Taking a bite at SFH, page-17

@natnicnak

Your description of the funding structure for a retailer, including the interplay between trade creditors and bank loan facility, makes complete sense to me.

The point where I disagree is when you claim that the net current liability calculation should include the bank loans that are drawn and classified as non-current. The reason why I disagree is that such a calculation does not reflect the capability of the Company to roll its Working Capital position into the following financial year.

In fact, the right for the Company to defer settlement of its bank liabilities for at least twelve months beyond the reporting date (which is what entitles the Company to classify such liabilities as non-current, according to AASB101.69(d)) is essential when it comes to assessing that capability.

In other words, it is no problem running a negative Net Current Asset position (i.e. [Total Current Assets] – [Total Liabilities] < 0), when the Company has the right to roll a sufficient portion of its Total Liabilities into the following year (thereby classifying them as non-current), so that the Working Capital position is positive (i.e. [Total Current Assets] – [Total Current Liabilities] > 0).

But, when the Working Capital position is negative (i.e. [Total Current Assets] – [Total Current Liabilities] > 0), the Company must be able to

either

1) Cover the shortfall with Free Cash Flow,

or

2) Borrow the amount necessary to cover the shortfall (net of the Free Cash Flow generated) from a credit facility whose settlement can be deferred to the following financial year (i.e. a non-current one).

Therefore, what I think is really important to check is not the amount of non-current bank loans (i.e. what has already been drawn from the bank facility), but whether the undrawn portion of the credit line (together with the expected future Free Cash Flow) is enough to cover the Working Capital deficit.

I will better illustrate my point by showing the evolution of SFH’s Working Capital position over time, vis-à-vis its availability for credit (i.e. its undrawn credit line) and its Free Cash Flow generation.

Working Capital (WC) = [Current Assets] – [Current Liabilities]

FY2008: -25.91m$
FY2009: -47.69m$
FY2010: -10.66m$
FY2011: -17.66m$
FY2012: -22.18m$
FY2013: +6.92m$
FY2014: +12.27m$
FY2015: +14.99m$
FY2016: +2.61m$
FY2017: +2.57m$
HY2018: -20.45m$

Undrawn Credit Line (UCL)

FY2008: 18.18m$
FY2009: 29.25m$
FY2010: 92.00m$
FY2011: 78.00m$
FY2012: 78.50m$
FY2013: 48.00m$
FY2014: 40.88m$
FY2015: 50.78m$
FY2016: 30.56m$
FY2017: 24.68m$
HY2018: 14.37m$ [*]

[*]: includes the scheduled reduction in total credit availability to 22.00m$ as of Jun 30th 2018.

As you can see, the Company has run a negative Working Capital position before (namely between FY2008 and FY2012). In particular, in FY2008 and FY2009 the Undrawn Credit Line was not sufficient to cover the Working Capital Deficit, as we can see from looking at the aggregate:

WC + UCL

FY2008: -7.74m$
FY2009: -18.45m$
FY2010: +81.34m$
FY2011: +60.34m$
FY2012: +56.32m$
FY2013: +54.92m$
FY2014: +53.15m$
FY2015: +65.77m$
FY2016: +33.17m$
FY2017: +27.25m$
HY2018: -6.13m$ [*]

But, when WC + UCL was negative in the past, the Free Cash Flow generated in the next financial year was always enough to cover the shortfall; indeed, the Company generated +15.99m$ in Free Cash Flow in FY2009 and +22.69m$ in FY2010. And, between FY2010 and FY2017, WC + UCL has always been comfortably positive, before dropping to negative in HY2018 (once the scheduled reduction in the UCL is factored in).

The difference this time is that the Free Cash Flow expectation for the next semester (to Jun 30th 2018) is negative (as you have calculated by yourself), therefore the shortfall is no longer covered.

So, let’s take SFH’s Working Capital position as of Dec 31st 2017:

Current Assets
Cash: 27.7m$
Receivables: 11.3m$
Inventory: 81.9m$
Total Current Assets: 120.9m$
Current Liabilities
Payables: 103.7m$
Provisions: 21.3m$
Other: 16.4m$
Total Current Liabilities: 141.4m$
Net Working Capital: -20.5m$

For the sake of simplicity, I will just use your assumption of a -8.5m$ negative Free Cash Flow in the half year to Jun 30th 2018 (on aggregate, it does look like a reasonably conservative assumption to me). I will also work under your assumption (which I agree with) that any residual Cash needs to be used to bring Payables roughly back in line with the level of Inventory.

Before any further movements, the Working Capital situation as of Jun 30th 2018 will then look as follows:

Current Assets
Cash: nil
Receivables: 11.3m$
Inventory: 81.9m$
Total Current Assets: 93.2m$
Current Liabilities
Payables: 84.5m$ (=103.7m$-27.7m$+8.5m$)
Provisions: 21.3m$
Other: 16.4m$
Total Current Liabilities: 122.2m$
Net Working Capital: -29.0m$

You are right in that Inventory will have to be lower, after the closure of an additional 50-60 shops in the second half, and that the reduction in Inventory will allow for a corresponding reduction in Payables. I do not see that as being really relevant, though, when it comes to figuring out how the Working Capital deficit can be sustained.

From the 2017 Annual Report (pages 77-79), one can see that Provisions and Other Current Liabilities (which will be the drivers of the Working Capital deficit once Net Payables are back in line with Inventory) contain the following items:

a) Income Tax Provision
b) Employee Benefits Provision
c) Sales Return Provision
d) Lease Make Good Provision
e) Stepped Lease Provision
f) Deferred Lease Incentives
g) Deferred Revenue

These are all expected payments (or differences vis-à-vis reported Revenues/Costs) whose exact timing and/or amount is uncertain (hence why they are classified as Provisions, as per AASB137); nevertheless, their inclusion under Current Liabilities does reflect the expectation that commensurate amounts will actually have to be settled and will therefore impact the net cash position of the Company.

Quoting directly from AASB137.14:

A provision shall be recognised when: (a) an entity has a present obligation (legal or constructive) as a result of a past event; (b) it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and (c) a reliable estimate can be made of the amount of the obligation. If these conditions are not met, no provision shall be recognised.

To conclude, I do agree that, under the assumption of a negative -8.5m$ net cash flow in JH2018, the Company would still be able to roughly realign Payables with Inventory without running out of cash. But, because the Working Capital position would further deteriorate to a negative 29.0m$, with only 14.4m$ of available credit line to draw from, after Jun 30th 2018, I do still see a real chance of fresh equity capital being needed, if new funding arrangement with lenders cannot be secured.

As usual, all IMHO

Thanks