The following excerpt was taken from a financial report of Cummins Engine Company, a manufacturer of heavy-duty truck engines. Loan agreements contain covenants that impose restrictions on the payment of dividends and distributions of stock, require maintenance of a 1.25:1 current ratio, and limit the amount of future borrowings. Under the most restrictive covenants, retained earnings of approximately $351 million were available for payment of dividends.
REQUIRED:
a. Briefly explain the meaning of this excerpt.
b. Why would a bank or other creditor impose such restrictions on a borrowing company?
c. Explain the role of financial accounting numbers in the restrictions described above.