Working capital requirement and financial debt: where to draw the line?

The distinction between financial/banking debt and working capital is becoming blurred. For example, are pensions financial debt or an operating liability? Financially speaking, must securitised receivables be placed among assets with debt due, like outstanding discounted bills? What if it is securitisation without recourse?

Such issues are all the more pressing as the distinction between debt and working capital is becoming crucial, for two reasons:
- Valuation models - both those based on both discounted free cash flow and those based on multiples - focus on enterprise value, from which the value of debt is subtracted to obtain the value of equity;
- Loans almost routinely carry clauses limiting the amount of debt to a percentage of equity or EBITDA.

You would have to be naive to believe that these two trends do not have at least something to do with the blurring of the line between debt and working capital.

Let us first recall the fact that businesses' operations are sometimes seasonal in nature, with a lag between the processes of purchasing, producing and selling. Working capital requirement thus fluctuates during the course of the year.

The following charts show that, when business is highly seasonal, working capital requirement is also seasonal, even though it never falls all the way to zero. In vegetable canning, say, or the manufacturer of raincoats, a minimum inventory must always be kept on hand to provide a seamless connection with the following production cycle.

Monthly trends in working capital requirement

An outside observer might confuse the working capital on the balance sheet with average Working capital, as 30% of all companies close their books on a date other than 31 December - for example, 30 September for Bordeaux winemakers, or 30 April for car rental agencies in the West Indies. They have chosen these dates because the working capital requirement that will appear on their balance sheets is then at the lowest point of the year, along with the debt that finances it.

For companies with seasonal business, the difference between average working capital and the working capital on the balance sheet is simply added to debt.

Companies having difficulties will draw the most possible on supplier credit, thus skewing that item. Any supplier credit that is above normal would then have to be restated in the balance sheet working capital. It will also be necessary to subtract from permanent WCR an abnormal amount of inventory built up speculatively at the end of one year, for example, to take advantage of low raw material prices. And we have seen companies pay their suppliers early at year-end in order to reduce the amount of cash on their balance sheets, based on the principle that it's better to inspire pity than envy! In this case, this is no longer working capital requirement but rather a cash investment.

A simple way of detecting a level of debt at closing date that does not correspond to an annual average is to carry over net financial income (i.e. financing costs minus financial income) to net financial and bank debt minus cash and marketable securities. If the interest rate thus calculated is close to the market rate, then debt as it appears on the balance sheet is close to average debt. Otherwise, it is not.
Regardless of the point of view of the financier - shareholder, lender, consultant, etc. - we advise him to reason not in legal or accounting terms, but rather in terms of average working capital, the standard that reconstitutes the capital employed for the company's normal operations.
This is what the financier should seek to determine. In buying the company, it will help him avoid a situation in which the seller has drawn on supplier credit to reduce debt at the transaction date, thus raising by sale price by as much, as it this price is most often based on enterprise value, less the debt at the benchmark date. Let's call a spade a spade. Any operating debt that is unpaid at the benchmark date, while the normal payment date is past, is financial debt.

Based on this simple and sensible rule, we can deduce that:

• Securitised receivables can be a smart way of lowering the company's cost of financing, as the investor is taking a specific and isolated risk, for which he is therefore willing to pay a premium or which will give the company access to a new source of funding when others are closed to it (e.g. Altran Technologies, which securitised its receivables to cope with a cash crunch). But it is a trap to believe that in securitising its receivables, the company has reduced its debt by as much. Rather, it has simply sold an operating asset before its normal maturity.
  To reconstitute a company's normal capital employed, securitised receivables must be added back to receivables and to financial debt. After all, isn't securitisation's cost (i.e. from selling receivables at below their face value) not a financing cost? This is the way that outstanding discounted bills have been treated for years.
  Whether the securitisation deal is with or without recourse does not change much, as we are seeking to reconstitute normal WCR and not the risk of possible having to restore some of the affect funds if certain clients turn out to be insolvent. The same reasoning applies to factoring.
   
• Leasebacks: More than once we have heard companies tell us that "by selling my capital assets for 100 and then leasing them back for 9%, I have improved my equity value, as my enterprise value is 8 times EBITDA". The math is right, but what a mistake, financially speaking!
  For why would we apply the same multiple to a company that has become riskier, now that it has to make regular cash payments for rents that did not exist before? There is no reason, as will be apparent by reasoning in terms of cash flow. Rents are financial debt and not operating debt.
  Few lenders are taken in, as they calculate maximum debt ratios by capitalising rents and by reasoning in terms of EBITDA before rents, or EBITDAR (the "R" is for rent).
   
• Pension provisions: on the liabilities side, they represent the discounted value of gross future commitments. After deducting assets that may have been assigned to covering these liabilities, we obtain net present value. On the P&L the change in pension provisions corresponds:
  - To the cost of financing the annual passage-of-time revaluation of already provisioned liabilities and to any income produced by assets used to cover those liabilities;
  - To the provisioning of pension accruals during the year by personnel still working, net of provisions that correspond to payments during the year to current retirees. So this would come under personnel costs.
  If provisions, net of any assets used to cover liabilities, is equivalent to debt, then the fraction of annual provisions corresponding to the financing costs due at the annual passage-of-time revaluation should naturally not come under operating costs, but rather financing costs.
   
• Provisions for restructuring or litigation: for a full understanding of this problem, we have to look again at what working capital requirement is exactly. Working capital is a gap in cash flow due to the lag between when operating costs are paid out and when customer payments are received.
  Is a provision for non-recurrent restructuring or litigation a part of normal operations? No, this is a cash disbursement that will help improve operations (i.e. by producing more and/or producing less expensively). It is, in a way, an investment or a debt of financial nature, but not a form of working capital.
  It might be worth discounting the provision and subtracting the implied financing costs from the operating profit and adding them to the financing costs.
  If this restructuring provision is recurrent, as is often the case with large companies, does that change anything?
  We don't think so. This is merely a series of "maintenance investments". A provision for paid leave, however, would come under working capital.

It is probably clear to you by now that in the fine line that separates operating debt and financial debt, the traditional distinction of whether the debt bears interest is insufficient. Rather, we suggest getting a fix on normal capital employed - ownership, standard duration of accounts payable/receivable and normal inventory levels - in order to efficiently separate working capital from net banking and other financial debt.