The Influence of the Organizational Life Cycle on the Violation of Financial Covenants.
| Autor | de Oliveira, Willams da Conceicao |
1 Introduction
Covenants are restrictive clauses inserted in loan and bank finance contracts that aim to protect the interests of the financial institutions and other creditors (Oliveira et al., 2020; Watts & Zimmerman, 1990). The insertion of such restrictive clauses is associated with the need to monitor and control indicators that provide relevant information about the companies during the negotiation process and lifetime of the financing contracts (Demerjian, 2017; Prilmeier, 2017). Within this context, specific covenants based on financial indicators come to act as a disciplinary mechanism controlling conflicts of interest between managers and creditors in that they limit the managers' discretionary actions (Oliveira & Monte-Mor, 2020) and minimize the probability of default and credit recovery risk (Prilmeier, 2017).
The violation of financial covenants occurs in many cases due to operational problems faced by companies (Beneish & Press, 1993), governance problems (Nini et al., 2009), or even due to growth strategies that place solvency and loan repayment capacity at risk (Christensen & Nikolaev, 2012; Prilmeier, 2017). The literature shows that these problems are also related to the organizational life cycles of companies (introduction, growth, maturity, turbulence, and decline) in that each stage subjects companies to different challenges and market needs, whether linked to structural investments, verticalization processes, company acquisitions, expansion of the market and areas of operation, and diversification and consolidation of company strategies, among other points inherent to each one of the phases of organizational life (Costa et al., 2015).
Therefore, besides presenting companies' economic-financial performance information, financial covenants can also limit actions linked to risk strategies and associated with each one of the phases of the organizational life cycle. In this case, the strategic actions and level of risk exposure of each phase of organizational life can provide information that explains not only banks' decisions to grant lines of credit (Anthony & Ramesh, 1992; Dickinson, 2011), but also the probability of the companies violating these covenants during the lifetime of their debt contracts. Seeking to shed light on these relationships, this article investigates how the stages of the organizational life cycle influence the probability of violation of financial covenants. More specifically, it investigates whether the probability of violation of financial covenants is related with the stages of the organizational life cycle.
This study jointly addresses two relevant topics in the international literature that directly interfere in the fundraising and continuity of firms (De Angelo et al., 2006; Dickinson, 2011; Kim et al., 2010). For example, firms in the maturity stage tend to restructure their assets, and companies in the growth stage tend to reduce their workforce when they face financial difficulties (Koh et al., 2015). These same characteristics were found in companies that violated the limits of their financial covenants (Falato & Liang, 2016). In general, it is verified that by presenting distinct financial characteristics, needs, and strategies in each stage of the organizational life cycle companies may have affected their performance (Feltham & Ohlson, 1995), which can compromise their capacity to comply with the limits imposed by their financial covenants.
This study further extends national research such as that of Frezatti et al. (2010) and Costa et al. (2015), who highlight that Brazilian companies also present distinct financial characteristics in the different life cycle stages, as highlighted in international studies (Anthony & Ramesh, 1992; De Angelo et al., 2006; Dickinson, 2011; Fama & French, 1996; Miller & Friesen, 1984). Complementarily, this study analyzes the relationship between the life phases and the management of indicators present in debt contracts by investigating the relationship between the organizational life cycle and the probability of violation of financial covenants.
In order carry out the study, we considered 1,328 observations of 197 publicly-traded non-financial Brazilian companies listed on the B3, covering the period from 2010 to 2018. Accounting data and financial indicators were obtained from the Economatica database. Financial covenant information was obtained by analyzing the companies' explanatory notes, according to guidance featured Comite de Pronunciamentos Contabeis (2011)--CPC 26 (R1), in which companies should disclose additional information about their financial and patrimonial position so that users understand the impact of transactions and debt contracts (Oliveira et al., 2020).
So that it was possible to identify whether the probability of violation of financial covenants is related with the stages of the organizational life cycle, logistic regression analysis was carried out in an unbalanced panel with year fixed effects. In general, the results highlight that the companies fitting the maturity stage presented a greater probability of violation of financial covenants compared with those fitting the introduction, growth, turbulence, and decline stages.
