14.02 Debt Covenant Compliance Flashcards
What is a covenant?
Covenants are legally enforceable promises made by a debtor (i.e. borrower) to its creditors (i.e. lender). These promises are set forth in the contract related to the debt. A covenant also describes the responses available to the lender if certain events or conditions occur. The covenant may allow the lender to call the debt if the borrower commits any violations.
How are covenants established?
Covenants can be established either unilaterally by the lender or through negotiation between lender and borrower.
What is the disclosure requirement for a covenant?
A description of the covenant must be disclosed in the notes to the borrower’s financial statements.
How often must the borrower demonstrate compliance with the covenants?
The borrower must periodically demonstrate compliance with the covenants. The frequency is set at the time of borrowing and varies according to the perceived riskiness of the borrower.
True or false: typically, minimum or maximum values are specified in the agreement.
True. Typically, minimum or maximum values are specified in the agreement, and any reported values outside the required limits are a violation.
What are examples of minimum-level debt covenants?
Current ratio; Working capital; Interest coverage ratio; Income measures.
Debt covenants may specify that minimum levels of assets or retained earnings must be maintained as well.
What are examples of maximum-level debt covenants?
Debt to equity ratio; Total debt ratio.
Debt covenants may specify that the company cannot exceed a maximum amount of interest expense or total debt.
What are examples of transactions restrictions that can be included in a covenant?
Limiting or prohibiting declaration of dividends or purchases of treasury shares; Limiting additional borrowings; Prohibiting the borrower from voluntarily reducing net assets; Prohibiting risky investments or expansion projects.
What is a debt rating minimum?
A covenant may require the firm to maintain a minimum debt rating. Two rating agencies commonly used are Standard & Poor’s Corporation (S&P) and Moody’s Investor Services (Moody’s). For example, a borrower may be required to maintain an S&P rating of A or better for compliance with the covenant.
True or false: ensuring compliance with covenants is an ongoing task for the borrower.
True. Both management and the audit committee continuously monitor the financial condition of the firm so that adjustments can be made in time to avoid situations that could cause a violation. Periodic internal self-evaluation precedes the formal compliance review that involves the lender. Before making any operating decisions that could alter the financial metrics, a borrower should analyze the impact of its options and determine which will improve compliance or perhaps cause a violation with the loan covenant.
What actions can a lender take if the borrower violates the covenant?
The debt contract describes the actions that may be taken by the lender in the event of a covenant violation by the borrower. Typically, these are options rather than requirements.
