Q: Does the RMA Annual Statement Studies calculate industry benchmarks for the Financing Gap ratio?
A: No, the Financing Gap ratio is not one of the ratios that RMA calculates within the Annual Statement Studies.
Q: Please review poll question #8 which was: A borrowing base is intended to assure sufficient cash from the liquidation of collateral to repay interest-bearing debt associated with the collateral. True or False.
A: True. The purpose of a borrowing base is to assure, or attempt to assure, that there will be sufficient cash value of liquidated assets to repay the outstanding balance of short-term debt, should it come to that. A borrowing base is the application of a loan to its underlying value. When we establish a borrowing base, we are saying that we will advance against collateral, such as receivables or inventory, some percent; we won’t go above that percent, for example, 80% of eligible receivables, or 50% of eligible inventory. In other words, the outstanding balance of short term-debt is not to exceed the stated percent of financed assets at any point in time. The advance rates established will reflect the perceived risk that the liquidated assets might not be sufficient to repay the debt in full. Higher risk translates to lower advance rates.
Q: How do you calculate what the accounts receivable or inventory balance would be when days change?
A: To calculate the projected balance, we begin with the formula for accounts receivable days:
Solve for the Inventory Balance
A: If the Financing Gap Ratio is held constant and the company grows, the net balance sheet will grow, reflecting the cash impact of sales growth. The values (and days ratio) of receivables and inventory may bounce around - and the same for payables and accruals.
For Total Coverage Inc, in the 2006 adjusted column, we assumed that the days stayed the same for each operating asset and operating liability account and, therefore, the operating assets and operating liabilities grew at the sales growth rate.
That resulted in a constant Financing Gap Ratio of 13.06%. The operating assets totaled $735,673. Accounts receivable could have grown to $531,263 and inventory could have declined to $204,410 as long as the total remained at $735,673 – or less and then the financing gap ratio would not exceed 13.06%
The same is true for operating liabilities – some balances could be higher and some could be lower, as long as the total was $286,065 – or more.
The key issue is that the net operating asset number stays at $449,608 or less. At the end of the day there will be no net cash outflow by virtue of movements in operating asset and liability accounts so long as the Financing Gap Ratio limit is honored.
There is no implicit assumption that A/R days, inventory days, etc. stay constant in the growth period. A company could tighten receivables and receivable days and relax inventory and inventory days and stay within the Financing Gap Ratio limit. The same is true on the liability side. Think of it as assuring the collective impact of changes in A/R days, Inventory days, A/P days, and accrual days sums to zero. There is no increase in ((operating assets – operating liabilities) / (sales)) even though the composition changes
The Financing Gap Ratio reflects the relationship of the financing gap to sales and if that ratio stays the same, then there is no cash outflow from changes in the operating asset and operating liability accounts.
If the Financing Gap Ratio increases, it means that the collective impact of movements in A/R days and inventory days outpaced the collective impact of movements in A/P days and accrual days. And vice versa.
It gets back to the borrowing cause: Negative cash flow from sales growth is okay. We like to finance growing, profitable companies and growth absorbs cash. Negative cash flow from poor balance sheet management is not okay.
If the Financing Gap Ratio is honored and Business Cash Income is negative, then the cash deficit is explained by sales growth or by business loss – or by both.
If the Financing Gap Ratio is honored and Business Profit Coverage > 1.00, then the cash flow sufficient to service debt, absence cash impact from sales growth.
We have two critical covenants – Business Profit Coverage and Financing Gap Ratio.
If Business Profit Coverage is set at a level greater than 1.00 (commensurate with risk), and the Financing Gap Ratio is required to stay the same or decrease from one period to the next, and if these two covenants are met, then the borrower will be sufficiently profitable to repay long-term debt as scheduled and will generate sufficient cash flow to repay long-term debt as scheduled absent the cash impact of sales. And if these two covenants are met, the borrower meets two necessary conditions for business success.
Q: How does Business Profit Coverage work to assure sufficient cash flow to repay debt?
A: Business Profit Coverage by itself does not assure sufficient cash flow to properly service interest bearing debt. There are two financial loan covenants that, working together – if both are met, then the borrower will generate cash flow from business operations sufficient to properly service debt, absence cash impact of sales growth :
The two covenants are a debt service coverage ratio – this minimum Business Profit Coverage and a maximum Financing Gap Ratio. These two covenants assure sufficient cash flow from business operations if both are honored.
Let’s look at the Business Profit Coverage ratio: Reported profit adjusted by distributions, owner loans, one-time events, which is Business Profit, must exceed scheduled debt repayment by a risk factor. And that risk factor is the estimate of risk that not all of the Business Profit will be converted to cash. The formula for the Business Profit Coverage ratio is-
The concept is that the borrower must be sufficiently profitable today to have sufficient cash flow in the subsequent period. If the borrower reflects an accrual loss today, then that translates into a cash loss in the subsequent period. So it must be sufficiently profitable today to have the cash flow tomorrow to service interest bearing debt tomorrow.
