Friedman's Inc is a leading fine jewellery retailer.
In Nov 04, the firm said that it might default on certain of the financial covenants contained in 1 of the firm loan agreement. The following is an excerpt from the company's press release:
In particular, Friedman's expects that it will fail to meet cumulative EBITDA requirements for the period ending Oct 30 '04 constituting a default under its term loan and its revolving loan. Friedman's is currently in discussions with its senior lenders under the credit facility regarding the amendment of its covenants to eliminate the default.
Apparently, Friedman's term loan contained a provision that required the maintain a minimum level of profitability measured by EBITDA over several periods.
1. What will happen to the company if it violates these 2 covenants & is unsuccessful in obtaining a waiver or amendment from senior lenders?
2. Elaborate how the EBITDA covenant creates an incentive for Friedman's to engage in aggressive accounting practices. Provide 1 or more examples of aggressive accounting that Friedman's might use to avoid violating the EBITDA covenant.
3. Elaborate how the accounts payable to inventory covenant also creates an incentive for Friedman's to engage in aggressive accounting practices.
1. If Friedman's Inc violates these two covenants and is unsuccessful in obtaining a waiver or amendment from senior lenders, it could potentially face serious consequences. The lenders may declare the company in default, which would trigger certain actions. These actions could include accelerating the repayment of the loan, demanding immediate payment, imposing higher interest rates, and seizing company assets. In extreme cases, the lenders might take legal action to recover their funds, which could potentially lead to bankruptcy or liquidation of the company.
2. The EBITDA covenant creates an incentive for Friedman's to engage in aggressive accounting practices because it measures profitability based on a specific financial metric. Friedman's might try to manipulate its financial statements to increase EBITDA in order to avoid violating the covenant. Here are a few examples of aggressive accounting practices Friedman's might employ:
a) Revenue recognition manipulation: Friedman's might recognize revenue before it is actually earned, accelerating the recognition of sales to increase EBITDA.
b) Expense deferral: The company might delay recording certain expenses, such as advertising or maintenance costs, to show higher EBITDA.
c) Inventory valuation: Friedman's might overstate the value of its inventory, leading to higher gross profit margins and, subsequently, higher EBITDA.
d) One-time non-recurring gains: The company might include one-time gains, such as the sale of an asset, as part of its EBITDA calculation, artificially inflating the profitability figure.
3. The accounts payable to inventory covenant creates an incentive for Friedman's to engage in aggressive accounting practices as well. This covenant measures the relationship between the company's accounts payable (amount owed to suppliers) and its inventory. Friedman's may attempt to manipulate this covenant to its advantage by employing aggressive accounting practices. Examples of how the company might do this include:
a) Extending accounts payable terms: Friedman's could delay payment to its suppliers, temporarily increasing its cash position and reducing accounts payable. This would improve the accounts payable to inventory ratio.
b) Manipulating inventory valuation: Similar to the EBITDA covenant, the company might overstate the value of its inventory, leading to a higher inventory figure and a lower accounts payable to inventory ratio.
It is important to note that engaging in aggressive accounting practices is unethical and can have severe consequences, including damage to the company's reputation, legal repercussions, and the loss of investor confidence.
1. If Friedman's Inc violates these two covenants and is unsuccessful in obtaining a waiver or amendment from senior lenders, it could potentially face severe consequences. Firstly, it could be considered in default under its loan agreement, which may trigger a demand for immediate repayment of the loan. This can put significant financial strain on the company, especially if it does not have sufficient cash flow or alternative sources of funding to meet this demand. If the company fails to repay the loan, it may face legal actions from the lenders, such as foreclosing on the company's assets or taking control of the company. Ultimately, this could lead to bankruptcy or liquidation of the company.
2. The EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) covenant creates an incentive for Friedman's to engage in aggressive accounting practices in order to manipulate its financial results and meet the required profitability levels. One example of aggressive accounting that Friedman's might use is capitalizing expenses instead of recording them as immediate expenses. By capitalizing expenses, the company can spread the cost over a longer period, thereby reducing immediate expenses and boosting EBITDA. This can make the company's financial performance appear better than it actually is.
Another example of aggressive accounting is recognizing revenue prematurely. By recording revenue before it is actually earned, Friedman's can inflate its EBITDA. This can be done by recognizing revenue from advance sales or through aggressive revenue recognition policies that push the boundaries of accounting rules.
These examples illustrate how Friedman's might manipulate its financial statements to inflate EBITDA and meet the required covenant, even if their underlying financial performance does not actually support it. However, it's important to note that engaging in aggressive accounting practices is unethical and can have serious legal and reputational consequences.
3. The accounts payable to inventory covenant creates an incentive for Friedman's to engage in aggressive accounting practices as well. This covenant measures the relationship between the amount of money owed to suppliers (accounts payable) and the value of the company's inventory. Maintaining a certain ratio between these two accounts can indicate the company's ability to manage its working capital effectively.
To avoid violating this covenant, Friedman's may adopt aggressive practices such as intentionally delaying payments to suppliers, extending payment terms, or negotiating discounts for early payment but delaying actual payment. These practices artificially reduce accounts payable and improve the ratio between accounts payable and inventory. By doing so, the company can make its financial position appear stronger than it actually is.
However, engaging in such practices can harm relationships with suppliers and may lead to reputational damage. It can also strain cash flow management and potentially result in supply chain disruptions if suppliers refuse to extend credit or stop providing goods and services to the company.
It is crucial to acknowledge that while aggressive accounting practices may temporarily help meet covenant requirements, they can have serious long-term implications and should be avoided.