EBITDA is an acronym of great importance if you’re a small business owner with a commercial business loan. It stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is a metric used extensively by analysts, investors, and conventional lenders to measure the baseline profitability of a business. EBITDA is not a Generally Accepted Accounting Principle (GAAP) measure, which means it isn’t standardized, and companies may calculate it in different ways. Yet, despite this, EBITDA is an integral component of many loan covenants banks use to monitor the risk associated with borrowers. This can be very important because, under specific circumstances, such as a breach of loan covenants, a bank can demand repayment even if your loan service is current. Despite this, most business owners rarely think about EBITDA and are often unaware of this vital metric’s impact on their business and their banking relationships.
As a business owner, it is important to understand exactly what EBITDA is and how banks use it to monitor your business’s status as a borrower. Understanding your EBITDA can keep you ahead of the game by recognizing financial risks before you break a covenant, and have the bank move your lending account to workout. Monitoring EBITDA and taking pre-emptive action when needed will help prevent banks from knocking your business down through the unexpected recall of your commercial financing.
What exactly is EBITDA?
EBITDA is used with other metrics, such as revenue, earnings, and net income, to measure the financial performance of a business. It can make it easier to compare your business’s operating profitability to the operating profitability of similar businesses. EBITDA is seen as a reliable measure of core profit trends because it places emphasis on how operating decisions translate into financial outcomes. It does this by taking non-operating activities such as interest expenses, tax strategies, and capital investment out of the equation. Analysts have recognized over the years that the “ITDA” part of EBITDA can be distorted by subjective financial engineering to make a company look financially healthier than it is.
Let’s take a closer look at the ITDA in EBITDA:
- Interest: These are a company’s costs attributable to interest rates, generally from loans by banks or other third-party lenders.
- Taxes: These are a company’s costs attributable to tax rates charged federally, provincially/territorially, and municipally.
- Depreciation: This is a non-cash expense that describes the gradual decrease in value experienced by a business’s assets.
- Amortization: This is a non-cash expense that describes the costs of intangible assets (assets that are not on the balance sheet) over time.
There are two ways to calculate EBITDA:
- EBITDA = Operating Income (from your income statement) + Depreciation and Amortization (from your cash flow statement)
- EBITDA = Net Income + Taxes + Interest Expense (from your income statement) + Depreciation and Amortization (from your cash flow statement)
Depending on which formula you use, the results may vary because net income may include items that aren’t part of operating income. However, since both calculations are accepted, the main point is simply to be consistent and use the same formula each time you calculate EBITDA.
How do banks use EBITDA?
Banks typically put financial covenants in place to keep tabs on the performance of the businesses that borrow money from them. Financial covenants are monitored closely to keep a vigil on a borrower’s level of risk to the bank. For example, working from, your EBITDA, the bank could then apply a debt/EBITDA ratio to measure your company’s operational efficiency and financial soundness. Maintaining a defined debt/EBITDA ratio of less than three is a common requirement. So, lets suppose your business loan has a similar covenant and your business’s debt/EBITDA ratio rises above the bank’s threshold. In that case, banks may opt to move your business loan to “workout” — at which point, you will likely need to find alternative financing quickly.
Banks may also require businesses to maintain specific cash flow and operating expense levels or a minimum EBITDA.
Under a financial covenant, if a company breaches the terms of the loan, the lender can:
- Require repayment of the entire loan amount
- Collect agreed-upon collateral
- Increase the interest rate
Before taking these actions, a bank will normally move the lending account to their workout department — also known as special assets, troubled credit, and corporate recovery. If covenant conditions are rectified during the workout period, the bank may restore the loan to the terms of its original loan agreement. If not, the loan may be recalled.
How does “workout” work?
Violating EBITDA based covenant restrictions is probable cause for your bank to send your loan to its workout department. Workout is often (but not always) a step towards the exit door with your bank. It can happen when the bank’s internal risk rating system flags your business loan as too high. From the bank’s perspective, the more risk it must bear in relation to a specific loan, the more capital it must hold against the loan — and that costs the bank because it can’t use that capital for other more profitable purposes.
Even if you have never been late with or missed a loan payment, the bank’s assessment of the risk of your loan can rise based on your inability to meet EBITDA benchmarks, or other terms of a financial covenant. And, as that risk increases, the bank can become concerned about whether your loan remains profitable for it or whether it costs the bank more than it’s worth.