Depreciation expense is not a cash expense today, but we leave depreciation as a required expense because it is a proxy for the amount of cash that a company will have to use to replace fixed assets that it uses up. Therefore, we do not remove depreciation expense; we leave it as required expense in coming to an estimate of the amount of Business Profit available to service debt.
Business Profit and accrual accounting records transactions as they take place, not when cash changes hands. Reported revenue, expenses, and profits, are estimates of final cash events that may or may not materialize. Therefore, we use a risk factor, and Business Profit must exceed scheduled debt repayment by that risk factor. And the risk factor is the risk that not all of the adjusted profit will be converted to cash. So if we think about a risk factor of 1.25, a premium of 0.25, we want Business Profit to exceed the debt service by that amount.
The risk factor that we assign is highly subjective and depends on our judgment of a variety of factors. It is a function of potential volatility in financial performance, which may reflect the borrower, the industry, or both. A stable, low risk company, with little history of bad debts and inventory obsolescence might carry a risk factor of 0.10, while a company with a history of substantial bad debts and heavy inventory obsolescence might carry a risk factor of 0.50.
Business Profit does not address the management of operating assets and liabilities on the balance sheet, and that balance sheet management obviously has an affect on the cash flow available to service debt. Balance sheet management is measured by the Financing Gap Ratio: ((operating assets) – (operating liabilities) / (sales).
These two critical concepts work in tandem. If Business Profit Coverage is set at a level greater than 1.00, a level is based on the risk that we perceive that all of the Business Profit might not be converted to cash, and if the Financing Gap Ratio is required to stay the same or decrease from one period to the next, then, if these two covenants are met, the borrower will be sufficiently profitable to repay long-term debt as scheduled and will generate sufficient cash flow to repay long-term debt as scheduled, absent the cash impact of sales growth.
And if these two covenants are met, the borrower will meet the two necessary conditions for business success – sufficient profitability and sufficient cash flow to properly service interest bearing debt.
A: No, the Financing Gap ratio is not one of the ratios that RMA calculates within the Annual Statement Studies.
Q: Please review poll question #8 which was: A borrowing base is intended to assure sufficient cash from the liquidation of collateral to repay interest-bearing debt associated with the collateral. True or False.
A: True. The purpose of a borrowing base is to assure, or attempt to assure, that there will be sufficient cash value of liquidated assets to repay the outstanding balance of short-term debt, should it come to that. A borrowing base is the application of a loan to its underlying value. When we establish a borrowing base, we are saying that we will advance against collateral, such as receivables or inventory, some percent; we won’t go above that percent, for example, 80% of eligible receivables, or 50% of eligible inventory. In other words, the outstanding balance of short term-debt is not to exceed the stated percent of financed assets at any point in time. The advance rates established will reflect the perceived risk that the liquidated assets might not be sufficient to repay the debt in full. Higher risk translates to lower advance rates.
Q: How do you calculate what the accounts receivable or inventory balance would be when days change?
A: To calculate the projected balance, we begin with the formula for accounts receivable days:
- (receivable balance) / (sales) x 365 = receivable days
- receivable balance = ((receivable days) x (sales)) / 365
- (inventory balance) / (COGS ex depreciation) x 365 = inventory days
- (inventory balance = ((inventory days) x (COGS ex depreciation)) / 365
Solve for the Inventory Balance
- inventory balance = ((inventory days) x (COGS ex depreciation)) / 365
- inventory balance = (90) x (COGS ex depreciation)) / 365
The 2005 Cost of Goods Sold was $1,405,512, therefore:
- (inventory balance) = (90) x ((($1,405,512) x (1.0594)) )) / 365
- (inventory balance) = $367,151
- (($1,405,512) x (1.0594)) x (90/365) = $367,151
- 2005 inventory of ($287,342) x (1.0594) = $304,410
- 2006 inventory balance @ 75 days = $304,410
- 2006 inventory balance @ 90 days = $367,151
- difference between 75 days and 90 days = $62,741 cash drain
A: If the Financing Gap Ratio is held constant and the company grows, the net balance sheet will grow, reflecting the cash impact of sales growth. The values (and days ratio) of receivables and inventory may bounce around - and the same for payables and accruals.
For Total Coverage Inc, in the 2006 adjusted column, we assumed that the days stayed the same for each operating asset and operating liability account and, therefore, the operating assets and operating liabilities grew at the sales growth rate.
That resulted in a constant Financing Gap Ratio of 13.06%. The operating assets totaled $735,673. Accounts receivable could have grown to $531,263 and inventory could have declined to $204,410 as long as the total remained at $735,673 – or less and then the financing gap ratio would not exceed 13.06%
The same is true for operating liabilities – some balances could be higher and some could be lower, as long as the total was $286,065 – or more.
The key issue is that the net operating asset number stays at $449,608 or less. At the end of the day there will be no net cash outflow by virtue of movements in operating asset and liability accounts so long as the Financing Gap Ratio limit is honored.
