The Mortgage Crisis

Are the nation’s current mortgage industry crisis and home care connected? You bet. And the really frustrating thing about the situation is that HME companies had nothing to do with the cause but must deal with the aftershock.

Recall the advertising from only two or three years ago when the cost of a house was rising. Mortgage companies offered below-market rates, non-amortizing loans, lower equity requirements and other inducements to home buyers. Interest rates went up, delinquencies followed, and now the country is awash in foreclosures.

Think about who owns those bad home loans: mortgage companies, commercial banks and other equity investors. Many of the mortgage companies are themselves owned by commercial banks, and the banks are to some extent among the other equity investors.

Home care gets a lot of its capital from commercial banks. Some of the leasing companies are owned by commercial banks, and the others borrow from commercial banks. These are the same banks that have seen the increase in bad loans from their mortgage investments.

Beginning in 1988, bank regulators adopted risk-based capital requirements. This means that the risk associated with the bank’s assets (loans and investments) are ranked. As the risk associated with assets increases, so does the requirement for equity. If the equity doesn’t increase appropriately, the bank and the regulators have issues to deal with.

Lately, the risk associated with mortgage-related assets has gone up. So to avoid issues with regulators, bank managers will offset this increased risk with a decrease in the risk they accept in their other assets. Those other assets include (but are not limited to) small business loans, equipment leases and consumer loans.

To achieve a lower risk level, the banks will do a few things: They will likely hold more cash (pretty low risk). But the increase in cash will decrease the funds available for loans and leases of any type. They will also require a higher standard for new small-business loans and equipment leases. So, when a small business — an HME company, for instance — applies for a loan, it will have to be of higher quality to be approved. When a small-business loan comes up for renewal, the standard for approval will be higher, too.

Proactive HME providers will be sure their company’s financial condition allows them to be viable in the credit markets. To prepare, these are the things you should do before your next request for a loan or lease:

• Calculate “cash coverage” and be sure that it is greater than 1.3. Cash coverage is the annual EBITDA (earnings before interest taxes depreciation and amortization) divided by the sum of principal and interest payments (and capital leases) a borrower is making and proposes to make. It is worthwhile to note that some credit analysts may use “cash flow from operations” as reported on the statement of cash flows instead of EBITDA. If your company’s cash coverage is not greater than 1.3, either cash flow must increase or debt service must decrease. No matter how cash flow is defined or calculated, earnings are a common thread. So increasing cash flow is best done by increasing earnings.
• Calculate “leverage” and be sure that it is less than 2. Leverage is calculated by dividing total liabilities by total equity. Reducing leverage can be accomplished by eliminating debt or increasing equity. Most small-business owners are reluctant to increase equity because that often means selling a stake in the company to someone else. Another way to increase equity is to increase earnings, but that is sometimes too slow.
• Finally, calculate your “current ratio” and be sure that it is greater than 1.8. Dividing current assets by current liabilities to calculate current ratio. You can adjust current ratio by moving current liabilities to deferred liabilities if the leverage ratio is acceptable. Increasing current assets to make the adjustment should be limited to increasing cash.

Taking these steps now may give an HME manager enough time to make any needed adjustments to the company’s financial condition. Although this will not guarantee that a provider gets or keeps the credit facilities that it needs, it will get the company past the first step.

Wallace Weeks is founder and president of Weeks Group Inc., a Melbourne, Fla.-based strategy consulting firm. He can be reached at 321/752-4514 or by e-mail at [email protected].