7/23/12

Hi All,

So I was reading through a guide and came across the content below:

Q. What does negative Working Capital mean? Is that a bad sign?

A. Not necessarily. It depends on the type of company and the specific situation - here are a few different things it could mean:

  1. Some companies with subscriptions or longer-term contracts often have negative Working Capital because of high Deferred Revenue balances.
  2. Retail and restaurant companies like Amazon, Wal-Mart, and McDonald's often have negative Working Capital because customers pay upfront - so they can use the cash generated to pay off their Accounts Payable rather than keeping a large cash balance on-hand. This can be a sign of business efficiency.

But my arguments against the answers are:
1. when you have high deferred revenue (a liability) balance, shouldn't you also have received the same amount of cash or AR? That's how I picture the journal entries. So I don't really see how WC could go negative. They cancel each other out.

  1. Same thing. If pay cash to reduce AP, your cash decreases but so does your AP, by the same amount. So they cancel each other out. In which case I see no reason why WC would become negative...

Thanks for your help in advance!

Comments (32)

7/23/12

Same answer for both. Its a timing issue.

Paying upfront doesn't mean Walmart or whoever is doing the same. They can stretch out their payables and use the cash they get from turning their products quickly to incur more payables, which results in negative working capital.

The WSO Advantage - Investment Banking

Financial Modeling Training

IB Templates, M&A, LBO, Valuation +

IB Interview Prep Pack

30,000+ sold & REAL questions.

Resume Help from Actual IB Pros

Land More IB Interviews.

Find Your Perfect IB Mentor

Realistic IB Mock Interviews.

7/24/12

let me just give you an example of negative working capital. say that you loan 1000 dollars from a bank in the form of a short term liability. you would receive 1000 dollars cash and your current assets and current liabilities will go up by 1000. Lets say you use that 1000 dollars to buy some long term asset such as a stove. This would reduce your current assets by 1000 dollars because you spent the cash. However, this "stove" would be considered a capital good and therefore you wouldn't have any current assets. You are then left with 1000 dollars in current liabilities. current assets - current liabilities = working capital. 0 - 1000 = -1000.

7/24/12
coach01:

Hi All,

So I was reading through a guide and came across the content below:

Q. What does negative Working Capital mean? Is that a bad sign?

A. Not necessarily. It depends on the type of company and the specific situation - here are a few different things it could mean:

  1. Some companies with subscriptions or longer-term contracts often have negative Working Capital because of high Deferred Revenue balances.
  2. Retail and restaurant companies like Amazon, Wal-Mart, and McDonald's often have negative Working Capital because customers pay upfront - so they can use the cash generated to pay off their Accounts Payable rather than keeping a large cash balance on-hand. This can be a sign of business efficiency.

But my arguments against the answers are:
1. when you have high deferred revenue (a liability) balance, shouldn't you also have received the same amount of cash or AR? That's how I picture the journal entries. So I don't really see how WC could go negative. They cancel each other out.

  1. Same thing. If pay cash to reduce AP, your cash decreases but so does your AP, by the same amount. So they cancel each other out. In which case I see no reason why WC would become negative...

Thanks for your help in advance!

I think everyone's over-complicating things. Just assume that you're looking at non-cash current assets and there is your answer (i.e. you want to look at AP, AR, Inv only).

7/24/12
kingb:
coach01:

Hi All,

So I was reading through a guide and came across the content below:

Q. What does negative Working Capital mean? Is that a bad sign?

A. Not necessarily. It depends on the type of company and the specific situation - here are a few different things it could mean:

  1. Some companies with subscriptions or longer-term contracts often have negative Working Capital because of high Deferred Revenue balances.
  2. Retail and restaurant companies like Amazon, Wal-Mart, and McDonald's often have negative Working Capital because customers pay upfront - so they can use the cash generated to pay off their Accounts Payable rather than keeping a large cash balance on-hand. This can be a sign of business efficiency.

But my arguments against the answers are:
1. when you have high deferred revenue (a liability) balance, shouldn't you also have received the same amount of cash or AR? That's how I picture the journal entries. So I don't really see how WC could go negative. They cancel each other out.

  1. Same thing. If pay cash to reduce AP, your cash decreases but so does your AP, by the same amount. So they cancel each other out. In which case I see no reason why WC would become negative...

Thanks for your help in advance!

I think everyone's over-complicating things. Just assume that you're looking at non-cash current assets and there is your answer (i.e. you want to look at AP, AR, Inv only).

What he said. operating working capital doesn't include cash assets.

7/24/12

It would take forever to explain so it's not really worth my time, but here is what you need to research to build the intuition and find the answer.

