Q: How can we expect that Larry Crevin, the owner of Total Coverage, Inc. won't take out distributions that include excess compensation in 2019, if historical trends point to him always taking out cash from the company in this manner? Isn't saying he won't take out any cash from the company just wishful thinking?
A: It is indeed wishful thinking unless there is a loan covenant in place that restricts compensation or is structured in such a way to cause Mr. Crevin to choose not to take distributions in excess of taxes. We'll get into such restrictions in depth in Session 7 where we focus on covenants.
Covenants are a contractually enforceable part of the lending contract. One way to control the use of distributions is through a debt service covenant (DSC) to which the lender and borrower agree. A DSC covenant simply requires the borrower to generate profit adequate to exceed debt service by some factor.
The covenant will work to assure that the owner’s incremental compensation (distributions and loans) is limited if both are included in the calculation as a reduction of net income. In setting this covenant, the lender would define profit available to service debt as, for example, net income increased by removing interest expense but decreased by subtracting distributions and loans to owners. This amount of profit must then exceed debt service – the sum of interest expense and last year's current maturities of long-term debt – by some factor, e.g., (Profit Available for Debt Service) / (Debt Service) = 1.25 or greater. In this way, the borrower decides on the amount of distributions and loans to owner(s) that allows the company to meet the covenant.
Course overview: Management Assessment, Projected Cash Flow, and the First Way Out