A BANKER'S PERSPECTIVE on WORKING CAPITAL and CASH FLOW MANAGEMENT.
So when you try to obtain a loan, what are bankers really looking at? Your banker judges your working capital and cash flow management skills, which certainly impact your cost of capital. This is why lenders have a vested interest in three key areas: sound collection practices, inventory controls, and trade credit discipline. Investors are also interested in working capital and cash flow management skills because a major component of shareholder value is the cost of capital, and bank credit composes much of this key factor.
Economist Alfred Marshall described quite well how working capital and cash flow contribute to shareholder wealth when he observed that "capital is that part of wealth which is devoted to obtaining further wealth." After all, efficient working capital management means more cash flow to repay bankers as well as more value to reward investors.
I'll show you how a banker views working capital and cash flow management. I'll explain how to determine net working capital (NWC) by using modified numbers from an actual company and calling it "Seedy Company." I'll also compare Seedy to its industry counterparts and then demonstrate how a small percentage decrease in the additional working capital investment can increase the stock price. The goal: You can incorporate this perspective on working capital into your own strategy for maintaining access to debt capital and increasing shareholder value.
IT'S ALL IN HOW YOU LOOK AT IT
The banker's philosophy can be summarized in triple trinities--purpose, repayment ability, and structure. First, is the purpose of a loan legal, ethical, and within the bank's policy? Second, can the loan be repaid from cash flow, collateral, and guaranties? Third, can the loan be structured so that it is repaid on time, in full, and as agreed?
Of the three trinities, the banker is drawn most to repayment ability, which, in turn, leads the lender into cash flow evaluation from operations. Critical to operating cash flow is the cash cycle's revolution through the working capital assets and liabilities. So, given its pivotal role in the cash cycle, working capital is a good place to begin.
WORKING CAPITAL FUNDAMENTALS
A company's working assets and the liabilities that fund them are collectively referred to as working capital. Ideally, current assets are partly funded by current liabilities and the remainder by the owners, so a banker's shorthand way of quantifying the excess or net investment in current assets over current liabilities is to subtract current liabilities from current assets to arrive at net working capital (NWC).
Let's demonstrate this approach for Seedy, which sells vegetable, flower, and grass seed to wholesalers and retailers. Seedy has established a reputation among analysts as a reliable, predictable dividend payer and that return to stockholders is an implicit part of its market price.
Seedy's NWC increased by $74 million because of more receivables and inventory from 1998 to 1999. Trade credit also increased, but only by $55 million, which wasn't enough to fund all of the $136 million expansion in inventory and the additional $54 million in receivables. From a banker's perspective, NWC repr esents the owner's equity in these working assets, and, up to a point, that's a good thing. Bank debt and trade credit shouldn't pay for all the earning assets. Instead, the company should have some of its own money at risk for these operating assets. In fact, Seedy did have at risk $103 million of its own money at 1998 fiscal year-end and $177 million at 1999 fiscal year-end. The question now is whether that's enough. After all, net working capital expansion absorbs cash that might otherwise be available to repay creditors.
NET WORKING CAPITAL AND SALES GROWTH
One way to gauge the appropriateness of net working capital is to relate it to sales. Sales growth usually requires more working capital, as illustrated by Seedy's figures showing sales up 48% and NWC up 72% for fiscal year 1999:
FY99 sales $1,648 NWC $177 NWC/Sls 10.7% FY98 sales 1,113 NWC 103 NWC/Sls 9.3% Sales up 48% NWC up 72% Change in NWC/Change in Sales = 74/535 = 13.8%
All things being equal, working capital should remain proportional to sales, so the increase from 9.3% to 10.7% of sales suggests that a bigger investment of inventory and receivables was needed in 1999 to gain more revenues. Although sales rose 48%, it took 72% more NWC to support the sales growth, part of the NWC maintaining base sales of $1,113 million and the $74 million remainder of the NWC to fuel the $535 million increase in sales. Incrementally, the gain in NWC to the gain in sales was 13.8%, so it took 13.8 cents of new networking capital for every new dollar of sales. Is this incremental investment too little or too much? One way to gauge the size is to compare the company with its peers in the industry.
A common technique that bankers use to measure the appropriateness of working capital investment is to compare the company's working capital ratios with the industry statistics published by Risk Management Associates (RMA), formerly the Robert Morris Associates. Bankers contribute financial statements to RMA's database in order to maintain this source of information, which features hundreds of lines of business arrayed by both asset and sales size. One particular advantage of the annual RMA data is that its asset and sales classifications provide data on many smaller, privately held companies that stock analyst data don't cover.
