Notes Payable: Operating Or Financing Cash Flows?

A common question posed to us is the treatment of notes payable. Are notes payable part of total debt, or is it something else? You should note that there is an unavoidable inconsistency in dealing with notes payable and cash flow from assets. The same thing occurs when calculate EFN. In both contexts, NWC is essentially treated as an asset, which means that notes payable have been netted out (treated as a contra-asset). On the other hand, interest paid shows up in cash flow to creditors, but not repayments of note principal (which show up in the change in NWC). Interestingly, a similar inconsistency shows up in the standard statement of cash flows, where interest paid is treated as an operating cost.

Some argue that it would be more consistent to define net operating working capital (NOWC), which is just NWC with notes payable left out.

In our view, this issue runs much deeper. First, notes payable are operating liabilities for many businesses. Any company, such as a car dealer, that uses bank borrowing to floor plan inventory is using notes as operating liabilities. In this case, the interest paid actually is an operating cost. Very commonly, companies with seasonal sales use revolvers (a form of notes payable) to crank up inventory. Same story. Making matters more complicated, accounts payable is the single most important form of business financing (not just operating financing) for small businesses. The distinction between accounts payable and notes payable is pretty artificial in these cases. Both are debts, just different creditors. However, long-term secured debt maturing in the current year is clearly not an operating flow.

But wait, there is more.

Large corporations are increasingly holding huge amounts of cash, far more than needed for operations. This excess cash is properly viewed as a short-term investment portfolio. If we are trying to be very rigorous in our definitions of operating assets and liabilities, then we have to somehow separate out the operating cash (this is why we subtract cash in calculating enterprise value, but that’s also wrong because some of the cash is needed for operations).

So, in light of all this, we made the decision to follow common business practice and call NWC the difference between current assets and current liabilities. The cash flow to shareholders comes out correctly, EFN comes out correctly, and in capital budgeting, none of these issues exist. As you go out in the world and use what we have taught you, you may run into these issues. Hopefully, for your company, you should have more information available which will allow you to separate cash and notes payable into separate operating and financing cash flows.