1) working capital has several definitions. Some people only look at AR AP and Inv, others look at it ex-cash etc.. Each one has a slightly diff interpretation so your answer changes.

2) like the guy said above, working capital can be a timing issue. Look up cash vs. accrual accounting. ALso the cash cycle

3) different business have different working capaital profiles. A negative vs. low vs. high working capital all have their drawbacks and benefits. What really matters in change in working capital (think DCF)

12/6/12

Might find this whitepaper I wrote on Working Capital useful -

total-logistics(dot)eu(dot)com/contact/download.php?doc=Principles-of-Cashflow-and-Working-Capital(dot)pdf

Best Response
12/6/12

Working capital is HELLLLLA important. Ordinarily healthy companies, at time go bankrupt because they can't fund their working capital requirements. For one, its one of the primary factors impacting liquidity.

In a nutshell, its important because its a primary source/use of cash in an ongoing enterprise. From a transaction perspective its important because its cash... when buy/selling a company you're assuming the company is being run somewhat efficiently, well you're not just assuming you're kicking the tires on the company as well.

In a transaction perspective, there are typically 'post closing adjustments' which true-up the company's working capital to an agreed upon level. So if the merger was agreed upon at a say, for simplicity purposes, to have 5% of sales as working capital, and when the transaction closes and ownership is transferred its at 4% of sales, a post closing adjustment will be made to deduct 1% of sales from the consideration paid to the sellers.

As for working capital lines... its a VERY important source of capital for select industries. Take an oil refinery. Refineries typically have a few days of inventory. Lets assume theres no pricing lag and AR and AP always offset each other. So oil prices spike from $50 to $150, they now have to increase their inventory by 200%. If they previously had $1bln inventory they now need 3bln inventory. Not cool. So whats an oil refiner to do.... well they are to secure working capital lines of credit which is simply an asset backed loan with the underlying asset being either receivables or inventory. So when oil price spikes, the new need for capital will be provided from the working capital line. Its much like a revolver, except secured by a specific asset and intended to fund working capital needs.

12/6/12
Marcus_Halberstram:

As for working capital lines... its a VERY important source of capital for select industries. Take an oil refinery. Refineries typically have a few days of inventory. Lets assume theres no pricing lag and AR and AP always offset each other. So oil prices spike from $50 to $150, they now have to increase their inventory by 200%. If they previously had $1bln inventory they now need 3bln inventory. Not cool. So whats an oil refiner to do.... well they are to secure working capital lines of credit which is simply an asset backed loan with the underlying asset being either receivables or inventory. So when oil price spikes, the new need for capital will be provided from the working capital line. Its much like a revolver, except secured by a specific asset and intended to fund working capital needs.

Question: Is the asset backed loan that Marcus is describing can also be known as ''Credit Sleeve''? My 2 cent is that they will provide ST Credit facility to the company and can be backed by any asset commodity or future contracts.

12/6/12

Are there generally negotiations on WHAT qualifies as working capital, i.e. the proper way to go about the calculation? Also, by post-closing adjustment, do you simply mean the buyers would pay 1% of sales less than they would have if it was at 5%?

So for my understanding... It's similar to cash, which makes sense because it's expected to turn to cash fairly soon. The excess of current assets is considered "cash" because it covers the current liabilities. If it's cash and the level of WC is not at the level agreed upon (essentially a cash shortage), the buyer will pay less.

OK, got that. But what is determined to be a "reasonable" and "fair" level of WC? Is it determined by the industry?

I also do not fully comprehend why the historical WC analysis is totally necessary. It's not difficult to do, but in the sell-side process I was on recently we did a monthly WC analysis going back 24-months... What does that tell a buyer?

12/6/12

1- it should be pretty standard, dependent on practices for that industry. And yes thats what I mean (re: WC true-up). This is because the target is being purchased at a given price assuming its a turn key operation, and no further investment needs to be made. If I get the keys to the company, and all the computers are gone from the offices, I'm going to tell the sellers "fuck you, i agreed to buy this company with the computers I need to run the business"... (computers are not considered working capital, they are PP&E, but this is just an example for the layperson). So we agree that Ill buy the company with a computer for every administrative employee, when I get the keys if they sold 10 computers without replacing them or firing 10 admins employees, Im going to deduct the cost of 10 computers from the amount I'm paying them, reason being... I agreed to buy this company turnkey, so you're going to pay for the 10 computers I need to buy.

2- Well its not cash per se. But yeah, you get the gist of it.

3- level of working capital is specific to the industry and the company, depending on the industry characteristics and the company's business model.

