Food Lion, Inc., operates a chain of retail supermarkets principally in the southeastern United States. The supermarket business is highly competitive, and it is characterized by low profit margins. Food Lion competes with national, regional, and local supermarket chains; discount food stores; single-unit stores; convenience stores; and warehouse clubs. Food Lion recently entered into a credit agreement with a group of banks. Excerpts taken from the loan agreement follow.
Section 5.19. Limitation on Incurrence of Funded Debt The Borrower will not create, assume or incur or in any manner be or become liable in respect of any [additional] Funded Debt . . . [unless] the ratio of Income Available for Fixed Charges for the immediately preceding four Fiscal Quarters to Pro Forma Fixed Charges for such four Fiscal Quarters shall have been at least 2.00 to 1.00. Section 5.20. Fixed Charges Coverage At the end of each Fiscal Quarter . . . the ratio of Income Available for Fixed Charges for the immediately preceding four Fiscal Quarters then ended to Consolidated Fixed Charges for the immediately preceding four Fiscal Quarters then ended, shall not be less than . . . 1.75 to 1.0. Section 5.21. Minimum Consolidated Tangible Net Worth Consolidated Tangible Net Worth will at no time be less than (i) $706,575,475 plus (ii) 30.0% of the cumulative Consolidated Net Income of the Borrower during any period after [the new loan agreement is signed], calculated quarterly but excluding from such calculations of Consolidated Net Income for purposes of this clause (ii), any quarter in which the Consolidated Net Income of the Borrower and its Consolidated Subsidiaries is negative.
1. In two more weeks, the company’s books will be closed for the quarter, and the fixed charges coverage might fall below the level required by the loan agreement. How can management avoid violating this covenant?
2. The company’s tangible net worth may also fall below the amount specified in the loan agreement. How can management avoid violating this covenant?
3. Elsewhere in the loan agreement it says that the company’s ratio of consolidated debt to total capitalization must be no more than 0.75 to 1.0. How can management avoid violating this covenant?
4. Suppose you were one of Food Lion’s bankers, and you were thinking about making changes to the loan covenants. What management activities would you most want to limit? Why?