The following information is based on an actual annual report. In a recent lending agreement (dated March 3, 2014), Guaraldi Bank, Inc., included the following definitions for terms used in its loan covenants with a borrower:
Fixed Charges means the sum of, for Borrower and its Subsidiaries, determined in accordance with GAAP on a consolidated basis, (a) interest expense (including interest expense pursuant to Capital Leases), plus (b) lease expense payable for Operating Leases, determined for the four fiscal quarters preceding the date of calculation.
Net Earnings Available for Fixed Charges means, for Borrower and its Subsidiaries, determined in accordance with GAAP on a consolidated basis, (a) Net Income before Taxes, plus (b) extraordinary noncash charges, plus (c) interest expense (including interest expense pursuant to Capital Leases), plus (d) lease expense pursuant to Operating Leases, determined for the fiscal quarter preceding the date of calculation.
Fixed Charges Coverage Ratio means the ratio of Net Earnings Available for Fixed Charges to Fixed Charges.
Required:
1. Assume that the borrower "somehow" restructures the existing lease to have it qualify as an operating lease. What effect will this change in lease classification have on the times interest-earned ratio as typically defined? (See Chapter 5.) What effect will this change have on the fixed charges coverage ratio as defined in the lending agreement? What does your answer to this part tell you about the vigilance that credit analysts must exert in designing and monitoring financial contractual restrictions?
2. Now assume that the initial times-interest-earned ratio was less than 1.00 to 1.00. Would changing the capital lease to an operating lease benefit the borrower's compliance with lending covenants?