The following excerpt was taken from a recent annual report of JCPenney:
The . . . Credit Agreement includes a requirement that the Company maintain, as of the last day of each fiscal quarter, a Leverage Ratio (a ratio of Funded Indebtedness to Consolidated EBITDA) . . . of no more than 3.0 to 1.0.
Assume that Funded Indebtedness approximates long-term debt on the balance sheet. As of year-end, JCPenney had long-term debt of $3,505 million and earnings before interest, taxes, depreciation, and amortization (EBITDA) of $1,604 million.
a. How much long-term debt can JCPenney add to its balance sheet and still remain in compliance with the financial covenant described above?
b. Why would the creditors of JCPenney limit the company’s indebtedness relative to the cash flow of the company?
c. Describe some possible actions if the company violates the financial covenant.