How not having the right tools can be disastrous

A while back I wrote on this blog about forecasting the likelihood of a company meeting its loan covenants with its lenders Will you Breach your Loan Covenants?. I normally wouldn’t repeat this or be redundant unless I thought it was of great importance to the readers of this blog.

I recently visited a high mid-market company on the West Coast where I have done internal control work in the past. During my engagement I was made aware of the fact that the company had failed meeting one of its loan covenants with its primary lender for the second year in a row. The first year they came pretty close to meeting the value derived from a formula dictated by the bank, but the second year it appears that the value had further drifted apart from the minimum required number.

As it is usual in cases like this the company entered into negotiations with its primary and other lenders in an effort to remediate the situation. Without going into great detail, this was not a pleasant experience for those involved, although a solution was found and agreed on. Using actual accounting data this company knew they were going to blow the covenant, but they were not able to forecast it early enough in order to make changes in anticipation of the worsening of their financial health, of which this particular loan covenant was an obvious indicator.

What makes the situation worse is that this company, despite having a solid management in place, good and dedicated workforce, including the accounting and finance organization, great work ethics and an incredible array of information technology hardware and software solutions, has no ability to properly forecast their balance sheet, where key data elements can be extracted and used to calculate forecasted financial ratios and in this example use the exact formula needed to determine the specific loan covenant they failed to meet.

The software application used in that company to perform all planning, budgeting and other corporate performance management (CPM) functions, is considered a Tier 1 application in its category, along with a popular Tier 1 ERP solution; however, management was just not capable of answering two simple questions: “Will we be able to meet our loan covenants, and at what safety margin?” and, “Will there be a deterioration or strengthening of our future financial health and at what rate?”.

Finance professionals know that a company’s financial health does not deteriorate overnight. It often takes years of bad performance by certain business units, bad management decisions about acquisitions, product development, marketing efforts, etc., to put the financial health of the company on a noticeable decline. The sad part is that you often can’t easily detect that from reading financial statements and management disclosures to these statements, even when they are prepared in compliance with GAAP rules or meet SEC reporting standards.

As the link above shows, there are technology products that were designed to address these major challenges that so many organizations face. It is clear to me that just investing in expensive IT solutions without completely and clearly defining the needs of the organization (e.g., ability to forecast a complete and accurate balance sheet) can lead it down a path where due to lack of visibility can cause unnoticeable worsening of the financial health of the company until it becomes apparent that something is very wrong. This, often, it is too late and frequently results in either the failure of the business, or an unplanned acquisition at a deep discount.

As the title of this blog post suggests, I urge you to seriously look at what matters in your finance organization and equip it with the right tools that can make a clear difference between meeting or blowing your loan covenants. If loan covenants are not applicable in your business, the strength of your balance sheet certainly is and should be regularly forecasted.