Bankers also look to CEO magazine's annual working capital survey. Its fourth annual 2000 survey compiled data on working capital efficiency at 1,000 public companies with 1999 sales of more than $500 million. Although lacking RMA's more than eight decades of data, CFO's survey provides turnover information on receivables, inventory, and cash by broad industry segments for large, publicly traded firms.
Based on RMA information, Seedy falls into the 0181 SIC (Standard Industrial Classification) code. The RMA data yields some preliminary observations about Seedy's working capital management. Seedy keeps only about half the cash that the industry does, a level that may reflect Seedy's efficient cash management or its relative illiquidity. Also, the sales/net working capital ratio is a little lower at Seedy despite its apparent lower NWC investment as a percentage of total assets. When compared to sales, Seedy just doesn't get as much sales per dollar of working capital as its industry counterparts. The bottom line: Seedy has too much cash tied up in its receivables and inventory working capital assets relative to its industry peers, so its cash balances are lower than average.
Seedy's lower cash balances are of interest to bankers because of the implications for loan repayment. Lenders take receivables and inventory for collateral, but the borrower is typically better positioned to generate more cash out of converting inventory to receivables to cash than the lenders. The difference in the yield from a revolution of this cash conversion cycle is the gap between a borrower realizing market value from its working assets and its lenders squeezing out liquidation value from the same assets. Of course, bankers don't want to get involved in this level of detail, but, rather, they prefer to emphasize the long-term view of the importance of operating cash flows, financing flows, and investing flows. Investors also share the same interest in the long-term perspective.
SEEDY'S NWC PROBLEMS
Since cash flow appears to be a problem, bankers are particularly interested in Seedy's most recent two years that illustrate the adverse impact of its receivables and inventory growth on cash flow from operations:
Seedy's Indirect Cash Flow 1998 1999 Profit after taxes (PAT) 36 63 +depreciation 22 29 +amortization 16 31 traditional cash flow (TCF) 74 123 (incr)/decr: receivables (43) (54) (incr)/decr: inventory (31) (136) decr/(incr): accounts pay 24 55 decr/(incr): accrued expenses 67 33 decr/(incr): taxes payable (10) 4 sub-tot (incr)/decr NWC 7 (98) cash flow from operations (CFO) 81 25
Imagine the disappointment of the bankers using traditional cash flow as a gauge in 1999 (see sidebar, "Cash Flows: Dollars and Sense," p. 42, for more on traditional cash flow). These bankers expected $123 million of cash available to repay their loans when instead they find that working capital expansion has swallowed up $98 million and left them with cash flow from operations of $25 million.
As its inventory and receivables growth outstripped trade creditor credit, the gap between traditional cash flow and cash flow from operations widened to almost $100 million. This gap between the TCF perception and the CFO reality is why bankers are more inclined to rely on CFO's more accurate assessment of cash flow. Bankers betting on $123 million to repay a $100 million loan would be very disappointed in the actual $25 million CFO, especially when examining the debt service requirements and trying to meet the basic principle that cash flow available to service the debt (CASD) should be equal to or greater than debt service (DS). In order to accurately measure the cash flow pool available to cover principal and interest, bankers typically add back the interest expense to cash flow from operations so all the debt service can be summarized in one place:
1998 1999 cash flow from operations (CFO) 81 25 +existing interest expense 32 79 cash available to service debt (CASD) 113 104 -debt service (DS): interest expense on existing debt 32 79 interest expense on proposed debt [*] -- -- preferred stock dividends 10 10 principal on existing debt 1 13 principal on proposed debt -- -- total principal, prfd div, and interest (DS) 43 102 excess csh to pay CAPEX, NWC, com div 70 2 CASD/DS [greater than or equal to] 1.00 2.63 1.02
Seedy's cash available to service debt declined from a comfortable 2.63 times in 1998 to a very thin 1.02 coverage in 1999. With CASD barely enough to cover debt service, there isn't much left over for capital expenditures, working capital, and dividends, especially if the lenders are anticipating more cash flow from the additional sales that ultimately depend on expanding fixed assets and working capital while mollifying investors with dividend payments and stock price appreciation.
