SCL 3 Permanent Working Capital Loans

Question 1

Working Capital - General Principles

Answer 1

• Working capital simply refers to that layer of capital that is used exclusively for the day-to-day operations of the business. For example, money that is spent to purchase inventory, pay expenses, or finance credit all falls into the category of working capital.

Question 2

Permanent working capital, or PWC,

Answer 2

• Is the permanent layer of working capital that, month after month, year after year, never goes away.
• Permanent working capital loans are needed when the working capital cycle is continuous for a company over the entire fiscal year. This is unlike a seasonal business, where the working capital cycle is specific within a fiscal year.
• the purpose of a permanent working capital loan is to provide the borrower with the financing needed to purchase current assets or to pay current liabilities.
• the amount below which adjusted working capital never drops
• It is the absolute minimum layer of adjusted working capital that is required for a business to operate normally and is typically financed through equity, long-term financing, or a combination of the two.
• Ideally, banks like to see a permanent working capital need financed through equity since equity is the most permanent source and best matches the permanent nature of the need.
• The minimum point in each year is the amount of permanent working capital.
• It’s the amount by which adjusted current assets always exceed adjusted current liabilities.

Question 3

Permanent working capital needs can also be impacted by certain events

Answer 3

1) One such event is rapid expansion in sales resulting from unexpected growth or expansion.
2) New companies may also need permanent working capital loans as they make their initial investment in inventory or accounts receivable.
3) Some companies need PWC loans because they have used existing short-term resources, like cash on hand or bank facilities, to meet long-term obligations, like capital expenditures, dividend payments, or long-term debt payments.
4) Failed seasonal loan

Question 4

Snow & Ice makes a variety of products used in the snow-clearing industry. After experiencing the warmest weather on record, Snow & Ice found itself with warehouses full of inventory that it wasn’t able to sell and with a seasonal loan that it couldn’t afford to repay. Is this company a good candidate for a PWC loan?

Answer 4

Yes, when the seasonal loan can’t be repaid, the bank is left carrying the loan as a more permanent working capital loan, which makes Snow & Ice a candidate for a permanent working capital loan.

Question 5

PWC - Collateral considerations

Answer 5

• At an absolute minimum, the loan should be secured by a perfected security interest in accounts receivable and inventory.
• Plant and equipment might also be considered if reliance on inventory to repay the loan is high,
  especially if the inventory is perishable, trendy, or has other potential marketability issues.

Question 6

Atlantic Diamond Wire is experiencing rapid growth, which is throwing its working capital needs into a tailspin. It needs a permanent working capital loan to balance its cash flow needs. The following are ways that the bank can finance Atlantic Diamond Wire’s permanent working capital needs:

Answer 6

1) Term loan
2) The bank can issue a standalone term loan or combine it with a term facility used to support capital asset purchases.
3) Revolving line of credit
4) Loans from stockholders or owners (subordinated debt)
5) Asset-based loan
6) Equity financing

Question 7

Term Loan

Answer 7

• refers to a loan with a determined lifespan, an established interest rate, and the expectation that it will be repaid in full upon the maturity of the loan.
• When using a term loan in this scenario, the bank will typically rely more on fixed assets than working capital assets as collateral, unless there is a carveout. The bank should, at a minimum, include accounts receivable and inventory as collateral.
• when using a term loan to finance permanent working capital, the bank will set the term within five years. With regular amortization, the principal decreases over the life of the loan, resulting in a full and complete payoff by the time the loan matures

Question 8

standalone term loan or combine it with a term facility used to support capital asset purchases

Answer 8

the bank will typically rely more on fixed assets than working capital assets as collateral, unless there is a carveout. The bank should, at a minimum, include accounts receivable and inventory as collateral.

Question 9

Short-term revolving credits

Answer 9

Short-term revolving credits, such as seasonal lines and other lines of credit for general business purposes, generally have maturities of one year or less. Revolving loans with maturities over one year may revolve to maturity—sometimes called a bullet revolver—or may revolve for a specific time period, usually no more than three to four years, and then convert to a term loan

Question 10

Revolver/term loans

Answer 10

• may revolve for a specific time period, usually no more than three to four years, and then convert to a term loan
• For example, the credit might revolve for three years and be termed out over four years. There may or may not be a larger final payment.
• Revolvers are often used by larger companies that want to show their debt as long-term debt on the balance sheet or are used in acquisition situations where working capital needs may be unknown at the outset.

Question 11

Bullet revolver

Answer 11

• Revolving loans with maturities over one year may revolve to maturity
• may revolve for a specific time period, usually no more than three to four years, and then convert to a term loan. Such loans are typically referred to as revolver/term loans, and they typically do not have a final term longer than seven years and usually have a shorter revolving period than the term period.

Question 12

Subordindated debt

Answer 12

• source of capital
• subordinated debt must wait until the borrower pays off its senior debt before the lender can expect principal payment on its subordinated debt.
• carries a higher interest rate to justify the greater risk

Question 13

Equity financing

Answer 13

• involves issuing stock in exchange for funds and is often a last resort for a company looking to borrow.

Question 14

Option if PWC loan fails

Answer 14

1) Professional ABL lender to take over the loan

2) Liquidation of collateral

Question 15

Adjusted Working Capital

Answer 15

• eliminates cash, short-term bank debt, and current maturities of long-term debt from the working capital accounts.

Question 16

Steps in calculating Adjusted Working Capital

Answer 16

1) In order to calculate adjusted working capital, you must first deduct cash from current assets, which gives you your adjusted current assets.
2) Then deduct notes payable and current maturities of long-term debt from current liabilities to arrive at your adjusted current liabilities.
3) Finally, deduct your adjusted current liabilities from your adjusted current assets, and there you have it—you’ve calculated the adjusted working capital.

Question 17

At what point on the UCA Direct Cash Flow statement do we account for cash generated from operations that will represent a source of payment for principal and interest and other obligations?

Answer 17

All other investing and financing needs appear after calculating Net Cash After Operations. Net Cash After Operations from the Direct Cash Flow statement includes taxes but excludes cash, interest, current maturities of long-term debt, capital expenditures, and other investing or financing activities.

Question 18

Why are these other items not included when calculating Net Cash after Operations?

Answer 18

These items are excluded because the analyst needs to determine how much the company can generate without recourse to external financing. Ultimately, we want to know how much the company depends on external financing. The exact same principles apply when determining a company’s permanent working capital layer. By excluding cash, notes payable, and current maturities of long-term debt from the equation, the analyst gets a much more realistic picture of how efficient a company is in managing its working capital position.

Question 19

Permanent working capital needs

Answer 19

• refers to the need for long-term working capital financing