WORKING CAPITAL IN BUSINESS BROKERAGE June 20- 2017

Understanding Working Capital Workshop 1 Presenter: Pino L. Bacinello CBI, M&AMI, CMEA, CSBA [email protected]

1 OBJECTIVE

2 WORKING CAPITAL WHAT IS IT

• Generally Defined as: – The “Capital” of a business that is used in its day-to-day operations – “Money” available to the company for its day-to-day operations

• Generally Calculated as: – Current Assets Minus Current Liabilities – Typically: • Cash, AR’s, Inventory, Pre Paid Expenses Minus AP’s, Accrued Expenses

3 UNDERSTANDING & EXPECTATIONS

• Familiar Concept but not well understood • NWC affects Enterprise Value – A buyer typically bases its price on the enterprise value of the business on a cash free, debt free basis, “assuming a normal level of working capital” • Purchase Price Adjustment Mechanism in OTP or LOI or PSA – An easy way to lose significant value in a deal if it is not understood, structured and negotiated properly • Expectations – Purchaser funds available (buyer and seller expectations) – Purchase price paid post closing adjustments (buyer and seller expectations) – Seasonality

4 ENTERPRISE VALUE AND WC

• Important:

– The calculation of enterprise value of a business must account for WC because it affects cash flow! – Anything that affects cash flow, affects returns! – Anything that affects returns, affects the value of an investment!

• Enterprise Value Calculation: EV = WC + Tangible Assets + Intangible Assets

5 WORKING CAPITAL DEFINED

• Gross Working Capital – Is a Financial Concept – Is the Total Aggregate value of all Current Assets – Does not reveal true financial position – Example:

CA (inventory) by borrowing = GWC but CL = GWC but the NWC remains same.

• Net Working Capital – Accounting Concept – Represents Excess/Shortage Current Assets over Current Liabilities – Represent liquidity of enterprise – Total Current Assets Minus Total Current Liabilities • Business Brokerage - Most often excludes cash and debt as they are considered management style specific.

6 WORKING CAPITAL DEFINED

• Normal Working Capital – That which is required in the normal day-to-day operations excluding surplus in the case where excess inventory is carried or deficit in the case where payables are stretched. Can be Gross or Net. Also often referred to as “Target WC”

• Required Working Capital – Similar to Normal Working Capital - That which is expected by a buyer or, to be included in the purchase price, or is often a bench mark. Can be Gross or Net. Can also often referred to as “Target WC”

7 WORKING CAPITAL DEFINED

• Average Working Capital – Can be Gross or Net and is calculated based on an average over a specified period. This is often yearly or seasonal • Excess Working Capital – This can be Gross or Net but in essence it is the amount over and above the anticipated or included Normal or Required or Target Working Capital • Deficit Working Capital – This can be Gross or Net but in essence it is the amount short of the anticipated or included Normal or Required or Target Working Capital

8 ESSENCE OF NWC

• Common Measure of a business’: • Liquidity • Efficiency • Overall Wealth & Health • Reflects Results of: – Inventory Management – AR and AP management • Positive NWC typically indicates: – Ability to pay off Short Term Liabilities • Negative NWC typically indicates: – Inability to pay off short Term Liabilities (without cash infusion)

9 WC COMPONENTS

• Inventory – The longer inventory stays in Company, (low inventory turns) the Longer the WC is tied up – The greater the inventory the company carries, the more WC it requires – Seasonality of inventory requirements affect WC requirements – Failure to manage inventory = failure to manage WC • Accounts Receivables – Time it takes to collect AR’s, affects WC requirements • Accounts Payables – Time it takes to pay bills, affects WC requirements

10 IMPORTANT

Working Capital Requirements and Benchmarks Vary

from Industry to Industry and Accounting Methods

11 CHANGES IN WORKING CAPITAL

Changes in WC impact Cash Flow • Creditors paid prior to Debtors paying you: – Cash Drain – Cash infusion required to support lag in payments • Revenue Growth requires growth in WC, or injection of funds required thereby affecting value • Negative change in NWC means CA are increasing higher then CL, and the reverse is true • If AR and Inventory goes up, the Cash flow goes down while the reverse is true • Cash flow (in particular FCF) impacts valuations

12 NEGATIVE CHANGES IN NWC

Q1 Q2 Cash $ - Cash $ - Marketable securities $ - Marketable securities $ - Accounts Receivable $ 100,000 Accounts Receivable $ 100,000 Inventory $ 350,000 Inventory $ 450,000 Pre Paid Expenses $ 50,000 Pre Paid Expenses $ 50,000 Total Current Assets $ 500,000 Total Current Assets $ 600,000

Accounts Payable $ 75,000 Accounts Payable $ 75,000 Accrued Liabilities $ 25,000 Accrued Liabilities $ 25,000 Short Term Debt $ - Short Term Debt $ - Total Current Liabilities $ 100,000 Total Current Liabilities $ 100,000

Net Working Capital $ 400,000 Net Working Capital $ 500,000

CHANGE IN NWC $ (100,000)

• This increase in NWC from Q1 to Q2 is not as important as the change in the NWC between the 2 periods • The change from Q1 to Q2 is Negative and as such this company in effect reduced its cash flow (FCF) by encumbering it in inventory in this case, thereby reducing its cash flow and increasing its Required Working Capital in Q2 from Q1

13 POSITIVE CHANGES IN NWC

Q1 Q2 Cash $ - Cash $ - Marketable securities $ - Marketable securities $ - Accounts Receivable $ 100,000 Accounts Receivable $ 100,000 Inventory $ 350,000 Inventory $ 350,000 Pre Paid Expenses $ 50,000 Pre Paid Expenses $ 50,000

