Clichéd as one may consider the phrase – ‘cash is king’, it’s become more relevant than ever in today’s context.
As external sources of funding dry up, organizations look inward to survive and grow. Whilst cash management has become an imperative to retain competitiveness and staying afloat, working capital is an area that can both, deliver and consume significant amounts of cash in relatively quick time. Organizations that can optimize their working capital will be more successful, since they can expand and improve their operations, while those without optimal working capital may lack the funds necessary for growth.
So what’s the significance of working capital analysis during a due diligence exercise while evaluating a transaction from the viewpoint of a potential buyer?
Working capital represents the level of investment in the business necessary to – allow normal settlement cycle on trade items; accommodate customer expectations about the timing and availability of inventory; and meet other operating needs of the business.
Working capital and cash flow analyses are an important aspect of review in financial due diligence since changes in working capital are a key component of free cash flow, which in turn drives valuation and purchase price.
The level of working capital is often driven by industry norms e.g. a supermarket chain often has a negative working capital, as customers pay for goods before the supermarket has paid its suppliers, while a professional services business will often have a longer working capital cycle.
Adequacy of existing bank facilities to fund working capital
Buyers, more often than not, need to assess the adequacy of the existing bank facilities available to the business (post transaction) to support the investment required in working capital and provide for any shortfalls.
An analysis of working capital, as part of due diligence review helps the buyer to understand the “normal” level of working capital for the business and the range of variation – peak to trough. This understanding enables the buyer to effectively forecast the working capital of the business and then factor it into the valuation model.
For example – an event management business embeds seasonality in its operations, where Q3 and Q4 account for 70% to 80% of the revenues and accordingly, the level of working capital required for Q3 and Q4 would be different from Q1 and Q2. Similarly, a retail industry, witnesses increase in sales during festive seasons and promotional offers leading to additional requirement of working capital in those months as compared to the other months of the year.
The factors that impact movement in historical working capital levels and which often impair the visibility of “normal” working capital in a business are – a)growth profile of a business; b)seasonality and trade cycles, which influence intra-month peaks and troughs; c)collection and payment terms – contractual VS actual; d)changes in the nature of the business (acquisitions and disposals); e)impact of foreign exchange and; f)fluctuations in input costs and the extent to which these have been passed on to customers. These necessitate a deep dive during due diligence before the buyer can accurately ascertain the working capital requirements of a business.
Additionally, the impact of the transaction on all of these factors should be evaluated. A commercially savvy buyer also strives to identify working capital improvement opportunities that could be realized quickly without significant additional efforts post ownership, thereby, providing himself with a competitive edge in a bidding process for the acquisition.
In the acquisition of a business, the working capital provision in the purchase agreement which states that the vendor must deliver a certain level of working capital to the buyer at completion is often one of the last items negotiated by the parties to the transaction. Post the signing date and until completion of a transaction, the vendor has to run the business normally and often has to deliver the business with a normal level of working capital.
Effective financial diligence helps the buyer stipulate appropriate completion mechanism and evaluate the normality of working capital at the completion date to avoid any cash stripping by the vendor e.g. accelerated collection of receivables, understated liabilities etc.
Working capital can be a significant element of the overall purchase price, but historically, buyers have not expended appropriate time and resources on effective working capital due diligence. Whilst private equity investors have been more careful in evaluating working capital, as their objective revolves around putting in and taking out cash from investees, corporate buyers are soon catching up. Now that we’re in a world of scarce liquidity, greater attention to working capital when determining the price for a transaction is inevitable.
Views expressed are personal
The author is a Partner in Ernst & Young’s Transaction Advisory Services.
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