Working Capital vs. Cash Flow Questions and Answers II
In the Question and Answer segment of Webcast on Working Capital vs. Cash Flow on February 12th, we responded to the questions submitted. However, we have repeated the questions (slightly edited in some instances) and have provided more detailed answers to each below.
Mark asks: In order to compute the reconciliation to changes in working capital you must consider long-term debt and not CMLTD. Is that correct? Please explain.
Answer: The issue gets back to the definition of working capital and what explains changes in it. The point you raise is quite interesting because it illustrates how critical balance sheet classification decisions are to the resulting dollar amount of working capital.
For example, if a company increases its short-term financing, the amount of the increase has no impact on working capital. Cash (until used) goes up but so, too, does short-term debt. The increase in a current asset account is matched by an increase in a current liability account and working capital is unaffected.
However, if the company had classified the increase in interest-bearing debt as a long-term liability, then the cash account would increase but no current liability account would be impact by the classification of interest-bearing debt as a long-term liability and, therefore, working capital would increase.
This classification issue is in play with CMLTD. Even though CMLTD is still long-term debt, it is classified as a current liability. Therefore, it has no impact on working capital. However, the remaining long-term debt balance does impact working capital since it is classified as a long-term liability.
Note how different working capital is from cash flow. If a company increases its interest-bearing debt, cash flow is impacted regardless of how the company classifies the event on its balance sheet. Not so with respect to working capital. An increase in interest-bearing debt can leave working capital untouched or not, depending on account classification.
At the end of the day, cash flow counts. Working capital is not cash flow.
Jack asks: What caused Seaside's current maturities to rise so drastically in 2004, while long-term debt only rose slightly from 2003?
Answer: It’s very unclear why the current maturities rose so dramatically in 2004. It is in the company’s interest to stretch out the repayment period rather than to shorten it, but it looks as if its term debt repayment schedule went through a severe revision in late 2003 or 2004 that carried into 2005. In very general terms, the term debt on the books in both 2004 and 2005 seems to roughly follow a three-year amortization schedule.
The most likely explanation for this structural adjustment may lie with the type of fixed assets the company purchased and financed. If those fixed assets were hardware or software systems, the company may have selected a more rapid depreciation schedule. However, without better information, we can only guess at this point.
Sean asks: Please cover the measurements you discussed in closing, i.e., the profitability covenant and the financing gap ratio.
Answer: Because the UCA cash flow statement is difficult to properly interpret, particularly for a borrower unaccustomed to its format and terms, we can get at the issue of containing business cash flow by using two covenants that work in tandem to do so.
The first – a debt service covenant – is designed to provide maximum assurance the borrower will generate sufficient business profit to service interest-bearing debt. We define business profit as reported net profit less the sum of distributions (or withdrawals) and loans to owners. Loans to owners may increase or decrease over a period. If they decrease, i.e., if a Due from Owner balance on the asset side of the balance sheet decreases, that frequently reflects the conversion of some, or all, of the outstanding loan from the owners to a distribution. The resulting sum represents the amount of cash flowing from the business to the owners to satisfy their personal income tax obligation on company profit or to provide additional compensation. Regardless of purpose, the sum of these two amounts drains cash from the company and impacts its debt service ability.
Given these comments, a debt service covenant (DSC) can be expressed as follows:
Net Profit – sum (Distributions + Loans to Owners) + Int. Exp.
DSC = ———–——————————————————————————— > 1.25
Interest Expense + CMLTD (prior period)
The 1.25 factor in the equation above is for illustration only. We want the DSC to be at least equal to 1.00, which means the borrower just meets the debt service. However, if we have doubts about the prospects of fully converting accrual profit to cash, we increase the requirement above 1.00 by some risk factor, such as 0.25 in this instance.
Meeting the DSC is only half the battle in assuring proper cash flow. The second useful, and complementary, covenant is a financing gap ratio based on a borrower’s performance in the last historical period. If a borrower can maintain the financing gap ratio in the next period, it means that any cash outflow from movements in operating balance sheet accounts, e.g., receivables, inventory, or payables, will be attributed only to sales growth and not to poor management of those operating balance sheet accounts.
For example, if a financing gap ratio for the last historical period were calculated at 15.00% and the borrower maintained that ratio in the next period, it tells us that the operating balance sheet relationships remained stable. Even so, a net cash outflow would occur if the set of operating assets exceeded the set of operating liabilities – which is usually the case – as the borrower increases sales in the period. But the cash outflow would reflect the impact of sales growth and not management’s inability to maintain receivables at last year’s number of days, for example.
The financing gap ratio is defined as follows:
Operating Assets – Operating Liabilities
Financing Gap
Ratio = ———–——————————————— x 100
Sales
The lender must determine those operating assets and operating liabilities to include in the ratio. For example, receivables and inventory may represent major operating asset accounts while prepaid expenses play no role. Further, accrued expenses and deferred revenue may represent a significant operating liability accounts while the accounts payable balance is minor or non-existent. Therefore, the applicable financing gap ratio in this instance would be the sum of receivables and inventory minus the sum of accrued expenses and deferred revenue divided by sales for the period.
If that ratio increases in the next period, it means the borrower let the operating assets grow more rapidly than the operating liabilities, which will add to the cash outflow. On the other hand, if the borrower reduced the ratio in the next period, it means the borrower squeezed cash out of its balance sheet by constraining operating asset growth relative to operating liability growth.
