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Testing for Compliance with Bond Covenants

Dallas Instruments has a large bond issue whose covenants require:

(1) that DI's interest coverage ratio exceeds 4.0;
(2) that DI's ratio of tangible assets to longterm debt exceeds 1.50; and
(3) that cumulative dividends and share repurchases not exceed 60% of cumulative earnings since the date of the issuance of the bonds.

DI has earnings before interest and taxes of $70 million and interest expense of $14 million. Tangible assets are $400 million and long-term debt is $175 million. Since the bonds were issued, DI has earned $200 million, paid dividends of $40 million, and repurchased $40 million of common stock. Is DI in compliance with its bond covenants? Why or Why Not?

Solution Preview

Let us take the provisions one at a time:

(1) that DI's interest coverage ratio exceeds 4.0.

Interest coverage ratio = Earnings before interest and taxes/Interest expense
Interest coverage ratio = $70,000,000/$14,000,000
Interest coverage ratio = 5.0

Because the interest coverage ratio is 5.0 and it needs to exceed 4.0, DI has complied with this provision of the covenant.

(2) that DI's ratio of tangible assets to long-term debt exceeds ...

Solution Summary

This solution illustrates how to test financial conditions for compliance with bond covenants.