Oracle Corporation says it will use customer advance payments to enhance cash flow and mitigate the amount of debt required to finance its AI infrastructure investment. We think investors should consider whether this, and other components of net working capital, are in-substance debt financing and adjust their analysis accordingly.
The standard approach of treating working capital as operating assets and liabilities for DCF valuation may not always be the best. In an interactive model, we demonstrate how receivables and payables (and similar working capital items) can be treated as financing items in an enterprise free cash flow DCF valuation.
In our recent article ‘Receivables, payables and (hidden) financial leverage’ we explain how trade receivables, trade payables, and other similar assets and liabilities included in working capital, contribute to financial leverage. Notwithstanding this leverage effect, investors generally treat these items as part of net operating assets and do not adjust debt finance or enterprise value. In other words, the liabilities are not regarded as a source of finance, and the assets are not non-operating investments.
Working capital items are generally regarded as operating assets and liabilities
An operating approach to receivables and payables means their leverage effect contributes to asset or business risk, and is therefore a factor that determines cost of capital, which in turn influences valuation metrics, including enterprise value based multiples. It also means that any change in these working capital balances affects operating cash flow. An increase in trade payables or customer advances (or a reduction in receivables due to factoring) has a positive effect on operating and free cash flow.
While it is reasonable to regard most working capital items as operating in nature (although you still need to be aware of their leverage effects), we think some balances, particularly those arising from customer advances, factoring of receivables, and abnormal credit periods (including those associated with reverse factoring), may be better treated as debt finance in equity analysis and valuation.
In our previous article we explained how to adjust valuation multiples if some or all working capital balances are treated as debt (or non-operating assets). However, we did not show how this applies to DCF models. We explain this below and include an interactive model to demonstrate.
First, an example of where we think working capital balances should be treated like debt in equity analysis.
Debt-like customer advance payments of Oracle Corporation
We recently came across a comment in an earnings call by Oracle, which shows they plan to expand a working capital liability to mitigate the amount of debt they need to raise to fund their AI infrastructure expansion.
Oracle earnings call transcript extract
“On our last earnings call, I shared multiple ideas for how we can incrementally grow our AI infrastructure without Oracle Corporation raising more debt or issuing equity. We have signed more than $29 billion of contracts since then, across multiple customers using that new model. A combination of bring-your-own-hardware and upfront customer payments enables us to continue expanding without any negative cash flow from Oracle Corporation. Of course, this $29 billion is in addition to other deals we signed this quarter.”
Oracle Q3 FY 2026 earnings call, March 10, 2026
Oracle already has a significant customer advances liability (“upfront customer payments”) that arises from the nature of their contracts with customers. This likely includes software licences where advance payments often cover ongoing services delivered over a period of time. In the extract below the balance is called deferred revenues. The terminology used in IFRS and US GAAP standards is contract liabilities – the company has an obligation to perform under contracts for which advance payments have been received.
Oracle deferred revenue footnote
Oracle Corporation 2025 financial statements
The total advance payments (deferred revenue) of $10.7bn for 2025 is relatively modest when compared with the $93bn total debt of the company. There has also been little change from the previous year, which means the company has not received any significant operating cash flow advantage in 2025. The earnings call comment above suggests that this balance will soon increase significantly, although not by the amount of the $29bn mentioned – the actual advance payments balance will depend on multiple factors, including how far in advance of performance the payments are received.
Customer advances are in-substance debt finance
Nevertheless, the increase in advance payments achieved by Oracle will provide financing for the business, reduce the amount of additional debt required to fund capital expenditure, and increase operating cash flow. Using advance payments as a source of finance also has the advantage of producing ‘customer financed growth’ where financing automatically grows in line with the business. For the company this will be a welcome effect considering the increased capital expenditure Oracle and other ‘hyperscalers’ are planning that will normally produce a strain on free cash flow. However, although headline debt may be lower and operating cash flow higher than they otherwise would be, in our view the economics of customer advances, including the impact on leverage and cost of capital, is similar to regular debt finance.
It is possible to treat all receivables, payables (and similar financial working capital assets and liabilities) as financing rather than operating in valuation multiples, DCF (as we show below) and other metrics such as ROIC. However, we think a better approach is to make adjustments only where working capital balances, including customer advances, differ from ‘normal’ working capital amounts. Treating these as financing (or non-operating) items in your analysis better reflects the underlying economics, results in more comparable valuation multiples, and makes it more likely you will produce realistic assumptions for valuation models.
