Operationalizing Financial Covenants

We study the interplay between financial covenants and the operational decisions of a retailer that obtains financing through a secured, inventory-based lending contract. We characterize how leverage affects dynamic inventory decisions, and find that it can lead to surprising non-threshold policies, and perverse incentives such as sales under-reporting. We show that, under perfectly competitive lending, financial covenants are necessary and sufficient to restore channel optimality, and emerge as critical contract parameters. We characterize the optimal covenant terms in equilibrium, and perform comparative statics with respect to important operational details. Surprisingly, we find that retailers operating under higher demands, lower inventory depreciation rates or higher profit margins face more stringent covenants. Furthermore, we show that covenants are not substitutable by other contractual terms, such as interest rates and loan limits, even under a monopolistic lending market. We study the effect of additional operational flexibility, and show that it can impact covenant effectiveness in a surprising, non-monotonic way. Our results are well aligned with empirical findings in the finance and accounting literature, and also yield new insights that could be tested empirically.