In this video, we walk through 5 FAR practice questions covering debt covenant compliance calculations. These questions are from FAR content area 2 on the AICPA CPA exam blueprints: Select Balance Sheet Accounts.
The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.
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Debt Covenant Compliance Calculations
Debt covenants are conditions set by lenders in loan agreements that require borrowers to maintain certain financial metrics. Compliance with these covenants demonstrates a company’s financial stability and reduces the risk for lenders.
Understanding Debt Covenants
Debt covenants specify financial ratios or thresholds that a borrower must meet to avoid loan default or penalties. Commonly, these include metrics like the debt-to-equity ratio, current ratio, and interest coverage ratio. Ensuring compliance involves accurately calculating these metrics based on financial data.
Step-by-Step Guide to Calculating Debt-to-Equity Ratio
The debt-to-equity ratio assesses a company’s leverage and is calculated as:
Debt-to-Equity Ratio = Total Debt / Total Equity
Example: Suppose a company has total debt of $12,500,000 and total equity of $5,000,000. The debt-to-equity ratio would be:
Debt-to-Equity Ratio = $12,500,000 / $5,000,000 = 2.5
If the debt covenant requires a maximum debt-to-equity ratio of 2.0, this company would not be in compliance, indicating the need for strategic adjustments.
Calculating the Current Ratio
The current ratio measures a company’s ability to meet short-term obligations and is defined as:
Current Ratio = Current Assets / Current Liabilities
Example: A company with current assets of $3,600,000 and current liabilities of $2,000,000 would calculate:
Current Ratio = $3,600,000 / $2,000,000 = 1.8
If the debt covenant stipulates a minimum current ratio of 1.75, this company would be compliant.
Interest Coverage Ratio (Times Interest Earned)
The interest coverage ratio, also known as the times interest earned (TIE) ratio, measures a company’s ability to cover interest expenses with its earnings. It is calculated as:
Interest Coverage Ratio = EBIT (Earnings Before Interest and Taxes) / Interest Expense
Example: If a company’s EBIT is $4,500,000 and its annual interest expense is $900,000:
Interest Coverage Ratio = $4,500,000 / $900,000 = 5.0
If the covenant requires an interest coverage ratio of at least 4.0, the company is compliant.
Steps to Ensure Compliance
- Gather Accurate Financial Data: Ensure that the data used for calculations (e.g., total debt, equity, EBIT) is up-to-date and accurate.
- Calculate Each Ratio: Apply the appropriate formulas for each covenant requirement.
- Compare Results to Covenant Requirements: Assess whether the calculated figures meet or exceed the stipulated thresholds.
- Document Results: Keep records of calculations and any additional supporting data for lender review.
Consequences of Non-Compliance
If a company fails to meet its debt covenants, potential outcomes include:
- Increased Interest Rates: Lenders may raise the interest rate on the outstanding loan.
- Accelerated Repayment Terms: The lender could demand repayment sooner than expected.
- Operational Restrictions: Limitations on certain financial activities or expenditures.
- Reputational Impact: Reduced creditworthiness that affects future financing.
Example Scenario of Non-Compliance Penalty: A company with a loan agreement stipulating a 2% interest rate increase for failing a debt-to-equity covenant with a $10,000,000 loan balance. If the company’s actual debt-to-equity ratio exceeds the limit, the penalty would be:
Additional Interest Expense = 2% of $10,000,000 = $200,000
This increase would affect the company’s financial results and cash flow.
