Q: What is the difference between UCA Cash Flow and Business Cash Flow?

A: Business Cash Flow, as we use the term in the webinar, is operating cash flow captured at the Business Cash Income summation line on the Uniform Credit Analysis (UCA) cash flow statement.

Business Cash Flow is the cash counterpart, or cash equivalent, of Net Income on the accrual income statement. It identifies the amount of net cash inflow generated by a business from a) the sale of its products and services and b) other cash revenue sources, such as cash interest income, and matches these cash inflows against the cash paid out by the business for production costs, operating expenses, interest expense, distributions, and loans to owners. The result is the amount of cash identified at the Business Cash Income line on the UCA cash flow statement. It reports the amount of cash available to pay down long-term debt as scheduled. It may be a positive amount or a negative amount. If the latter, it means the business paid out more cash for operating expenses than it took in from its cash collection from sales and service activities and from other cash income sources.

As a reminder, the UCA cash flow statement is a format, or template, for mapping and tracking the actual cash flowing through a business. It identifies all cash inflows to the business over a specific time period from sales and other activities. It also identifies all cash outflows from the business for payment of the cash cost of operations as well as the cash cost of purchasing fixed or intangible assets and providing loans to related parties. Finally, it identifies the sources of cash financing to meet a company’s financing requirements for the period in question.

Q: How are Payroll Protection Plan funds treated in preparing a UCA cash flow statement?

A: Payroll Protection Plan (PPP) loans are recorded on the UCA cash flow statement in the same way as any other loan the company arranges. The cash proceeds on initiating the loan are included as a cash inflow in calculating either the Change in Short-Term Debt or New Long-Term Debt. The forgiven loan obligation is ignored in the UCA cash flow statement, since recording loan forgiveness is recorded by an accrual accounting entry that has no impact on the company’s cash position, nor does it affect company cash inflow or outflow since no cash changes hands in liquidating the PPP loan.

If, for example, a business received a $100,000 loan, its cash balance on the UCA cash flow statement would increase by that amount at inception and matched by a $100,000 increase in either short-term or long-term debt. If $50,000 of the loan is subsequently forgiven, the amount of debt on the company’s accrual balance sheet is reduced by $50,000 and other income on its income statement is increased by $50,000, but the $100,000 cash inflow from the new loan on the UCA cash flow statement remains at $100,000.

Note, too, that there is no income tax obligation associated with the $50,000 increase in other income.

With respect to the impact on working capital from this example, the initial loan would not alter existing working capital if it were classified as short-term debt. A current asset – cash – would increase by $100,000, which is precisely matched by a $100,000 increase in a current liability – short-term debt. If $50,000 of the loan is subsequently forgiven, current liabilities are decreased by that amount, which increases working capital by $50,000.

However, if the PPP loan were classified as a long-term liability, working capital would increase initially by $100,000 since cash would increase by that amount but current liabilities would remain untouched. Given a subsequent $50,000 loan forgiveness and debt write-off, working capital would remain unchanged at a $100,000 increase since the write-off would impact only a long-term liability account.

Course overview: Working Capital and UCA Cash Flow

Q: Because FY 2017 net income of $265,467 is net of interest expense, and this is our first cash flow item in our UCA cash flow statement, wouldn't this mean the cash flow prepared already assumes interest expense is met before taking into account changes in the balance sheet?

A:  I see your point as interest expense is already deducted as an expense to arrive at net income. But this tells us that accrual profit, not cash flow, was sufficient to cover the interest expense since $265,467 is the FY 2017 accrual net income not cash income. Adjusted Net Income is really our first accrual item rather than our first cash item. To identify actual cash flow and cash flow availability, we need to calculate the actual 2017 cash amount of sales, cash cost of goods sold, and cash operating expenses. Those cash amounts will result in a cash amount for net income that may be considerably different from the accrual amount of net income.

For example, to calculate the cash amount of sales in 2017, take the accrual sales amount of $10,667,992 less the increase in accounts receivable of $218,002 for a 2017 cash from sales of $10,449,990. This $218,000 reduction reduces the accrual net income amount by $218,002. We need to follow the same computation process for the cost of goods sold and for operating expenses. Only when we covert each accrual balance to a cash balance and total up these cash amounts can we determine if company cash flow was sufficient to meet interest expense and scheduled debt repayment.

In this respect, it is interesting to note that the company fell short of meeting its interest expense in 2017 by $483,321 which is the amount of deficit Business Cash Income in 2017 when we compute and use the UCA cash flow statement. Please see the Modified Cash Flow Statements attached to the case materials we use in this webinar.

Course overview: Working Capital and UCA Cash Flow

Q: It seems strange that more working capital is generally perceived as positive, if it opposes cash flow.

A: An increase in working capital is, as you note, generally considered a positive development. It is considered as such because it implies that the company will have more cash from current asset conversion in the next period to meet the cash requirements as today's current liabilities become due in the next period. But, as we note, an increase in working capital is invariably accompanied by a decrease in operating cash flow in the present period since a relative build-up in working capital drains operating cash flow. In a growing company that has negative cash flow driven by sales growth and proportionate growth in accounts receivable, inventory, and accounts payable (which means no change in the financing gap), a strong current ratio compounded with profitability is perceived as positive.

A key point to keep in mind is that an increase in working capital is not an increase in cash flow in the present period. Quite the opposite. Whether an increase in working capital is an increase in operating cash flow in the next period is an open question and depends on the manner in which the company manages its profitability, its operating assets, such as receivables and inventory, and its operating liabilities, such as payables and accruals.

Course overview: Working Capital and UCA Cash Flow

Q: Would it be a good idea to measure cash flow cycle days and % increase in sales /expenses to better determine where working capital went/came from?

A: Yes, doing so can be helpful. For example, an increase in the duration of the cash flow cycle – or financing gap – points to a more rapid buildup in working assets (accounts receivable and inventory) compared to a slower increase in operating liabilities (accounts payable and accrued liabilities). Such a pattern will increase working capital but, not surprisingly, will reduce cash flow at the same time.

