In many owner-run businesses the relationship with the bank runs on requests. The bank asks for something and the owner finds it. A quarterly certificate falls due, so the owner and the bookkeeper put together a figure that looks like what the loan agreement describes. A renewal comes up, and the owner sends the year-end accounts and a spreadsheet. When a new facility is discussed, the credit analyst asks for the last twelve months by month, and the owner builds that too. Each request produces a slightly different number, because each was built by different people, at a different time, in a different way.
A credit committee looking at three versions of the same figure takes the lowest. It also notices that the business does not know its own number, and it prices that fact in its own way.
Lender Reporting ends this. It produces cash flow available for debt service every month, on the lender's own definition and reconciled to the statements, so that the number a credit analyst computes is one the business already reports.
Where Lender Reporting sits
Two drivers translate the business's cash into the lender's figure. This essay covers the first.
Free cash flow to the firm
- Lender ReportingThis essayProduces the lender's number every month on the loan agreement's definition, reconciled to the statements
- Capital Structure FileBrings every claim that ranks ahead of the owners onto one schedule, shareholder loans subordinated
Cash flow available for debt service
A pack on a fixed day
The pack goes to the lender on a fixed day soon after every month-end, month after month without a break. It holds the statements, cash flow available for debt service, free cash flow to equity once there is debt in place, and every covenant test.
Two habits make it work. The first is adopting the lender's definitions before the first pack is built. Where an owner would usually invent a version of the figure and hope the lender agrees, the business takes the definitions a typical senior credit agreement uses, or the term sheet's once there is one, and builds them directly from the chart of accounts, so the accounting system produces the figure and nobody assembles it by hand.
The second is putting the pack on the close calendar. Its day is a line on the close checklist, owned by the finance seat. The record counts from the first pack delivered on time, and packs rebuilt afterwards for months already past do not count. That rule carries most of the driver's weight. A business that decides it wants two years of packs can produce them in a week from the statements, and all they prove is that someone can build a spreadsheet. A pack delivered on its day for the month just closed, and then the next, and the next, proves that the business produces the lender's number as routine, and routine is what a lender relies on when it lends for five years.
A year of lender packs
Illustrative. Each cell is a month. A solid cell is a pack delivered by its fixed day, in this illustration twenty days after month-end; a dashed cell is a late one. The number is the days it took. Only packs delivered on time count toward the record; a late month restarts the count of consecutive packs. Select a month for its detail.
Delivered by the fixed dayLate2Days from month-end to pack delivered
Assembled on requestOn time in 0 of 12 months
On the close calendarOn time in 11 of 12 months
A lender who has had the figure on time for as long as the record runs, built the same way every month, has little reason to doubt the next one. That is the discount for certainty, and the record is what removes it.
Every line of the difference explained
Every pack also carries a bridge from free cash flow to the firm to cash flow available for debt service, with each line tied to the statements and nothing left unexplained.
The bridge starts from free cash flow to the firm as it was inspected at the start of the bridge, so the lender's figure and the buyer's figure share a root. Each adjustment the lender's definition makes is then a named line with its source account. Tax is the tax actually paid, where free cash flow to the firm uses the tax an unlevered business would pay. Capital spending is only what the business funds itself. And the add-backs are the ones the agreement permits.
For the lender, the bridge answers the question every analyst asks of a cash flow figure, which is where it came from. For the business, it keeps the two figures connected. A business that reports one number to its buyers and another to its lender, with nothing linking them, will eventually be asked by one of them to explain the other, usually at the worst moment.
Once a year, at the annual review, the outside accountant reperforms one month's bridge and the finding goes into the management letter. It is a small test, and it is enough. A lender who sees that an independent accountant reperformed the bridge and found nothing has a reason to trust the other eleven months.
Why the lowest version wins
Owners often take this behaviour personally, but the committee is not being unfair. It is lending money it cannot get back if it is wrong, and its return is capped at the interest rate. A lender that sizes debt on an optimistic figure and turns out to be right earns its margin; one that sizes on an optimistic figure and turns out to be wrong loses its principal. Faced with three figures and no way to tell which is right, the lowest is the rational choice.
Lending on the lowest version
Illustrative, and a price effect rather than value. A credit committee shown several versions of the same figure sizes debt service on the lowest. Annual debt service allowed is the figure divided by the coverage the lender requires.
In the illustration, a business shows a lender three versions of its cash flow available for debt service over the course of a negotiation: $950,000, $910,000 and $870,000. A lender that requires coverage of 1.25 will allow annual debt service of $760,000 on the highest figure, but $696,000 on the lowest. The $64,000 of annual debt service lost to the inconsistency says nothing about the business itself. It is what the lender's uncertainty about the number costs.
What it does to value
Most of what this driver wins shows up in the price of debt: the basis points a lender leaves off its margin for a reconciled bridge, its willingness to lend at all, and the wider pool of lenders a clean pack attracts. The framework records all of that as price.
The value sits in the covenant tests. A pack that tests every covenant every month, on the agreement's definitions, is read by the business before the lender reads it, so a tightening covenant shows months ahead of the lender's quarterly test, while there is still time to act. That lowers the probability of a breach, and breaches are expensive: waiver fees, new conditions, a higher margin and, at worst, a forced sale. The fall in that probability, multiplied by what a breach would cost the owners, is the value the framework counts, and on that basis the driver ranks seventh on the bridge.
What has to be in place first
The pack rests on three pieces of earlier work. It needs the fast close from Books on the second bridge, because a pack due soon after month-end cannot be built on a slow close. It needs the capital spending classification and the working-capital peg inspected at the start of this bridge, because the bridge to the lender's figure starts from those numbers and moves when they move. And it needs a finance seat with hours for the pack, named on the organization chart from Management Install, with the pack written into the role.
Knowing that it works
The driver is tracked on three measures: the days from month-end to pack delivered, against the fixed day; the run of consecutive on-time packs on hand; and the unexplained difference in the bridge each month, in dollars, which should be nothing.
Recomputed by the owner for one month from the statements and the definition alone, without the finance lead, cash flow available for debt service should match the pack. An owner who cannot do this is relying on the finance lead to speak to the bank for them, which works until the finance lead leaves. Reading the pack before it is sent, the owner can write down the three questions a credit analyst would ask of it and check that the pack already answers them.
Why it slips, and what holds it
The record breaks in one of two ways. Packs slip past their day, a day at a time, as month-ends run late. Or the finance function hollows out: a finance lead leaves or is stretched, and the owner is back managing the bank, assembling numbers on request as before.
The safeguards turn the pack from a habit into an obligation. The deadline is written into the finance lead's job description and, once debt is in place, into the loan agreement's reporting covenant, so a late pack is a breach. And a named deputy prepares one pack each quarter, so the pack survives the finance lead's absence or departure without the owner having to assemble it.