Leverage arising from working capital balances is similar to that from regular debt
In our earlier article we explained how higher leverage from financial net working capital should result in lower valuation multiples, even though it may also produce a higher return on investment. To improve comparability of valuation metrics we suggested that investors can alternatively treat these financial net working capital items as ‘financing’ in nature and demonstrate how this would work in the context of valuation multiples. However, in that earlier article we did not cover how this financing approach can be applied in a DCF model, which is what we explain below.
Before we move onto DCF, you will have noticed a second debt-mitigation policy mentioned by Oracle in the conference call transcript extract we show above – “bring you own hardware”. While we do not know exactly how this will work, it presumably involves customers providing part of the hardware necessary for Oracle to deliver services, thereby reducing the fixed asset purchases of Oracle and protecting free cash flow. Or will it? Whether it has the desired effect partly depends on how ‘bring your own hardware’ is itself accounted for by Oracle, and also the method of analysis chosen by investors.
Determining the appropriate accounting depends on the specific facts and circumstances of the transaction. We think there are least three possibilities:
- Advance payment: It could be that the hardware is in effect a ‘payment in kind’ and is treated the same way as other advance payments by customers. If this is the case, the above comments equally apply. Although not reported as debt, the advance payment has a similar effect, and many investors may adjust along the lines of what we suggest.
- Leasing: Alternatively, while ownership of the hardware may remain with the customer, Oracle could be deemed to be a lessee if they control the use of the asset. This would result in the capitalisation of a ‘right-of-use’ asset and recognition of a lease liability. Most investors would treat the lease liability in the same way as debt.
- Customers’ asset: Only if the customer retains control of the asset hosted by Oracle will it remain off balance sheet. However, if this is the case, we presume revenue and operating profit will be negatively impacted.
It will be interesting to see what accounting is applied to ‘bring your own hardware’, whether auditors will highlight it as a key audit matter, and how investors react.
Working capital in DCF valuation models
If working capital assets and liabilities are judged to be in-substance debt (which is how we would regard customer advances), and therefore best analysed from a financing rather than perspective, it is important that they are correctly included in DCF valuations.
The choice of operating or financing classification is not limited to working capital. It is relevant for several aspects of DCF valuation that we have covered in earlier articles, supplemented by downloadable supporting DCF valuation models:
- Leasing: In ‘DCF valuation: Have you updated for IFRS 16?’ we explain how lease flows can be regarded as either operating flows and directly included in free cash flow, or as financing flows with the effective lease capex included in free cash flow. Both approaches work, as we demonstrate in the downloadable model, but it is vital not to mix and match and end up double counting.
- Pension liabilities: In ’DCF and pensions: Enterprise or equity cash flow?’ we explain (and also provide a model to illustrate) different ways to include pensions in DCF valuation. In addition to the choice of pensions being regarded as an operating or financing liability, there is also the question of how the effects of asset allocation leverage are dealt with. In all, four different approaches are possible but, as we illustrate, if applied consistently all should produce the same result.
- Forecast capital raising: In ‘DCF valuation: Operating versus financing flows’ we explain the importance of not including future capital raising in an enterprise free cash flow DCF model. This does not illustrate an operating versus financing choice but rather the importance of correctly identifying the operating flows. The model we provide also shows the calculation of ‘pre-money’ and ‘post-money’ equity values.
Treating working capital items as either operating or financing in DCF is not dissimilar to the pensions and leasing issues we have previously discussed. What is important is that, whichever approach you decide to use, you must make sure that the three aspects of DCF – cash flows, discount rate and enterprise to equity bridge – are consistent. Operating and financing approaches should always produce the same result if done correctly, although we think adopting an approach that is most consistent with the underlying economics should result in a more reliable answer.
Interest income and expense may be explicit or implicit
One of the added complications when analysing net working capital is that the accounting for these items is usually incomplete. Typically, receivables and payables are not measured at a present value in the balance sheet, and no explicit interest income or expense is reported in the income statement. Strictly speaking this is incorrect and all financial instruments should initially be measured at fair value – in the case of receivables and payables the present value of the expected settlement amount. To simplify reporting, and considering the amounts involved may be relatively small, both IFRS and US GAAP allow companies to ignore the discounting effects if the period of credit is less than one year. Time value of money effects are still present but the simplification means the effects are implicit in other amounts.
