How Can We Live with Debt Covenant Requirements?
Bohr Company has a credit agreement with a syndicate of banks. In order to impose some limitations on Bohr’s financial riskiness, the credit agreement requires Bohr to maintain a current ratio of at least 1.4 and a debt ratio of 0.55 or less. The following summary data reflect a projection of Bohr’s balance sheet for the coming year end.
|
Current assets |
$1,200,000 |
|
Long term assets |
1,800,000 |
|
Current liabilities |
900,000 |
|
Long term liabilities |
800,000 |
|
Equity |
1,300,000 |
The following information has also been prepared.
(a) If Bohr were to use FIFO instead of LIFO for inventory valuation, ending inventory would increase by $50,000.
(b) The amounts listed for long term assets and liabilities include the anticipated purchase (and associated mortgage payable) of a building costing $100,000, or Bohr can lease the building instead. The lease would qualify for treatment as an operating lease.
(c) Projected amounts include a planned declaration of cash dividends totaling $40,000 to be paid next year. Bohr has consistently paid dividends of equivalent amounts. As a consultant to Bohr, you are asked to respond to the following two questions.
1. What steps can Bohr take to avoid violating the current ratio constraint?
2. What steps can Bohr take to avoid violating the debt ratio constraint? Of the steps that you propose, which ones do you think the banks had in mind when they imposed the loan covenants? If you had assisted the banks in Dr. awing up the loan covenants, how would you have written them differently to avoid unintended consequences?