4- If you're buying a company and need to know how to capitalize the company to weather any routine ups-and-downs, like increased working capital needs, you'll want to understand what impact working capital requirements have historically had on the company's liquidity. You'll need to determine a level of working capital you need and you'll need to determine how much flexibility you need to bake into your capital structure to handle the types of cash needs your company will have going forward. I've seen quarterly historicals going back 10 years to determine optimal capital structure, cash flow volatility, and to plan for cash needs.

12/6/12

Working capital is account receivables plus inventory minus account payables instead of the difference between current assets and current liabilities. It is not cash, but can be 'converted' into cash within one year. It is very important to optimize working capital as it represents a companys' day to day cash flows. This means for example stricter deadlines for receivables and postpone payables.

12/6/12
dagobert_duck:

Working capital is account receivables plus inventory minus account payables instead of the difference between current assets and current liabilities. It is not cash, but can be 'converted' into cash within one year. It is very important to optimize working capital as it represents a companys' day to day cash flows. This means for example stricter deadlines for receivables and postpone payables.

Is this true? For the WC analysis I've done (and for purposes of calculating FCF in DCFs, LBOs, etc.), it's always non-cash current assets less non-interest bearing current liabilities.

12/6/12

Thanks, Marcus. So fair to say it's a form of measure of operational efficiency? I would assume a more efficient company could operate on a lower level of working capital, whereas a less efficient company would need more WC to support its day-to-day operations?

12/6/12
jimbrowngoU:

Thanks, Marcus. So fair to say it's a form of measure of operational efficiency? I would assume a more efficient company could operate on a lower level of working capital, whereas a less efficient company would need more WC to support its day-to-day operations?

Well its not necessarily a component of how efficient a company is. Take Apple (cell phones only) for example, they have retail stores so they may have higher levels of inventory as compared to say.... other electronics manufacturers like Nokia or RIMM. Its very dependent on the industry for a general framework, and then dictated by the company's business model.

12/6/12

As a closing condition in the acquisition agreement, the seller is typically expected to maintain a normalized level of working capital that should have already been agreed to by the buy and sell side during negotiations.

To the extent that the seller leaves too little working capital (sometimes we use tangible net worth based on GAAP balance sheet items, depends on industry), the buyer would have the right to reduce the purchase price by the working capital deficiency, and to the extent that the seller leaves excess working capital, the buyer would have to increase the purchase price equal to the excess working capital less the normalized working capital. The normalized working capital level is based on historical financials, i.e., median WC/Revenue ratio over last X years. Pull a DEFM or PREFM and search for "purchase price adjustments" typically in the closing conditions.

You had another post on purchase price allocations, and I didn't quite understand your question, but in a PPA you are just allocating the purchase price to the target's identifiable assets, so the existing basis for each balance sheet item (including existing goodwill on target B/S if any) is basically written up or down to the calculated fair values determined in the 141R purchase price allocation.

12/6/12

thadonmega, thanks for the walk-thru on WC.

In regards to purchase price allocation... My question is more to the proper way to calculate the allocable portion of the purchase price, i.e. the excess. What is subtracted from the equity purchase price? Shareholder's equity? Or is it tangible book value (SHE - goodwill - intangibles). And when making the balance sheet adjustments, do you write down the target's intangibles to zero and then write-up based on the allocated percentage? Or do you add on the write-up to the existing intangibles balance?

Sorry, I am having trouble explaining this clearly. May have to use examples... Or if someone could just explain using an example (proper adjustments, etc.).

12/6/12

Target B/S before PPA:
Cash: $20
PP&E: $10
Intangibles: $10
Existing Goodwill: $10

Target is acquired for $100 all cash, fully financed bid, and deal has closed.

Target fair values from PPA:
Cash: $20
PPE: $40
Intangibles: $20
Goodwill=PurchasePrice - (FV of all identifiable assets)
=$100 - ($20+$40+$20) = $20

So your write up or write down is just the new FV minus the old basis, e.g., write up for PP&E is $40 - $10 = $30, etc. The other side of the balance sheet would also show the $100 either as debt or stock holder's equity depending on how the deal is financed, e.g., cash financed with debt, cash financed with cash on balance sheet or buyer's stock. The stepped up assets would all come over to the buyer's balance sheet and as far as the target's fair valued balance sheet ties, everything should tie out.

Also check up wiki, for a more detailed example.

12/6/12

A big reason to call out working capital in purchase agreements is because of its liquidity, it can change lot between coming to a substantial agreement and actually closing the deal and wiring the cash. It'd be tough to sell a bunch of factories (or even computers) in a matter of weeks, but monetizing AR or inventory and moving cash around quickly isn't that difficult. To try to avoid that messy scenario, which would probably be illegal anyway even without the clause in the purchase agreement, they make sure they mention it.

