.
If you can’t negotiate terms you can live with, consider "shopping" your banking business around to other banks. Every bank is different. Creditworthiness, like beauty, is in the eye of the individual beholder.
Get answers to your questions about design firm and project management, finances, marketing, and related topics by sending them to Q&A c/o: CE News, One IBM Plaza, 330 N. Wabash, Suite 3201, Chicago, IL 60611, or faxing them to CE News at 312-628-5878. Include your name and telephone number in all correspondence. Your name will not be used in connection with published questions. David Wahby is president of Wahby & Associates (www.wahby.com), a management consulting firm serving A/E clients. He can be reached at 616-977-9756 or via e-mail at firstname.lastname@example.org.