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Foot Locker, Inc. loan covenants

Foot Locker, Inc., reported an $18 million loss on sales of $1,283 million for the quarter ended August 4, 2007. The quarterly financial filling (10-Q) also contained this warning for investors and creditors.

Source: Foot Locker Inc. Form 10-Q for the quarter ended August 4, 2007.
"Under the Company's revolving credit and term loan agreement, the Company is required to satisfy certain financial and operating covenants, including a minimum fixed charge coverage ration. In addition, this agreement restricts the amount the Company may expend in any year for dividends to 50 percent of its prior year's net income. Based upon the Company's second quarter financial results and business uncertainties for the second half of the year, the Company may not continue to be in compliance with the fixed charge coverage ratio. In addition, the restricted payment provision may prohibit the company from the payment of the dividend at the current rate in 2008."

1. What is a minimum fixed charge coverage ration, and what purpose does it serve int he company's loan agreements?
2. Why would Foot Locker agree to restrict dividends to just 50% of its prior year's net income?
3. In general terms, explain how a company such as Foot Locker might use accounting tricks to avoid violating debt covenants tied to financial statement numbers.
4. What is likely to happen if Foot Locker does not satisfy one or more of the loan covenants at year-end?

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1. What is a minimum fixed charge coverage ratio, and what purpose does it serve in the company's loan agreements?

Earnings Before Interest and Taxes (EBIT) + Lease Payments (fixed charges)
--------------------------------------------------------------------------------------------------- = fixed charge coverage
Interest Expense + Lease Payments (fixed charges)

A minimum fixed charge coverage ratio is a general measure of debt capacity. It compares profits to interest and lease payments that are currently a financial commitment of the firm. If the commitments of interest and lease payments are small compared to earnings, the ratio is high. Setting a minimum for this ratio is a way to be sure that a firm doesn't take on too many ...

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