3 Biggest Ramifications of an Inaccurate Financial Model
An inaccurate financial model can cost you, as a borrower, reasonable terms on credit facilities as well as other debt financing options. At the very least, an inaccurate model makes you look unprofessional and can harm your credibility.
Developing a thoughtful financial model is one of the most important things you should do as a borrower before engaging with lenders for refinancing or sourcing new credit facilities. Below are the three most significant ramifications that an inaccurate financial model can trigger.
1) An inaccurate model causes impractical covenant ratios.
Lenders base their covenant ratios off the borrower's verbal commitments and financial projections.
To allow wiggle room, lenders will first take a small percentage off the projections so the company will not be under pressure to hit exact targets. It is likely that a lender will take a 10% to 20% trim off of the model numbers before setting ratios and covenants. If the model is too bearish to begin with, then the borrower effectively gets penalized twice. For this reason, accuracy of the model is more important than being too conservative.
All lenders will have internal policy limits that govern how relaxed those covenants can be. It can vary greatly from different industries and types of lenders. However, the lender will also want to structure a deal to allow for a contingency plan if the borrower misses their covenant. That might mean receiving a waiver, paying a penalty fee or submitting new projections.
For example, a common covenant set by lenders is cash flow leverage which calculates as Total Debt / EBITDA. If the lender’s policy maximum is 4x, but the financial model shows the borrower projecting to be below 2x for the foreseeable future, then the lender is likely to set the cash flow leverage at 2.5x offering a desirable amount of cushion for the 2x, but certainly far away from the 4x limit.
Setting the wrong model could result in having covenants that aren’t anywhere close to the lender’s maximum flexibility.
2) An inaccurate model can lead credit committees to approve the wrong amount of credit.
This is most often an issue when a company is looking to put a working capital line of credit in place.
Term loans for real estate expansion, acquisitions, and other projects are usually more of a set amount. However, working capital amounts are set based on the borrower’s financial model. If the company fails to predict the proper amount of cash inflows and outflows, then the credit amount may be too big or too small.
Receiving to large of a credit line might result in the borrower paying unnecessary unused fees ranging between 25 bps and 50 bps per year. Receiving too small of a line of credit binds the company and restricts its plan forward.
3) An inaccurate model harms the lenders’ confidence in the company's management.
Finally, one of the biggest reasons that lenders turn down borrowers is that they have little to no faith in the management of the company. No lender wants to initiate or continue a relationship with a borrower if they have lost confidence in the management.
One way to demonstrate your business’ competence is to have a model that is well thought out and accurately reflect the current state of the company and its trajectory. If you, as a borrower, have some uncertain variables, then it would be wise to generate various scenarios to help the lender understand that management is anticipating challenges and obstacles professionally.
If your forecasts are wildly wrong, management will need to act quickly to explain the variances with the projections. Provide sufficient reasons to shows the lenders why they should trust the revised forecasts and what you are doing to anticipate any future variances.
If the forecasts consistently miss the expectations due to foreseeable reasons, then the lender will likely get “deal fatigue” and will be unmotivated to continue the talk. In such cases, the CFOs are often replaced.
We know it is hard to build a high-quality financial model for debt deals overnight and we are here to help. Click here to contact us today.