24 Jul 4 “Gotchas” to Watch for In Your Commitment Letter
We’ve had a lot of interest in the prior line of credit (LOC) articles on choosing the right type of LOC and mistakes to avoid, so I wanted to continue discussing that topic since it seems to be pertinent.
Watch out for these “gotchas” in your line of credit commitment letter.
1) Your commitment letter says, “This line of credit is to be used for short-term working capital purposes.” You may not know that your bank cares about what your line of credit is used for. Short-term working capital to a bank means there is a timing gap between when receivables or inventory turn in to cash and when accounts payable, expenses or monthly debt payments are due. If you use your line of credit to fund a business acquisition, to purchase fixed assets, to fund operating losses or to make distributions to yourself, you run the risk of violating the purpose language of your line of credit.
2) Your commitment letter might say, “A 30 day annual payout is required.” For the bank this is the proof for item 1. If you can keep your line at a 0 balance for 30 consecutive days in a year, then the line truly has been used for short-term working capital. If you can’t do this, that could signal to the bank that you’ve used the line for something other than it’s intended purpose. Many business owners skim over this language or forget it’s in their commitment letter. Then they’re called on the carpet by the bank and bear the consequences of violating that part of the commitment.
3) Banks care about your balance sheet and income statement. It’s common for the bank to put two financials covenants in your line of credit commitment letter, one for the balance sheet and one for the income statement. The most common balance sheet covenant is debt to worth or a leverage covenant defined as total debt/total net worth. Most banks like to see leverage in the 3 or 4-1 range. If your leverage is higher than that the bank starts to get nervous.
4) The income statement covenant is the cash flow covenant or cash flow coverage ratio defined as EBITDA/total principal and interest payments. They like to see this at 1.25-1.3 or higher, lower than that and they could get nervous.
If you don’t have a line of credit, then you don’t need to worry about these things, but most growing businesses have a line of credit. Be sure to read the fine print in your commitment letter and line of credit documents or have a trusted advisor review it for you to determine if any of these “gotchas” apply to you.