Growing law firms need cash, but cash can get tight. All firms should have access to reserve cash, such as a line of credit, but applying for a loan can be nerve-wracking — especially when bankers start throwing out unfamiliar terms. One of my clients (now in his second year on the Inc. 5000) needed to secure funding to keep growing. When he went to the bank, they said they needed to see his “pro formas.” He didn’t know what they were talking about and began to panic. Once I explained what a pro forma is (see below), he was mad the bankers didn’t just say that!
Hold Your Own in Loan Discussions
To help with your next loan, here are seven banking terms defined in plain English. Armed with these few phrases, you should be able to hold your own in any loan discussion.
1. Pro forma. This is a fancy term for next year’s budget or projections. Basically, bankers want to see if you will be able to pay back the loan. Create a spreadsheet that shows the revenue you anticipate having, then list all the expenses, and tally it all up. It should look just like your profit-and-loss statement (P&L). There should be plenty of profit at the bottom to show that you can make payments. Be aware that the numbers need to be supportable, and you need to be able to explain them.
2. PG. Bankers like abbreviations, and this one stands for personal guarantee. Until a business has been above $5 million for a couple of years, it won’t start building its credit score. As a result, you will need to use your own. Typically, bankers will ask that you sign a personal guarantee taking full financial responsibility if your firm can’t repay the loan.
3. PFS. This abbreviation stands for personal financial statement. It lists all your assets (bank, brokerage and retirement accounts; house; cars; and personal possessions), your expenses and debt (credit cards; student loans; mortgage; and car payments) and shows what’s left over, meaning your net worth. Bankers use this to see what happens to all the profits from your law firm. If your firm is clearing $50,000 a month, but you need every penny of that to live your life, it will be hard for the firm to repay debt. The lesson here is to always try to live within your means — not doing so can strangle your firm’s growth.
4. Debt coverage, Debt ratio, Leverage ratio, DI (debt to income). Bankers will look at this for your firm and for you personally. Take all your firm debt and divide it by your revenue. Then, using your PFS, do the same for your personal debt divided by your income. Bankers generally want to see this at 40 percent or under. If you go beyond that number, bankers worry that you won’t have enough cash to pay back the loan.
5. Collateral. Collateral is an asset pledged to guarantee a loan. Usually, assets are things that can be easily sold, so the bank can recover its money if you don’t repay the loan. Most law firms are low on collateral — all those computers, conference tables and law books won’t bring in much cash. However, firms can use things such as accounts receivable or even some large settlements to guarantee a loan.
6. Covenants. These are conditions of your loan that can be operational or financial in nature. Financial covenants generally say you have to maintain your DI (debt to income) at a certain level or get approval before taking on more debt. Operational covenants might require you to maintain a certain amount of insurance or not sell certain assets that may be tied to the loan. Covenants aren’t bad — but you need to be aware of and abide by them. Not doing so will trigger a technical default, which means you have to immediately pay back all money owed.
7. EBITDA. We hear this acronym on TV all the time. It stands for earnings before interest, taxes, depreciation and amortization. Essentially, bankers are looking for the net income number from your P&L because it’s a measure of your operating performance before you make financing or accounting decisions. If your bookkeeper is really on top of things and is subtracting depreciation and amortization from your P&L every month, simply add those back in when you are discussing EBITDA.
These words and acronyms sound more intimidating than they actually are. Bankers like to use shorthand terms and often forget that most businesspeople aren’t familiar with them. It happens in every industry — even in the law.
Brooke Lively is the CEO and founder of Cathedral Capital, a consortium of CFOs and profitability strategists committed to equipping entrepreneurs and small businesses with the tools and expertise to take their business to the next level. Leading with her competencies of financial expertise and executive coaching, Brooke nurtures her clients’ growth, whether in the bottom line or their impact in their communities and industries. Follow her on Facebook, Twitter and LinkedIn.
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