You might also measure the increase in EBITDA% or the net profit margin along with increased sales since any increase in profit and associated net income + depreciation (traditional “cash flow”) increases working capital...and vice versa.

In referencing an analysis of the cash flow cycle days and changes in sales activity, you have also touched on the key factors affecting the cash flow of the borrower. Using the same implications as used in considering their impact on working capital, the dynamics also drive cash flow performance. There is much we can gain from a dual-purpose analysis of the same data.

Course overview: Working Capital and Cash Flow

Q: Can you expand on Slide 6 and explain how working capital increases if net long-term assets increase?

A: Focus on the accounting entries that would lead to an increase in net-long term liabilities to help see how, as a general rule, this statement is true.
For example – a re-classification of short-term debt to long-term debt decreases a current liability account – short-term debt – while increasing long-term debt. The result is an increase in working capital, since a current liability account decreased. Or if newly disbursed long-term debt increases, the cash account increases, initially at least, which is a current asset and a working capital account. Therefore, working capital increases. Or if a company receives a long-term loan from a related party, the loan increases the cash account, and working capital, while increasing long-term liabilities. And so on.

Q: Are the Current Maturities of LTD on the balance sheet exercise the same as Current Portion of LTD?

A:  Yes. The two terms are used interchangeably.

Course overview: Working Capital vs. UCA Cash Flow
 

Q: Are depreciation and amortization expenses removed from the income statement because they are non-cash expenses?

A: Depreciation expense is the allocated portion of the cost of a company's fixed assets that are appropriate for the period. Depreciation expense is recognized on the income statement as a non-cash expense that reduces the company's net income. For accounting purposes, the depreciation expense is debited, and accumulated depreciation is credited.

Amortization expense is applied in the same manner in allocating the cost of intangible assets.
Depreciation expense is considered a non-cash expense because the recurring monthly depreciation entry does not involve a cash transaction. Because of this, the statement of cash flows adds the depreciation expense back to calculate cash flow from operations and uses that depreciation expense in order to calculate fixed asset spending for the year.

In addition, typical depreciation methods can be straight line (on a company’s books) or accelerated (on tax returns) and, therefore, accelerated depreciation can be used to lower income tax liability for the year.

Q: The CMLTD increased in 2014 vs. 2013. So did the working capital increase actually help the company meet its debt service?

A: We can only determine if a working capital increase had a positive impact on operating cash flow by examining the UCA cash flow statement. This statement is the sole analytical tool that identifies if a borrower generated sufficient operating cash flow to meet its debt service.

Q: Why is Depreciation Expense added with the Net Income to determine Adjusted Net Income on Slide 18?

A: The journal entries to post depreciation expense do not touch a working capital account. We debit an expense on the income statement but then credit accumulated depreciation on the balance sheet, which is a contra account to gross fixes assets – a non-working capital account.

Q: What is the usefulness of analyzing working capital?

A: Our webcast focused on the change in working capital and its possible signals about the ability of a company to service its interest-bearing debt. We found that it is not possible to do so without conducting a full UCA cash flow analysis. However, there is certainly value in analyzing working capital components.

We can attempt to identify the time horizon over which current liabilities are due for payment, which helps us understand the likely pressure on a borrower’s cash resources in the near future. For example, by reference to an accounts payable aging schedule, we can quickly determine if the majority of payables are overdue, or if they are within a standard payment period. If the majority of payables are overdue, and perhaps seriously overdue, then we can be fairly well assured that our borrower’s suppliers will exert considerable pressure for immediate payment. As a result, we would expect the borrower to a) use existing cash resources to meet supplier demand, b) to use incoming cash from sales and the collection of receivables to meet supplier demand, or c) to arrange for additional short-term financing to meet supplier demand – or, perhaps, to resort to some combination of these options in order to satisfy supplier demand for payment.

The same analysis would apply to accrued expenses, but, unfortunately, we rarely – if ever – have access to information that indicates the aging of accrued expenses or accrued liabilities.

With respect to the other side of the balance sheet, we can benefit by examining an aging schedule for accounts receivable. If such an examination indicates the majority of receivables overdue, we might than anticipate continued difficulties in collecting receivables, which translates to a slower pace of cash inflows. However, if an aging schedule indicates that our borrower’s clients pay rapidly, we can then expect a more rapid inflow of cash from converting sales to cash.

We should, in addition, examine inventory and the length of time it takes to convert inventory to sales. The less that time period, the more quickly inventory moves from the balance sheet to the income statement in the form of revenue reflected in either cash or accounts receivable. If we see the number of inventory days increasing, we know that the company will experience slower conversion from inventory purchases to cash collections from the sales of products that include – in whole or in part – the inventory purchased by our borrower. The reverse holds, of course. If the number of inventory days is decreasing, then the cash conversion cycle will lead to more rapid conversion of inventory purchases to cash collection from sales.

Keep in mind, too, that the relative quantities of working capital components are important in arriving at any tentative conclusions about cash inflows or outflows in the near future. For example, if a company has relative few accounts payable but a relatively large amount of accounts receivable, our examination of an accounts receivable aging schedule will be more relevant to estimating cash inflows in the near future than an examination of an accounts payable aging schedule.

In general, an analysis of working capital components of this nature can be conducted at ongoing, regular intervals. In effect, such an analysis provides a very rough approximation of a company’s operating cash flow over a short time period from movements in the operating balance sheet accounts. But such a working capital analysis provides only components of a projected UCA cash flow statement, which incorporates revenue, expenses, and changes in balance sheet accounts and over any given time period in estimating operating cash flow.
 

Q: Why does a decrease in long-term assets reflect an increase in working capital?

A: A decrease in long-term assets is usually accompanied by a cash inflow from a sale of assets or an increase in a current receivable or note receivable (or some combination of the two), both of which increase working capital. Cash balances go up and / or an accounts receivable balance goes up.

However, if a company writes off a long-term asset, it would post a non-cash expense or loss to its income statement, which would reduce working capital since a loss reduces working capital.

