How Financial Bank Covenants Affect Your Trucking Business
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Fact-checked by: Bruce Sayer
During this period of national crisis, the extreme peaks in demand for capacity combined with a faltering economy have heightened the difficulty of maintaining positive cash flow for truck company owners. Whether through bank financing, government-assisted programs or alternative funding options, access to working capital is essential.
To alleviate the situation the federal government has launched its historic stimulus package to help the general public and businesses survive. Alternatively, funding options designed specifically for trucking companies such as a Factoring Line of Credit are also available to provide immediate funding without restrictions.
The CARES Act permits banks to offer disaster assistance loans backed by the Small Business Association (SBA) to businesses directly. Compared to a conventional commercial bank loan, these small business loans are easier to qualify for and have no financial covenant restrictions attached. The newly introduced Paycheck Protection Program provides an 8-week forgiveness period plus low interest payments, deferred payments and extended maturity dates to add greater assistance.
As much as these business loans are needed during these tumultuous times, they are nonetheless financial obligatory agreements. Further, if your trucking business already has a bank loan, without doubt it will have financial covenants that will restrict taking on additional debt. Your bank will need to waive these bank loan covenants prior to issuing an SBA loan.
What is a Financial Covenant
A financial covenant is a set of conditions in a commercial loan that requires the borrower to fulfill certain conditions or which forbids certain actions. These conditions are either restrictive or protective in nature. Restrictive covenants will likely dictate limits, forcing the borrower not to exceed certain financial ratios or control certain activities such as limiting dividend payment options. On the other hand, protective covenants enforce certain actions that the borrower must comply with in order to safeguard the interests of the lender. These actions will define a strict payment schedule and will likely include obligations to maintain a minimum level of working capital, carrying specific insurances and more.
Every conventional loan agreement made between a bank and a trucking company will carry some form of financial covenant to protect the interests of the bank. It is important to understand that only the portion of a loan utilized during the 8-week covered period of a Paycheck Protection Program will be forgiven. The remainder of the loan will operate according to the terms agreed upon with your bank.
Why Understanding Covenants is Critically Important
If you are going to commit your trucking company to a commercial loan agreement, be sure to understand all the implications and obligations tied to it. At minimum, the bank will insist on analyzing your balance sheet and income statement on a regular basis. It could also involve more complex conditions such as requiring bank approval on all major financial decisions that you make. Understanding the terms of your loan agreement and the covenants that apply are critically important prior to committing your company’s future financial health to the control of your bank.
Covenants are Associated with Financial Benchmarks of Your Business Performance
Loan covenants are generally associated with financial benchmarks of your business performance and are closely monitored by the bank to assure adherence. Covenants are tested at regular intervals, depending on the risk the lender associates with your business. It is important to note that at any time, the bank has the right to conduct spot checks and demand access to your financials.
How Covenants are Calculated
Types of Benchmarks/Debt Covenants:
Below is a list of some of the different types of common calculations or formulas used as debt covenants for trucking business bank loan borrowers.
Debt Service Coverage Ratio
This cash flow metric reflects a company’s ability to service its debt obligations. The ratio is a calculation of the company’s net cash flow during a specific period of time divided by the required debt payment during that same period. Banks are in the business practice of mitigating their own risk and therefore prefer a cushion when analyzing your company’s Debt Service Coverage Ratio. Normally a ratio of 1.25 or higher is required. This translates to your trucking company having $1.25 in net cash for every $1 of outstanding debt.
Debt-to-Equity Ratio
This benchmark (sometimes referred to as a Leverage Ratio) is a measure of your business’ total long-term liabilities divided by common shareholders equity. If a company has long-term debt of $100,000 and shareholder’s equity of $125,000, then the debt/equity ratio would be 100,000 divided by 125,000 = 0.80. It is important to realize that if the ratio is greater than 1, the majority of assets are financed through debt. If it is smaller than 1, assets are primarily financed through equity. Typically the data from the prior fiscal year is used in the calculation.
Trucking is a highly capital intensive industry, and therefore tends to have relatively high debt-to-equity ratios. This higher ratio reflects an industry that typically depends on financing its growth with debt. However, it may also indicate a greater potential for financial distress if your company’s earnings do not exceed the cost of borrowed funds. Banks prefer to see a ratio ranging from 2.5:1 to 4:1 for trucking companies.
Current Ratio
The measure of cash or liquid assets available for the day-to-day operation of your company is considered working capital or your current ratio. It is a calculation of current assets (cash reserves, accounts receivables and other assets that will convert to cash within 12 months) vs. current liabilities (things that you will have to pay within 12 months). A minimum working capital covenant ensures that the borrower exercises prudent cash flow management. Banks require a ratio ranging between 1.2 and 2.0. If your working capital ratio is 1.2 this would mean that you will have $1.20 of available cash to pay for every $1 you have to pay out.
Borrowing Base Terms and Compliance
It is common for banks to require a monthly certification process in order for your company to draw upon the line of credit, and alternatively to pay back principal payments. These are further control measures by the borrower to minimize the risk the bank wants to assume.
As an example; the bank may establish a borrowing base formula that limits your company to draw up to a maximum of 80% of the business’ current accounts receivable. Generally, monthly monitoring of accounts receivable is required to assess its aging status. Due to the aging of accounts receivable, trucking companies often find themselves with ineligible receivables which results in restricting access to funds. In this instance, the company now has a dilemma, needing to pay down the line of credit to meet the borrowing base without having the available funds to do so.
All aspects of a commercial loan agreement are intended to protect the interests of the lender. The language, terms, conditions and all covenants are designed to protect the bank and minimize its risk. It is clearly understood that the banks demand and wield the upper hand when your trucking business is in need of funding. It is therefore highly recommended to request a copy of all loan documents well in advance, read and thoroughly understand the implications prior to signing an agreement.
These are extraordinary times requiring extraordinary action. Traditional bank financing is no longer the only mainstream funding option available to trucking businesses. It is important to consider all forms of funding solutions prior to signing a commercial loan agreement with a bank. There are excellent alternative financial options available to meet your needs such as invoice factoring, Factoring Line of Credit, cash advance on loads in transit, asset-based lending and more.
At eCapital, we deeply honor the critical service trucking companies are providing to the nation’s efforts to combat the COVID-19 global pandemic. This information has been presented in the hopes it will assist you to understand the short-term and long-term effects of both disaster assistance and conventional loans on your trucking company. We wish you continued success and more importantly, safe and healthy trucking.
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eCapital Corp
eCapital Corp. is committed to supporting small and middle-market companies in the United States, Canada, and the UK by accelerating their access to capital through financial solutions like invoice factoring, factoring lines of credit, asset-based lending and equipment refinancing. Headquartered in Miami, Florida, eCapital is an innovative leader in providing flexible, customized cash flow to businesses. For more information about eCapital, visit eCapital.com.