3 Stress-Tests to Perform on Your Borrowers’ Financials

Mark Twain once recalled, “I’ve had a lot of worries in my life, most of which never happened.”  A lot of worries add up to a lot of stress, which the Oxford Languages Dictionary defines as a “state of mental or emotional strain or tension resulting from adverse or very demanding circumstances.”  We bankers undergo stress when our borrowers reveal that they may not be able to pay us back, so we try to get ahead of the curve by putting a little stress on borrower financials. That is what we will explore now.  What are some quick stress tests that we can employ to check out our borrower’s ability to repay?  Let’s look at interest expense, break-even revenue, and sustainable revenue growth.

Interest Stress Test

The long recovery from the Great Recession lulled bankers to sleep because interest rates remained unchanged for so long, but as 2020 came to an end, the COVID-19 epidemic and the consequent brief recession reminded us that interest rates can rise.  A combination of work-from-home strategies, supply chain kinks, the war in Ukraine and other geopolitical issues found the Fed fighting inflation by simply pushing up interest rates.  So, maybe it is time to dust off the credit analysis manual and evaluate your borrower’s ability to repay under a rising rate environment. 

Here is an example of how to stress-test interest rates; Devco pays 6% on its fully funded $1,000,000 line of credit (LOC) totaling $60,000, resulting in interest coverage of 1.6x:

However, if the borrowing rate rises to 8% on the $1MM line of credit, the coverage ratio falls to only 1.2x, but we can introduce more what-if’s into this interest rate stress test by dropping  sales to $900,000 to simulate a possible recessionary environment.  Now the coverage ratio falls to 0.95x, indicating that there is not enough EBIT to cover interest expense.

Further refinements to interest coverage would switching from EBIT to operating cash flow and measuring its coverage of principal as well as interest.  But you get the picture—a borrower unable to pay interest is unlikely to repay principal unless there is enough collateral to liquidate.

Revenue Stress Test

You might not think about stress-testing revenues, but nearly all cash flow projections for determining repayment ability start with revenues.  Think about it—you need to project the income statement and the balance sheet to derive the cash flow.  Future revenues drive the income statement, and because those revenues depend on having inventory to sell and facilities to house the unsold inventory, you have to project future inventory and fixed assets to support the revenue growth.  You also have to figure out how to pay for it, and that means future funding by debt or equity.  So, ask yourself these two questions—how much revenue does your borrower have to generate just to break even, and how much revenue can your borrower actually sustain from its own resources?  Think of the break-even point as the floor and the sustainable growth rate as the ceiling in revenue growth.

Break-Even Analysis:  How Low Can You Go?

The traditional method for calculating break-even sales derives from how much gross profit is needed to cover fixed expenses. Figure 2 provides an example of Devco, a $1 million firm with $820,000 as its break-even point:

We assume that all the operating expenses between the gross profit line and pre-tax line are overhead and therefore fixed, so by dividing the $164 by the gross profit margin ($200/$1,000 = 20%), we can calculate the break-even sales point (BES):

• (BES) = ($164,000)/ (gross profit margin of 20%) = $820,000

Figure 3 shows that $820,000 is indeed the break-even sales level:

The point of all this math is simply to say, the lower the gross margin, the higher the break-even point. Too high a break-even point could break both the borrower and the banker, so a couple of ways to reduce the break-even point are to boost gross profit and cut expenses.

One pragmatic way to determine the reasonableness of this and all other expenses between the gross profit margin line and the pretax profit margin line is to compare the borrower’s GPM and pre-tax profit (PBT) margin with the Risk Management Association’s Annual Statement Studies of industry averages. If the firm’s gross profit margin is in line with RMA averages but its PBT margin is below average, then its operating expenses are too high. If the borrower’s GPM is below RMA averages, then the alternative solution may be to raise prices or reduce its cost of goods sold (COGS)

Recession reminds us all how vital a role business profits play in recovery, and break-even analysis’ identification of the minimum sales needed to break even is critical to a firm’s survival. Remember Chubby Checker’s sage question from his 1962 Limbo Rock: “Limbo lower now, Limbo lower now, how low can you go? ” Don’t let borrowers dance around the question, set the expectations bar as low as your borrowers can go. The lower they can reduce their fixed costs, the lower their break-even points will be, and the happier both borrowers and bankers will be. Now that we have plumbed the depths of revenues, we can turn our attention to those sky-high projections.

Sustainable Growth Rate:  How High Can You Fly?

As the breakeven point sets the “floor” for a client’s sales growth, the absolute minimum in sales needed to stay in business, then the sustainable growth rate sets the “ceiling” for sales growth. It is the most a client’s sales can grow without new external financing from additional investment or more debt.  Said another way, it is the maximum sales growth rate that can be achieved given the company’s profitability, asset utilization, dividend payout and debt ratios.

