Normalizing Working Capital Before a Growth Forecast
Cedarline Distribution Ltd. (CDL) is a private distributor of industrial supplies. FY20X4 revenue was $120.0 million, reported EBITDA $20.4 million (17.0% margin), and net income $6.1 million. Management's FY20X5 plan shows 20% revenue growth and a 17.5% EBITDA margin to support a $45 million term loan. Your review finds: DSO is 68 days versus a 45-day historical norm; inventory days are 78 versus 65; payable days are 52 versus 60; EBITDA includes a $1.2 million gain on a sale-leaseback of a warehouse; and $0.9 million of customer acquisition costs were capitalized rather than expensed even though there is no reliable evidence of future economic benefit. Capex is $6.0 million, depreciation $5.5 million, and the tax rate is 25%. The bank covenant is debt/EBITDA ≤ 3.0x. Existing debt is $30 million. The CFO says the working capital changes are "permanent improvements from better processes."
1. Quantify the quality-of-earnings adjustments and the cumulative cash flow effect of the working capital changes. Explain why the working capital trend matters to the forecast.
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EBITDA adjustments.
- Reported EBITDA: $20.4M
- Remove non-recurring sale-leaseback gain: −$1.2M
- Expense capitalized customer acquisition costs: −$0.9M
- Adjusted EBITDA: $18.3M
- Adjusted margin: $18.3M ÷ $120.0M = 15.25%, not 17.0%
The capitalized costs do not meet the criteria for an asset because there is no reliable evidence of future economic benefit; they are period costs. The sale-leaseback gain is not recurring operating earnings.
Working capital cash effect. Using cost of goods sold at 70% of revenue ($84.0M):
- Excess receivables: $120.0M × (68 − 45) ÷ 365 = $7.56M
- Excess inventory: $84.0M × (78 − 65) ÷ 365 = $2.99M
- Lower payables: $84.0M × (52 − 60) ÷ 365 = −$1.84M
- Net cumulative cash benefit: $7.56M + $2.99M − $1.84M = $8.71M
CDL has generated about $8.71M of cumulative cash by stretching customers and inventory and by paying suppliers faster than normal. That is a one-time source of cash, not recurring free cash flow. If terms revert even partially, the cash reverses. The 20% growth plan also requires working capital investment at the inflated day counts, so the forecast must not treat the current cash release as sustainable. A quality-of-earnings review should also test bad-debt reserves, returns, and customer concentration, because sales on extended terms may be lower quality.
2. Rebuild the FY20X5 forecast and free cash flow under normalized assumptions (8% revenue growth, 15.0% EBITDA margin, DSO 55 days, inventory days 70, payable days 58). Compare with management's plan.
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Management plan (20% growth, 17.5% margin).
- Revenue: $144.0M; EBITDA: $25.2M
- EBIT: $25.2M − $5.5M = $19.7M; tax: $4.925M; NOPAT: $14.775M
- Operating cash flow before working capital: $14.775M + $5.5M − $6.0M capex = $14.275M
- Receivables: $144.0M × 68 ÷ 365 = $26.83M
- Inventory: $100.8M COGS × 78 ÷ 365 = $21.54M
- Payables: $100.8M × 52 ÷ 365 = $14.36M
- NWC: $34.01M; prior-year NWC: $28.34M; increase: $5.67M
- FCF: $14.275M − $5.67M = $8.61M
Normalized plan (8% growth, 15.0% margin).
- Revenue: $129.6M; EBITDA: $19.44M
- EBIT: $13.94M; tax: $3.485M; NOPAT: $10.455M
- Operating cash flow before working capital: $10.455M + $5.5M − $6.0M = $9.955M
- Receivables: $129.6M × 55 ÷ 365 = $19.53M
- Inventory: $90.72M COGS × 70 ÷ 365 = $17.40M
- Payables: $90.72M × 58 ÷ 365 = $14.42M
- NWC: $22.51M
- Normalized prior-year NWC: $120.0M × 45 ÷ 365 = $14.80M; $84.0M × 65 ÷ 365 = $14.96M; $84.0M × 60 ÷ 365 = $13.81M; total $15.95M
- Increase in NWC: $22.51M − $15.95M = $6.56M
- FCF: $9.955M − $6.56M = $3.39M
If measured from actual FY20X4 NWC of $28.34M, FY20X5 shows a one-time release of about $5.83M and FCF of about $15.8M. That is a transition-year effect from reversing stretched terms, not a sustainable number. The recurring FCF is closer to $3.4M.
Comparison. Management's $8.61M is about 2.5x the normalized $3.39M. Management also assumes faster growth and a higher margin while ignoring the working capital investment needed to support it.
3. Recommend a credit decision and the covenants you would require. Address the CFO's claim that the working capital changes are permanent improvements.
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Recommendation: Do not approve the $45M term loan on the presented plan. On adjusted EBITDA of $18.3M, total debt of $75M ($30M existing + $45M new) would be 4.10x, versus a 3.0x covenant. Even the existing $30M is only comfortably serviced if adjusted EBITDA holds. The loan as structured fails the covenant before considering the normalized FCF of about $3.4M.
On the CFO's claim. The working capital changes may be partly permanent if process improvements reduced the true operating requirement. But the evidence points the other way: DSO rose from 45 to 68 days and inventory days from 65 to 78, which is a deterioration in collection and inventory management, not an efficiency gain. Paying suppliers faster also uses cash. A company cannot repeatedly generate cash by stretching terms; the benefit reverses when customers pay or inventory is replenished. The $8.71M should be treated as a one-time source, and the forecast should assume normalized terms.
Covenants and conditions I would require:
- Price the loan off adjusted EBITDA, not reported EBITDA, with a clear definition excluding sale-leaseback gains and capitalized costs.
- A minimum FCCR of 1.25x and a maximum debt/EBITDA of 3.0x, tested quarterly.
- A minimum equity injection or subordinated shareholder loan to reduce funded debt to a level that passes at close.
- A working capital covenant or quarterly DSO/inventory reporting trigger.
- Restrictions on further capitalization of acquisition costs and on related-party payments.
- A borrowing base tied to eligible receivables, with concentration and dilution reserves.
If the company will not accept these terms, decline the facility. The normalized cash flow does not support the requested leverage.