Summertime Blues: Corporate Finance Faces a Financial Reporting Reckoning | By Marianne Martin

Below is a look at some of the key market indicators likely to be strained when second quarter reports are available, and what borrowers and lenders alike can do to avoid or reduce the damage.

• EBITDA ills– The past few months have seen a topsy-turvy effect in the markets due to a number of factors. War, tariffs, inflation and now even immigration effects have put a tremendous strain on companies’ bottom lines, and we predict that earnings-based covenants, such as leverage tests hinged on EBITDA (or earnings before interest, taxes, depreciation and amortisation, a concept often defined differently per borrower) will be the first indicator that trouble is brewing. Even companies that have additional availability on their existing lines may find reduced EBITDA restricts their borrowing capacity and growth, and reductions in EBITDA can cause increases in interest margins in some credits.
• Asset tests dip – Inventory strains, given logistical issues caused by tariffs and other disruptions, may harken concerns – but these same economic pressures are being felt by borrowers’ account debtors as well. This is likely to have a diminishing effect on the valuation and validity of accounts and other assets used in asset-based financial covenants (such as borrowing base measurements and loan to value, current ratio or liquidity/net worth covenants). The same impact will be felt more broadly in specific industries as certain asset classes, real estate as an example, continue to meander in their recovery – putting borrowers in a deficit from which they simply cannot recover.
• Coverage tests shorten – Financial coverage tests (such as fixed-charge and interest coverage ratios), which reflect how far cash flow can cover costs, such as interest and other debt costs, are beginning to tighten for many companies. As overall business costs consume cash and thin out liquidity, a company’s ability to cover debt costs will be constrained. These cash flow strains are often viewed by lenders as a window to a company’s financial health – and a failure to maintain sufficient coverage can be seen as irreversible and fatal in the eyes of a lender, handicapping a borrower’s ability to get back to better health.

For lenders, there are steps that can be taken now to anticipate soft or poor upcoming financial results, and to be proactive with respect to any concerns.

• Review financial covenants– The first step is likely the most simple, which is to refresh and review the financial covenants in existing loan documents for any borrower that you suspect will have less-than-stellar returns. Depending on when the credit was struck, and depending on the strength of the borrower when the loan was executed, you may be surprised to find you have more, or less, leverage than anticipated. Covenants may be light on triggers and remedies, or may give you a number of leverage grips. Either way, knowing the playing field is a critical place to start.
• Preserve your rights– If an event of default has occurred under your credit, seek counsel around sending a notice of default or reservation letter to preserve your rights. While the general rule is that lenders prefer to send such notices upon a payment or material default, if the defaults are significant and/or multiple, you need to consider preserving your rights. Typically, at this stage, you’ll want to consider bringing in your attorney if you haven’t already to help walk you through this process and avoid a foot-fault.
• Negotiate a pre-workout agreement – If the resultant next step is a simple forbearance or waiver, again an attorney can assist on that documentation. If the next step, however, is going to be a workout – negotiating a short-form pre-workout agreement is a best practice. At the very least, the agreement obtains a borrower’s admission that an event of default has occurred. Such an agreement also provides value in preserving a lender’s rights should the negotiations fall apart, something your attorney can also walk you through.
• Consider your options on remedies – There are a multitude of ways in which you can proceed on remedies, should you need to pursue this route. Remedies could include initiating foreclosure proceedings (including the simplified and out-of-court process provided under the uniform commercial code), litigation, “ABC’s” (assignments for the benefit of creditors – a state-specific statutory process), and even bankruptcy. Again, pulling in your attorney at this stage (and before) is critical, particularly if you are considering a more assertive approach, to avoid costly missteps or sanctions.
• Always be thinking of the “B”– As in bankruptcy. It should always be an option in your mind vis-à-vis your borrower or other obligors. But beware of the traps for the unwary. Workout “settlements” may seem like they should be protected from bankruptcy and state clawback actions, but oftentimes they are naturally structured in such a way (e.g., providing catch-up payment on long over-due debts) as to be a prime target for a bankruptcy or other clawback lawsuit. Not all risks can be avoided, but anticipating this outcome can help shape how you negotiate with your borrower.

For borrowers, there are, similarly, ways to get ahead of poor financial reporting, and to soften the likely blow that may come from your lender.

• Get a handle on your business and financials– This sounds simple enough, but frequently it can be more complicated. More often than not, borrowers may have a complex financial picture, or perhaps an accounting firm that the company has outgrown. This can catch up to a company and its executives quickly. Getting ahead of this issue at the forefront, preventing delayed reporting for instance, is critical to both meeting your covenant requirements, and preserving your standing with your lender.
• Communicate, communicate, communicate – Before you run aground with an issue in your covenants, make sure that you are having frequent and transparent discussions with your lender team. If a lender is accustomed to having an open dialogue with a borrower, more often than not – they will be more amenable to dealing with hiccups along the way. Even if you don’t have the ideal relationship with your lender, consider picking up the phone first to communicate major issues personally, before sending a communication that might be viewed as “blindsiding” your lender.
• Anticipate needs, and be patient – Lenders, particularly large institutional lenders, are not typically one-man shops – they have credit committees to address. If waivers, forbearances or concessions are requested by borrowers, the committee has to consider the ask. To do so, requires lots of data from the borrower – and a strong narrative addressing any issues the company may be experiencing. Work with your lender to ensure that they understand the reasoning behind any covenant shortfalls, arm yourself with sufficient backup – and expect that the process will take some time.
• Know your rights and options– If you don’t believe that your financials reflect any issues with your covenants, but your lender is saying otherwise, you should confirm your rights and push back. Not all lenders are created equally, and some can be overly aggressive. Certain lender actions can lead to lender liability and other claims that you may hold to your benefit. You may also want to consider pursuing your own recourse options, including injunctive relief or bankruptcy protections. The pathways available to you will range in cost, complexity and sometimes risk, but seeking out counsel to explain your options can provide needed strategic guidance.
• Understand that bankruptcy is not always the panacea– It is a hard truth that you cannot typically file a bankruptcy case – and expect to reorganize your company or pursue a sale – when the business is running on fumes. To reach an ongoing outcome or exit in bankruptcy requires money. Too often management will run a company until it is nearly illiquid, which at that point leaves only one real option: liquidation. Even a bankruptcy liquidation presents its own set of potential risks for owners, officers/directors and other constituents. Be realistic in your planning for this option as you work with counsel, and avoid throwing around the “B” word carelessly with lenders, as that will present strong credibility risks.

We predict that as Q2 results come through – many, many corporate finance and restructuring professionals will be busy. But whether you are a borrower or a lender, the same antidote holds true – anticipate that upcoming quarterlies will not be friendly, and work to avoid any hiccups. Regardless of any economic turmoil, keep in mind that better planning will beget a better result.

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Summertime Blues: Corporate Finance Faces a Financial Reporting Reckoning