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Wall Street Prep Restructuring Modeling Program

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FORECASTING WORKING CAPITAL

Working capital overview

Below the balance sheet, we will establish our WC schedules. WC management is a primary operating consideration in restructuring. In this section we focus on projecting WC assets. Assumptions about future accounts receivable (A/R), inventories, and other current assets are critical for estimating financing and cash needs and have a material impact on valuation.

Models need to be able to sensitize these variables and identify how changing assumptions affect overall model output.

Effective WC management is another way to say “cash is king” in bankruptcy.

WC liabilities such as accounts payable (A/P) and other accruals need to be analyzed separately in restructuring as some of them may become subject to compromise.

Table 1: Below are the ratios most widely used for forecasting WC assets Asset Ratio for

forecasting Definition Example Comments

Accounts receivable

Days sales outstanding (DSO), aka average collection period

Average (or end of period) AR / Credit Sales x days in period

End of period AR: $100, Credit Sales: $1,000, period: 365 days. DSO = 36.5 days

Notes receivable, sometimes aggregated into AR, receive interest payments

Inventory Inventory turnover

COGS / Average (or end of period) inventory

End of period inventory: $200, COGS: $800 Inventory turnover = 4.0x

Prepaid expenses

Project prepaids as a function of sales or SG&A

Typically comprised of rents, utilities, etc.

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Modeling working capital

The historical balance on the balance sheet is referenced into a working capital schedule.

The user inputs certain working capital assumptions, which are then used to back into the year-end balances

Common drivers for working capital items are: o AR: Average collection period assumption, or revenue growth o Inventory: turnover assumption or COGS growth o Prepaids and other assets: revenue growth (fixed % of sales)

The roll-forward schedule

Mechanically, all working capital items are projected in a similar manner: The prior year’s end of period (EOP) “rolls forward” to the next period beginning of period (BOP). The EOP projections are projected using the assumptions aggregated in rows below the schedule. The year over year changes, can thus be backed into using simple arithmetic.

AR Roll forward logic Historical Projected Q1 Q2 Q3 Q4 Accounts Receivable (BOP) 150.0 179.9 +/- increases / decreases in AR ? ? Accounts Receivable (EOP) 120.0 150.0 ? ?

Calculating DSO Historical Projected Q1 Q2 Q3 Q4 Days in period 91 92 91 91 Revenue 1,200.0 1,440.0 1,728.0 2,073.6 Accounts Receivable (EOP) 120.0 150.0 ? ? DSO (avg. collection period) 9.1 9.6 9.5 9.4

Accounts receivable

AR trends in bankruptcy

Forecast by either 1) Making a DSO assumption (see below) or 2) Growing at the same rate as revenues

Reference historical EOP from balance sheet

Plug (EOP – BOP)

Reference from prior period EOP

DSO = 91 x (120 / 1,200) = 9.1 We make a DSO assumption

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When customers become aware of an impending bankruptcy or potential distress, they may be less inclined to pay on time, or at all.

Conversely, companies in distress may ratchet up collections when confronted with a liquidity crunch.

As a result, the A/R pattern depends on the nature of the business, the publicity of the distress, and the effectiveness of working capital management.

Inventory

Inventory trends in bankruptcy

As a company faces an operational downturn, an inefficient inventory system will lead to bloated inventories and reduction in inventory turnover.

Once the company recognizes the operational downturn and begins turnaround efforts, a pullback in inventory purchases may occur.

Inventory liquidations may also occur, and are often associated with deep discounts.

Depleted inventories must often be rebuilt and factored in determining the cash needs of the turnaround until inventories reach normalized levels.

Prepaid expenses

Prepaid expenses – trends in bankruptcy

Although some prepaid expenses such as rents and utilities are fixed, discretionary prepaid expenses tend to decline during distress, as a company strives to conserve cash.

Offsetting this is the possibility that certain service providers will require prepayment if they become aware or concerned about the distress.