Wednesday, January 6, 2010

Jumps In Current Debt

The importance of considering a company's debt repayment schedule cannot be overstated. As discussed here with a live example, debt due in 25 years does not represent the same danger to solvency as debt due in 1 year, though they both may be painted with the same brush ("long-term debt") on the balance sheet. However, a repayment schedule that does not require large payments for several years does not leave the company off the hook. The investor must be aware of issues that can accelerate repayment requirements, as such untimely accelerations are likely to come at a time when a company is already in a weak financial position.

Consider TLC Vision (TLCV), a company we discussed two weeks ago due to its bankruptcy announcement. Last year at this time, it showed current debt of $8 million against current assets of $42 million. Just one quarter later, however, current debt skyrocketed to $89 million. The increase in current debt was not the result of a new loan, however, and so current assets did not increase, leaving the company in a rather precarious situation.

The reason for the unceremonious and abrupt increase in the current debt level was due to the fact that the company was no longer meeting covenants in its long-term debt contract due to operational losses. As a result, what had previously been considered long-term debt (with a great part of the payments not due for several years) became due within the next year. Investors relying on the fact that certain debt payments were not due for several years were sorely disappointed.

In the notes to the financial statements, companies break down their long-term debt due dates so that investors can estimate for themselves the company's ability to service its long-term obligations. Unfortunately, certain triggering events can result in the acceleration of certain payment requirements, and in some circumstances it can force the company into bankruptcy.

Disclosure: None


Ben said...


Great article!

I often read annual reports of both American and European companies and very rarely find information about covenants.

Do you know where some information about a company's covenants can be found please? Or have any advise to avoid situations like the one at TLC.

Thank you.

Unknown said...

Hi Saj,

Your blog is extremely informative and gives me a high because every day I visit I learn something new and interesting. You have this wonderful ability to break down complex financial transactions into simple concepts. Please keep it going.

An aspiring Value investor,

Saj Karsan said...

Thanks, Ben! Yeah, they don't always put details about the covenants in the financial note dedicated to discussing debt, but they will often release the whole lending agreement at the time the debt is issued.

Thanks, Pradeep! Much appreciated!