PROJECTING FINANCIAL FLEXIBILITY
Just as projected statements can reveal a company’s probable future financial profile, they can also indicate the likely direction of its financial flexibility, a concept discussed in Chapter 4.
For example, the projected statement of cash flows shows by how comfortable a margin the company will be able to cover its dividend with internally generated funds. Likewise, the amount by which debt is projected to rise determines the extent to which nondiscretionary costs (in the form of interest charges) will increase in future income statements.There is one important aspect of financial flexibility, continuing compliance with loan covenants, for which projections are indispensable. As Exhibit 12.14 illustrates, debt covenants may require the borrower to maintain a specified level of financial strength. Compliance may be measured
EXHIBIT 12.14 Sample Debt Restriction Disclosures
“The credit agreement contains various financial and operating covenants, which, among other things, require the maintenance of certain financial ratios, place limitations on distributions to stockholders and restrict the Company’s ability to borrow funds from other sources. In July 1999, the Company obtained a waiver which, among other things, raised the existing limitations on stockholder distributions.”
(World Wrestling Federation Entertainment, Inc. 2000 Annual Report)
“Each bank’s obligation to make loans under the Credit Facility is subject to, among other things, compliance by the Corporation with various representations, warranties, and covenants, including, but not limited to, covenants limiting the ability of the Corporation and certain of its subsidiaries to encumber their assets and a covenant not to exceed a maximum leverage ratio....
Certain of the Corporation’s other financing agreements contain restrictive covenants relating to debt, limitations on encumbrances and sale and leaseback transactions, and provisions which relate to certain changes in control.”(Lockheed Martin Corporation 2000 Annual Report)
“The covenant restrictions for the Syndicated Facility and Credit Facility include, among others, interest coverage and debt capitalization ratios, limitations on dividends, additional indebtedness and liens.... Under the termf of the Syndicated Facility and the Credit Facility, the Company is obligated to repay the borrowings under the facilities with the cash proceeds from the strategic plan divestitures. The Company was required to use all of the first $1,500 million of net proceeds from the divestitures to repay indebtedness, which it has done. Additionally, the Company is required to use 50% of the additional cash proceeds greater than $1,500 million and up to $2,500 million from divestitures to repay the indebtedness under the Syndicated and Credit Facilities.”
(Waste Management, Inc. 2000 Annual Report)
“The May 15, 2000 refinancing agreements require the Company to maintain a minimum EBITDA on a quarterly basis, a minimum fixed charge coverage amount on a quarterly basis, and a positive quarterly EBITDA (beginning with the quarter ending September 30, 2000) at the Cleveland SBQ facility. In addition, quarterly dividend and all other restricted payments, as defined, are limited to the lesser of $750,000 or 50% of income from continuing operations.”
(Birmingham Steel Corporation, 2000 Annual Report)
either by absolute dollar amounts of certain items or by ratios.1 Sanctions against an issuer that commits a technical default (violation of a covenant, as opposed to the failure to pay interest or principal on schedule) can be severe.
The issuer may be barred from paying further dividends or compelled to repay a huge loan at a time when refinancing may be difficult. Curing the default may necessitate unpleasant actions such as a dilution of shareholders’ interests by the sale of new equity at less than book value. Alternatively, the borrower can request that its lenders waive their right to accelerate payment of the debt. The lenders, however, are likely to demand some quid pro quo along the lines of reducing management’s freedom to act without consulting them.Analysts can anticipate this sort of loss of financial flexibility by applying covenanted tests of net worth, leverage, and fixed charge coverage to projected balance sheets and income statements. General descriptions of the tests can be found in the Notes to Financial Statements. These descriptions may omit some subtleties involving definitions of terms, but since the projections are by their nature also prone to imprecision, the objective is not in any case absolute certainty regarding a possible breach of covenants. Rather, the discovery that a company is likely to be bumping up against covenanted limits a year or two into the future means it is time to ask management how it plans to preserve its financial flexibility. If the answers prove unsatisfactory, the effort of having made the projections and run the tests may be rewarded by a warning, well in advance, of serious trouble ahead.