Managing the Debtor-Creditor Relationship

During the current economic environment, a business owner reads news every day of businesses suffering financial hardship. This hardship often stems from  macroeconomic variables such as an industry slowdown or higher commodity prices. But the current credit market appears to be a common challenge for both large and small businesses in every industry.

Most businesses have relationships as both a debtor and creditor. For instance, a business may be acting in the capacity as a debtor when it owes money on a business line of credit, under a mortgage loan, or under a lease. In contrast, many businesses often extend credit in the form of customer accounts or as a lessor of space. The approach a business takes to manage its credit relationships can be a critical factor in determining the profitability or survival of the company. In most instances, these relationships are governed by a written agreement such as a loan or credit agreement, mortgage, vendor agreement, or lease agreement.

Owners and managers of a business should diligently review any agreements providing for the extension of credit. As a debtor, it may appear that your business currently complies  with the terms of such agreements. However, lenders are requiring strict compliance not only in terms of making payment but also in terms of compliance with the “covenants” included in the credit agreement. These covenants may include maintaining certain financial standards based on debt service coverage ratios, net worth ratios, or liquidity ratios. Further, creditors are more carefully reviewing the quality of  assets on the balance sheet. In some cases, lenders may challenge the  valuation of your assets. For instance, creditors now tend to apply a higher discount to aged accounts receivable. During this process, creditors may also review the credit of your customers and clients to determine the collectability of your accounts receivable.

Due to the lack of credit availability, a prudent approach would be to preserve the current credit relationship with your lender. One of the best tactics is to ensure  that your business is complying with the terms of your current credit agreements. Accordingly, we suggest the following:

  • Prepare carefully and diligently for any review by a creditor. Most credit agreements include a provision that requires the debtor to provide periodic financial statements. This year, it is reasonable to expect your  creditors to require you to comply with this covenant.
  • Make no assumption that a lender or creditor will provide an “automatic” renewal of your credit agreement or loan agreement as in previous years.
  • Assess and actively manage the quality of assets on the balance sheet of your business. Strictly scrutinize your accounts receivable from the perspective of the lender.
  • Negotiate with customers to convert  overdue accounts into promissory notes, and request that such promissory notes be secured by collateral (e.g. real estate, equipment). Lenders will be less likely to discount an account that is liquidated  into a note and is secured.
  • Prepare to substantiate valuations of  assets on the balance sheet, especially illiquid assets such as equipment and real estate.
  • Prepare to explain to your lender in detail any decline in revenues or profits along with any  extraordinary charges against earnings.
  • Seek outside advice from your advisors, such as your attorney and certified public accountants to prepare for the credit review.

Again, a primary concern of any lender will be the quality of your accounts receivable, or the amounts that other people owe you. If an account becomes doubtful, immediately communicate with the debtor and consider filing a lien to secure your account. Both Ohio and Kentucky have enacted statutes that give lien rights to certain types of businesses and professionals. Remember, however, that the lien holder must strictly comply with sections of the statute in order to file a lien. These rules include both the timing of  the filing of the lien and the form of the lien documents.

In sum, your creditor will focus on both your cash flow from operations and the strength of your balance sheet. Correspondingly, a proactive business owner should strictly scrutinize its accounts receivable or other debtor accounts to manage the relationships with people that owe them money. In an economy that appears to be in a period of “deleveraging,” you must assure that you business is not serving as a bank to another business that may be failing.