Seedy's problem is basic: It can't satisfy both the bankers and investors. The following chart summarizes the financial conflict between bankers and investors from the viewpoint of stock market analysts who rely on a variation of traditional cash flow called EBITDA (earnings before interest, taxes, depreciation, and amortization). EBITDA is employed both as an estimate of core earnings cash flow and as a variable in bank loan covenants. Even by this simplistic measure, Seedy comes up short.
Seedy's options for improvement are several: It can improve its profit margins, increase its revenue generation from its asset base, or reduce its taxes. Each of these options can add real value to Seedy's market valuation as well as improve its chances of bank financing.
SHAREHOLDER VALUE MODELS
Besides loans, more and more banks are adding investment banking services as well as linking trust and treasury management to augment their lending functions. Loan officers are likely to operate as teams with product specialists from the trust division and investment banking. If the company is a private company, valuation services become key to estate planning. If the firm is public, investment bankers offer advice on strategies to increase market value.
To arrive at a shareholder value, most valuation models employ a discounted cash flow approach driven by several key variables. Alfred Rappaport's model, for example, uses six variables or drivers: sales growth rate, operating profit margin, tax rate, working capital investment, capital expenditures, and the cost of capital.
Rappaport's approach estimates the economic value of an investment by discounting forecasted cash flows by the cost of capital. In turn, these cash flows serve as the foundation for shareholder returns from dividends and share-price appreciation. In order to determine shareholder value, you must first determine the value of the total firm. This value is composed of two parts: the present value of forecasted cash flow from operations and the residual value, which represents the present value of the business attributable to the period beyond the cash flow forecast period.
Cash flow from operations is the difference between cash inflows and cash outflows, and it can be expressed in terms of the drivers mentioned previously:
Cash flow = cash inflow - cash outflow
where cash inflow = [(sales in prior year)(1 + sales growth rate)(operating profit margin)(1 - cash income tax rate),
and cash outflow = incremental capital expenditure + incremental WC investment.
Each of these drivers is expressed in terms of sales:
* The sales growth rate is the annual percentage increase in sales.
* The operating profit margin is the ratio of pre-interest, pre-tax operating profit to sales, or EBITDA/sales.
* Incremental working capital investment is the additional working capital required to support new sales, so it's a change in working capital/change in the sales calculation.
* The cash income tax rate is usually the book income tax expense less deferred tax changes divided by pretax income.
* The last driver, cost of capital, is the weighted average of the costs of debt and equity.
We can summarize the impact of a change in working capital investment on Seedy's stock price while holding the other drivers constant. The base driver values are drawn from Seedy's 1998-1999 historical results (see Figures 1 and 2 for the calculations):
cash flow and valuation drivers: Base NWC -sales growth rate 15.0% same -operating prft (ebitda/sales) 13.7% same -tax rate (taxes/profit bef tax) 41.0% same -wkg cptl investment/sales 10.0% 15.0% -CAPEX investment/sales 25.0% same -cost of capital 10.0% same share price valuation (Figures 1&2) $33.46 $35.66
Decreasing working capital investment from 15% to 10% of sales would add $2.20 to Seedy's stock price. This calculation shows the value of working capital management and explains in part why both banks and the markets pay so much attention to how well companies collect their receivables, turn over their inventories, and pay their trade creditors on time.
ENDING ON A HIGH NOTE
Capital's okay with us as long as it works for you. Efficient working capital management--the unsung hero of finance--means more cash flow to repay bankers and more value to reward investors. Both are critical to your company's success. So improving collection practices, inventory controls, and trade credit practices is a win/win for your company, the bankers, and the investors.
Dev Strischek is managing director of corporate and commercial credit policy at Sun Trust Banks, Inc. in Atlanta.
