Your firm successfully issued new debt last year, but the debt carries covenants

Question

Your firm successfully issued new debt last year, but the debt carries covenants. Specifically, you can only pay dividends out of earnings made after the debt issue and you must maintain a minimum quick (acid-test) ratio of 1.2. Your net income this year was $70.3 million. Your cash is $10.2 million, your receivables are $8.1 million, and your inventory is $4.6 million. You have current liabilities of $18.9 million. What is the maximum dividend you could pay (in cash and in stock) this year and still comply with your covenants?

Explanation / Answer

Net income = $70.3 million

Quick (acid-test) ratio = (Cash + Receivables) / Current liabilities

1.2 = (Cash + 8.1) / 18.9

1.2*18.9 = (Cash + 8.1)

22.68 = Cash + 8.1

Cash = 22.68 - 8.1 = 14.58

Cash required is 14.58 to maintain quick ratio of 1.2 but opening cash balance is 10.2, So, cash to be reserved in net income = 14.58 - 10.2 = 4.38

Maximum dividend payment = Net income - Reserved cash

= $70.3 million - $4.38 million = $65.92 million

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