Q: I was curious why (when looking at owner payout) more emphasis isn’t placed on Gross Cash Flow vs Net Profit? In the context of debt service, wouldn’t that matter more?

A: Without doubt more emphasis should be placed on gross cash flow - or cash flow available to service debt from the UCA cash flow statement - than on net profit or on any of the cash flow proxies such as EBITDA and traditional "cash flow". The cash flow proxies, net income included, are only rough guesses at actual cash flow. The UCA cash flow statement specifies exactly whether there is - or isn't - sufficient cash flow to service debt.

Q: You said the Gain on Sale of Assets is included with the change in Fixed Asset Spending?

A: This is correct. In computing fixed assets spending, use this general formula:

• Change in property, plant, and equipment, net and intangible assets, net (cash inflow or cash outflow)
• Adjusted by depreciation and amortization expense (cash outflow)
• Adjusted by gain on sale, if any (cash inflow)
• Adjusted by loss on sale, if any (cash outflow)

The sum of these entries is the cash cost of fixed and intangible asset spending. The example used in the webcast for Seaside Marble for 2014 is as follows:

Change in: Fixed and Intangible Assets, net (balance sheet)	– 474,531
Adjusted by Depreciation and Amortization Expense (income statement)	– 167,675
Adjusted by Gain on Sale of Asset (income statement)	28,732
Adjusted by Loss on Sale of Asset (income statement)	000
Equals: 2014 Fixed and Intangible Asset Spending, net	– 613,474

Q: Would you lend to this company?

A: Yes, with proper loan covenants that cause the company to establish sufficient cash flow to service debt. Seaside Marble’s high sales growth and ability to rebuild profitability makes them a worthy loan candidate. Some additional factors leading to our conclusion lie in the fact that EBITDA is up, the financing gap is stable, and the owner payout rate is not excessive.

The cash flow deficits facing the company over the last two years come primarily from high but profitable growth driving increased inventory and accounts receivable - all of which we like as lenders. The company is managing the balance sheet in a responsible way in that both accounts receivable and inventory days have actually improved in the face of the dramatic sales growth.

We certainly need to further assess management before a final decision, but the financial results make Seaside Marble a worthy loan candidate.

Q: What does the term “vice versa” refer to at the end of the statements describing the Cash Flow Drivers movements that increase Business Cash Flow on Slide 9?

A: The term is used to indicate that if a Cash Flow Driver moves in the opposite direction of the listed movement, the Driver will then decrease Business Cash Flow.

For example if the gross margin DECREASES (rather than increase as presented), then Business Cash Flow also DECREASES (rather than increase as presented).

Q: Is the big picture then that Seaside Marble grew too quickly? The company experienced huge revenue increases and significant fixed asset spending in each of the last two years.

A: Seaside Marble did indeed experience dramatic sales growth and fixed asset expansion in each of the last two years. It’s important to note that Seaside Marble has managed the high growth very well. EBITDA% and net profit % all increased between 2013 and 2014. The management team also managed its financing gap well (stayed flat at 113 days). The owner payout rate dropped; and business profit turned positive in 2014.

The issue associated with their growth is not one of displaying an increasing working capital or striving to increase cash flow. The real issue, in analysis, is understanding why working capital has changed and why cash flow as an independent metric has also changed. The cash flow problem the company now faces is simply the fact that sales grew 47% in 2014. With that growth came equally significant demands to support COGS, working assets, and expenses plus the fixed asset growth you cited.

The company managed the growth very effectively in 2014.

Q: What are the differences between the UCA Cash Flow Statement and the FASB 95 Statement of Cash Flows in terms of understanding a company's ability to service debt?

A: A key difference lies in the purpose of the two statement formats. The UCA cash flow statement is designed by lenders to reveal borrowing causes, cash sources to service debt, the financing requirement, and how the requirement was met. In addition, the UCA cash flow statement clearly defines the company’s ability to service debt with cash from operations. With this information, a lender can make a more responsible credit decision and, in turn, more readily work with the borrower as a true consultant.

The FASB 95 Statement of Cash Flows is designed to present a complete statement of cash flows grouped into operating, investing, and financing activities. Because of both classification and formatting issues, the FASB 95 statement is not readily usable to assess a company’s ability to service debt.

A key difference that arises with FASB 95 is the classification of distributions as a financing activity rather as an operating activity as is done with the UCA cash flow statement. The underlying reason for the different treatment is the fact that distributions are charged to retained earnings and FASB categorizes the event as a financing activity. The UCA cash flow statement treatment is driven by the fact that distributions are in effect a payment of taxes and to the extent that they exceed taxes payable by the owner of non-Sub C businesses, they become untaxed compensation (also an operating expense) to the owner.

For an in-depth examination of the differences in these two cash flow statements, please see our FASB 95 vs. UCA Cash Flow webcast.

Q: How do we use UCA cash flow analysis to determine the borrower’s future ability to service additional debt?

A: In order to effectively use UCA cash flow analysis to determine a borrower’s future ability to service debt, we first must have a set of financial projections with assumptions from the borrower.

Once the projections are received, we must determine if they appear viable by measuring them against the last actual financial results, and then apply UCA cash flow analysis which will address and identify a) borrowing causes, b) sources of cash for debt service, c) the financing requirement, and d) the source of cash to meet financing requirement.

If Cash after Debt Repayment on the UCA cash flow statement is positive in the projection scenario, which must include additional interest expense and scheduled debt repayment on additional term debt, the borrower will generate sufficient operating cash flow to serve existing and additional interest-bearing debt – if the projections match reality as events unfold.

Q: When you say “vice versa” on each of these, can you give an example?

A: As an example "an increase in working capital may signal an increase in a borrower's profitability...and vice versa" where the “vice versa” means a decrease in working capital may signal a decrease in borrower's profitability. And so on for each of the five suppositions.

Q: Can we have the components of cash flow and the components for working capital again?

With respect to the working capital drivers, working capital increases if:

• Traditional “cash flow” – net income + depreciation – increases…and vice versa.
• Net long-term assets decrease…and vice versa.
• Net long-term liabilities increase…and vice versa.
• Owners provide capital injections…and vice versa, e.g., if owners take distributions or withdrawals.