These results extend the literature by presenting evidence that it is not only the turbulence and decline phases that bring operational risks that can culminate in an increased probability of violation of financial covenants, but also the initial introduction and growth phases of companies. As the violation of covenants can compromise companies' operational continuity through triggering the accelerated receipt of debt (Borges, 1999; Prilmeier, 2017), the possibility of demands for new guarantees (Press & Weintrop, 1991), or even an increase in loan rates and remodeling of debt contracts (Kim et al., 2010), this prompts the monitoring of these contracts primarily in companies in the initial introduction and growth phases, given that in these phases strategy errors can be crucial and compromise the companies' operational continuity. In regulatory terms, the results presented further reinforce the need to revise Comite de Pronunciamentos Contabeis (2011)--CPC 26 (R1), making it obligatory to disclose the limits of restrictive clauses in the explanatory notes for corporations.
2 Literature review
2.1 Financial covenants
A financial covenant is a restrictive financial clause included in a bank loan contract aiming to control the conflicts of interest between lenders and borrowers, with its insertion being associated with the need for relevant information about the borrower during the fundraising process (Christensen & Nikolaev, 2012; Demerjian, 2017; Prilmeier, 2017).
Financial covenants are generally classified as capital covenants, when they are used to minimize agency problems by limiting dividend payments, new fundraising, and the carrying out of investments; or they are classified as performance covenants, when they are established based on efficiency indicators and are related to cash generating potential, to bank debt, to net equity, to coverage, and to payment capacity (Beneish & Press, 1993; Christensen & Nikolaev, 2012; Nini et al., 2009; Prilmeier, 2017; Smith & Warner, 1979).
Studies have highlighted that companies that recognize more losses and show high levels of leverage are subject to having more financial covenants in their debt contracts (Bradley & Roberts, 2015; Nikolaev, 2010). On the other hand, companies that present relevant weaknesses in their internal controls are subject to a lower quantity of covenants based on financial indicators and have greater monitoring through credit protection mechanisms (Costello & Wittenberg-Moerman, 2011). Within the accounting perspective, companies with a high level of accounting conservatism tend to have less restrictive contractual clauses and lower loan interest rates compared to companies with a lower level of conservatism, which minimizes the probability of violation of financial covenants (Callen et al., 2016; Zhang, 2008).
When companies are close to violating the limits of covenants, these companies present indications of earnings management to mitigate the probability of violation. These discretionary actions occur to impede the early maturity of the debt and a surcharge on the interest rate in a possible debt renegotiation (Beneish & Press, 1993; Fan et al., 2019; Franz et al., 2014; Iatridis & Kadorinis, 2009; Pinto et al., 2015; Press & Weintrop, 1991; Prilmeier, 2017; Reisel, 2014; Rezende Duarte et al., 2020; Silva, 2008).
Altogether, these points indicate that the presence of financial covenants is directly associated with the firm's future performance expectations, thus being linked to the phases of companies' organizational cycle. Ghosh and Moon (2010), for example, highlighted a positive association between levels of indebtedness and earnings quality, identifying that companies with high levels of bank debt tend to present a greater probability of violating the limits of their debt financial covenants. And it is precisely the companies that fit the growth, turbulence, or decline stages that have higher leverage levels on average (Costa et al., 2015).
Besides managerial and operational incentives, studies such as those of Lin, Song, and Tian (2016) highlight that the good reputation of a CEO influences fundraising with low interest rates and the inclusion of less restrictive financial covenants. This is because the risk exposure comes to be mitigated by the quality of the corporate governance. This point is also directly associated with the literature on organizational life stages, which highlights that companies in the maturity stage adopt better corporate governance practices (Habib et al., 2018; Hasan & Habib, 2017; O'Connor & Byrne, 2015).
Based on the synergy between these results, it is expected that companies in the maturity stage tend to minimize the probability of violation of their...
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