Total Current Assets $ 500,000 Total Current Assets $ 500,000

Accounts Payable $ 75,000 Accounts Payable $ 150,000 Accrued Liabilities $ 25,000 Accrued Liabilities $ 25,000 Short Term Debt $ - Short Term Debt $ -

Total Current Liabilities $ 100,000 Total Current Liabilities $ 175,000

Net Working Capital $ 400,000 Net Working Capital $ 325,000

CHANGE IN NWC $ 75,000 • This decrease in NWC from Q1 to Q2 is not as important as the change in the NWC between the 2 periods • The change in NWC is Positive and as such this company in effect increased its cash flow (FCF) by stretching its payables (or it could be by reducing its inventory) thereby increasing its cash flow and decreasing its Required Working Capital in Q2 from Q1

14 WHY ARE D IN NWC IMPORTANT

• True earning power of any business is measured by Cash Flow • Often SDE is not as good a measure as EBITDA and EBITDA is not as good a measure as Free Cash Flow (FCF) • FCF is: – earnings that can be taken out by the owners and debt holders without impairing the continued operations of the business – a measure of a company's financial performance, calculated as “operating cash flow” minus “capital expenditures” and represents the cash that a company is able to generate after spending the money required to maintain or expand its asset base – the measure used in the Discounted Cash Flow (DCF) method under the Income Approach • A key component of the FCF calculation is the change in NWC - Formula for FCF:

EBIT + Amort. & Dep. - D in NWC - CAPEX 15 WHY ARE D IN NWC IMPORTANT

THEREFORE: • An increase in NWC or a negative change in NWC over a period of time indicates an investment of resources in short term thereby draining available cash flow from operating, financing or other investment activities – This generally results in a cash flow decrease – Reduction in owner earnings (FCF)

• Conversely, a decrease in NWC or a positve change in NWC over a period of time indicates that the business has relied upon short term borrowing (either through financial institutions or other debt holders including suppliers) to finance its operations – This generally results in a cash flow increase – Increase in owner earnings (FCF)

16 METHODS USED

• Traditional (Current Assets Minus Current Liabilities) – Unless the business is small and very predictable this should not be used

• Simple – Used where the business operates mostly in a positive cash flow with pre paid orders or services – Typically uses one to four months of operating expenses

17 METHODS USED

• Benchmark – Used primarily in cases where high inventory levels are evident – A hybrid method that considers the time it takes to covert: • inventory into sales (inventory cycle) • Sales into AR (AR cycle) • AR’s into cash (AR credit cycle) Then takes the average operating cycles and multiplies it by the yearly projected operating expenses

18 METHODS USED

• Percentage of Sales – Based on the assumption that the level of WC for any firm is directly related to its sales value – Tells how much of every sales dollar must go to meet working capital requirements including operational expenses and short term debt obligations – Assumes history repeats itself

19 METHODS USED

• Regression – based upon the statistical technique of estimating or predicting the unknown value of a dependent variable from the known value of an independent variable – It is the measure of the average relationship between sales and WC • Trailing Months – Typically uses monthly figures for the trailing 12 or 24 or more months – Particularly useful in seasonal situations – Can use average, median or specific points • Operating Cycle – based upon the operating cycle concept of WC – Cycle starts with the purchase of raw material and other resources and ends with the realization of cash from the sale of finished goods (Manufacturing Businesses)

20 METHODS USED

• Days Working Capital – Shows how many days it takes to convert WC into actual revenue – Companies that need fewer days to turn working capital into sales revenue are better off than those that take longer.  First Calculate the Average WC  Then multiply the result by 365 days in year  Then divide by Annual Sales Revenue – Increase in Days WC means sales are growing – Decrease in Days WC means sales are slowing

21 NWC ADJUSTMENTS

• While the concept of WC is familiar to most, it is often misunderstood in the context of purchase price adjustment mechanisms in a PSA • Not understanding WC can be an easy way to lose significant value in a deal, and increase liability, if it is not structured and or negotiated properly • Typically buyers of private enterprises base their price on a cash free, debt free basis and assuming a normal level of working capital. (The level of WC that is required to generate the earnings that served as the basis of the EV calculation)

22 WC IN BUSINESS BROKERAGE

• Seller Side – Important for sellers to know and understand the expectations of the buyers and realities of the market – Important to understand the NWC included in the Price and how any variance will be dealt with • Buyer Side – Is the required NWC included in the purchase price? – Is the NWC adequate to: • Operate the business? On a day-to-day? • fund the anticipated or projected growth? • Ensure the buyer does not fail due to lack of WC • Broker Side – You are the expert so you NEED to know – Avoid potential liability 23 CAUTION NOTES

• Important that where valuations are based primarily on the Income approach and future earnings, where growth is a major factor, that the WC calculation considered the required WC for the assessed or assumed growth • Revenue recognition policies can make interpreting WC difficult • Ensure that the WC calculation methodology used in the valuation is the same as the one used in the closing adjustments

24 IN CLOSING

WC adjustments lie at the intersection of corporate finance, accounting and law

Well advised Brokers can take advantage of NWC to support the pricing model and minimize any potential value shifts that may result between buyers and sellers

25 WORKING CAPITAL IN BUSINESS BROKERAGE June 20 - 2017

Understanding Working Capital Workshop 1 Presenter: Pino L. Bacinello CBI, M&AMI, CMEA, CSBA [email protected]

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