Figure 1: Base Valuation of $33.46 with 15% NWC Seedy Corporation Shareholder Value $937 Shareholder Value Per Share $33.46 Units: $000s (all numbers are in millions) SHAREHOLDER VALUE CALCULATION Year 1999 2000 2001 2002 2003 Sales (Year 0) 1,648 G 15.0% 15.0% 15.0% 15.0% P 13.7% 13.7% 13.7% 13.7% T 41.0% 41.0% 41.0% 41.0% F 25.0 25.0% 25.0% 25.0% W 15.0% 15.0% 15.0% 15.0% K 10.0% 10.0% 10.0% 10.0% N 5 5 5 5 Mkt. Securities 10 10 10 10 Mkt. Value Debt 1,007 1,007 1,007 1,007 # of Shares 28 28 28 28 Sales 1,648.0 1,895.2 2,179.5 2,506.4 2,882.4 Operating Costs 1,635.6 1,880.9 2,163.0 2,487.5 Operating Profit 259.6 298.6 343.4 394.9 Taxes 106.5 122.4 140.8 161.9 NOPAT 153.2 176.2 202.6 233.0 Incr. F 61.8 71.1 81.7 94.0 Incr. W 37.1 42.6 49.0 56.4 Cash Flow (CF) 54.3 62.5 71.8 82.6 Discount Factor 0.9091 0.8264 0.7513 0.6830 PV of CF 49.4 51.6 54.0 56.4 Cum PV of CF 49.4 101.0 155.0 211.4 Residual Value (RV) 1,531.9 1,761.7 2,025.9 2,329.8 PV of Perpetuity RV 1,392.6 1,455.9 1,522.1 1,591.3 Mkt. Securities 10.0 10.0 10.0 10.0 Corporate Value (CV) 1,452.0 1,566.9 1,687.1 1,812.7 Mkt Value of Debt 1,007.0 1,007.0 1,007.0 1,007.0 Shareholder Value (SHV) $445.0 $555.9 $680.1 $805.7 Share Price $15.89 $20.00 $24.29 $28.77 Year 2004 Sales (Year 0) G 15.0% P 13.7% T 41.0% F 25.0% W 15.0% K 10.0% N 5 Mkt. Securities 10 Mkt. Value Debt 1,007 # of Shares 28 Sales 3,314.7 Operating Costs 2,860.6 Operating Profit 454.1 Taxes 186.2 NOPAT 267.9 Incr. F 108.1 Incr. W 64.9 Cash Flow (CF) 95.0 Discount Factor 0.6209 PV of CF 59.0 Cum PV of CF 270.3 Residual Value (RV) 2,679.3 PV of Perpetuity RV 1,663.6 Mkt. Securities 10.0 Corporate Value (CV) 1,944.0 Mkt Value of Debt 1,007.0 Shareholder Value (SHV) $937.0 Share Price $33.46 G = annual sales growth rate; P = operating profit as % of sales; T = cash tax rate, essentially accrual taxes adjusted for changes in deferred taxes and expressed as a % of operating profit; F = change in capital expenditures as a % of change in sales, or the additional fixed assets needed to support the additional sales growth; W = change in working capital as a % of change in sales, or the additional working capital needed to support the additional sales growth; K = weighted average cost of debt and equity capital; cost of debt based on current cost of new debt, not historic debt; cost of equity equals a risk-free rate plus an equity risk premium; N = management's best estimate of the number of years that investments can be expected to yield rates of return greater than the cost of capital. Figure 2: Alternate Value of $35.66 with 10% NWC Seedy Corporation Shareholder Value $998 Shareholder Value Per Share $35.66 Units: $000s (all numbers are in millions) SHARE HOLDER VALUE CALCULATION Year 1999 2000 2001 2002 2003 Sales (Year 0) 1,648 G 15.0% 15.0% 15.0% 15.0% P 13.7% 13.7% 13.7% 13.7% T 41.0% 41.0% 41.0% 41.0% F 25.0% 25.0% 25.0% 25.0% W 10.0% 10.0% 10.0% 10.0% K 10.0% 10.0% 10.0% 10.0% N 5 5 5 5 Mkt. Securities 10 10 10 10 Mkt. Value Debt 1,007 1,007 1,007 1,007 # of Shares 28 28 28 28 Sales 1,648.0 1,895.2 2,179.5 2,506.4 2,882.4 Operating Costs 1,635.6 1,880.9 2,163.0 2,487.5 Operating Profit 259.6 298.6 343.4 394.9 Taxes 106.5 122.4 140.8 161.9 NOPAT 153.2 176.2 202.6 233.0 Incr. F 61.8 71.1 81.7 94.0 Incr. W 24.7 28.4 32.7 37.6 Cash Flow (CF) 66.7 76.7 88.2 101.4 Discount Factor 0.9091 0.8264 0.7513 0.6830 PV of CF 60.6 63.4 66.2 69.3 Cum PV of CF 60.6 124.0 190.2 259.5 Residual Value (RV) 1,531.9 1,761.7 2,025.9 2,329.8 PV of Perpetuity RV 1,392.6 1,455.9 1,522.1 1,591.3 Mkt. Securities 10.0 10.0 10.0 10.0 Corporate Value (CV) 1,463.2 1,589.9 1,722.3 1,860.8 Mkt Value of Debt 1,007.0 1,007.0 1,007.0 1,007.0 Shareholder Value (SHV) $456.2 $582.9 $715.3 $853.8 Share Price $16.29 $20.82 $25.55 $30.49 Year 2004 Sales (Year 0) G 15.0% P 13.7% T 41.0% F 25.0% W 10.0% K 10.0% N 5 Mkt. Securities 10 Mkt. Value Debt 1,007 # of Shares 28 Sales 3,314.7 Operating Costs 2,860.6 Operating Profit 454.1 Taxes 186.2 NOPAT 267.9 Incr. F 108.1 Incr. W 43.2 Cash