The Distributor With Growing Sales and Shrinking Cash
Northwind Supply Co. is a regional industrial distributor. Over the last two years revenue grew from $40.0M to $48.0M (+20%), and EBITDA margin held steady at 9.0%. Net income was $2.1M in the most recent year. However, cash and equivalents fell from $3.2M to $1.4M. Days sales outstanding rose from 52 to 71 days, and days inventory outstanding rose from 60 to 78 days. Days payable outstanding was flat at 45 days. Capex was $0.9M (vs. $1.1M depreciation), and the company paid $1.0M in dividends. The revolver balance rose from $1.5M to $4.2M. Management points to record sales and stable margins as evidence of improving health, and is requesting a larger credit line to fund further growth.
1. Estimate the cash impact of the working-capital deterioration and reconcile why profitability and liquidity are diverging.
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Working-capital drag (use the cash conversion cycle logic):
- DSO +19 days on ~$48M revenue: incremental receivables ≈ 19/365 × $48.0M ≈ $2.5M tied up.
- DIO +18 days on COGS. COGS ≈ revenue × (1 − gross margin). With 9% EBITDA margin, gross margin is somewhat higher; approximate COGS at ~$40M. Incremental inventory ≈ 18/365 × $40M ≈ $2.0M.
- DPO flat, so no offset from suppliers.
- Combined WC drag ≈ $4.5M - roughly matching the $2.7M revolver draw plus the $1.8M cash decline.
Reconciliation: EBITDA was ~$4.3M (9% × $48M). Subtract ~$0.9M capex, ~$1.0M dividends, and ~$4.5M WC absorption → free cash flow is negative. The P&L is fine; the balance sheet is consuming the cash. Stable margins with deteriorating DSO/DIO is a classic warning sign - either customers are paying slower (credit quality/collection issues) or the company is buying growth with looser terms. Growth is not self-funding; a larger revolver treats the symptom, not the cause.
2. As the credit analyst, what conditions would you attach before expanding the line, and what single metric would you monitor most closely?
Read the worked answer
Diagnose before lending. Require an aging of receivables and inventory to separate (a) genuine customer stress from (b) lax collection or over-ordering. Ask whether the DSO jump is concentrated in a few accounts.
Conditions:
- Working-capital covenants - e.g., DSO must return toward 55–60 days within two quarters, with a mandatory cleanup/collection plan.
- Borrowing base tied to eligible receivables/inventory (not a clean line), so the facility self-limits as WC quality degrades.
- Suspend or cap the $1.0M dividend while the revolver is drawn - paying shareholders with borrowed money is a red flag.
- Tie any line increase to a defined use (funding genuine growth) with a maturity/step-down schedule as WC normalizes.
Metric to watch: the cash conversion cycle (DSO + DIO − DPO) and its trend, because it is the leading indicator that converts reported profit into (or away from) cash. A widening CCC alongside rising revolver usage is the earliest signal of distress.