With respect to cash flow drivers, business cash flow increases if:

• The gross margin increases…and vice versa.
• SG&A (operating expenses) % decreases…and vice versa.
• Accounts receivable days decrease…and vice versa.
• Inventory days decrease…and vice versa.
• Accounts payable days increase…and vice versa.
• The owner payout rate decreases…and vice versa.
• Fixed assets spending as % of sales decreases…and vice versa…via impact on interest expense from fixed asset financing.

Q: Slide 24 is a bit misleading. The first bullet point states that working capital increased because traditional cash flow and the increase in long-term debt exceeded distributions and the increase in fixed assets and long-term assets. Shouldn’t it be a "change in fixed assets and long-term assets" rather than an “increase”?

A: The $189,755 increase in working capital was primarily due to the fact that traditional “cash flow” plus the increase in long-term debt exceeded distributions plus the increase in both fixed and other long-term assets. The key word here is “increase” since it is the direction of the change, i.e., an increase or a decrease, that determines the impact on working capital. The increase in long-term debt increases working capital while an increase in fixed and other long-term assets decreases working capital.

Q: What are the answers to Poll Questions 8 and 9?

Poll Question 8 is as follows:

“Working capital and business cash flow frequently offer conflicting signals about a company’s ability to service its interest-bearing debt, i.e., an increase in working capital may actually result in a decrease in business cash flow and vice versa.

• Agree.
• Disagree.”

The answer is “Agree” because working capital and cash flow can offer conflicting signals.

Poll Question 9 is as follows:

“As the 2013 and 2014 financial performance for Seaside Marble indicates, a decrease in working capital in one year always results in improved business cash flow in the following year…and vice versa.

• Agree.
• Disagree.”

The answer is “Disagree” because there is no relationship between the movement in working capital and the movement in cash flow in the next year.

Q: What's the difference between operating cash flow and normal cash flow?

A: All true cash flow formats have three major sections – Operating, Investing (Capital Expenditures) and Financing – and these cash flow formats measure cash inflows and outflows from both the balance sheet and the income statement. We use the operating cash flow section of a true cash flow statement to determine if a company can service its interest-bearing debt.

Two other common cash flow formats, Traditional Cash Flow (Net Income plus Depreciation) and EBITDA are cash flow proxies only as they do not include balance sheet cash inflows and outflows. Therefore, in most instances, they are not representative of true cash flow.

Q: Can we revisit Poll Question 4 regarding the movement of the short-term debt to long term debt and the relation to working capital and cash flow?

A: It is Poll Question 4 that addresses this subject.

“Poll Question 4
If Seaside Marble, Inc. classified the 2014 Due to Related Parties balance of $76,244 as a long-term liability rather than a short-term liability, both 2014 working capital and business cash flow would increase.

• Agree.
• Disagree.”

The answer is “Disagree” because working capital would increase since $76,244 would be removed from current liabilities and reclassified as a long-term liability. However, business cash flow would remain the same because the change in Due to Related Parties is classified as a related party transaction that appears after Business Cash Income and Cash after Debt Repayment in the UCA cash flow statement. Whether Due to Related Parties is classified as a current or long-term liability, the change in the account remains at the same point in the UCA cash flow statement.

Q: What is the difference between Question 1 and 2 regarding short-term borrowings?

A: Question 1 is intended to bring out that short term loans from any source do not increase working capital. Of the options offered only capital contributions and an increase in long-term loans generate an increase in working capital.

The wording of Question 2 incorrectly references an increase in short-term debt as a dynamic driving a change in working capital. Although an increase in short-term debt contributes to meeting the financial requirement identified by a UCA cash flow statement, it does not add to working capital.

The over-riding purpose of the two questions is to reinforce the factors that drive working capital up or down.

Q: Do you have Excel spreadsheet templates for the W/C and UCA cash flow you can send? Thank you.

A: We don’t have a spreadsheet template that would be sufficiently generic, but we’ll look around and see if we can provide something useful.

March 25, 2015

Q: I am a little confused about why an increase in long-term would increase working capital? Typically long-term debt (in addition to some cash) is used to purchase a long-term asset. If anything, I would expect it to reduce working capital since some cash was used to make the purchase.

A: An excellent question. You point out the need to work through all the events that are associated with an increase or decrease in long-term debt or with increases or decreases in the other three working capital drivers.

In the case of an increase in long-term debt, there are many possible events that can be associated with it. For example, if a borrower arranged long-term debt from a related party in order to meet various operational or financing needs, the initial steps of the transaction could be an increase in working capital that matches the amount of the loan. The borrower initially debits cash – a working capital account – and credits a long-term liability account – a non-working capital account. The net effect, in the first instance, is an increase in working capital in the full amount of the loan.

If the borrower then uses 50% of the new loan to pay down trade credit, both the cash account and account payable decrease by the same amount. The net effect is neutral – no change in working capital since a current asset account and a current liability account decrease by identical amounts.

And if the borrower now uses the remaining 50% of the loan to buy fixed assets, the cash account and working capital fall by that amount.

In this example, the ultimate bottom line impact on working capital is positive and equal to half the original loan amount once these events have taken place. The balance sheet would reflect an increase in fixed assets that is half the increase in long-term liabilities.

In your example, the opposite net effect would likely materialize. If a borrower arranged a long-term loan equal to 80% of a fixed asset purchase and paid the remaining 20% from its cash account, the decrease in the cash account would represent a decrease in working capital. The balance sheet would now show an increase in fixed assets that exceeded the increase in long-term liabilities by the 20% cash financing amount.

The moral of the story is that nothing takes place in a vacuum. We need to trace through all the events associated with changes in a working capital driver. Some are simple, such as a distributions which directly reduces cash and working capital, but others are far more complex.
 

September 24, 2014

Q: What was the answer to Poll Question 4?

