FROST, PLLC Says Most Companies Can Prevent Debt Covenant Violations

Online, September 18, 2009 (Newswire.com) - Violating debt covenants can tarnish a company's credibility within the business community with lightening speed. At a minimum, debt covenant violations cause issues between the borrower and the lending institution - a relationship that is vital to the livelihood of most businesses. Available credit options can be reduced significantly or disappear completely. Even the possibility of a debt covenant violation is viewed as an indication that a company is not financially strong. In many instances, the problem grows as lenders react by tightening credit lines.

"One of the first lessons new or even more experienced business owners should understand is the value of credit worthiness," says Rachel Kremer, FROST, PLLC audit member. "One of the foundations of credit worthiness is fiscal discipline. Obtaining financing and liquidity comes at a cost that is more than just the interest cost of the debt. Many times contained within debt agreements are provisions called debt covenants."

Debt covenants can be affirmative, negative, or restrictive covenants. Essentially, covenants are agreements between a company and its creditors that the company should operate within certain prescribed limits. The restrictions contained with the debt agreement might specify that a certain level of sales or profits be generated or might limit the company's ability to incur other debt. If debt covenants are violated, often the loan becomes due immediately.

"Debt covenant violations can be signs of short-term financial strain or even precursors to bankruptcy," Kremer says. "But these violations aren't always indicators of financial weakness. Debt covenant violations can also be the result of changes to accounting standards or lack of planning on the part of financial managers."

Financial managers may fail to anticipate the impact of accounting pronouncements such as new accounting rules surrounding variable interest entities, uncertain tax positions or mandatory buyout provisions in equity agreements.

"Unintended consequences of implementation of new accounting standards and potential violations can be handled by obtaining waivers in advance from lenders by communication of the issues in the financial statements as a result of new standards," Kremer says. "Additionally, managers could seek revisions to current debt covenants from its lenders when circumstances, including new accounting standards, create accounting results that were unanticipated at the time of the original debt agreement."

The purpose behind covenants is to set up parameters in certain key areas of financial performance. The lenders identify which performance measurements will provide indications of the viability and likelihood of future repayment. Savvy financial managers will anticipate negative results from standards implementation and be prepared to explain to lenders why these results are not indicative of any change in credit worthiness or impact the likelihood of repayment.

"Debt covenants violations often occur simply due to the inability of the financial managers within an organization to properly plan," says Kremer. " Acquisitions, dispositions, fixed asset additions, or even an unexpected bulk purchase at period end can have unintended consequence to a financial statement and the resulting financial ratios."

For entities that operate within the parameters of credit facilities that contain restrictive covenants, most decisions will have to be made with one eye on the financial impact on its financial statements and the ratios which are being scrutinized by lenders. Using financial models that project the financial implications of hypothetical situations will greatly assist financial managers in understanding the wide reaching implications of executive decisions.

"Assistance from outside experts, such as independent auditors, tax preparers, and attorneys, should be part of a company's decision making process, to ensure that any scenario is considered from all perspectives," adds Kremer. "Companies should also communicate with lenders as to the necessity of the planned action and the intended results of the action, whether it is to purchase inventory at year end or to acquire a competitor in another market. This dialogue should include why the action is beneficial to the company despite the short-term violation of debt covenants."

Despite the cause of a debt covenant violation or the potential breach of debt covenant, planning and communication can help most companies navigate through the current economic and regulatory storms. Strong business teams including management, lenders and outside advisors, can anticipate issues and resolve them before they arise. Sometimes promises must be broken, but no company should risk the potential damage that a debt covenant violation can cause if it can be avoided.