A working capital facility is sanctioned to fund the borrower’s operating cycle: the gap between paying suppliers and collecting from customers. As revenue grows, the working capital requirement grows, and the facility usage grows. This is the normal, healthy use of working capital finance.
What is not normal, but what occurs with surprising frequency, is a facility where the usage grows faster than the revenue, where the drawing power is perpetually at the limit and where the borrower could not repay the facility if the lender demanded it. In these cases, the working capital facility is not temporary (bridging a timing gap). It is permanent (funding a structural cash deficit that the business cannot resolve from its own operations).
The Working Capital Reality Test determines which situation applies and what the lender should do about it.
The four diagnostic steps (Assumed numbers)
Step 1: Track the working capital cycle over time. Calculate receivable days, inventory days and payable days for each of the last 12 quarters. Plot the trends on a single graph.
The healthy pattern: all three metrics stable or improving. The borrower is managing its working capital efficiently. The facility usage grows proportionally with revenue.
The deteriorating pattern: receivable days increasing (customers are taking longer to pay), inventory days increasing (stock is sitting longer in the godown), payable days stable or decreasing (the borrower cannot stretch suppliers further, possibly because suppliers are demanding faster payment as they sense the borrower’s stress). The working capital requirement is expanding structurally, not cyclically.
In the borrower described above: receivable days moved from 60 to 82 over three years. Inventory days moved from 45 to 65. Payable days remained at 30. The funding gap (receivable days plus inventory days minus payable days) expanded from 75 days to 117 days, a 56% increase. Revenue grew 25% over the same period. The facility would need to grow 56% just to fund the same volume of business at the deteriorated cycle, before funding any revenue growth.
Step 2: Compare facility usage to revenue growth. If the facility usage has grown 50% while revenue has grown 25%, the excess 25% is not funding revenue growth. It is funding a widening gap in the operating cycle. The lender is financing the borrower’s inability to manage its working capital, not the borrower’s commercial growth.
Step 3: Test the drawing power quality. The drawing power is calculated from the stock statement and the receivable book. Both are the borrower’s own claims about its own assets.
If 25% of the claimed stock is older than 180 days (slow-moving, potentially obsolete), the drawing power includes inventory that cannot realistically be converted to cash within the normal operating cycle. If 20% of the receivables are older than 90 days (potentially irrecoverable, possibly disputed, possibly from counterparties in financial difficulty), the drawing power includes receivables that may never produce cash.
The drawing power, recalculated on verified, current, realisable stock and confirmed, collectible receivables, may be 15% to 30% below the reported figure. The facility utilisation that appears to be at 85% of the limit may actually be at 110% of the verified drawing power. The facility is effectively over-drawn against the actual security.
Step 4: Determine whether the facility is revolving or permanent. A genuine working capital facility revolves: the borrower draws, buys inventory, sells, collects and repays. Then draws again. The cycle repeats, and the facility balance fluctuates with the operating cycle.
If the facility has been at or near the limit continuously for 12 or more months with no significant repayment, it is not revolving. It is a permanent funding source disguised as a short-term facility. The borrower has effectively converted short-term borrowing into long-term borrowing without the lender’s explicit consent, without a defined repayment schedule and without the pricing that permanent debt should carry.
What the lender should do
A working capital facility that is permanently drawn is a term loan with a revolving label. The lender that identifies this pattern has several options: restructure the facility (convert the permanent component to a term loan with defined repayment, leaving only the genuinely revolving component as working capital), require additional security proportionate to the permanent usage, enhance monitoring (monthly verified stock and receivable reports rather than quarterly self-certified statements), reduce the facility to the revolving component and require the borrower to fund the permanent component from equity or term debt, or (in early-stage cases) work with the borrower to improve the working capital cycle through receivable collection discipline, inventory management and supplier negotiation, so the structural gap narrows over time.
The worst response is to continue accepting the facility as “revolving” when it is not, because the lender’s risk is priced and structured for a temporary facility while the economic reality is a permanent one.
Northrop applies this test in continuous credit surveillance across borrower portfolios. [email protected] | +91 92899 25657.