You bet you are! No one and no company can eliminate all risks. I was listening to a webinar put on by the Motor & Equipment Manufacturers Association this last week to get the latest on tariffs and more for the automotive and truck industry. Two of the slides caught my attention that were titled
Supplier “Watch List”
The first slide discussed today and the second looked at 7 years. As you would expect, the percentage of suppliers “at risk” were higher during the pandemic and had just declined to “normal” levels. With the current tariffs and more, the watch list has again grown. You don’t want to me on that list, but you might end up there with supply chain shortages, prohibitions on exports of materials from Chine, prohibitions on exports from the US to other countries, or any number of reasons outside your direct control.
Learn even more at a webinar on June 11 at 10AM.
https://www.eventbrite.com/e/manage-your-risk-tickets-1362254131779?aff=oddtdtcreator
Banks also have a name for those businesses at risk of breaching a covenant or otherwise not able to pay back their loans. I’ve run across these a couple of times in my business coaching activities. I’ll list the titles of seven of the covenants here and at the end provide a brief explanation of a larger number of them.
- Minimum Working Capital
- Current Ratio
- Debt-to-Equity Radio
- Limitations and Asset Sales
- Limitations on Mergers and Acquisitions
- Maintain Adequate Insurance
- Pay Taxes and Other Obligations
The titles that banks give to companies that breach covenants are not nice, such as stressed, distressed, troubled, or at-risk. The titles of the departments at the bank tasked with fixing things are no less ominous such as special assets group, workout group (it’s not an exercise), credit restructuring, problem loan department, or distressed debt group. You will want to stay away from being labelled and having to meet the people in these bank areas. How to do it?
Here are seven suggestions by title only to deal with risk in your business.
- Avoid
- Reduce or Mitigate
- Transfer
- Accept
- Control
- Share
- Contingent Planning
Financial Covenants (Focus on Performance & Condition)
Minimum Working Capital: This requires the borrower to maintain a certain level of liquid assets (current assets minus current liabilities). It ensures the company has enough short-term funds to operate and meet its obligations. For example, a covenant might state: “Borrower shall maintain minimum working capital of $\$500,000 at all times.”
Current Ratio: This ratio (current assets divided by current liabilities) measures a company’s ability to pay short-term obligations with its short-term assets. A typical covenant might be: “Borrower shall maintain a current ratio of not less than 1.25:1.”
Debt-to-Equity Ratio: This ratio (total debt divided by shareholders’ equity) indicates the extent to which a company is financing its operations with debt versus equity. A covenant might set a maximum limit: “Borrower shall not permit its total debt to exceed 2.0 times its shareholders’ equity.”
Minimum Debt Service Coverage Ratio (DSCR): This ratio (typically calculated as EBITDA or Net Operating Income divided by total debt service, including principal and interest payments) shows the company’s ability to cover its debt obligations. An example: “Borrower shall maintain a debt service coverage ratio of not less than 1.15:1.”
Minimum EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization): This sets a floor on the company’s operating profitability. For instance: “Borrower shall maintain minimum EBITDA of $\$1,000,000 per fiscal year.”
Reporting Covenants (Focus on Information Transparency)
Delivery of Financial Statements: Borrowers are usually required to provide periodic financial statements (monthly, quarterly, and annually), often prepared in accordance with Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). The covenant will specify the frequency and the level of assurance (e.g., reviewed or audited).
Compliance Certificates: These are often required along with the financial statements, signed by a company officer, certifying that the borrower is in compliance with all covenants or detailing any instances of non-compliance.
Notice of Default: Borrowers are obligated to promptly inform the bank of any event that constitutes a default or could potentially lead to a default.
Negative Covenants (Restrictions on Borrower Actions)
Limitations on Indebtedness: These restrict the borrower from taking on additional debt without the bank’s consent, ensuring they don’t become over-leveraged.
Limitations on Liens: These prevent the borrower from granting liens or security interests on their assets to other lenders, which could impair the bank’s collateral position (if the line of credit is secured).
Limitations on Asset Sales: These may restrict the borrower from selling a significant portion of their assets without the bank’s approval, as this could weaken their ability to repay the loan.
Limitations on Dividends and Distributions: These can restrict the borrower from paying out excessive dividends or making other distributions to owners, conserving cash flow for debt repayment.
Limitations on Capital Expenditures: These may limit the amount of money the borrower can spend on fixed assets.
Limitations on Mergers and Acquisitions: These can prevent the borrower from entering into significant business combinations without the bank’s consent.
Affirmative Covenants (Actions the Borrower Must Take)
Maintain Adequate Insurance: The borrower is typically required to maintain insurance coverage on their assets and operations at levels deemed adequate by the bank.
Pay Taxes and Other Obligations: The borrower must ensure timely payment of all taxes and other material obligations.
Maintain Legal Existence and Good Standing: The borrower must maintain its legal existence and comply with all applicable laws and regulations.
Allow Bank Inspections: The bank may have the right to inspect the borrower’s books and records and facilities.
Addressing Risk:
Avoidance: This involves completely eliminating the activity or situation that creates the risk. If the potential negative consequences outweigh the benefits, or if the risk is simply unacceptable, avoidance might be the best strategy.
Example: A company decides not to enter a new market due to high political instability.
Reduction (or Mitigation): This focuses on lowering the probability or the potential impact of a risk event. It involves taking proactive steps to minimize the likelihood of the risk occurring and/or reducing the severity of its consequences if it does.
Example: Implementing safety training for employees to reduce the risk of workplace accidents.
Transfer: This strategy shifts the financial burden or responsibility for a risk to a third party. Insurance is a common method of risk transfer. Contracts can also be used to transfer specific risks to other parties involved in a project or business relationship.
Example: Purchasing an insurance policy to cover potential property damage or liability claims.
Acceptance: This involves acknowledging the existence of a particular risk and deciding to bear the potential consequences if it occurs. This is often used for risks that are low in probability or impact, or where the cost of other risk treatment options outweighs the benefits.
Example: A business deciding to self-insure against minor, infrequent losses.
Control: This is closely related to risk reduction and involves implementing specific actions or processes to manage and contain risks. Controls can be preventative (to stop a risk from happening) or detective (to identify if a risk has occurred).
Example: Implementing strong cybersecurity measures like firewalls and intrusion detection systems.
Sharing: This involves distributing the potential negative consequences of a risk among multiple parties. Joint ventures or partnerships can be a way to share risks and resources.
Example: Two companies collaborating on a research and development project, sharing the financial and technological risks.
Contingency Planning: This involves developing backup plans and procedures to deal with potential negative events if they occur. It doesn’t necessarily reduce the likelihood or impact of the initial risk but ensures the organization can respond effectively and recover quickly.
Example: Creating a disaster recovery plan for IT systems in case of a hardware failure or natural disaster.
These seven approaches provide a comprehensive framework for dealing with the various risks that individuals and organizations face. The most effective risk management often involves using a combination of these strategies.
Yes, I used Google’s free version of Gemini to help with this post.
