Capital Markets

Securitization: Cash Flow on Tap

A popular financing technique, sometimes criticized for its off-balance-sheet treatment, may be skewing cash-flow statements too, says a new report.
Tim ReasonJune 30, 2006

Securitization of customer receivables — a popular source of cash financing for many companies — often causes dramatic swings in a company’s operating cash flow, and may be being used by some to manage cash-flow volatility, a new report says.

Securitization has occasionally come under fire because it is a form of financing that typically does not appear on the balance sheet, and thus can mislead investors about a company’s leverage. But the new report, released in late June by the Georgia Tech Financial Analysis Lab, focuses primarily on an aspect of securitization that is rarely considered: its impact on cash flow.

Even though banking regulations typically require securitizations to be renewed every 364 days, they’re generally viewed in the market as a source of long-term financing. Yet the report calls that conventional view into question, noting that, in fact, “companies actively move in and out of their securitization programs,” or change the securitized amounts — with corresponding swings in operating cash flow.

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“It’s almost like a drug,” says lab director Charles W. Mulford, a professor of accounting at Georgia Tech. “It’s an easy source of cash. You see companies weaning themselves off and then going back on again.”

A good example of that behavior, says Mulford, is Halliburton. In 2003, on track to post a negative operating cash flow of $595 million, the company terminated its securitization program, causing operating cash flow to drop even further, to $775 million. The following year, Halliburton entered into a new, $519 million securitization, boosting operating cash flow from $409 million to a reported $928 million — 56 percent higher than it would have been without the securitization. Last year, the company again terminated its securitization program. Had it not done so, its reported operating cash flow of $701 million would have exceeded $1.2 billion.

“Securitization,” the report notes, “can help companies manage the volatility of their operating cash flow.”

In other cases, securitization simply seems to boost cash flow. Rite Aid, which reported an operating cash flow of $228 million in 2004, boosted it to $518 million in 2005. Yet without a new securitization of $150 million that year, operating cash flow would have been $368 million, or 29 percent lower. In 2006, Rite Aid’s reported operating cash flow fell to $417 million; however, without another securitization increase — this time for $180 million — it would have been just $237 million, or 43 percent lower.

“A securitization can be used to increase or decrease operating cash flow in any reporting period,” the report notes. “Thus, a securitization can obscure financial analysis based on sustainable cash flows from operations.”

Securitization is a process whereby companies sell receivables — money owed by customers, but not yet collected — for cash. The buyer, typically a special-purpose entity (SPE) created expressly for the purpose, raises funds for the purchase by issuing commercial paper backed by the future stream of money to be collected. The commercial paper often attracts a better rate than the company could by issuing CP of its own, because the sale puts the receivables out of reach of the company’s own creditors in the event of bankruptcy.

Although the Georgia Tech lab’s research typically focuses on reporting practices that may give investors misleading signals of corporate earning power, Mulford is careful to note that securitization is an accepted technique. “I’m not saying you shouldn’t do it,” he says. “It’s a cheap form of financing. But users of financial statements, beware: The increase in operating cash flow that you see will beget a reduction at some future date.”

The report also gives high marks to several companies — including Metaldyne, United Stationers, and Convergys — that went beyond GAAP requirements to highlight the impact of their securitizations on operating cash flow, leverage, or both. “While not compulsory,” the report notes, “these companies nonetheless decided that investors may be misled if such disclosures were not made.”

For example, United Stationers noted in its annual report that GAAP requires that it not report the securitization as debt. However, it stated: “Internally, the Company considers accounts receivable sold to be a financing mechanism [and]…therefore, believes it is helpful to provide readers of its financial statements with a measure that adds accounts receivable sold to debt.”

The Georgia Tech report also examines the impact of securitization on financial leverage. “In a future period, when the securitization program is reduced or unwound, those commercial paper borrowings are reduced or repaid from the firm’s future cash collections,” the report notes. “In effect, a current benefit is repaid with a future sacrifice, much like the repayment of borrowed funds.”

“In every sense of the word, it is like a borrowing,” says Mulford. Indeed, the report points out that small shifts in a securitization can actually change its accounting treatment, noting that a securitization program at Arvinmeritor “shows what a thin line exists between the debt and non-debt treatment of securitized receivables.”

In September 2005, the company consolidated its securitization SPE, reporting its debt on its own balance sheet, and reporting the cash proceeds in the financing cash-flow portion of the cash-flow statement. Yet under Arvinmeritor’s earlier securitization program, in which two SPEs were used, the company did not report the debt, and the cash proceeds appeared in the operating cash-flow section.

“Arvinmeritor points to the arbitrary, rule-based nature of securitization,” says Mulford. “You jump through one hoop and it shows up as debt and financing cash flow. You jump through two hoops, and it’s off-balance-sheet and operating cash flow.”