MODELLING WORKING CAPITAL - BEST PRACTICES
Beyond the normally accepted WC Peg of average working capital for the last 12 months, what are some best practices/modelling techniques to arrive at the ideal level of WC for a transaction, knowing that you don't know the target company's operations that well compared to the seller?
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There is also a great older post from ^[redacted] on this topic: www.searchfunder.com/post/why-working-capital-matters-in-your-search-fund-acquisition
p.s. - as an aside, and see other posts on the subject, the "normally accepted NWC peg" depends greatly on the size of the transaction, the industry, the data set used for comps, and thus the basis of the price (base, base+inventory, base+inventory+AR-AP, etc.).
For #1, comparing NWC at the time of transaction to the LTM average should be sufficient.
For #2, the historical working capital needs of any business are only useful as an estimate of future requirements. As a simplified example: If at any point over the next 12 months, you’re going to have to shell out $500K on inventory, and you’ll have $500K in uncollected sales (AR), but you’ll only have $100K in unpaid bills (AP), you need to make sure you have $900K in liquidity (cash + line of credit). You can model this sort of thing by connecting NWC to sales and COGS and basing the items off things like days in inventory, AR turnaround time, days to pay bills, etc.
2. M&A NWC is different than accounting NWC.
3. What should be included in M&A NWC? Many good points by others. But, one should not include items like A/R and A/P just based on label. Often certain trade A/R or trade A/P need to be excluded.
4. What should one do with prepaid deposits, deferred revenue? Starting point is that they are debt-type liabilities and hence excluded. Some can be included subject for deeper drive.
5. Should buyer assume all accrued expenses and accrued wages? This is a complex subject. Often can be ignored of amount is not material. Accounting practice for COGS impacts this analysis.
6. Changes in accounting policy can impact NWC. They should be analyzed. Things get tricky whether they are on the left-side or right-side of BS.
7. NWC for businesses in healthcare, construction (w/% completion method), long production cycle get even more challenging. Recently a $40 M purchase price healthcare deal had collapsed after 12 months on WC issue. They contacted me and we brought both sides to reality. Buyer was represented by PwC.
8. I teach this subject. I share my unpublished book with the class (wrote it 10+ years ago). I introduce benefit theory and the debt-type liabilities to resolve buyer/seller conflict on the subject. Hope one of these days I can publish the book. . (I believe Deloitte has changed debt-type to debt-like)
1) Representing buyer: We could not understand WC fluctuations by looking at 24 months. It turned out they had two suppliers, one with 15 days A/P, and other with 45 days A/P. We segregated the two A/P and associated revenue. Even though yearly numbers looked steady, the monthly numbers showed big changes in the product mix. That dramatically changed the WC. We modelled a line-of-credit and deducted associated interest from EBITDA. (This is the concept of "operating interest" rather the "financing interest"). After that WC was easy to calculate and negotiate with seller..
2) Representing Seller: Another business had 70-80% of sales in Q4. We modeled a credit facility to smooth out WC. Again, reduced EBITDA by the "operating interest".
3) Representing Seller: A seasonal product manufacturer (firewood cutting products) sold products with A/R paid over 3 months. This added another twist. to calculating NWC. We worked out a contingent WC formula. .