Flow (CF) 116.6 Discount Factor 0.6209 PV of CF 72.4 Cum PV of CF 331.9 Residual Value (RV) 2,679.3 PV of Perpetuity RV 1,663.6 Mkt. Securities 10.0 Corporate Value (CV) 2,005.5 Mkt Value of Debt 1,007.0 Shareholder Value (SHV) $998.5 Share Price $35.66 G = annual sales growth rate; P = operating profit as % of sales; T = cash tax rate, essentially accrual taxes adjusted for changes in deferred taxes and expressed as a % of operating profit; F = change in capital expenditures as a % of change in sales, or the additional fixed assets needed to support the additional sales growth; W = change in working capital as a % of change in sales, or the additional working capital needed to support the additional sales growth; K = weighted average cost of debt and equity capital; cost of debt based on current cost of new debt, not historic debt; cost of equity equals a risk-free rate plus an equity risk premium; N = management's best estimate of the number of years that investments can be expected to yield rates of return greater than the cost of capital. Seedy ($MM) 1998 1999 1998 1999 Cash 11 30 notes payable -0- -0- mkt sec -0- -0- cur mat LT dbt 13 56 receivables 147 201 accounts payable 78 133 inventory 177 313 accrued expenses 125 158 prepaids -0- -0- taxes payable 16 20 other CA -0- -0- other CL -0- -0- Tot CA 335 544 Tot CL 232 367 Mkt sec = marketable securities Other CA = other current assets Tot CA = total current assets Cur mat LT dbt = current maturities of long-term debt Other CL = other current liabilities Tot CL = total current liabilities
Working Capital Calculation:
335 - 232 = 103 = NWC at FYE 9/30/98
544 - 367 = 177 = NWC at FYE 9/3O/99
209 - 135 = 74 = change in NWC from FYE'98 to FYE'99
Seedy's FCF ($MM) 1998 1999 PAT 36 63 +depreciation 22 29 +amortization 16 31 traditional cash flow 74 123 +existing interest 32 79 +taxes 25 48 EBITDA bef extraord chg 131 250 +extraordinary charge 1 6 EBITDA 132 256 -taxes (25) (48) -CAPEX (73) (91) -(incr)/decr in wkg capital [*] 7 (98) free cash flow (FCF) 41 19 -existing interest (32) (79) -proposed interest - - -existing principal ( 1) (13) -proposed principal - - -existing prfd div (10) (10) -total debt service (DS) (43) (102) excess csh flw available for common dividends, acqtns, share repurch, etc. ( 2) (83) FCF/DS [greater than] 1.00 .95 .19 (*.) changes in working capital excludes changes in cash, notes payable, current maturities of long-term debt.
Cash Flows: Dollars and Sense
Statement of Financial Accounting Standards No. 95 (SFAS 95) established the current cash flow format to replace the old sources and uses of funds statements in 1987. Bankers lobbied hard for this change that segregates cash flows into operating, investing, and financing flows. In particular, operating cash flow is desirable to lenders because of its incorporation of working capital changes into the income statement.
Before the implementation of SFAS 95 in 1987, bankers and analysts used traditional cash flow (TCF) as a proxy for cash flow to gauge debt repayment capacity. TCF worked well enough for firms that had relatively slow, stable sales growth rates that generated enough cash flow to support working capital expansion, but as the economy accelerated in the postwar period, traditional cash flow tended to overestimate cash flow.
It became obvious that this approach didn't work in 1975. The nation's largest retailer, W.T. Grant, filed bankruptcy in 1975 and became a financial poster child for the campaign to disclose cash flows as its optimistic earnings reports masked a receivables collection breakdown and too much unsold inventory in its new, larger stores. Four months later, the creditors' committee voted for liquidation, and W. T. Grant ceased to exist. Subsequent analysis of the company's financials revealed that the company's cash flow from operations was almost always negative from 1966 to 1975.
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|Date:||Oct 1, 2001|
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