What are the most common debt covenants, and how do accounting choices affect covenant compliance?

Question

AcadiFi · Accepted Answer

Debt covenants are contractual restrictions placed by lenders to protect their investment. They typically require the borrower to maintain certain financial ratios or refrain from specific actions. Violation can trigger technical default, giving the lender the right to demand immediate repayment.

**Common Financial Covenants**

| Covenant Type | Typical Threshold | Formula |
|---|---|---|
| Interest coverage | Minimum 2.0x - 3.5x | EBIT(DA) / Interest |
| Debt-to-equity | Maximum 1.5x - 3.0x | Total debt / Equity |
| Current ratio | Minimum 1.2x - 1.5x | Current assets / Current liabilities |
| Debt-to-EBITDA | Maximum 3.0x - 5.0x | Total debt / EBITDA |
| Tangible net worth | Minimum dollar floor | Equity - Intangibles |

**Non-Financial (Affirmative and Negative) Covenants**
- Maintain insurance on assets
- Provide audited financials on time
- No additional debt above specified limits
- No asset sales without lender approval
- No dividend payments above a threshold

**How Accounting Choices Affect Compliance**
Companies approaching covenant violations have incentives to choose accounting methods that improve reported ratios:

1. **Capitalize vs. expense** -- Capitalizing costs (e.g., interest, development) increases assets and equity, improving debt-to-equity and tangible net worth. It also shifts expenses to future periods, boosting current EBIT and interest coverage.

2. **Depreciation method** -- Using straight-line instead of accelerated depreciation keeps early-year expenses lower, supporting higher EBIT.

3. **Revenue recognition timing** -- Recognizing revenue earlier (e.g., aggressive percentage-of-completion estimates) inflates income and equity.

4. **Lease classification** -- Under older standards, keeping leases off-balance-sheet improved debt ratios. Under IFRS 16 and ASC 842, most leases are on-balance-sheet, but exemptions for short-term and low-value leases still exist.

5. **Inventory method** -- FIFO in a rising-cost environment produces higher inventory values and higher equity compared to LIFO.

**Example:** Ridgecrest Industries has a debt-to-equity covenant maximum of 2.5x. Current metrics:
- Total debt: $50M
- Total equity: $18M
- D/E ratio: 2.78x -- **in violation**

Management's options:
- Capitalize $5M of software development costs: Equity rises to $23M (pre-tax), D/E drops to 2.17x.
- Switch from LIFO to FIFO: If LIFO reserve is $3M, equity rises by $3M x (1-tax rate), potentially pushing D/E below 2.5x.
- Reclassify short-term debt as long-term: No impact on D/E, but may help current ratio covenants.

**Analyst Response**
Analysts should read covenant terms in the debt footnotes, monitor ratios against thresholds, watch for accounting changes near covenant boundaries, and assess the consequences of a breach (waiver negotiations, higher rates, forced asset sales).

**Exam Tip:** The CFA exam tests your understanding of how management's accounting choices interact with covenant constraints. Expect scenarios where you identify which policy change would help or hurt covenant compliance.

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What are the most common debt covenants, and how do accounting choices affect covenant compliance?

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