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:

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.