A: Poll question 4 reads as follows:

“If Seaside Marble, Inc. classified the 2005 Due to Related Parties balance of $76,244 as a long-term liability rather than a short-term liability, both 2005 working capital and business cash flow would increase.”

The answer is false. Working capital would increase since a $76,244 current liability has now been removed and reclassified as a long-term liability, which increases working capital by $76,244.

However, business cash flow would remain unchanged because the change in Due to Related Parties is considered a financing transaction and, therefore, does not affect operational cash flow.

July 2, 2014

Q: When calculating CAPEX, why would one not find the net change in depreciation year-over-year and add that figure to the year-over-year change in net fixed assets. It seems like simply adding back depreciation would overstate CAPEX by the depreciation figure from the previous year.

A: Adding back depreciation expense for the year is simply adjusting the fixed asset balance to the balance that existed prior to the non-cash reduction for the year, which is depreciation expense.

Therefore, we measure last year's ending balance with this year's balance BEFORE the artificial reduction in the form of a non-cash write down.

Using the net change in depreciation expense, rather than depreciation expense for the year, would understate CAPEX.

Q: Can you please explain Poll Question 4 again. You said that the working capital would increase, and then you said that business cash flow would increase, but that you disagree overall?

A: Poll Question 4 reads as follows:

If Seaside Marble, Inc. classified the 2005 Due to Related Parties balance of $76,244 as a long-term liability rather than a short-term liability, both 2005 working capital and business cash flow would increase.

• Agree.
• Disagree

The correct answer is “Disagree” because working capital would increase but business cash flow would not be impacted. A reclassification of the Due to Related Parties balance in 2005 from a short-term to long-term liability would have no impact on the change in that account between 2004 and 2005 and, therefore, on the cash impact from changes in the account. In other words, the cash inflow from related parties would be $40,661 in 2005 regardless of whether the balance sheet account were classified as a short-term or long-term liability.
 

March 26, 2014

Q: I am still confused. If the definition of working capital is current assets less current liabilities, why are we concerned with long term assets and liabilities?

A: It might make most sense to follow the accounting entries associated with any net change in long-term assets and long-term liabilities to identify the impact on working capital.

For example, if a borrower acquires fixed assets, which it largely finances, its cash account decrease by the amount of cash used in the acquisition.  Therefore, the increase in fixed assets leads to a decrease in working capital.  Or, if a borrower reclassifies loans from owners from current liabilities to long-term liabilities, long-term liabilities increase and, correspondingly, short-term liabilities decrease.  As a result, working capital increases.

Q: How did you get $613m in fixed asset spending?

A: Slide 20 in the presentation provided the details for the fixed asset spending computation.  Net fixed assets increased by $474,531, a cash outflow prior to adjustments for depreciation expense.  Since depreciation expense was $167,675, the change in fixed assets prior to a non-cash write-down (depreciation) was $474,531 + $167,675 = $642,206.  However, we need to account for the gain on sale of $28,732, which, therefore, reduces the adjusted change in fixed assets to $613,474.  $613,474 represents the net cash outflow from the purchase and sale of fixed assets.

Q: Can't you just get fixed asset spending from the cash flow statement, if available?

A: You can do so if the cash flow statement in question is a UCA cash flow statement. However, if it is a FASB 95 statement of cash flows, there may be other non-fixed assets included in the computation, such as intangible spending.

Consequently, it can be very useful to understand the computations necessary to identify fixed asset spending rather than relying on a FASB 95 statement of cash flows that may not be precisely accurate in this area.

Question & Answer, Working Capital vs. Cash Flow Webcast, October 3, 2012

Q: Out of curiosity, would you, instructor, lend money to these companies? I presume the answer is no, based on the negative cash flow trends and use of short and long-term debt year-over-year (i.e. the companies generated insufficient cash flow from operations).

A: In my opinion, we need more information in order to make an informed credit decision on Seaside Marble, Inc.

In our webcast we completed a partial credit analysis in which we discussed how the changes in working capital affect cash flow, i.e. how a decrease in working capital increases cash flow and an increase in working capital decreases cash flow.

We discovered that there was a $308,963 decrease in working capital in 2004 and that working capital increased by $189,755 in 2005. In addition, we determined that the company did not generate sufficient operational cash flow to service interest bearing debt in either 2004 or 2005. The company was, however, profitable in both years.

Certainly, we cannot make a credit decision based solely upon this information. We need to also consider the following in our analysis:

1. Ratio trends and analysis to determine the quality of inventory and accounts receivable as well as income statement performance.
2. Determine how the level of sales growth as well as the change in turnover ratios affect cash flow? It makes a big difference if we are financing profitable sales growth or deteriorating turnover ratios and profit margins.
3. Address distributions and loans to owners. Less in distributions means an increase in cash flow.
4. Discuss the level of fixed asset spending to determine if it is reasonable, necessary and affordable.

After a more thorough analysis, to include all of the above areas, we should be able to make a proper credit decision on Seaside Marble, Inc.

Questions & Answers, W/C vs. C/F, June 21, 2012
Q:  Should deficit working capital be treated as capital debt?

A:  Negative working capital means that current assets are less than current liabilities.  It also means that long-term assets are greater than the sum of long-term liabilities and net worth.  How we interpret negative working capital is really an issue of understanding the events that explain negative working capital.  Consider these possibilities in which we’ll assume the event was sufficient to transform positive working capital into negative working capital:

• A company used its cash balances to buy equipment or a building.  Current assets and working capital decrease while long-term assets increase.
• A company reclassified loans to a related party from short-term to long-term assets.  Current assets and working capital decrease while long-term assets increase.
• A company borrowed short-term to finance equipment.  Current liabilities and long-term assets increase while working capital decreases.
• A company bought out an owner, using its cash balances to do so.  Current assets, net worth, and working capital all decrease.
• A company distributed more to its owners in cash than the profit it generated for the period.  Current assets, net worth, and working capital all decrease.

From these examples, we might conclude that negative working capital reflects financing decisions on the part of the company.   That is, if it had used long-term financing in four of the five examples, its working capital would have remained positive.  In the remaining example – the reclassification of related party debt – a simple classification decision explains the transformation in working capital.  In other words, there is no generic label we can attach to negative working capital.

