Acquisition Line for a Growth Company With Negative Operating Cash Flow
Ridgeway Components Inc. requests a $4.0 million acquisition line. Revenue rose 22% to $31.0 million and reported EBITDA to $3.6 million. Operating cash flow was negative $1.1 million. Days sales outstanding increased from 61 to 92; inventory days from 110 to 140. The CFO explains growth and a new customer with 120-day terms. The company capitalized $1.8 million of software development costs this year, up from $0.4 million, and changed the useful life of equipment from seven to ten years, adding $0.5 million to EBITDA. Management's covenant EBITDA adds back $0.9 million of non-recurring ERP and hiring costs, although hiring is ongoing. Existing debt is $7.2 million; cash is $0.8 million. The proposed line would be 60% drawn at closing. Policy maximum leverage is 3.0x adjusted EBITDA and minimum fixed-charge coverage 1.3x.
1. Build a normalized EBITDA and assess the quality of earnings.
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Start with reported EBITDA of $3.6m and remove items that flatter it. The incremental software capitalization is $1.8m - $0.4m = $1.4m; if the development spending is recurring, policy should treat it as an operating cost, so subtract $1.4m. The useful-life change reduced depreciation and added $0.5m to EBITDA; that is an accounting change, not improved cash generation, so subtract $0.5m. Of the $0.9m of management addbacks, allow perhaps $0.2m for genuine one-time ERP implementation and disallow $0.7m of ongoing hiring and integration costs. Normalized EBITDA is approximately $3.6m - $1.4m - $0.5m - $0.7m = $1.0m. The quality-of-earnings signal is poor: revenue is growing, but operating cash flow is negative $1.1m, DSO has risen from 61 to 92 days, and inventory days from 110 to 140. A 31-day DSO increase on $31m of revenue ties up roughly $2.6m of cash. The company is funding growth with working capital and capitalization, not with sustainable operating cash. Normalized EBITDA of about $1.0m is the defensible starting point until an independent quality-of-earnings review supports more.
2. Calculate pro forma leverage under policy and management definitions, and interpret the gap.
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Under policy normalized EBITDA of about $1.0m, existing leverage is $7.2m / $1.0m = 7.2x, already far above the 3.0x maximum. The proposed line would be 60% drawn, or $2.4m, taking debt to $9.6m and pro forma leverage to 9.6x. Under management's definition, EBITDA is $3.6m + $0.9m = $4.5m; existing leverage looks like 1.6x and pro forma 2.1x, comfortably inside policy. The gap between 2.1x and 9.6x is the credit issue. Management is relying on addbacks and accounting changes that do not produce cash. Fixed-charge coverage is also likely below 1.3x once maintenance capex, taxes and the negative working-capital swing are included, although the exact figure needs interest and capex detail. The bank should not use management's covenant EBITDA for approval unless an independent accountant validates the addbacks and the software spending is genuinely non-recurring. On the policy definition, the request fails by a wide margin; on management's definition, it passes only because the denominator is overstated.
3. Recommend conditions or a decline.
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Decline the $4.0m acquisition line as structured. The company may be a viable growth story, but it is not generating cash and the proposed debt would be used to buy another business before the existing working-capital problem is fixed. If the bank wants to preserve the relationship, offer a much smaller working-capital revolver secured by a borrowing base of eligible receivables and inventory, with a $1.0m availability cap and a 30-day clean-up. Require at least $2.0m of new equity, an independent quality-of-earnings review, and a covenant package based on normalized EBITDA with no addbacks for ongoing hiring or software capitalization. Add DSO and inventory triggers, a cash sweep above a minimum operating balance, and a guarantor. Set a 12-month milestone: positive operating cash flow and DSO below 75 days before any acquisition financing is reconsidered. If the customer insists on the full line, escalate to a senior credit committee with a written decline rationale so the decision is consistent and documented.