For business owners, reconciling covenant conditions in a workout session may mean you have to:
- Provide the bank with a lot more information, a lot more frequently, and sometimes in unfamiliar formats.
- Pay a higher interest rate to compensate the bank for what it sees as extra risk, as well as additional legal and accounting fees.
- Turn management’s attention towards cutting costs and selling assets rather than generating sales for the business.
It’s important to remember that a transfer to a bank’s workout department doesn’t necessarily mean an end of the lending arrangement. Seeing it from the bank’s perspective can help identify the results needed to restore the loan to good standing — ultimately, it comes down to restoring profitability. A business that restructures and monitors EBITDA metrics closely during the workout will have clear insights into the financial strategies and tactics that best result in positive outcomes. Borrowers that react accordingly to return the business to sustainable profitability as quickly as possible regain trust and credibility allowing the bank to move the loan out of workout and back to standard terms. However, the process can be costly, time-consuming, and frustrating.
In addition, there is considerable risk for business owners in workout. Banks consider two things to be “indicators of default”:
- Failing to make agreed-to payments
- Failing to meet agreed-to financial covenants.
If either is true and the borrower hasn’t taken steps to remedy the situation to the bank’s satisfaction, the bank may declare a default and start legal or other action to collect the money the borrower owes.
If your business utilizes a commercial business loan, closely monitor the same metrics that your bank uses to assess your business’s creditworthiness. Tracking metrics, such as your Debt/EBITDA ratio, can help you identify potential red flags well before your bank needs to move your loan to workout. Understanding the importance of and keeping tabs on these metrics allows you to correct course if necessary and focus on improving critical elements of your balance sheet.
It’s a good idea to have a backup plan if you think you’re at risk of breaching the terms of your financial covenant or have already been moved to workout. One way to find a constructive path forward is to explore different forms of financing that are more forgiving when it comes to ratios.
EBITDA is important, but have a Plan B in place
Despite your best efforts to keep your EBITDA and other indicators of profitability in good shape, sometimes unexpected circumstance can keep your company’s financial performance at an unacceptable level. In the unfortunate event that the bank then calls in your loan, it’s wise to have a “plan B” in place- establish a relationship with an alternative lender. You’ll then have a predetermined path to streamline transitioning to a replacement funding solution.
If you’re already in workout, keep in mind that an alternative lender may be able to work directly with your bank as a referral partner. Together, the two lenders may be able to find a way to repair your relationship with the bank by moving some liabilities into other forms of debt, so the bank is left with a level of risk it is comfortable with. Alternatively, if you and the bank decide to part ways, an alternative lender can help transition loans from the bank into alternative funding such as asset-based lending or invoice factoring.
Alternative lending options
Not all providers of business capital rely on extensive auditing and measuring of metrics, such as EBITDA-based ratios, to underwrite funding agreements. Lenders that offer alternative funding, such as asset-based lending and invoice factoring, base credit decisions much more on character and the quality of collateral assets.
Asset-based lending can unlock the value your business holds within its inventory, machinery, equipment, and real estate. It’s ideal for companies that need financing between $1 million and $10 million because they’re growing, experiencing a merger or acquisition, or facing financial challenges.
Invoice factoring improves your cash flow by paying accounts receivable invoices immediately and then taking care of collections on your behalf. It’s a quick way to make sure you maintain positive cash flow to keep your operations going when a bank won’t extend further credit to you.
In the end, an alternative lender is motivated to be a problem-solver, to present more flexible options, and to help you find a positive way to deal with financial challenges. With simple qualification requirements and fast underwriting processes, alternative lenders can work quickly to facilitate access to working capital, so you can get back to focusing on managing and growing your business.
If your business is facing workout, contact an experienced alternative lender like eCapital. Our consultants can guide you towards funding options that will allow you to recover. With funding that doesn’t require a strictly enforced Debt/EBITDA ratio, you can focus on riding out tough times and getting your business back on track.
eCapital is an innovative alternative lender with the flexibility, resources, and forward-thinking approach to manage even the most complex financial challenges. Working in collaboration with our clients, we shape customized factoring facilities to meet the working capital needs and cash flow requirements specific to each business. Strong client relationships anchored in mutual trust has been an essential part of our business model since 2006.
For more information about how invoice factoring supports business through all stages of development, visit eCapital.com