12/6/12

Agree with all of the comments above. For MM transactions, deals are typically done on a cash free / debt free basis. This means that the seller gets to keep all of the cash on the balance sheet and assumes all of the debt. Without a target working capital number, the seller could alter standard business practices to accelerate the generation of cash. Then, when the transaction closes, all the cash would accumulate to the seller and the buyer would have to spend additional money returning working capital to normalized levels. Some examples below.

Example 1 - Seller could offer its customers 5% off their outstanding balances if they pay within 15 days (or 5% off if they pay with cash). This would substantially reduce accounts receivable, and therefore working capital, but would not sustained by the new owners.
Example 2 - If the seller was a distributor, they could slow down the replenishment of inventory on hand, increasing their cash position. When they turned over the keys to the new owner, the new owner would have to spend a bunch of cash to bring inventory up to normalized levels.

As you can tell, a working capital target is extremely necessary, and it wouldn't be unheard of to see a lawsuit arise over WC if no target was set. Also, what wasn't mentioned above was what a target looks like or how it is determined. As part of the agreement, the Buyer and Seller negotiate how they want to handle WC. Sometimes it is a set number, and anything above or below it results in a purchase price adjustment. Sometimes it is a band, and as long as the WC delivered is within the band, there is no adjustment (example: $1bn target, with $100mm band, as long as WC delivered is $0.9bn to $1.1bn, no adjustment is made).

In terms of setting the target or the band, this can be done through a number of approaches. Sometimes it is the last 12 months, sometimes last 3 months annualized, 6 months annualized, etc. Sometimes it's a percent of sales, etc. It all depends on the negotiation, and both sides typically fight for a WC target that favors them. For example, if the company is growing rapidly, you'd expect the WC needs to also be growing rapidly. As a result, the average WC over the last 12 months would likely favor the seller as it would set the target much lower than the current needs of the company. In a declining business, the opposite is true, with the last 12 months favoring the buyer.

For those prospective analysts reading this: Don't be afraid if it doesn't make sense. WC targets can be a complicated concept if you aren't familiar with transaction structures.

CompBanker

12/6/12

CB PM'd

12/6/12

CB, I think you may be getting sick of hearing this but... thanks. Great explanation. Clarifies everything from above -- thanks to all contributors.

The WSO Advantage - Investment Banking

Financial Modeling Training

IB Templates, M&A, LBO, Valuation +

IB Interview Prep Pack

30,000+ sold & REAL questions.

Resume Help from Actual IB Pros

Land More IB Interviews.

Find Your Perfect IB Mentor

Realistic IB Mock Interviews.

12/6/12

Deleted

12/6/12

because you would also have a liability related to the prepayment -- something along the lines of unearned revenue or prepaid revenue.

12/6/12

The situations where this would happen are 1) cash is not included in the WC equation and 2) if they use the cash to pay off long term debt.

12/6/12

They could also use cash to purchase non-current assets, not completely congruent with your example but is one way in which quick turnover could create negative NWC

12/6/12

You see this a lot when companies have a lot of leverage over their suppliers. Look at Kroger or Walmart... other companies essentially have to be on their shelves so they can arrange payment structures that are quite favorable. Accounts payable for WMT are usually on par with Cash + Inventory + A/R.

12/6/12

What Gray Fox said. If you're big enough to get amazing credit days while stretching your payables as well, that's usually the reason. Pretty rare.

12/6/12

Other way around brother.

If the company fronts the cash and then has to wait to monetize its inventory and collect its receivables - this would create negative working capital.

Think of it like this, you build bikes. You need to buy the steel and rubber and pay people to make it before you can send it to stores, market it, sell it, and collect your cash from customers.

Computation of working capital:

An increase in an asset is a use of cash (period over period), therefore a negative number.
Likewise, a decline in an asset is a source of cash (period over period), therefore a positive number

for current liabilities, an increase is a source of cash, therefore a positive number
decrease in liability is a use of cash, therefore a negative number.

accounts you should use in computation

current assets - accounts receivable, inventory, etc, etc. other current assets (DO NOT INCLUDE CHANGE IN CASH)

current liabilities - accounts payable, unearned income, accruals ( DO NOT INCLUDE CHANGES IN SHORT TERM DEBT OR CURRENT PORTION OF LONG TERM DEBT - THATS A FINANCING CASH FLOW NOT OPERATING)

12/6/12
12/6/12
Add a Comment
WallStreet Prep Master Financial Modeling