Question

P8-8 Avoiding debt covenant violations ( LO 8-4) Page 8-38 Food Galore operates a chain of retail supermarkets. The supermarket business is highly competitive, and it is characterized by low profit margins. Food Galore recently entered into a credit agreement with a group of banks. Excerpts from the loan agreement follow. Fixed Charges Coverage The ratio of Income Available for Fixed Charges to Fixed Charges shall be at least 1.50 at every quarter end. Limitation on Additional Debt The Borrower will not create, assume or incur any additional debt unless the ratio of Income Available for Fixed Charges to Fixed Charges for each of the previous eight fiscal quarter ends has been at least 2.00. Minimum Tangible Net Worth Tangible Net Worth shall at no time be less than (i) $500 million plus (ii) 25% of the cumulative Net Income of the Borrower since the signing of the agreement minus (iii) 25% of the cumulative dividends declared by the Borrower since the signing of the agreement. Required: 1. In two more weeks, the company's books will be closed for the quarter, and the fixed charges coverage might fall below the level required by the loan agreement. How can management avoid violating this covenant? 2. The company's tangible net worth may also fall below the amount specified in the loan agreement. How can management avoid violating this covenant? 3. Elsewhere in the loan agreement it says that the company's ratio of consolidated debt to total capitalization must be no more than 0.75 to 1.0. How can management avoid violating this covenant? 4. Suppose you are one of Food Galore's bankers and you are considering making changes to the loan covenants. What management activities would you most want to limit? Why?

Answer 1

Requirement 1:

For most companies, the fixed charges ratio is just a variation of the interest coverage ratio.With only two weeks until the books are closed, the company needs to “find some income” that can increase the numerator of this ratio. Possible sources of income are:

• Accelerate the recognition of revenue from the first few days of next year into the last few days of this year (i.e., leave the books open past the fiscal year end).

• Delay the recognition of expenses from the last few days of this year until the first few days of next year (i.e., close the books early for expenses).

• Postpone discretionary expenses like maintenance, research and development, or advertising.

• Sell assets that have market values substantially in excess of their book values.

• Change one or more accounting methods to increase reported earnings. For instance:expand straight-line depreciation to all long-lived assets, eliminate LIFO accounting.

• Change one or more accounting estimates. For instance, increase the estimated useful lives of long-term assets, decrease salvage value estimates or bad debt allowances.

Requirements 2 and 3:

Some actions that could be taken to avoid violating the tangible net worth ratio are:

• Any of the actions outlined in (1) also apply here.

• Issue common stock before the end of the year.

• Reissue treasury stock before the end of the year.

• To reduce the ratio of consolidated debt to total capitalization (i.e., to total assets), the company could retire some debt before the end of the year. If the debt could be retired for a price close to its carrying amount, net worth would not change much.

• The last three items could be combined into a stock-for-debt exchange offer, although most transactions of this sort require more than two weeks’ time.

Requirement 4:

Answers to this question will vary from student to student. The dilemma confronting the banker involves a trade-off between (a) using covenants to restrict management’s action and thereby reduce credit risk and (b) inhibiting management from taking prudent actions that enhance cash flows and the likelihood of debt repayment. Students should be encouraged to see both sides of this situation.