C$7-2$

Sunny Day Stores: Analyzing debt covenants and financial distress $((7-7)$

Sunny Day Stores operates convenience stores throughout much of the United States. The industry is highly competitive, with low profit margins. The company's competition includes national,

regional, and local supermarkets; oil companies; and convenience store operators.

A note to the $20$X$1$ financial statements described the company's long$-$term debt:

Note payable to the Prudential Insurance Company of America $("$Prudential$")$ with annual principal payments of $$900,000,$ interest at $8\mathrm{.}93\%.$ Amount outstanding: $$5,700,000$ in $20x1$ and $$6,600,000$ in

$20$X$0.$

Term note payable to First Florida Bank $("$First Florida"$)$ maturing in September $20$X$6,$ with quarterly principal payments of $$125,000$ through June $30,20$X$2,$ and $$250,000$ thereafter, with interest at $1\%$

in excess of prime $(5\mathrm{.}5\%$ at December $26,20$X$1).$ Amount outstanding $$3,563,956$ in $20$ X $1$ and $$3,000,000$ in $20$ X $0.$

Revolving note payable to First Florida with interest at $1\%$ in excess of prime $(5\mathrm{.}5\%$ at December $26,20$X$1).$ Amount outstanding: $$7,400,000$ in $20$X$1$ and $20$X$0.$

Certain of the Company's loan agreements pertaining to the borrowings from Prudential and First Florida require the Company to maintain minimum interest coverage ratio, working capital, and net

worth levels; impose restrictions on additional borrowings; and prohibit the payment of dividends. Specifically, at the end of fiscal $20$X$1,$ Sunny Day must have a net worth of at least $$22,850,000,$

working capital $($on a FIFO inventory basis$)$ must be at least $$1,300,000,$ and the interest coverage ratio must be at least $1\mathrm{.}6.$

The company's $20$X$1$ financial statements that follow show that Sunny Day Stores was not in compliance with these loan covenants at year$-$end.

Sunny Day Stores, Inc.

Comparative Balance Sheets

December $31,$ Statement of Operations

Required:

It's late January $20$X$2,$ and Prudential and First Florida have hired you to act on their behalf in negotiations with Sunny Day Stores. Both lenders want to restructure their loans to address

the company's current financial problems, and the restructured loans may require covenant changes.

Prudential and First Florida seek your advice on the type and amount of collateral to be required, revised interest rates, and possible changes to the payment schedules. In addition, the lenders have

asked you to suggest new minimum net worth, working capital, and interest coverage ratios for $20$X$2$ and $20$X$3.$ Specifically:

What type and amount of collateral do you suggest be required?

Should a higher interest rate be charged? Why or why not?

What changes would you suggest be made to the payment schedule?

What new minimum net worth, working capital, and interest coverage limits would you suggest the lenders set?

Suppose the company asked permission to resume payment of its $$0\mathrm{.}12$ per share dividend, which was suspended in $20$X$0.$ What advice would you give Prudential and First Florida? Sunny Day Stores, Inc.

Statement of Cash Flows

$20$X$1$

$200$

$20$W$9$