For example, if a sale is made with a credit period of less than one year, the invoice amount is reported as a receivable and as revenue. But if this had initially been reported at a present value, revenue would have been lower and, when the receivable balance is settled, a separate interest income amount would be included in profit and loss. If discounting is not applied the interest income is still there but is simply an implicit part of reported revenue.
Investors need to identify whether receivables and payables have been discounted and the location of any resulting interest income and expense. Depending on whether you use the operating or financing approach in a DCF model, different adjustments will be required.
Here is our summary of the two approaches, including how to deal with explicit and implicit interest:
DCF when receivables and payables are treated as OPERATING
The most common approach to including receivables and payables in an enterprise DCF valuation model is to regard the balances as operating in nature. This is how to ensure that the components of the valuation are consistent with this objective:
- Free cash flow: Include the actual cash received from sales and cash paid for purchases. To achieve this, when starting the calculation of free cash flow from post-tax operating profit (NOPAT) include the change in receivables and payables (along with other NWC changes) as an adjustment to derive enterprise free cash flow. Remember that for the terminal value, the change in NWC in the terminal period must be consistent with the long-term growth rate.
- Implicit and explicit interest: Make no adjustment to operating profit to remove the implicit or explicit interest income or expense related to receivables and payables. This means simply using reported revenue and expenses. However, if receivables and payables are measured at a present value and related interest is not part of operating profit (which is the approach under IFRS 18 for this interest expense) then this will need to be reclassified and included in operating profit.
- Discount rate: Do not include payables or receivables cost / return in the WACC used as a discount rate. This means that the discount rate reflects operating asset risk inclusive of the leverage effects of receivables and payables. If this leverage effect changes then it may be necessary to apply a different discount rate each period (which is the case in the model below where the short-term and long-term growth inputs differ).
- Enterprise to equity bridge: Do not deduct the net trade payables less receivables balance in the enterprise to equity bridge.
DCF when receivables and payables are treated as FINANCING
A financing approach can be applied to some or all of receivables and payables, including contract assets and liabilities. Here is how to deal with the components of a DCF valuation in this situation:
- Free cash flow: Do not include an adjustment in enterprise free cash flow for the change in payable and receivable balances. Enterprise free cash flow is operating profit less the change in net operating assets. No adjustment is required if receivables and payables are not regarded as operating assets and liabilities. In effect the cash flow is the revenue and expenses recognised in profit and loss, with the trade credit treated as a loan, although of course there will be other adjustments for fixed assets and inventory.
- Implicit and explicit interest: Exclude from operating profit and enterprise free cash flow the implied interest expense or income applicable to receivables and payables. The lack of discounting applied to receivable and payable balances means that this interest is effectively included in revenue and expenses. The implicit interest needs to be removed if these balances are treated as financing. Ideally the implied interest should be based on the period average receivable or payable outstanding, although in our model we have simply used the opening amount.
- Discount rate: Include the cost of capital of the payables/receivables in the WACC discount rate calculation.
- Enterprise to equity bridge: Include the current (t0) payables less receivables amount as a separate adjustment in the enterprise to equity bridge.
Here is our DCF model illustrating that, if applied correctly, each approach will produce the same result.
Interactive model: Treating receivables and payables as operating or financing
The Footnotes Analyst
We have not included the cost of capital calculations in the extract of the model above. To see this, and to be able to trace all the underlying calculations, use the downloadable version.
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In our model we apply either an operating or financing approach to all receivables and payables of the company. We think it more likely that investors will choose to default to the standard approach of regarding all working capital as operating except for specific balances which they judge to be in-substance financing. This includes the customer advances we highlight above and potentially abnormal working capital balances that can arise from factoring and reverse factoring arrangements, when these do not result in explicit financing liabilities.
For Oracle, and other hyperscalers that may use working capital as a source of funding for their AI infrastructure investment, we think it is important that investors identify which balances represent effective debt finance and adjust both DCF valuation models and enterprise value based multiples such as EV/EBITDA accordingly.
Insights for investors
- The standard treatment of non-debt working capital receivables, payables and similar items as operating assets and liabilities is not the only approach. Investors should consider treating some or all components as in-substance financing.
- Structuring revenue contracts to increase advance payments increases reported cash flow and reduces debt finance requirements. However, for investment analysis, the working capital liability may in effect be debt.
- Treating working capital balances as in-substance debt, and working capital assets as in-substance non-operating assets, can result in more comparable valuation multiples, and other metrics such as return on capital.
- The same financing approach can also be applied in DCF models but be careful to ensure consistency across the different, cash flow, cost of capital and enterprise to equity bridge components.