How does working capital impact the value of my business? Firstly, an overriding principle of valuation, particularly in valuing operational going concerns businesses, is that working capital is included in the business. Working capital is typically a contentious issue over the course of a transaction as the vendor and the purchaser will often have divergent views as to what the business requires. Also, working capital is also often misunderstood. Ultimately, working capital will fall into one of three categories and, as the vendor, you must be ready to deal with the results:
- Sufficient / appropriate / adequate
- Surplus / excess
- Deficient / shortfall
The real question is how much working capital is required for this business to continue operating as it is now and to follow the stated growth trajectory? What is the level of working capital that is commensurate with earnings? Working capital levels are assessed to determine where a company sits. Working capital levels are measured against industry norms, typical banking covenant ratios, percentage of forecast sales, and requirements based on financial and operational forecasts.
How Much is Sufficient or Deficient?
Sufficient working capital levels are usually shown as amounts that have been consistently retained in the business, year after year, while allowing for distributions to shareholders for bonuses or dividends that have not been required to be re-loaned to the business as shareholder loans. What this means is that often a business owner receives an annual shareholder bonus to reduce the taxable income of the company, the company pays the tax on the lower income, the shareholder pays the tax on income received and then the shareholder loans the money back to the business to fund operations, and this often occurs year after year.
This is an example of a shareholder financing a company’s ongoing operations and shows that the shareholder loan capital is required for the ongoing operations of the business. If the annual distribution is paid out of the company and doesn’t come back in as a shareholder loan, this shows that the company is operating from its own resources and can actually distribute the discretionary cash flow.
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Deficient working capital levels are characterized in two ways. The first is where there are more current liabilities than current assets and the company will have ongoing difficulty meeting its obligations. The second, and less obvious, is where a company still has a positive working capital balance, but the amount of working capital is insufficient to take on new initiatives, support growth and generally requires the business to adopt the status quo.
What is considered a surplus working capital position and how can this be justified? Adequate working capital is the working capital to run the business in a sustained state, not considering growth. If the EBITDA that is being used in a multiple approach incorporates forecasted growth in EBITDA, then the amount of working capital should be sufficient to handle the growth profile which would be a higher requirement and may reduce perceived working capital surplus.
Every business is different and some of the items that should be considered in the determination of working capital surplus/deficiency are the following:
- Comparison to industry norms for top performing companies
- Revenue to working capital ratios
- Growth capital expenditure requirements
- Inventory turns
- A/R days
- A/P days
- Maximum amount of operating line of credit or cash available
- If surplus working capital is being used to gain purchasing discounts
A Tale of Two Companies
Set out below are examples of two companies that at first glance appear identical from a revenue and EBITDA perspective. However, when working capital is analyzed, Caliber Diversified Industries has much greater requirements than its erstwhile peer.
Caliber Diversified Industries:
- Caliber has a current ratio of 1.78 and a working capital balance of approximately $1.5 million. Next year’s sales are forecasted at $15 million.
- $2.2 million EBITDA x 4.0X Multiple = $8.8 million entity value. Working capital of $1.5 million, of which is $500,000, is considered a working capital surplus and, therefore, is added to the purchase price.
- $8.8 million entity value + $500,000 excess working capital = $9.3 million value.
- $9.3 million entity value / $2.2 million EBITDA = 4.23X EBITDA multiple.
- $2.2 million EBITDA x 4X Multiple = $8.8 million entity value.
- Working capital of $600,000 that is considered insufficient for normal operations by $400,000, and is deducted from the purchase price, to result in a $8.4 million purchase price.
- $8.4 million value / $2.2 million EBITDA = 3.82X EBITDA multiple.
By correctly positioning Caliber to the purchaser, the vendor in this situation receives the equivalent of a 9% higher EBITDA multiple (and $900,000 higher purchase price). As illustrated, if working capital is not positioned properly, a business owner may sell his business at a discount, not even realizing he is leaving money on the table. The astute business purchaser would not like to pay for excess working capital and views this as a discount to the purchase price. It is in the best interest of the purchaser to not make the vendor aware of any surplus working capital that may be included in the negotiated purchase price.