- Working capital, or lack thereof, can significantly impact a firm’s valuation, selling price, and M&A deal terms.
- Effectively managing a firm’s working capital can increase the seller’s exit price.
Buyers and sellers often overlook working capital when considering a potential M&A transaction. However, not many know that it plays a crucial role in company valuation. Working capital impacts the cash flow of a company, as it is a measure of liquidity. Also, several valuation methods use cash flows for calculation.
Working capital is the difference between current assets and current liabilities, and it also indicates the short-term health of a company. At times, buyers and sellers do not understand the impact of working capital on the cash flow. It’s because assigning a value to the assets is complex, and contingent liabilities do not appear on the balance sheet.
Buyers are usually attracted to companies that tightly manage their working capital. This scenario shows that the business can operate effectively with less working capital and benefit the investor.
High working capital requirements to sales ratios are not good indicators of growth. In such cases, the company needs to invest more cash in working capital when the sales grow. On the other hand, companies with low working capital can grow faster and provide better returns to shareholders.
The Impact of Working Capital on Company Valuation
Working capital plays a crucial role in company valuation. Most analysts consider three valuation methods: the income approach, the market approach, and the asset approach.
While the income approach considers future cash flows, a market approach reviews the selling price of similar companies, and an asset approach takes heed of the assets and liabilities of the company.
The Income Approach considers the change in working capital to calculate free cash flow, a key component when using a discounted cash flow analysis or capitalization of earnings method to value a company—as such, estimating the required level of working capital for operations can change the result of free cash flow drastically.
Another way working capital impacts the conclusion of value for a company is the amount an analyst defines as excess to running operations smoothly. A crucial part of analyzing a company is estimating the amount of working capital needed to run operations. Typically, this is between 30 and 45 days of working capital. Based on this estimate, an analyst can determine a company’s excess working capital based on their actual working capital, less their target working capital. The determined excess is then added to an analyst’s conclusion of value.
The Impact of Working Capital on M&A Deal Terms
As working capital is often a cause of dispute in a transaction, the buyer and seller need to negotiate in advance how they will treat it in the M&A deal. The conflict begins with setting the target working capital and defining what to include or exclude from the working capital.
Revenue and expenses of seasonal nature cause fluctuations in working capital levels throughout the year. The analysts need to identify one-off items impacting net working capital, which they do not anticipate to repeat in the future.
Analysts know closing the estimated working capital impacts the purchase price of the company on the closing date. It’s because the business continues to operate throughout the transaction process. Hence, after closing, they continue with the true-up phase to bring the networking capital balance in line with the actual.
Another source of conflict between the buyer and seller is the true-up calculation. They may disagree over the values of specific balance sheet accounts, their accounting methods, and the decision to include or exclude them from the true-up calculation.
How Does Managing Working Capital Helps the Selling Company Maximize Value?
The management of the selling company can work towards maximizing value and preventing problems in M&A transactions in many ways. These include:
- To improve its working capital turnover ratio, the management should proactively take such steps that enhance the efficiency of its working capital. The working capital turnover ratio indicates how well a company utilizes its working capital and is calculated by dividing sales by working capital.
- Management should also keep monthly records of working capital. They can avoid surprises during the sales transaction process by periodically analyzing their company’s historical working capital trends.
- Management should have a realistic expectation about the accounts receivable and investment in inventory needed as the company grows while projecting its future working capital.
- Management should inculcate the habit of periodic reevaluation of their accounts payable and borrowing practices. They should also consider modifying them if needed.
- They should also focus on reducing the requirements for inventory and the level of accounts receivables.
- Management should not refrain from making tough decisions to improve the working capital situation, such as replacing a vendor.
Related: Managing working capital.
Advantages of Managing Working Capital
- Increase in return on capital –Companies with low working capital provide a higher return on capital, and hence, shareholders benefit from a better return on their investment.
- Better credit profile – To attain long-term solvency, a company first needs to meet its short-term obligations. It is also a good indicator of the counterparty’s credit risk. Adequate working capital management allows an organization to pay its short-term obligations on time, such as purchasing raw materials, salaries, and other operating expenses.
- Improved Profitability – The profitability of small businesses is driven by the management of accounts receivables and payables. A correct working capital management strategy enhances the company’s profitability in the long run. It helps manage inventory to avoid operational failures and facilitates on-time collection from trade receivables. Proper management and allocation of cash help prevent cases of default in paying the trade payable.
- Higher Liquidity – At times, companies have a large amount of cash tied up in working capital. By employing a proper working capital management strategy and freeing up this cash, they can benefit from additional liquidity and depend less on external financing. Most small businesses have limited access to external funding sources, and effective cash management helps them better allocate resources while paying their bills on time.
- Favorable Financing terms – When companies pay their suppliers on time and maintain good relationships with trade partners, they win favorable financing terms such as discount payments from their banking partners and suppliers. It helps them get an edge over their competitors and build a positive reputation in the market.
- Uninterrupted Production – Companies enjoy the regular flow of raw materials when they pay their suppliers on time. Hence, they can evade interruptions in production and ensure the smooth flow of products in the market and to the end customers.
- Better Crisis Management – When companies efficiently manage working capital, they can survive through shocks that impact business-as-usual, such as natural calamities, terrorist acts, etc. Also, if they receive an unexpectedly large order, the cash flow situation allows them to ramp up production.
- Improved Competitive Ability – Efficient working capital management improves the sourcing capabilities of the company, giving it a price advantage and building an efficient supply chain. It, in turn, allows the company to offer rewards to its customers, making it more competitive in the marketplace.
- Enhanced Business Value – Efficient working capital management improves the company’s financial health and operational success, making it stand out amongst its peers. The business gets respect in the market due to more free cash flows and enjoys higher business valuation.
Efficient working capital management is essential for the smooth running of a business. Additionally, it impacts the value of the company at the time of exit. Business owners need to manage the working capital such that their organization remains attractive to prospective buyers and they maximize valuation.
On the other hand, buyers must employ thorough due diligence to protect themselves from working capital deficits.