There is no implicit assumption that A/R days, inventory days, etc. stay constant in the growth period. A company could tighten receivables and receivable days and relax inventory and inventory days and stay within the Financing Gap Ratio limit. The same is true on the liability side. Think of it as assuring the collective impact of changes in A/R days, Inventory days, A/P days, and accrual days sums to zero. There is no increase in ((operating assets – operating liabilities) / (sales)) even though the composition changes
The Financing Gap Ratio reflects the relationship of the financing gap to sales and if that ratio stays the same, then there is no cash outflow from changes in the operating asset and operating liability accounts.
If the Financing Gap Ratio increases, it means that the collective impact of movements in A/R days and inventory days outpaced the collective impact of movements in A/P days and accrual days. And vice versa.
It gets back to the borrowing cause: Negative cash flow from sales growth is okay. We like to finance growing, profitable companies and growth absorbs cash. Negative cash flow from poor balance sheet management is not okay.
If the Financing Gap Ratio is honored and Business Cash Income is negative, then the cash deficit is explained by sales growth or by business loss – or by both.
If the Financing Gap Ratio is honored and Business Profit Coverage > 1.00, then the cash flow sufficient to service debt, absence cash impact from sales growth.
We have two critical covenants – Business Profit Coverage and Financing Gap Ratio.
If Business Profit Coverage is set at a level greater than 1.00 (commensurate with risk), and the Financing Gap Ratio is required to stay the same or decrease from one period to the next, and if these two covenants are met, then the borrower will be sufficiently profitable to repay long-term debt as scheduled and will generate sufficient cash flow to repay long-term debt as scheduled absent the cash impact of sales. And if these two covenants are met, the borrower meets two necessary conditions for business success.
Q: How does Business Profit Coverage work to assure sufficient cash flow to repay debt?
A: Business Profit Coverage by itself does not assure sufficient cash flow to properly service interest bearing debt. There are two financial loan covenants that, working together – if both are met, then the borrower will generate cash flow from business operations sufficient to properly service debt, absence cash impact of sales growth :
The two covenants are a debt service coverage ratio – this minimum Business Profit Coverage and a maximum Financing Gap Ratio. These two covenants assure sufficient cash flow from business operations if both are honored.
Let’s look at the Business Profit Coverage ratio: Reported profit adjusted by distributions, owner loans, one-time events, which is Business Profit, must exceed scheduled debt repayment by a risk factor. And that risk factor is the estimate of risk that not all of the Business Profit will be converted to cash. The formula for the Business Profit Coverage ratio is-
- sum of a) Business Profit and b) interest expense divided by the
- sum of a) interest expense and b) scheduled long-term debt repayment
The concept is that the borrower must be sufficiently profitable today to have sufficient cash flow in the subsequent period. If the borrower reflects an accrual loss today, then that translates into a cash loss in the subsequent period. So it must be sufficiently profitable today to have the cash flow tomorrow to service interest bearing debt tomorrow.
Depreciation expense is not a cash expense today, but we leave depreciation as a required expense because it is a proxy for the amount of cash that a company will have to use to replace fixed assets that it uses up. Therefore, we do not remove depreciation expense; we leave it as required expense in coming to an estimate of the amount of Business Profit available to service debt.
Business Profit and accrual accounting records transactions as they take place, not when cash changes hands. Reported revenue, expenses, and profits, are estimates of final cash events that may or may not materialize. Therefore, we use a risk factor, and Business Profit must exceed scheduled debt repayment by that risk factor. And the risk factor is the risk that not all of the adjusted profit will be converted to cash. So if we think about a risk factor of 1.25, a premium of 0.25, we want Business Profit to exceed the debt service by that amount.
The risk factor that we assign is highly subjective and depends on our judgment of a variety of factors. It is a function of potential volatility in financial performance, which may reflect the borrower, the industry, or both. A stable, low risk company, with little history of bad debts and inventory obsolescence might carry a risk factor of 0.10, while a company with a history of substantial bad debts and heavy inventory obsolescence might carry a risk factor of 0.50.
Business Profit does not address the management of operating assets and liabilities on the balance sheet, and that balance sheet management obviously has an affect on the cash flow available to service debt. Balance sheet management is measured by the Financing Gap Ratio: ((operating assets) – (operating liabilities) / (sales).
These two critical concepts work in tandem. If Business Profit Coverage is set at a level greater than 1.00, a level is based on the risk that we perceive that all of the Business Profit might not be converted to cash, and if the Financing Gap Ratio is required to stay the same or decrease from one period to the next, then, if these two covenants are met, the borrower will be sufficiently profitable to repay long-term debt as scheduled and will generate sufficient cash flow to repay long-term debt as scheduled, absent the cash impact of sales growth.
And if these two covenants are met, the borrower will meet the two necessary conditions for business success – sufficient profitability and sufficient cash flow to properly service interest bearing debt.