Mark asks: In order to compute the reconciliation to changes in working capital you must consider long-term debt and not CMLTD. Is that correct? Please explain.
Answer: The issue gets back to the definition of working capital and what explains changes in it. The point you raise is quite interesting because it illustrates how critical balance sheet classification decisions are to the resulting dollar amount of working capital.
For example, if a company increases its short-term financing, the amount of the increase has no impact on working capital. Cash (until used) goes up but so, too, does short-term debt. The increase in a current asset account is matched by an increase in a current liability account and working capital is unaffected.
However, if the company had classified the increase in interest-bearing debt as a long-term liability, then the cash account would increase but no current liability account would be impact by the classification of interest-bearing debt as a long-term liability and, therefore, working capital would increase.
This classification issue is in play with CMLTD. Even though CMLTD is still long-term debt, it is classified as a current liability. Therefore, it has no impact on working capital. However, the remaining long-term debt balance does impact working capital since it is classified as a long-term liability.
Note how different working capital is from cash flow. If a company increases its interest-bearing debt, cash flow is impacted regardless of how the company classifies the event on its balance sheet. Not so with respect to working capital. An increase in interest-bearing debt can leave working capital untouched or not, depending on account classification.
At the end of the day, cash flow counts. Working capital is not cash flow.
Jack asks: What caused Seaside's current maturities to rise so drastically in 2004, while long-term debt only rose slightly from 2003?
Answer: It’s very unclear why the current maturities rose so dramatically in 2004. It is in the company’s interest to stretch out the repayment period rather than to shorten it, but it looks as if its term debt repayment schedule went through a severe revision in late 2003 or 2004 that carried into 2005. In very general terms, the term debt on the books in both 2004 and 2005 seems to roughly follow a three-year amortization schedule.
The most likely explanation for this structural adjustment may lie with the type of fixed assets the company purchased and financed. If those fixed assets were hardware or software systems, the company may have selected a more rapid depreciation schedule. However, without better information, we can only guess at this point.
Sean asks: Please cover the measurements you discussed in closing, i.e., the profitability covenant and the financing gap ratio.
Answer: Because the UCA cash flow statement is difficult to properly interpret, particularly for a borrower unaccustomed to its format and terms, we can get at the issue of containing business cash flow by using two covenants that work in tandem to do so.
The first – a debt service covenant – is designed to provide maximum assurance the borrower will generate sufficient business profit to service interest-bearing debt. We define business profit as reported net profit less the sum of distributions (or withdrawals) and loans to owners. Loans to owners may increase or decrease over a period. If they decrease, i.e., if a Due from Owner balance on the asset side of the balance sheet decreases, that frequently reflects the conversion of some, or all, of the outstanding loan from the owners to a distribution. The resulting sum represents the amount of cash flowing from the business to the owners to satisfy their personal income tax obligation on company profit or to provide additional compensation. Regardless of purpose, the sum of these two amounts drains cash from the company and impacts its debt service ability.
Given these comments, a debt service covenant (DSC) can be expressed as follows:
Net Profit – sum (Distributions + Loans to Owners) + Int. Exp.
DSC = ———–——————————————————————————— > 1.25
Interest Expense + CMLTD (prior period)
The 1.25 factor in the equation above is for illustration only. We want the DSC to be at least equal to 1.00, which means the borrower just meets the debt service. However, if we have doubts about the prospects of fully converting accrual profit to cash, we increase the requirement above 1.00 by some risk factor, such as 0.25 in this instance.
Meeting the DSC is only half the battle in assuring proper cash flow. The second useful, and complementary, covenant is a financing gap ratio based on a borrower’s performance in the last historical period. If a borrower can maintain the financing gap ratio in the next period, it means that any cash outflow from movements in operating balance sheet accounts, e.g., receivables, inventory, or payables, will be attributed only to sales growth and not to poor management of those operating balance sheet accounts.
For example, if a financing gap ratio for the last historical period were calculated at 15.00% and the borrower maintained that ratio in the next period, it tells us that the operating balance sheet relationships remained stable. Even so, a net cash outflow would occur if the set of operating assets exceeded the set of operating liabilities – which is usually the case – as the borrower increases sales in the period. But the cash outflow would reflect the impact of sales growth and not management’s inability to maintain receivables at last year’s number of days, for example.
The financing gap ratio is defined as follows:
Operating Assets – Operating Liabilities
Financing Gap
Ratio = ———–——————————————— x 100
Sales
The lender must determine those operating assets and operating liabilities to include in the ratio. For example, receivables and inventory may represent major operating asset accounts while prepaid expenses play no role. Further, accrued expenses and deferred revenue may represent a significant operating liability accounts while the accounts payable balance is minor or non-existent. Therefore, the applicable financing gap ratio in this instance would be the sum of receivables and inventory minus the sum of accrued expenses and deferred revenue divided by sales for the period.
If that ratio increases in the next period, it means the borrower let the operating assets grow more rapidly than the operating liabilities, which will add to the cash outflow. On the other hand, if the borrower reduced the ratio in the next period, it means the borrower squeezed cash out of its balance sheet by constraining operating asset growth relative to operating liability growth.
