Violating a Covenant
Response to the following problem:
Often banks will require a company that borrows money to agree to certain restrictions on its activities in order to protect the lending institution. These restrictions are called "debt covenants." An example of a common debt covenant is requiring a company to maintain its current ratio (which is current assets ÷ current liabilities) at a certain level, say, 2.0.
Your boss has just come to you and asked, "How can you make our current ratio higher?"
You know that the company has a line of credit with a local bank that requires the company to maintain its current ratio at 1.5. You also know that the company was dangerously close to violating this covenant during the previous quarter. The end of the fiscal period is next week, and some action must be taken to increase the current ratio. If the covenant is violated, the lending agreement allows the bank to significantly modify the terms of the debt (in the bank's favor) and also gives the bank a seat on the company's board of directors. Management would prefer not to have the bank involved in the day-to-day affairs of the business, nor do they want to alter the terms of the lending agreement
Identify ways in which the current ratio can be increased. Would any of the alternatives you identify be good for the business, e.g., selling equipment might raise the current ratio but would that be good for the business? Should a company engage in these types of transactions?