In the Question and Answer segment of Webcast on Working Capital vs. Cash Flow on May 21st, 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.

Q: Working capital is current assets - current liabilities. Why is long term debt being financed with short term working capital?

A: It may be the other way around.  Long-term debt has financed the increase in working capital.  For working capital to increase a) long-term debt must increase, or b) long term assets must decrease, or c) profitability must increase, or d) owners must make capital contributions to the company – or the combination of these four events must sum to a positive amount.  For example, a long-term debt increase could be sufficiently large that it offsets a) an increase in fixed assets, plus b) a decrease in profitability, plus c) a capital withdrawal in the form of distributions. 

Keep in mind that working capital is simply a definition.  Whether it goes up or down depends on the combination of the four factors that drive and determine working capital.

Q: Why consider long term changes in long term accounts in figuring working capital? I thought working capital was current assets - current liabilities.

A: It is.  But a change in working capital is a residual event determined by profit for the period and the cumulative net change in a) long-term debt, b) long-term assets, and c) owners’ capital (excluding changes in retained earnings).

Q: What is an example of a liability write-up?

A: If a company carried a liability expressed in a foreign currency, such as a trade payable in Sterling or Euros, it would be obligated to write-up that liability if the dollar fell in value vis-à-vis Sterling or the Euro.  That is, it would now take more dollars to satisfy the Sterling or Euro liability.  As a result, the company would credit (write-up) the appropriate liability account and debit a miscellaneous or foreign exchange expense account on the income statement.

Q: Please discuss negative working capital.

A: If current assets are less than current liabilities, a company would record negative working capital.  Trucking companies, for example, frequently report negative working capital.  Their accrued liabilities, including short-term interest-bearing debt, may exceed the sum of cash, receivables, and inventory.  But such companies may enjoy very robust cash flow from business operations.  The point, again, is that working capital is not cash flow.  Positive working capital may signal positive cash flow or it may not.  Negative working capital may signal negative cash flow or it may not.  The ultimate answer about operating liquidity rests with the UCA cash flow statement and not with working capital.

Q: Changes in working capital identify causes - growth vs. management of terms with clients and /or vendors?

A: Hard to say.  For example, a company may collect its receivables rapidly and pay its suppliers quickly enough to take discounts, yet experience a decline in working capital driven by a drop in profitability along with an increase in short-term debt that allows the company to take advantage of supplier discounts.  On the other hand, a company may borrow heavily from a related party and classify the debt as long-term, thereby increasing working capital.  The amount of cash flowing into the company is the same regardless of whether the company classifies the cash inflow as short or long-term debt.  But working capital will be impacted profoundly by the classification decision.

Whether growth contributes or uses working capital depends on the combination of profits, changes in long-term debt, changes in long-term assets, and changes in capital (apart from retained earnings).  The UCA cash flow statement is designed to address these issues and does so quite well.

Q: Why is interest income classified as contra operating income while interest expense is classified as a non operating expense on the cash flow analysis?

A: In the UCA cash flow statement, interest income and interest expense are classified in a manner identical to their classification in the accrual income statement.  Interest income is classified in a miscellaneous income/expense area of the statement.  Interest expense is classified as interest expense.  Both appear above Net Cash Income in the UCA cash flow statement, i.e., both appear in the operating section of the statement.

Q: We normally only receive company prepared financial statements (with no footnotes). How would we get information like footnote 4 in Sequoia Properties?

A: This is a critical issue with company prepared financial statements, i.e., lack of clarifying footnotes.  The only real solution is to go back to the company and ask about any account that appears suspicious – or requires more information – for any reason.  For example, there is every reason to ask if a) all depreciation expense has been posted for the period, b) the prepaid balance has been adjusted to recognize prepaid amounts used up, c) all interest expense has been posted for the period, d) there are bad debts or write-offs, e) the owners have borrowed from the company, f) the owners have received payment on loans to the company…and so on.  Identify financial statement accounts and amounts that catch your attention and ask questions.

Q: What are the effects on UCA of:

1. FOREX adjustments;
2. Seasonality;
3. Bad debt expense and A/R adjustments; and
4. Annuals and interims to compare cash conversion cycle and turnover.

A: 1) The most common adjustment would be to an asset or liability account denominated in a non U.S. currency and translated to U.S. dollars that requires adjustment over the period if the underlying exchange rate moves up or down.  For example, if a business held receivables denominated in Euros, the reported dollar balance of the receivables would increase as the dollar falls against the Euro and vice versa.  If the dollar fell against the Euro from one reporting period to the next, the company would increase the dollar value of its receivables by posting a debit to receivables.  It would then recognize a foreign exchange gain by posting an offsetting credit entry to a miscellaneous income statement account or to foreign exchange gains on the income statement.  Without an adjustment for this non-cash transaction, the resulting UCA cash flow statement would over-report the increase in receivables for the period (an implied cash outflow) but then over-report other income (an implied cash inflow). Since both accounts are accommodated and accounted for in the operating section of the UCA cash flow statement, the two entries offset each other resulting in no impact on Net Cash Income.

If we were purists about the matter, we would remove the non-cash write-up to the receivables (eliminating the implied cash outflow) and reverse the non-cash foreign exchange gain (eliminating the implied non-cash inflow).  Net Cash Income, however, would remain the same, i.e., as if there were no non-cash adjustments.

However, if the business in question held long-term assets denominated in a foreign currency, the resulting impact from a change in the exchange rate would require adjustments.  For example if long-term assets held in Euros increased in value, the company would post a debit entry to the proper fixed asset account and an offsetting credit entry to a miscellaneous income or foreign exchange account on the income statement.  Without adjusting for these non-cash events, Net Cash Income would now be over-reported, since the offsetting entry to a foreign exchange account impacts an account below Net Cash Income on the UCA cash flow statement.

2) With respect to seasonality, the UCA cash flow statement can be immensely insightful and helpful.  Since we can create a cash flow statement for any period of time, we can track a borrower’s seasonality by constructing a UCA cash flow statement for the seasonal period, perhaps on a month-by-month basis over the period.  The resulting monthly UCA cash flow statements will then identify precisely those events that explain the borrower’s monthly financing requirements. We may be surprised to learn that much more is driving monthly borrowing requirements than the usual build up in receivables or inventory.

3) The adjustments for bad debt expense are similar to the adjustments noted above for a foreign exchange gain or loss.  For example, since a bad debt expense is a non-cash charge, we should restore the receivables balance and eliminate the bad debt expense from the income statement.  But if we fail to do so, it all comes out in the wash, so to speak, because the unadjusted decrease in the receivables balance (an implied cash inflow) is precisely offset by an unadjusted bad debt expense on the income statement (an implied cash outflow).  Both accounts are accommodated and accounted for prior to Net Cash Income on the UCA cash flow statement.  Therefore, Net Cash Income will not be impacted if we do - or do not - make the non-cash adjustments.

4) Finally, with respect to annual and interim comparisons, all the usual caveats apply about such comparisons regardless of whether they involve balance sheet amounts, ratios, or cash flow statements.  Interim financial information is frequently incomplete or flawed.  Consequently, the comparison may be flawed and provide misleading signals about performance.