Q:  If a company is building its cash position, couldn't cash flow and working capital increase?

A:  It depends on the manner in which a company attempts to build its cash position.  For example, if it does so by increasing its net profit margins and retaining more profit in the business, its business cash flow and working capital would increase.  But if it does so by selling fixed assets, it could increase its cash balances but still run a business cash flow deficit if the cash proceeds from fixed asset sales exceeded the business cash flow deficit.

The key is to identify how a company is building its cash position – if that is indeed an objective – and to understand the resulting impact on the company’s ability to service its interest-bearing debt from business cash flow.  Our primary and preferred source of cash to service interest-bearing debt is business cash flow.

Q: Loans to shareholder reduces cash.  On a UCA Cash Flow statement, where does the cash withdrawal post?

A: The accounting entry for a, say, $50,000 loan to shareholder would be as follows:

Debit: Loans to Shareholder  $50,000
         Credit: Cash                                        $50,000

The effect of the transaction would be a $50,000 decrease in cash (a current asset) and an increase in Loan to Shareholder (also a current asset). There is obviously no effect on net worth.

From a cash flow perspective, you would see a $50,000 increase in Loan to Shareholder (a cash outflow), and, on the cash flow statement, that outflow would be summed with any distributions to arrive at Business Cash Income.  Therefore, Business Cash Income would be less by $50,000, and a company's ability to service debt would also be less by the same amount.

Q & A, W/C vs. C/F Webcast, April 10, 2012

Q: Since working capital, like the current ratio, provides the level of margin, can we use it to justify a level of confidence with respect to the borrower’s ability to convert current assets to cover short-term bank debt?

A: The working capital computation (current assets minus current liabilities) only provides us with a quantity of working capital.

In order to determine the quality of working capital and, therefore, the ability of current assets to cover current liabilities, we must verify condition of the current assets (usually accounts receivable and inventory).

We would accomplish this by analyzing the aging of accounts receivable as well as the turnover ratio and the effectiveness of the charge off policy. In addition, we would review the condition of inventory (by visual inspection) and the inventory turnover ratio.

Only after the analysis of the current assets could we have a level of confidence that current assets could satisfy current liabilities.   

However, keep in mind that the implicit assumption underlying working capital and the current ratio is that we freeze time.  If nothing changes, if the borrower does not generate another dollar of sales or incur another dollar of expenses, or withdraw a single dollar for personal use, then the message provided by working capital and the associated current ratio – after appropriate due diligence and any necessary adjustments – will be valid.  But if the business continues, there is no assurance that any working capital margin or any associated current ratio will translate to sufficient business cash flow to service interest-bearing debt.

For example, assume a borrower experiences a further build-up in receivables because of cash flow problems among its client base and experiences, as well, a further build-up in inventory because it misjudged demand for its products.  However, the borrower is able to increase working capital and the current ratio because of a combination of owner capital contributions and new long-term debt to fund its mounting cash flow difficulties.   Should the lender be satisfied under such circumstances?  Absolutely not, since it got repaid from capital contributions or from some portion of its newly disbursed long-term debt or from some combination of the two.

Working capital and the current ratio are, at best, crude indicators of future repayment prospects from business cash flow.  To understand the likely source of cash to meet future debt service, focus on the Business Drivers and their likely changes in the coming period.   How they turn out tells the whole story.

Questions & Answers, W/C or C/F Webcast, May 5, 2011

Q: Working Capital reconciliation question - while mathematically correct, this approach appears to be rarely used in today's commercial credit analysis. Rationale - it does not explain what truly caused the change in working capital; typical reasons being changes in collections, changes in inventory management, changes in payment experiences, etc. What are your thoughts?

A: We agree that the emphasis should be on A/R management, inventory management, A/P management and the resulting CASH implications, which takes us back to the pivotal role of cash flow - the key point in the webcast.

One major objective in the webcast, is to determine the relationship between working capital and cash flow. Does movement in working capital have an affect on a company’s ability to service its interest bearing debt from operating cash flow?

The emerging conclusion is that if working capital increases, it is because operating assets increase more than operating liabilities and, therefore cash flow decreases which, in turn, has a negative affect on debt service prospects. In other words, there is an unavoidable inverse relationship between working capital and cash flow.

Once we understand the inverse relationship between working capital and cash flow, we use cash flow analysis to assess debt service prospects and ratio analysis to ensure the quality and management of the major working capital components (accounts receivable, inventory, accounts payable). In this manner, we can determine both the cash flow affect of an increase or decrease in working capital as well as the true cause of changes in working capital.

Q: Just had a quick question on your rationale in Cash Flow from Business Operations (we see this as Net Operating Cash Flow, NOCF) for Distributions and Loans to Shareholders. We don’t consider these two items in our NOCF calculation because the shareholders/owners don’t get any proceeds prior to vendors or banks getting paid. We consider distribution at times to cover income tax, but definitely not Loans to Shareholders. Why do you factor this?

A:  Distributions and loans can only be "reserved" by conditions or stipulations in a loan agreement, something similar to a subordination agreement.  Absent such an agreement, the owners can take distributions and loans whenever they want to, providing the cash is available.

Regardless of whether an agreement is in place or will be put in place, we are constructing an actual historical cash flow, and if distributions and loans went out to the owner, then we need to accommodate those operating cash flows in the cash flows that sum to Business Cash Income.  As you state, distributions are for taxes; they provide cash to the owner(s) to pay the income tax obligation on the company profit.  If the amount of distributions is greater than the income tax obligation, the excess amount is compensation.  Loans to the owners are really the same thing.  A loan is an easy way for an owner to take money out of the company.  In my experience, those loans are rarely paid back.  These loans are usually advance distributions that are subsequently converted to distributions via accounting entries.  Regardless of whether or not the loans are converted to distributions, the money has gone out of the company to the owner(s). Neither loans nor distributions are reflected on the income statement, and the owners do not pay taxes on either distributions or loan proceeds.  They are virtually the same.

