Last issue we wrote about organizational restructuring strategies that enable teams to rejuvenate their companies.
While financial restructuring is not a prerogative to restructuring an organization, it is often entailed in the process when a drastic change in company direction is necessary. Since financial restructuring is a subject that needs comprehensive examination, in this article we’ll narrow our focus to debt restructuring for otherwise viable businesses.
Let’s start with an example of a fictitious company called Hot Fab Metals Inc. that has been in business for 30 years. It enjoys healthy margins and has had no issues finding work. It occupies a unique market niche and is well-liked by customers.
Unexpectedly, purchase orders from one of its three largest customers come to a halt. The management team finds out the customer just filed for creditor’s protection. In a nutshell, 30 per cent of Hot Fab’s business will likely disappear and there is no potential customer in its pipeline to replace that business. In the meantime, the company maxed out its $1 million line of credit and still needs to repay approximately $1 million in property mortgage on its manufacturing facility.
To make matters worse, approximately $1 million in accounts receivable from that one particular customer is now in serious jeopardy as Hot Fab was recently classified as an “unsecured creditor” by the customer’s Trustee.
Fast forward six months, Hot Fab Metals Inc. finds itself in an interesting predicament. The bank manager complains that the $1 million line of credit has not revolved in the past six months and is threatening to “term out” the line of credit if not paid down soon. While the sales team scrambled to replace the lost customer, Hot Fab’s lawyer broke the news that the company is fortunate to be entitled to $200K of the $1 million owed by the subject customer. In essence, $800K of the company’s receivables vanished into thin air. It is inevitable Hot Fab will show a negative bottom line in the forthcoming year end.
While Hot Fab has been a great customer since the relationship’s inception with its bank 10 years ago, the managers have been concerned over Hot Fab’s “concentration risk” and lack of customer diversification. Ideally, banks would like to see sales revenue spread out over several customers, preferably among a few industries, and that the top five customers do not make up 50 per cent of total sales.
Two or more possible scenarios can happen in the banking relationship during the annual review. These will depend on the following situations: (1) How strong is the balance sheet? Is the debt to tangible net worth ratio below 2:1? (2) Is there enough equity or working capital circulating in the business to withstand this type of temporary setback? (3) How profitable are the remaining two large customers and smaller customers combined? Would profits from the remaining customers be sufficient to service the principal and interest payments? (4) Were there discretionary (i.e. management salaries above and beyond market rates) or non-recurring expenses that they can add back to “normalize” the cash flow at year end so that the resulting figure is sufficient to make the required principal and interest payments? (5) Can the owners inject personal equity to temporarily prop up the business? (6) Are there redundant assets that the company can liquidate to service the debt or maintain adequate working capital?
These are mitigating factors that owners can discuss with their bank. If two or three of the above scenarios are missing, it is possible that the bank manager will either (A) put Hot Fab on a “Watchlist”, (B) ship Hot Fab’s file to special loans to rehabilitate the relationship, or worse, (C)divest the relationship to another institution that has higher tolerance for Hot Fab’s deteriorated risk profile.
If the third scenario occurs, the $1 million property mortgage will likely be taken over by a private lender and the $1 million line of credit will be “termed out”. If the property has surplus equity, both can be lumped into one term loan from a private lender. The “restructured” loans will now be financed at 8 to 9 per cent compared to 4 and 5 per cent previously. This is referred to as debt restructuring.
The good news is the reverse can also take place. Once the company bounces back, there is opportunity to restructure the debts back to when the company was healthy. It is highly recommended that Hot Fab establish a relationship with a new bank that has no “corporate memory” of its previous financial situation. It can wipe its slate clean and set up new facilities at previous interest rate levels.