Question

Discuss reasons why banks might choose to include the following covenants in a loan agreement: a. Cash dividends cannot exceed 60 percent of pretax income b. Interim financial statements must be provided quarterly c. Inventory turnover must be greater than five times annually d. Capital expenditures may not exceed $5 million annually

Answer 1

a. Cash dividends cannot exceed 60 percent of pretax income : Cash dividend cannot exceed 60% of income before tax so that company can grow by controlling outflow of cash.

b. Interim financial statements must be provided quarterly : So that banks can monitor debts and cash flows of the company at regular intervals.

c. Inventory turnover must be greater than five times annually : It would mean that the inventory is movable and the company is selling the products timely and the stock are not getting accumulated with the company.

d. Capital expenditures may not exceed $5 million annually : When capital expenditure exceed a certain level it results in decrease in cash in hands of company resulting in low cash in hand.