The owner(s) take money from the company via distributions and loans for taxes, and any amount of distributions and loans that exceeds the income tax obligation on the company profit is compensation. Taxes and compensation are operating expenses and are, therefore, included in the array of operating cash flows that sum to Business Cash Income.

If we were to constructing a projected UCA cash flow statement, and we plan to establish a loan covenant that limits the sum of distributions and shareholder loans to the implied income tax obligation on the company profit, then in that projected cash flow we would include only the amount of the projected income taxes in the operating cash flows. 

Questions and Answers, W/C vs. C/F Webcast, October 27, 2010

Q: On the "Working Capital vs. Cash Flow Exercise" handout, it says to record the gain on the sale of an asset as a negative amount, but it looks like in the power point presentation it was added and not subtracted.

A:  On the Working Capital Reconciliation Worksheet, the gain on the sale of an asset is not a use of cash, but may initially appear to be as the gain is subtracted from Net Income plus Depreciation.

A gain on the sale of an asset is related to fixed asset spending and, therefore, it is temporarily deducted from the income statement, but then included in the fixed asset spending calculation as follows:

Seaside Marble 2005 Fixed Asset Spending

Change in Fixed Assets and Intangibles, net (B/S)   -474,531
  Less: Depreciation and Amortization Expense (I/S) -167,675
  Plus: Gain on Sale of Asset (I/S)                   28,732
Equals: 2005 Fixed Asset Spending                   -613,474

Q: Is there a way you can go over the cash flow calculations again? I understand some parts of it, and in other parts I do not understand the reasons the cash inflows and outflows.

A: This webcast assumes some knowledge of the manual construction of a UCA Cash Flow statement, and, due to time constraints, it is difficult to cover in detail all the calculations that are completed in that process.

If they have not already done so, we highly recommend that all bankers take a UCA Cash Flow Analysis course which covers the complete manual construction of a UCA Cash Flow statement. The course is of great assistance to all bankers in understanding the analytical implications of the UCA Cash Flow statement.

Q: Would you say that the only reason for a company to have working capital loan would be if the company is expecting to increase their A/R and/or inventory?

A:  No, although an expected increase in accounts receivable and inventory may be a reason for a working capital line of credit or loan, the primary reason for a working capital line of credit is to support the cash operating cycle of a company, i.e. the time that it takes to convert inventory to accounts receivable to cash in the company’s normal operating cycle.

Q: So we want a negative cash flow? I do not know if I heard correctly, but I believe this is what you spoke about on adjusted cash flow for Seaside Marble.  [That question did come from you speaking on assets growing faster than liabilities and that may bring negative cash flow so I do understand now.  Thank you.]

A: We certainly do not want to see a negative cash flow from operations (Net Cash Income) because one of the conditions for business success is for a company to have sufficient Net Cash Income to repay the current portion of long-term debt (i.e. positive Cash after Debt Repayment).

During the webcast, I was making the point that a growth in working capital absorbs cash because current assets would grow at a faster rate than current liabilities, and, as a result, it is possible that Net Cash Income may be negative if that growth is too robust.
 
Q: In the calculation of Working Capital Reconciliation the “change in: Long-Term Debt” for 2004 is $26,269, yet in the Adjusted UCA Cash Flow Statements  the “adjustment: Change in Long-term Debt” for 2004 is $82,217.  Why the difference?

A: The computations for changes in long-term debt in the UCA cash flow statement calculate the amount of new long-term debt for the period.  In doing so, the current maturities of long-term debt play a role.  The prior year current maturities are paid down in the current period.  Therefore, the amount of new long-term debt raised in the current period is the difference between the prior period remaining long-term debt and the current period long-term debt.  The latter is the sum of the current maturities of long-term debt (long-term debt but reclassified as current) and the remaining long-term debt.

The computations for changes in long-term debt in determining the forces that explain movements in working capital focus only on those amounts of long-term debt that are classified on the balance sheet as long-term debt. The current maturities are ignored, since – by definition – an increase in a long-term liability account increases working capital.  Unless the current maturities in the current and prior period are identical, this computation process will not accurately calculate the amount of new long-term debt raised in the current period.

In the Working Capital Reconciliation worksheet, the change in long-term debt calculation is the change in long term debt on the balance sheet ($214,160 – 187,891 = $26,269). This calculation does not include the current portion of long term debt in either year because they are a component of working capital, and we, in this particular worksheet, we are simply determining the calculated change in working capital.
Remember that the drivers of working capital change are profitability (net income plus depreciation) and changes in fixed assets, long-term liabilities as well as capital injections and/or distributions.

For the purposes of the 2004 Adjusted UCA Cash Flow statement for Seaside Marble, we include the current portion of long-term debt due and payable in 2004 (2003 CMLTD of $21,116) on the line after Net Cash Income and before Cash after Debt Repayment.

Therefore, since we have already account for the 2003 CMLTD, the change in long term debt for 2004 is an increase of $82,217, as follows:

2004 CMLTD of $103,531 + 2004 LTD of $214,160 = $317,691 – 2003 LTD of $235,474 = $82,217.

Questions and Answers W/C vs. C/F Webcast (June 10, 2010)

Q: Regarding the Cash Flow Snapshot Worksheet, if one is using the UCA spreadsheet can't you just take the Cash Flow from Ops and deduct the next debt payment - so a negative CF from the previous FY operations would always be indicative of a lack in payment ability?

A: You may make the projection calculation in that manner; however, the purpose of the Cash Flow Snapshot Worksheet is not just to determine if estimated business cash income is sufficient to repay long term debt as scheduled, but we are most interested in the reasons that business cash income cannot service interest bearing debt (distributions, changes in loans to shareholders, changes in operating assets and liabilities, etc.).

This detailed information will enable us to perform a more thorough credit analysis on the company as opposed to simply stating, in this case, that business cash income is insufficient to service debt.

Additionally, if you are able to get projections from the company, it would enhance the value of the Cash Flow Snapshot Worksheet for the next year.

