Debt covenants expressed in terms of income
Morton Manufacturing maintains a credit line with First Bank that allows the company to borrow up to $1 million. A covenant associated with the loan contract limits the company”s dividends in any one year to 20 percent of net income. The 2012 income statement data of Morton Manufacturing is as follows:
|
Net sales |
$840,000 |
|
Less: Cost of goods sold |
570,000 |
|
Gross profit |
$270,000 |
|
Selling and administrative expenses |
120,000 |
|
Net operating income |
$150,000 |
|
Gain on sale of securities |
14,000 |
|
Interest expense |
(4,000) |
|
Net income From continuing operations before tax |
$160.000 |
|
Less: Income tax |
51,200 |
|
Net income From continuing operations |
$108,800 |
|
Extraordinary gain (net of tax) |
22,000 |
|
Net income before change in accounting principle |
$130,800 |
|
Income effect due to change in accounting principle |
52,000 |
|
Net income |
$182,800 |
a. Compute the maximum amount of dividends Morton can pay if the debt covenant is expressed as 20 percent of each of the following:
(1) Net income
(2) Income before change in accounting principle
(3) Income before extraordinary items (from continuing operations)
(4) Net operating income
b. Explain why the bank may wish to state the contractual limitation on dividends in terms of income from operations instead of net income.