When companies raise money through the issuance of bonds or other long-term debt instruments, debt holders typically require the company to comply with certain conditions, or covenants. The notes to Circle K’s 1989 financial statements provide an example of debt covenants:
The notes (Senior Secured Notes) required the Company to observe certain financial covenants, including covenants relating to maintenance of a minimum consolidated net worth, a fixed charge coverage ratio, limitations on dividends, purchases of capital stock and a requirement that any successor by merger or similar transaction to the Company have a comparable net worth and assume all the obligations under the notes.
In addition to using debt to finance expansion, Circle K financed many of its store acquisitions through sales and leaseback transactions. These types of transactions represent a form of long-term debt financing and often involve covenants as well. The notes to the 1989 financial statements detail the results of a violation of covenants:
As of April 30, 1989, the Company was not in compliance with the fixed charge ratio of one of its sale and leaseback transactions involving 250 stores. Because of its noncompliance with such ratio, the Company is required to place $5 million per year into escrow.
1. What is the purpose of debt covenants?
2. What is the purpose of requiring an annual $5 million payment into escrow?
3. If Circle K’s financial condition is such that it violates its financing covenants, will requiring the company to place $5 million in escrow help to ease the financial strains?