Q:  Why do the computations for changes in long-term debt in the UCA cash flow statement differ from the computation for changes in long debt in determining the forces that explain movements in working capital?

A:  The computations for changes in long-term debt in the UCA cash flow statement calculate the amount of new long-term debt for the period.  In doing so, the current maturities of long-term debt do play a role.  The prior year current maturities are paid down in the current period.  Therefore, the amount of new long-term debt raised in the current period is the difference between the prior period remaining long-term debt and the current period long-term debt.  The latter is the sum of the current maturities of long-term debt (long-term debt but reclassified as current) and the remaining long-term debt.

The computations for changes in long-term debt in determining the forces that explain movements in working capital focus only on those amounts of long-term debt that are classified on the balance sheet as long-term debt. The current maturities are ignored, since – by definition – an increase in a long-term liability account increases working capital.  Unless the current maturities in the current and prior period are identical, this computation process will not accurately calculate the amount of new long-term debt raised in the current period.

For more information on this topic, please the related question below: "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."

Q: Why is the gain on sale of an asset in the Working Capital Reconciliation Worksheet a use of cash?

A: It is not a use of cash, but may initially appear to be as the gain is subtracted from Net Income plus Depreciation.

A gain on the sale of an asset is related to fixed asset spending and, therefore, it is temporarily deducted from the income statement, but then included in the fixed asset spending calculation as follows:

Seaside Marble 2005 Fixed Asset Spending

Change in Fixed Assets and Intangibles, net (B/S)   -474,531
Less: Depreciation and Amortization Expense (I/S)   -167,675
Plus: Gain on Sale of Asset (I/S)                     28,732
Equals: 2005 Fixed Asset Spending                   -613,474

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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.

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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.

Q: 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.

A: 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.

Q: What caused Seaside's current maturities to rise so drastically in 2004, while long-term debt only rose slightly from 2003?

Q: 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.

Q: Please cover the measurements you discussed in closing, i.e., the profitability covenant and the financing gap ratio.

A: 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.

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Working Capital vs. Cash Flow Questions and Answers
In the Question and Answer segment of Webcast on Working Capital vs. Cash Flow on December 11th, 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:  How does the computation for changes in long-term debt in the UCA cash flow statement differ from the computation for changes in long debt in determining the forces that explain movements in working capital?

A: The computations for changes in long-term debt in the UCA cash flow statement calculate the amount of new long-term debt for the period.  In doing so, the current maturities of long-term debt play a role.  The prior year current maturities are paid down in the current period.  Therefore, the amount of new long-term debt raised in the current period is the difference between the prior period remaining long-term debt and the current period long-term debt.  The latter is the sum of the current maturities of long-term debt (long-term debt but reclassified as current) and the remaining long-term debt.

The computations for changes in long-term debt in determining the forces that explain movements in working capital focus only on those amounts of long-term debt that are classified on the balance sheet as long-term debt. The current maturities are ignored, since – by definition – an increase in a long-term liability account increases working capital.  Unless the current maturities in the current and prior period are identical, this computation process will not accurately calculate the amount of new long-term debt raised in the current period.

Q: Does the term working capital mean that I can write a check based on working capital or retained earnings?

A: No.  It does not.  Working capital is not cash.  It’s simply the difference between current assets and current liabilities and has no implication for the amount of cash a company has in its checking account.  The same is true for retained earnings.  That account reflects the amount of earnings – after adjustment for distributions and withdrawals – that remains in the company at some point in time.  It has absolutely no implications for the amount of cash a company has in its checking account.

Q: Working capital lines of credit?  Cash flow lender or working capital lender?  Are we talking about the same thing?

A: No.  Working capital and cash flow are two totally different concepts.  Working capital is the difference between current assets and current liabilities.  Cash flow reconfigures the income statement on a cash basis to determine the points at which a company enjoys a cash surplus or deficit in its array of cash receipts and expenses for the year.

A working capital lender will use movements in working capital and the associated current ratio to assess risk and prospects for repayment.  A cash flow lender will refer to both actual and projected cash results of a company’s performance in assessing risk and the prospects of repayment.

Q: I've never used working capital to try and determine a borrower's repayment ability.  Should I?  And what about the current ratio?

A: No.  For working capital and for the current ratio.  You are much better served by projecting a company’s cash flow and using those results to assess the likely sources of cash to service interest-bearing debt.

The assumption is that the greater working capital and the greater the current ratio, the greater the prospects the current assets will convert to sufficient cash in the next period to pay down all the current liabilities.  But a business is not static.  When the next period arrives, a business is back to generating sales, incurring expenses, booking receivables, buying inventory, using trade credit, running up accruals, and so on.  Business cash flow services interest-bearing debt.  Therefore, focus on business cash flow and not on the most recent relationship between current assets and current liabilities – which plays only one part of subsequent business cash flow.

Q: Can a debt service coverage ratio be calculated using the UCA statement? Would you use Net Cash Income divided by existing + proposed debt?

A: You could indeed fashion a debt service coverage ratio using elements of the UCA cash flow statement.  The problem, however, is that the borrower may have great difficulty in properly understanding the covenant and, therefore, difficulty in attempting to honor it.

There is an alternative approach.  Put in place a business profit coverage ratio – net income + interest expense – distributions – loans to owners divided by the sum of interest expense and scheduled debt repayment.  Set that ratio at something above 1.00, such as 1.25.  The extra 25 basis points represents the risk that not all of the accrual profit will be converted to actual cash.

Then complement the business profit coverage ratio with a financing gap ratio. Define the financing gap as operating assets, e.g., receivables and inventory, less operating liabilities, e.g., payables and accruals divided by sales.  That translates to a ratio.  Require the borrower to maintain that ratio going forward.  If the borrower does so, the only cash impact from balance sheet changes will be driven by sales growth and not by mismanagement of receivables, inventory, or payables.

The combination of the two covenants will assure that the borrower will experience a cash flow deficit at net cash income only if it grows.  And we like to finance growth for a healthy company.