But what if the firm’s actual growth exceeds its sustainable growth?  It can sell new equity to raise new money, raise more debt financing, permanently reduce dividend payments to shareholders, try to increase its profit margin, or try to generate more dollars out of its asset base.  Unfortunately, there are drawbacks to these options. First, selling new equity dilutes the owner’s shares. Second, raising more debt pushes the firm’s leverage higher and perhaps closer to debt covenant default. Third, reducing dividends makes shareholders unhappy. Fourth, mature firms often have sustainable growth rates somewhat less than their maximum rate because they distribute their excess cash to shareholders or put it to work in investments.  Finally, increasing the profit and generating more dollars out of its asset base are long-term strategies that are not as easy to accomplish as they sound.

You can calculate SGR in these seven steps:

Step 1. Asset Utilization

Divide sales by total assets. This is the asset utilization rate, the dollar amount of sales a firm generates each year as a percentage of its total assets.

Example: Total assets at year-end is $1,000,000. Total sales throughout year is $250,000, so the asset utilization rate is $250,000/$1,000,000, or 25%, which means every year the firm generates 25 cents of sales per $1.00 of assets.

Step 2. Profitability

Divide profit after taxes by total sales to calculate the company’s profitability rate, or the percentage of total sales that the business keeps at the end of the year after paying all its expenses.

Example: profit after taxes is $50,000. Using the $250,000 in revenues from Step 1, the firm’s profitability rate is $50,000/$250,000, or 20%, which means every year the firm keeps about 20% of revenues, and the rest goes to pay for the cost of business.

Step 3. Leverage

Divide total debt by total equity. This is the company’s leverage ratio or sometimes called its financial utilization rate.

Example: Total Debt is 500,000. Total Equity is 500,000. Therefore, the leverage ratio is 1.0x, or said another way, its financial utilization is 100%.

Step 4. ROE

Multiply the asset utilization, profitability, and financial utilization rates to calculate the firm’s return on equity (ROE). The ROE is the amount of the company’s profits that it keeps for itself and can use to generate future profits

Example: multiply the three rates together, i.e., 25% asset utilization x 20% profit x 100% financial utilization to calculate the firm’s ROE of 5%.

Step 5. Dividend Rate

Divide net income by total dividends to calculate the dividend rate, which is the percentage of the firm’s earnings given to its shareholders.

Example: Net Income is $50,000. Dividends are $5,000, so $5,000/$50,000 = 10% dividend rate.

Step 6. Retention Ratio

Subtract the dividend rate from 100% to determine the firm’s retention ratio, or the percentage of net income the business keeps for itself after it pays dividends.

Example: 100% – step 5’s 10% = 90% business earnings retention rate.

The business retention ratio integrates into the sustainable growth rate any amount the firm pays out as dividends, and assumes that the firm will continue to pay dividends at that rate in the future.  Of course, paying out dividends diverts profits from building equity internally.

Step 7. SGR

Multiply the earnings retention rate and the ROE to arrive at the sustainable growth rate. This figure represents the return on the firm’s investment it can achieve without issuing new stock, investing additional personal funds into equity, borrowing more debt, or increasing its profit margins.

Example: multiply the calculated 5% ROE by the 90% retention rate to calculate the final 4.5% SGR. Said another way, given its current asset utilization rate, profit margin, leverage, and dividend pay-out ratio, this firm can grow at 4.5% without having to seek outside additional equity or debt.

If a firm’s actual growth rate (AGR) is higher than its sustainable growth rate (SGR), it will have to fund the growth in assets and costs before it can generate the increased income. Possible funding sources include borrowing, issuing additional equity, investing personal funds, or reducing dividends. If the firm does not wish to take any of these actions, then it will have to reduce its growth to the sustainable growth rate at which level it will have no need for additional funds to finance the additional assets and costs no longer needed.  If a firm’s actual growth rate (AGR) is below its sustainable growth rate (SGR), the firm is able to finance its sales growth without going outside for more equity or debt.

Bankers sometimes provide the debt in exchange for covenants restricting dividends. So, in this example, the SGR can be boosted to 10% by curtailing dividends and raising the retention ratio to 100% and allowing the leverage ratio to rise from 1.0x to 2.0x, i.e., increasing debt from $50,000 to $100,000.

There are a few stress test indicators to build into your portfolio monitoring—interest rates, break-even analysis, and sustainable sales growth rate.  The current environment of rising interest rates playing over a background of potential recession necessitates that lenders measure how high interest rates can go before borrowers can no longer pay them.    Consider tracking your borrowers’ break-even sales points and sustainable growth rates to provide a floor and ceiling, respectively on revenues, respectively.   Simon and Garfunkel reminded us in their 1966 Feeling Groovy, “Slow down, you move too fast, got to make the morning last.” From morning until night, bankers review borrowers’ projections that sometimes do move too fast, relying heavily on a skyrocketing revenue forecast. The SGR offers a straightforward way to test its ability to achieve its sales given the firm’s sales productivity, its profit margin, its leverage, and its dividend pay-out ratio. Below SGR’s ceiling, look for a sound floor with break-even analysis to determine how much the firm must sell to begin generating profits for repayment.